History Of Banking
( Originally Published 1918 )
Trade is the calm health of nations. Credit is its lifeblood. Money is its nerve system.
Trade originated in barter between primitive peoples. The first property was communal owned by a group or a tribe. Personal property developed out of individual possession of ornaments, usually stones or shells having color or form that gave them a quality of decoration. The possessor of such property could exchange it for articles of utility, and this gave rise to individual barter and individual wealth.
This principle of barter next extended itself to exchange between groups or tribes each of which had a surplus of useful things desired by the other.
Primitive Barter necessitated physical exchange of the things involved. This exchange became burdensome and would have become impossible had it not been relieved by a transfer of evidence of value a medium of exchange which in itself was not wealth, but a token of wealth. That was the beginning of what we call money.
Wealth consists in things that have inherent utility.
Land is useful, therefore it is wealth. A deed to land is only an evidence of ownership of land; therefore in itself it is not wealth.
A gold coin is wealth only in so far as the metal it contains has a value of utility.
A man may be called a billionaire, and yet have very little money. His rating rests upon ownership or control of useful property, whether land or tools or goods.
The wealth of the world could not possibly be represented by actual money. Exchanges of it could not be carried on through accompanying transfers of actual money. They are effected through credit. Money is the active principle the nerve center of credit.
Banking grew out of the necessities of credit in exchange. The growth was forced, and slow.
The first banking system in known history was perfected about twelve thousand years ago, in the empire that preceded the Assyrian.
About 1890, in the ruins of the third city underlying the site of ancient Napur, Doctor Heilprecht, Professor of Archaeology in the University of Pennsylvania, uncovered the records and accounts of the family Engadi, that had built up a system which controlled the trade and finance of the whole empire, and had its tentacles twined around the throne itself. This great house was the prototype of the Asiatic house of Sassoon, that for centuries has been the center of finance in the Orient, and whose bare word is good in the remotest corners of Arabia, India, and northern Africa.
The Engadi were the Sassoons and the Rothschilds of a civilization that must have taken at least twelve thousand antecedent years to ripen.
Civilizations, empires and their centres of trade, rise and fall according to the flow of useful metals through channels that change with the changes between sources of supply and centres of demand; and with these shiftings there is always war, repeating its desolations until oblivion, falls over the story, and history suffers a lesion. Then in another part of the world the same things come again, the processes repeat themselves; for human nature is unalterable, and invariably creates and recreates the institutions we call human, wherever men appear and their inborn impulse toward interrelation asserts itself.
Our civilization differs from any of the old ones whereof any knowledge has been handed down to us, in that it rests mainly upon division of labor.
Division of Labor.-It is only within the eighteenth and nineteenth centuries that populations have been mainly engaged in producing things other than those intended or needed for their own use. The result has been a division of labor by sharply defined lines, which has multiplied quantity of production, and improvement in quality, many times over.
The point will be seen if you will try to figure out how much of our actual wealth produced we would have if we had to produce it ourselves, without the cooperation of others.
Each is engaged in producing for the use of others; and this means that we produce for purposes of exchange of commerce; and commerce in its turn must depend upon the rapidity by which this interchange may be made. It could not be made at all without our banks.
Thus civilization, commerce, money, have come to mean Banking. A central fact that is not generally known nor its significance fully appreciated.
It grew out of the necessities of the merchants, each of whom was in his own way a banker also, effecting as best he could the ex-changes in which he was engaged. His profits depended upon the element of banking his operations entailed. The gradual division of productive labor made an independent system of exchange imperative, but this, and its appearance and gradual growth, were at first and for a long time misunderstood, even obstructed. If a man in trade bought something at a given price and sold it for a higher, he was called grasping, and the man who bought it felt himself a victim of extortion. The merchant, banker, or individual who loaned money and charged interest for its use, was called a usurer, an enemy to society and religion, a parasite fattening upon the needs of his neighbors.
It was only when the course of increasing division and production of labor, with its accompanying increase of necessary exchange, developed a definite business of exchange carried on by merchants, through bankers and brokers, that this essential function of commerce emerged upon a new and recognized method of discharge, and modern banking took its place as a first necessity in the trade of the world.
Banking has enabled a ten-fold increase in general production, and set up that machinery of exchange without which industry and commerce would stagnate in a week. It has enabled those groupings of industry by which production costs and selling prices have in so many familiar cases put basic necessaries into the hands of all the people.
