The National Banking Era 1863 1914 Macroeconomics Civil

The National Banking Era 1863 -1914

Macroeconomics: Civil War to World War I • Civil War, 1861 -1864 – Fiscal: Huge Deficits Huge Increase in Federal Debt – Monetary: Abandon the Bimetallic (Effectively Gold) Standard – Monetary: Inflation in North, Hyperinflation in the South • Greenback Period, 1864 -1879 – Fiscal: Surplus Reduction in the Debt – Monetary: Deflation } Financial • “Resumption” 1879 Policy: The – Monetary: Return to the Gold Standard National • The Gold Standard, 1879 -1914 Banking Era – Fiscal: Surplus Reduction in the Debt 1863 -1914 – Monetary: Continued Deflation and Silver Politics, 1879 -1897 – Monetary: Gold Inflation, 1897 -1914

Banking • STRUCTURE – Regulation and Organization of the Banking Industry • CONDUCT – How do banks operate? Commercial Banks? Savings Banks? Investment Banks? • PERFORMANCE – Competitive markets? Integrated Markets? – Risk/Failures? Losses/Profits? Returns to Banking?

FIRST----STRUCTURE • WHAT WERE THE FACTORS SHAPING THE STRUCTURE OR ORGANIZATION OF THE BANKING SYSTEM? • Key---Return of the Federal Government to the Regulation of banks • During the Civil War – Partial collapse of state banking systems – Opportunity for Federal Government to create a new system---after it had abandoned an intervention in the system in 1836.

The National Banking System---a banking system without a central bank • National Currency Act 1863 • National Banking Act 1864 — creation of the Office of the Comptroller of the Currency (OCC) • http: //www. occ. treas. gov/ • Result: a federally-chartered system of “free banking. ” Free entry upon meeting minimum rules and a bond-backed Salmon P. Chase, U. S. Secretary currency of the Treasury, 1861 -1864, free men, free soil, free banking • Never important in wartime finance—too late. • REGULATIONS?

Justification for Regulation and Supervision: Asymmetric Information • Difficult for individuals to select and monitor borrowers. • Banks specialize and lower costs, but then the problem becomes how can depositors monitor the bank. – Adverse Selection Problem—to pick the right bank – Moral Hazard Problem—how to monitor bank’s behavior – Free Rider Problem • If not solved----less than optimal financial intermediation, less credit than economy needs. • If not solved---high propensity for depositors to panic and run • Potentially high costs to the economy • Desire for Reputation may control problems • If not sufficient may need to impose Regulations and Supervision to increase flow of information, monitor and discipline banks.

Taxonomy of Regulation and Supervision (9 factors with some justification) 1. 2. 3. 4. 5. 6. Entry Controlled to screen out dishonest or excessive risk-taking entrepreneurs. Capital requirements Control moral hazard by limiting leverage. Limits on economies of scale restrict branching and horizontal mergers. Limits on economies of scope and diversification constrain banks’ portfolio choices or activities to constrain risk-taking or conflicts of interest. Limits on pricing: Interest rate restrictions to control predatory behavior. Liability (deposit) insurance: free customers from monitoring banks and the incentive to panic.

Taxonomy of Regulation and Supervision 7. Disclosure requirements Reinforce market discipline if information is made public. 8. Examinations • Government-supplied auditing to examine proprietary information. • Complements disclosure and ensures compliance with regulations. 9. Bank supervision • Enforce regulations and control risk by imposition of penalties. • Rules-based or Discretion-based.

Five U. S. Policy Regimes • • • National Banking Era 1864 -1913 Early Federal Reserve Period, 1914 -1932 New Deal, 1933 -1970 Demise of the New Deal, 1971 -1990 The Contemporary Era, 1991 -2008

1. Supervision under the National Banking System, 1864 -1913 National Banking Era 1864 -1913 1. Entry Free Entry; Minimal Discretion 2. Capital Requirements Low Fixed Minimum; Double Liability 3. Limits on Economies of Scale Branching Virtually Prohibited 4. Limits on Economies of Scope & Diversification Banks Narrowly Defined; Loans Restricted 5. Limits on Pricing Usury Laws, vary state by state 6. Liability Insurance Bond-Secured Banknotes, Reserve Requirements 7 States Deposit Insuranceafter 1907 7. Disclosure 3 Yrly Surprise "Calls" after 1869 8. Examination 2 Yrly Surprise Exams: “Bottom Up” 9. Supervision & Enforcement Mark to market—Prompt Closure OCC--the federal regulator and each state has regulatory agency

Two Elements of a Free Banking System?

6. National Banknotes • National banks must buy federal bonds, which are deposited with the government. They are allowed to issue up to 90% of the par value of the bonds in banknotes. • If a bank fails, the bonds can be sold to guarantee value of its banknotes. • Collateral---safer than state bonds---default free. • Banknotes are “uniform” because collateral is uniform. • Banknotes are given uniform appearance. • No longer subject to bank run or doubt

From bondbacked state chartered banknotes to bond-backed national bank notes

Requirements for a national bank • 2. Minimum capital requirements---$50, 000 (for big cities $200, 000) • 2. Double liability------Why? • 4. Loans---maximum of 25% of capital in real estate loans ensures that most are short-term commercial loans (real bills doctrine)---Why? • 6. Reserve requirements---graded by city: – – Country banks 15% (3/5 on deposit with. . ) Reserve city banks 25% (1/2 on deposit with. ) Central Reserve City Banks 25%--all cash Contributes to a pyramiding of reserves.

