Free Banking and the National Banking Act of 1863

With the demise of the Second Bank of the United States in 1836, the state banks were once again free to print money, and during this time, the states started passing free banking laws that would make it much easier for anyone to start a bank. Consequently, financial panics would continue to plague the American economy.

Free Banking

Because of the importance of banks and money to an economy, a bank could not be formed by just anyone. They required a bank charter from the state to legally exist, and, although not just anyone could start a bank, anyone could with the right political connections, whether they knew how to run a bank or not. Before 1837, a state bank charter could only be obtained by the approval of the state's legislature; federal charters were not available until 1863. And because banks could print money in the form of banknotes, naturally, many people wanted to start banks. This fostered corruption and favoritism.

So that bank charters were not just granted to political cronies, Michigan, in 1837, began the trend of free banking where a bank charter could be obtained without an act of the legislature; only very minimal requirements had to be satisfied. Other states followed with New York enacting a free banking law in 1838, but required that banknotes be backed by government bonds.

Also during this era, some states started enacting legislation to protect the depositors, either as a form of deposit insurance or as reserve requirements. In the early 1800's, New York required banks to pay a small percentage of their capital to a state fund that would reimburse depositors in case of bank failure. In 1842, the state of Louisiana required banks to keep 1/3 of their capital as cash and 2/3 in short-term loans.

However, there was little actual oversight of the banks, so restrictions were not effective. Instead, they proliferated and printed more banknotes than what they had in specie. In fact, some banks—referred to as wildcat banks—deliberately located in the remote wilderness expressly to make it difficult for any of its banknote holders to redeem their notes for specie.

Unfortunately for merchants, this proliferation of banks created a proliferation of banknotes. The value of banknotes depended on the distance from the issuing bank, both because the banknote holder had to travel to the bank to redeem them in specie and because people were less familiar or unfamiliar with distant banks, and, hence, would not accept the banknotes as payment, at least not at full face value. It was, thus, difficult to know the value of a particular banknote, and it was difficult to distinguish counterfeit notes from real banknotes. To solve this problem, registers of banknotes were published periodically and distributed to merchants so that they could look up the value of a particular banknote. This was an inefficient process at best, and it created an appeal for a national uniform currency.

$2 private bank note issued by Stonington Bank, Connecticut and $5 private bank note issued by Allegany County Bank, Maryland.
$2 private bank note issued by Stonington Bank, Connecticut and $5 private bank note issued by Allegany County Bank, Maryland.
Source: Minneapolis Federal Reserve

The National Banking Acts of 1863, 1864, and 1865

During the Civil War, the federal government of the North set up a national banking system to provide a stable national currency and to finance the Civil War. The legislation creating the national banking system was enacted over a 3 year period, from 1863 - 1865:

This was the start of the dual banking system that exists today, where a bank can operate under a state or a federal charter.

National banks were allowed to issue a federal banknote that had the same value everywhere in the country and that was backed by government bonds. To improve their safety, national banks had to hold at least 1/3 of their capital in government bonds. To issue banknotes, the national banks had to deposit $100 worth of federal government bonds with the Comptroller of the Currency for every $90 of banknotes issued. If the bank failed, the bonds would be sold to reimburse banknote holders; however, it did not cover depositors.

The federal government wanted state banks to become national banks; however, most banks resisted because of the restrictions of a federally chartered bank. The imposition of a 10% annual excise tax on state banknotes caused many state banks to adopt a federal charter, but many others still refused; instead, they stopped issuing banknotes and starting using demand deposit accounts—checking accounts—that gave depositors another form of payment.

By the 1870's, checking accounts and the lax restrictions of state governments fueled the growth of state banks, since they had lower reserve and capital requirements, could make more types of loans, and had fewer restrictions on bank branches.

Demand Treasury note printed in 1861. These notes were the 1st paper currency printed by the United States government that were issued for the express purpose of serving as fiat money.
Demand Treasury note printed in 1861. These notes were the 1st paper currency printed by the United States government that were issued for the express purpose of serving as fiat money.
Source: http://www.federalreserve.gov/

National banknote, Winters National Bank of Dayton, Ohio, printed in 1901. To assure the holders of this note of its safety, the text in the top middle of this note states "This note is secured by bonds of the United States. Deposited with the U.S. Treasurer at Washington."

National bank note, Winters National Bank of Dayton, Ohio, printed in 1901.
Source: http://www.federalreserve.gov/
Front and back of a $1 National Bank Note issued by Central National Bank, Illinois, 1872.
Front and back of a $50 National Bank Note issued by First National Bank of San Francisco, 1890.
Source: Minneapolis Federal Reserve
Front and back of a $50 National Bank Note issued by First National Bank of San Francisco, 1890.
Front and back of a $1 National Bank Note issued by Central National Bank, Illinois, 1872.
Source: Minneapolis Federal Reserve

Correspondent Banking

One concept that was evolving during this time was the idea of correspondent banking. A bank could obtain the services of another bank by keeping a demand deposit account with the other bank—the correspondent bank. Demand deposits could not legally earn interest, but the correspondent bank would offer services in lieu of interest for the deposits. One of the 1st banks to begin offering correspondent bank services was the Suffolk Bank in Boston which would accept the banknotes of another bank if the bank held enough deposits in the Suffolk Bank to cover them. Because Boston was a major trading center, other banks felt obliged to keep deposits there to be competitive, since banknotes that were accepted in Boston would be more valuable, especially for banks outside of Boston.

The National Banking System had reserve requirements that could be distributed to correspondent banks. For this, national banks were divided into 3 classes: central reserve city banks, which were the largest banks located in the largest cities, initially New York, Chicago, and St. Louis; reserve city banks, which were originally located in 16 smaller cities but was later expanded to 49; and country banks, which categorized all national banks that were located elsewhere.

The country banks were required to keep at least 15% of their deposits as reserve requirements: 6% had to be kept in their own vaults, and the remaining 9% could be kept at reserve city bank. Both the central reserve city banks and the reserve city banks had a 25% reserve requirement. The reserve city banks had to keep only half of their reserve requirement in their own vaults, and half could be kept at a central reserve city bank, but the central reserve city bank had to keep its entire reserve requirement in its own vaults. The central reserve city bank could count the deposit of the reserve city banks as part of their reserves; likewise, the reserve city banks could count the 9% of their deposits from country banks as part of their own reserve requirements.

However, this stacking of reserves could, and did, create trouble if a country bank needed to withdraw its funds for its business. By drawing the money out of its reserve city bank account, that bank may, in turn, be forced to withdraw money from its central city bank account, which, in turn, may force the central city bank to call in their loans to the money market and to stock brokers. Hence, a contraction of a country bank's money supply could cause the money supply to contract in a distant city with its resulting depressive effect on the economy.

The National Banking System Couldn't Control the Money Supply

A major shortcoming of the National Banking System was that there was no way to directly control the money supply. The demand of money would fluctuate along with the economy, but the supply was relatively fixed. So when demand increased, interest rates—the cost of money—increased with it. This happened frequently during times of harvest since farmers needed more money to harvest their crop. As interest rates rose, the economy contracted.

The country experienced a severe depression in 1907, not only because of a shortage of the money supply, but also because of the frequent failures of state banks. State banks, because they were less regulated, had become far more numerous, so their frequent failures had severe economic repercussions. A National Monetary Commission was set up to find a better way to manage banks and the economy. Their solution was the Federal Reserve.