To quote a valuable book by Earl Dean Howard and Dr. Joseph French Johnson : "Money is an instrument and banking an institution to assist production of wealth and thereby increase the material welfare of the people by facilitating the indispensable operations of exchange without which all other productive effort would have but a fraction of its efficacy, without which we would still be in a state of industrial barbarism."
That is a plain and clear statement of the vitally important relation which Banking holds in the regular flow of production, and commerce between the nations.
The same book ("Money and Banking") has this lucid definition of credit: "The fact that a promise to pay money is a valuable thing in itself suggests immediately the possibility of using such promises as a medium of exchange if they can be put into such form that the ownership in them or the title to them can be transferred from hand to hand. Just as the value of money is an artificial quality, created by its exchangeability, so credit may come to have a value for the same reason.
"People accept money readily in exchange for anything else because they know that it gives them command over any piece of property that is for sale. In other words, because it is convertible into property practically at all times, in all places and under all circumstances. Likewise, credit has value as a medium of exchange to the extent to which it is convertible into money or directly into property. Convertibility is therefore the very essence of the value of money and credit."
The Bank of England: Back of the present banking system, and founded upon principles which still control, was the Bank of England, established in 1694, primarily for the purpose of assisting the fiscal operations of the government.
The charter empowered it to issue notes, to deal in coin, bullion and commercial bills (credits), and to make advances upon goods and merchandise; these powers being contingent upon a loan of £1,200,000 to the government, at 8 per cent. Its power to issue notes gave it possession of an equal amount of currency, available for loans. The notes were payable at specified dates, and bore interest. They were not payable to bearer, but were passed on by endorsement only.
Three years later, a further loan was made to the government, in consideration of which the bank was empowered to issue demand notes, bearing no interest. These notes became the established paper currency of the country.
In 1777 other banks and associations that had been issuing notes of small denominations were driven out of the field by the government prohibiting the issue of any notes of less than £5 denomination. This became and still is the smallest Bank of England note. Anything under that in England is in gold, silver or copper coin, from the sovereign down to the farthing.
In America, before the war for independence, banking was carried on by private enterprise, of slight responsibility but otherwise much as in the old country. The Continental Congress authorized the issue of treasury notes, which came to be known as continental currency "Continental" for short. But the credit of the government was low, the issue of the war uncertain, and the currency had little value. If a thing was no good it was said to be "not worth a continental," a depreciative phrase that still is used in some of the older eastern states.
The Bank of North America. Real banking in this country began in 1781, when Robert Morris established The Bank of North America at Philadelphia, under charter from the congress, with a capital of $400,000, of which $250,000 was sub-scribed by the government. The young nation was wofully poor, without any financial system to all intent, in chaos. Robert Morris, the first American financier, was a man of extraordinary ability, a genius. Under his guidance the bank was 6f inestimable service to the government. It is almost certain that without its loans and aid in public credits the army would have broken down and the war been either lost or dangerously crippled. Nevertheless, when the war was over the bank was vigorously assailed by political interests, and at one time was near suspension. But it pulled through, was rechartered by the state of Pennsylvania, and began a career of honorable prosperity which continues to this present day. It became a national bank in 1865.
The First State Banks. In 1784 the Bank of Massachusetts was chartered by that state, with a capital of $300,000. The same year, Alexander Hamilton organized the Bank of New York and conducted it as a private enterprise until 1791, when it took out a state charter.
Both these banks were considerably hampered by legislative restrictions. Massachusetts would not permit outstanding loans and notes, or credits and debts, to be more than double the amount of capital paid in. New York would not allow the debts, over the amount of money on actual deposit, to be more than three times the paid-in capital. A distinction was thus forced between their liability to the note holders and the depositors. Deposit currency was then unknown; and borrowers wanted notes they could use as money.
Deposits by loaning, as they are now made, had not been created. All deposits had to be in actual money, which did not increase the proportion of the bank's demand obligations to its unmatured assets. The deposit account was changed for money; the bank notes were exchanged for unmatured credit.
Neither bank could deal in bank stock or in merchandise. The Bank of Massachusetts not only could not deal in but could not loan on bank stocks.
