Banking History: Colonial Era
The history of banking can best be viewed as a series of changes in business practices, technology, and regulations, for these factors determine the overall structure of banking and banking services.
Before the 16th century, banking consisted mostly of holding deposits or valuables, and making loans. In Greece and Rome, religious temples served as banks, because they often had treasuries and held valuable items for its members. They could also make loans to people that they knew, which solved the problem of the informational asymmetry between lenders and borrowers. Moneychangers in 14th century Italy exchanged foreign currency for domestic currency for Italian traders. However, it is the evolution of banks and banking beginning in the 16th century that best illuminates how banks work today.
The 1st and foremost technology that allowed the beginnings of modern banking is the printing press, which allowed many copies of an identically printed paper to be made in exquisite detail—an absolute necessity for printing currency or receipts that could be exchanged for commodity money, such as gold; otherwise counterfeit money would destroy the value of paper currency or receipts, which would have limited the supply of money and prevented that very modern banking practice—fractional reserve banking.
Gold, Goldsmiths, Fractional Reserve Banking
In the 16th century, the goldsmiths of London began the practice of holding the gold of depositors and issuing receipts for the gold. The receipts started to be used as currency because people accepted them as a means of payment since they could be traded for the gold held by the goldsmith. Then goldsmiths started making loans with the receipts, and in the 17th century, after realizing that only a small number of people traded their receipts for gold at any one time, started making more loans than what they had in gold, the beginning of fractional reserve banking—lending out more money than what is actually held at the lender's premises. Eureka! The goldsmith discovered that he could create money.
Fractional reserve banking increases profits but also increases risks. For if any goldsmith fails to redeem its receipts in gold, word will spread causing those receipts to lose value as money, and every receipt holder will run to the goldsmith, trying to redeem them.
In the beginning, banks in Colonial America were highly unregulated and they were the main issuers of paper currency—not the government. This recipe for disaster was the cause of many bank failures, panics, and depressions.
Silver and gold coins, otherwise known as specie, were the main types of commodity money used at this time. However, silver and gold are limited in quantity, and new sources are not easily found nor easily mined, which is, of course, what made them valuable as money—they couldn't be counterfeited and their quantity could not be easily increased, so they kept their store of value.
However, an economy needs a quantity of money that is commensurate with the amount of business being transacted—too little causes depressions and too much causes speculations followed by depressions. Furthermore, as noted by Benjamin Franklin, much of the gold and silver in the American colonies was being exported to Europe to pay for imported goods, leaving little for the American colonies to conduct their own business. As Franklin also noted, an economy needs the right amount of currency to conduct its transactions, no more nor less; otherwise, there will be unemployment, deflation, and a contraction of the economy. As an economy expanded, it needed more money, but silver and gold could not be increased just when the economy demanded it—hence, another solution was needed.
Word Origins—Dollars, Bucks, Quarters, and Bits
During the colonial era, the 2 major types of specie circulating in the colonies were the British pound and the Spanish dollar. So why is the currency in America, a British colony, called a dollar instead of a pound?
Colonial America had a trade deficit with England and a trade surplus with Spain and its colonies to the south. America had to pay for its trade deficit to England with pounds, naturally, since the British exporters wanted to be paid in pounds. So there were more Spanish dollars circulating in America than British pounds; hence, Spanish dollars were the main coins used as currency in colonial America. To make change, the Spanish dollar was cut into 8 pieces, or bits, and, thus, a quarter was often referred to as two bits. A dollar was called a buck because in the 18th century, a buckskin, which is the hide of a male deer, was worth one dollar.
The solution, provided by banks, was to take deposits of silver and gold and issue bank notes that could be redeemed for silver or gold on demand. Bank notes were a record of deposit. If you deposited gold or silver, the bank would issue you the equivalent amount of notes, so these notes were, in effect, your "passbook" of savings. If you wanted to pay someone, it would be with the bank notes. The receiver of these notes could pay someone else with the same notes, or redeem the notes at the bank for its gold or silver. So, in this sense, they were also like a "check."
The redemption feature was necessary because otherwise no one would accept the bank notes for money. If a bank failed to redeem any of its notes, word would soon spread, causing a run on the bank where depositors would pull out their money while the bank still had silver or gold, for when it ran out, its bank notes would become worthless and the holders of these bank notes would lose their value. This would contract the local money supply, causing unemployment and business failures.
What limited the effect of a bank failure was that almost all banks were unit banks, which had no branches; hence, there was no economy of scale that would give any single bank an advantage over others, and since banks were so profitable, they had a lot of competition. A bank's influence was also limited because its notes became less valuable with distance, since people outside of the bank's area would be less familiar with it, and have less faith in its notes, and, in any case, would have to travel to redeem them. So if a bank failed, there were other banks in the area that also issued bank notes, which prevented a total collapse of the local economy. Hence, having many banks in an area may not have been efficient, but it was safer than having only one or a few.
Unfortunately, bankers then learned what bankers the world over know now, and what the goldsmiths of London learned in the 1600's—in normal times, only a small percentage of the depositors withdraw their money—by redeeming their bank notes for specie—at any one time. Hence, banks started issuing more bank notes than what they actually had specie for. So bank owners not only leveraged their capital by loaning out money that had been deposited, but they increased their leverage enormously by lending out money that they created! Needless to say, this increased the number of banks and greatly increased the money supply, which fueled speculations in land, which subsequently caused panics and depressions.