The First Bank of the United States was established in 1791, at Philadelphia, under United States charter, with a capital of $4,700,000. It was highly prosperous at the outset, and soon had branch banks at Boston, New York, Baltimore, Washington, Norfolk, Savannah, and New Orleans. It was a government depositary, holding most of the funds deposited by the Treasury in banks. For twenty years it made commercial loans and loans to the government, paid 8 per cent dividends, and wrought beneficially for the establishment of a sound currency system. But it overloaned to the government, and began to weaken. In 1809 it applied to Congress for renewal of its charter, but the application was strenuously opposed, then hung up for two years, and finally postponed indefinitely. Thereupon the bank dissolved, and the country suffered a panic.
Upon the disappearance of the First Bank of the United States there came a succession of state banks. In 1812 the government found itself a heavy depositor in some of these, with a war on its hands. The whole country was in distress. The state banks as a rule were badly managed. In 1814 all of them excepting a few in New England suspended specie payments. The government defaulted interest on the public debt. Bank notes passed at ruinous discounts. This state of things continued several years.
The Second Bank of the United States was founded in 1816, with $35,000,000 capital, of which the government subscribed $7,000,000. The private subscriptions were paid one-fourth in specie and three-fourths in government bonds, 30 per cent at the time of subscription, the remainder in equal installments at six and twelve months. The government subscription was paid in notes, and the bank allowed the government a bonus of $1,500,000 for its charter.
The charter was very much like the one issued to the First Bank. But its notes were made receivable for all debts of the government, and it was required to pay deposits as well as notes in specie, under a 12 per cent penalty for failure to do so.
Theretofore, with the state banks, although deposits were supposed to be paid in specie, they were in fact paid in notes of other specie-paying banks, no matter where situated, so that the cost of redemption varied widely and none of them was good for its face. Uniformity, in these conditions, was impossible. The specie-payment regulation laid upon The Second Bank of the United States, with its penalty clause, did not completely check the circulation of motley bank notes, but it helped, somewhat.
Twenty-five branch banks of The Second Bank of the United States were established, and through these, within two years, specie payment was reestablished.
The validity of the charter had been assailed on the ground that congress had no power to issue it.
Two Vastly Important Decisions. The question of the power of congress to issue the charter was disposed of in 1819, when Chief Justice Marshall of the Supreme Court decided that the establishment of a bank to assist the fiscal operations of the government was a power implied in the federal constitution. Chief justice Marshall also held that no state had a right to tax the notes of the federal bank, nor of banks chartered by other states. The effect of these decisions was immediate, and has continued. They opened the way to our present national banks.
The bank prospered handsomely during the next twelve years. Then its existence became a leading issue in a presidential election.
Andrew Jackson was out for a second term. In 1829, during his first term, he had attacked the bank in a message to congress. In 1831 he was opposed by Henry Clay, who was strong in its support. That year congress passed a bill renewing the bank's charter. President Jackson vetoed the bill. Clay attacked the veto, and on the question thus raised the campaign was fought.
Jackson won. The government deposits were withdrawn in 1833, and the government forced the cancellation of its holdings in the bank's stock. Connection with the government was severed, the original charter was not renewed, and the bank took out a new charter in Pennsylvania.
The field thus entered was too limited for its capital. It was obliged to find activity for its funds in loans on various promotional stocks, most of which became worthless in the panic of 1837. In 1841 the bank went into liquidation. It paid all its debts, but nothing was left for the shareholders.
From that time until about the close of the civil war, banking was rather promiscuous. The states issued charters of two kinds: one to private corporations, another to banks in which the state itself held an interest.
The soundest state banks were those of the New England states, and of New York.
The Suffolk System. Back in 1818 the Suffolk Bank, of Boston, tried to get a profit out of the redemption of country bank notes, by offering to act as redemption agent for any country bank that would deposit with it a fund for redemption purposes. The country bank notes were circulating at all sorts of discounts, but redemption was to be at par, the same as the currency of city banks. Only a few country banks responded; and the Suffolk Bank went after those that did not, by sending back for redemption at home all of their notes it could lay hands on. That little device worked so well that nearly all the country banks of New England came in. The Suffolk Fund System, as it was called, stiffened the public value of New England currency, and held it fairly steady until 1865, when the national bank act was passed. The Suffolk Bank became in a way a clearing house for country banks, offsetting them against each other, so that in effect it cancelled the bank obligations of all New England. The notes were not originally intended for use as currency, but were issued and redeemed as occasion required, somewhat as with our present checks and drafts. Redemption usually was quick. The life of a bank note was (in the aver-age) only about five weeks.
In 1858 the Massachusetts legislature passed an act requiring banks to keep a 15 per cent reserve against notes and deposits, thus recognizing each as an obligation equally with the other.
In the State of New York bank notes were issued under two systems : the safety fund system, and the bond deposit system.
The Safety Fund System simply required the banks to deposit with the state an amount equal to 3 per cent of their capital, out of which, if a bank failed, its debts (in excess of its assets) would be paid. The act was passed in 1829, but in 1837 it was so amended as to require that the outstanding notes of a failed bank should be paid off at once. That same year several banks went under, but their notes were redeemed in full. Three years later so many banks failed that the fund was insufficient to pay up all their notes. To protect the future, another amendment was made in 1843 by which the fund could be used to pay out the notes only not the debts, as before. In 1846 the state of New York adopted a new constitution, one feature of which gave note holders a first lien on assets, imposed a double liability on bank stockholders, and forbade reissue of charters to safety fund banks. The last of those charters died in 1866.
The trouble with the safety fund system was that it undertook to do too much. Had its purpose been confined to protecting the validity of current bank notes and thereby establishing a uniform and safe currency, it might have gone on until the new departure of 1865 set up the national banks. But the overzeal that broke it down brought about a new feature in banking that became the cornerstone of the national bank system. The bond or stock deposit plan, up to then had not been thought of. It was created by an act of the state legislature, called the Free Banking Law.
The Free Banking Law provided that any person or association depositing with the state comptroller United States stocks, stocks of the state of New York or of other approved states, or mortgages on real estate worth twice the mortgage sum, to receive circulating notes to be signed and issued as money. The deposit was held by the comptroller as collateral, for the protection of note holders. No redemption in specie was required.
The principle was sound, but its application was too broad. Anybody who could put up the collateral could be a banker. The result was a sudden multiplication of banks. Between 1838 and 1840 more than 125 new banks were organized in New York state, and then an epidemic of failures set in. In many cases the collateral deposits were found insufficient to cover the note issues. Some of the stocks were weak, and the real estate mortgages were of slow convertibility. So the act was amended to admit only United States stocks and stocks of the state of New York as collateral.
Under the amended law a regular trade in making and selling bank notes sprang up, for the amendment directed that notes issued by interior banks be redeemed in Albany or New York at a discount of not more than one-half of 1, per cent, and the country bankers went joyously about the business of issuing at par, redeeming at a discount, and pocketing the difference. Many of these paper bankers had no banking offices, nor any deposits. They were out for easy money. That was all.
In 1848 the game was somewhat gummed up by a new law requiring banks of issue to be also banks of deposit. The situation was cleared by this act, so that after a year or two there were few failures, and almost no loss by failure to redeem.
The Experience of Three States. The collateral deposit plan was adopted by Illinois, Wisconsin and Indiana. How it worked there is indicated by the fact that Illinois in 1857 had 112 banks; in 1861, only 7. They had deposited collateral largely made up of securities issued by southern states, which were made worthless by the war.
The Bank Note Reporter. The money of Illinois, Wisconsin and Indiana was abundant, but all subject to fluctuating discounts. In less degree this was true of the money of all the states excepting New York and the states in the New England group., The fluctuations were so rapid that a publication called the Bank Note Reporter got rich by giving a list of all the banks, with the week's quotation of, their discount values. A man could not tell the purchasing power of the money in his pocket until he had looked it up in that valuable magazine. It had a big circulation. With sad humor, Indiana currency was called "wildcat money." Your true American can get a joke out of his misery.
Other States. In most of the southern states the state governments held investments in the banks with unsatisfactory results, especially disastrous in Alabama. On the organization of the Bank of Alabama in 1820, the state subscribed two-fifths of the capital. Proper and prudent restrictions were thrown around the loaning power of the bank, but they were commonly disregarded. In the ten years from 1820 to 1830 loans and discounts increased from $500,000 to $20,000,000. Loans were freely made to politicians, to friends of the bank officials, and to members of the legislature. When the panic of 1837 came, most of these loans were found uncollectible, worthless, and the money issued by the bank had no standing with the public. The charter ran out in 1845, and was not renewed.
Kentucky tried the state interest system twice, and then gave it up. Too much politics, and too many banking favors to politicians.
Arkansas, Louisiana, Mississippi and Florida had experiences painfully like that of Alabama. In Louisiana the Union Bank of Louisiana was started with a capital of $7,000,000 raised by the sale of state bonds. It ran out in ten years. After that the state encouraged the establishment of private banks, which demanded and were successful in getting good banking laws, and set up a sound business condition in the state.
Missouri got off with less calamity than Alabama or Louisiana, but the State Bank of Missouri never amounted to much, and the state broke relations with it in 1866, when the national banks took hold.
The State Bank of Indiana was one outstanding exception to the rule of wildcatting. It was a sound and successful institution. In the beginning it loaned rather freely on real estate, but uneasy values caused it to shift its loans to farmers, for short periods, on crops or on personal paper. This policy had the effect of increasing the prosperity and raising the credit of the people of the state in general, for Indiana was then, as now, distinctively agricultural. The bank was driven out by the United States tax on bank notes issued by state banks.
The State Bank of Ohio was another exception to the same rule. It had $3,300,000 capital and a 10 per cent safety fund on deposit with the comptroller. It issued notes up to twice the amount of its capital, but no more. It quit when its charter expired in 1866.
By that year the National Bank Act had come into pretty full action, and the history of banking in this country under that system and the Federal Reserve Bank system to which it has adapted itself is summarized in what follows herein.
From 1860 Until 1865 banking and money conditions were severely disturbed. With the first call for volunteers the north went wild. State bank money depreciated, the costs of war began to be felt, currency ran short. Early in the summer of 1861 merchants, even retailers, issued paper tokens for neighborhood circulation. Nobody knew where any value really was. Some-how they all rubbed through, with patient good nature.
In February, 1862, a legal tender act was passed by congress, authorizing the issue of $150,000,000 non-interest bearing treasury notes, payable to bearer, receivable for all government dues, made legal tender for all public and private debts, and exchangeable for United States twenty-year 6 per cent bonds. In August an additional legal tender issue of $150,000,000 was authorized; and in January, 1863, another $100,000,000.
The worth of this "greenback" money was responsive to the changing fortunes of war. A union success would brace it up, a confederate success would send it down. Up to that time gold had been the standard of money. The legal tender acts substituted for the gold dollar a promise to pay a gold dollar. By the operative principle known as Gresham's Law, the appearance of this cheaper money caused the disappearance of the dearer. Gold simply and in a double meaning, went out of sight. Subsidiary silver coins began to be hoarded and were replaced by little paper bills bearing silver-coin de-nominations. These little bills were called "shin-plasters."
Values at once began to be expressed in terms of legal tender money. It was a common belief that gold had gone to a premium. The fact was that the paper money had gone to a discount. In the latter part of 1864 gold was quoted in the New York market at 280, which did not mean that a gold dollar was worth more than a dollar, but that a paper dollar was worth only thirty-five cents.
The status of greenback money was given a setback when in July, 1863, congress repealed that part of the law which permitted its exchange for six-twenty bonds.
It is proper to say in passing that the issue of those bonds was a surprising operation, a stroke of finance by Jay Cooke, the Philadelphia banker, who took upon himself the whole burden of flotation and carried it through by a splendid run of liberal, cleverly devised public advertisements. His plan became standard. It has been followed ever since in every important flotation of securities here and in Europe, Mr. Cooke was a great banker the sort of man now called a go-getter. If a thing were to be done, he went and did it without regard to precedent; and magnitude never troubled him.
The money muddle lasted almost eight years after the war had closed. Then, in 1873, congress passed an act restoring the gold standard, and in 1879 the treasury began to redeem its notes in gold. Meanwhile the National Bank Act had come into play, the whole banking situation had improved, and the country entered upon that course which finally brought about the present Federal Reserve Bank system, the elasticity of which has enabled us to preserve commercial credit and equilibrium while carrying on another and most stupendous war.
Banking conditions in the southern states after the first year of the civil war became deplorable, then desperate. The confederated states followed the example set by the north, and issued currency promising to pay. This currency went so low that it used to be said a housewife had to take her money in a basket but could bring back her purchase in her purse. No one now can realize the heroic patience, the steadfast courage of those people through those years. They were not whipped. They simply wore out.
The difference was due to the fact that the north was industrial and its ports were kept open, while the south was agricultural and its ports were closed. Equalization of banking between the two and its ensuant restoration of trade and credits came slowly, after the war, but they were fully established long since, and the old sectional differences have disappeared.