National bank regulations • 3. National banks may not have branches (concern about wildcat banking). Not considered a problem until 1890 s. • 8. & 9. OCC operates system of examination, sends out regular bank examiners to enforce rules.

What Happens to the State Banks? • Do they join? • Hardly---rules are more onerous than state rules. • 1865 U. S. slaps 10% tax on state banknotes---forcing them to join

Revival of state banking • State banks find it prohibitive to issue banknotes---helps to encourage the growth of deposit banking • States begin to adjust their regulations and set lower requirements for capital and reserve requirements, loans • Result the “Dual Banking System” with “competition in laxity”. And 51 regulators! • Still no branching is permitted • Increased demand for banking services met by new banks ---in suburbs or on the frontier---not new branches

States try to increase their state-chartered banks advantages and charter more banks

Thousands of Banks and few branches 1910, there are over 19, 000 banks

But, even state banking systems find competition from new intermediaries--the Trust Companies who have even lighter regulation than state banks Trust Companies become major banks (especially NY and MA) with very low regulations An increasingly complex set of institutions

DEPOSITS ARE PYRAMIDED because of (1) reserve requirements, clearing and collection of checks, and transfer of investment funds

Problems of a fragmented banking system • Payments System Problems: Most of clearing and collection of checks cannot be done internally. Banks must form relationships---the rise of “correspondent banking”— Result “Pyramiding” worsens panics • Allocation of Funds Problem: Interregional transfers of bank funds from region to region cannot be done internally. Need for correspondents— Result “Pyramiding” worsens panics • Portfolio Diversification Problem: Many banks cannot fully diversify sources of deposits or loans– Result: More Prone to Failure

What do banks do with their surplus funds: brokers loans---call and time loans to the stock market, the equivalent of federal funds Compounds pyramiding of reserves and investment especially in NYC

Effects of Structure on Banking, 1864 -1913 • (Factors 1, 2, 3) Free entry, low minimum capital requirements, branching prohibited thousands of small undiversified banks More likely to fail and fragile in a panic • (Factors 3, 6) No branching and reserve requirements Fragmented banking system for payments and interregional transfers leads to development of correspondent in big cities with pyramiding of reserves and other funds Fragile in a panic • (Factors 2, 6) Double liability, no deposit insurance Make shareholders and depositors monitor bank management carefully • (Factors 7, 8) Surprise disclosure and examination Improve monitoring of management • (Factor 9) Prompt closure of failed banks Lower Losses • Factor 5, little effect; Factor 4 Leads to growth of investment banking

How important were Banks? Financial Intermediaries Shares of Assets (%) Commercial. B anks Insurance Companies Other Intermediaries 1880 86. 5 10. 5 3. 1 1900 81. 1 10. 7 8. 2 1922 75. 7 11. 6 12. 7 1950 64. 1 21. 1 14. 8 1990 38. 0 11. 1 50. 9

Structure, and now CONDUCT • HOW DID COMMERCIAL BANKS OPERATE? • HOW DID INVESTMENT BANKS OPERATE?

What makes commercial banks “special? ” • Banks have a special capacity to collect information on borrowers and monitor them – Monitor their checking accounts etc. – Interview them & ask them to disclose information – Result lots of information—proprietary information • It is generally difficult to market loans to outsiders without access to banks proprietary information. They can’t be valued by someone else • Many loans are not marketed and are held until maturity with banks managing risk. (Subprime disaster proves this point.

How did banks screen their customers in the 19 th century? • • Little formal standardized information. No financial statements, income taxes etc. For individuals or for companies. Accounting only begins to develop late in the 19 th century

How to be a banker in the 19 th century: a case study, the Bank of A. Levy • A small town bank in Ventura, California, the Bank of A. Levy, was founded in 1885 by Achille Levy • Mostly short-term loans to landowners for farming. • The “character loan” method. • If an applicant was “of good character, a loan was forthcoming. If the borrower’s reputation was flawed, the offer of thousands of dollars worth of collateral could not persuade him to make a loan. ” • He did take on questionable borrowers and if they faithfully repaid small loans, the size of the loans increased and the interest rate fell. • Case of the Chinese laundryman.

Levy carefully monitored his customers’ activities, watching their banking activities in his office, and traveling around the county on horseback, recording information in his pocket notebook.

Bank Lending • More generally, a 1918 Journal of Political Economy study offered the following advice on how to judge a potential borrower: “The amount that may be safely loaned…. can be ascertained only from an intimate personal acquaintanceship with the borrower and his business or from a study of a balance sheet or financial statement setting forth the condition of the business. ” • Banks were dominant intermediaries because they gained special knowledge of borrower that was not marketable.

Investment Banking: Structure • No Federal Regulations (Some state laws”Blue Sky” laws) • But, Factors 3 & 4 for commercial banking limit ability of commercial banks to make large long-term loans alternative issue stocks and bonds • Banks are agents not principals – Primary markets: Issue of new securities (IPOs and Seasoned) – Secondary Markets: Brokerage

Growth of Investment Banking • Securities (stock and bond) markets were limited before the Civil War. Most businesses were relatively small. • In 1860, the average firm produced value added of only $6, 000 a year. • Beginning in 1890 s, there was a huge merger wave that put together huge integrated firms: U. S. Steel, Standard Oil, AT&T, International Harvester—giant firms. • These firms cannot rely on funding of banks, which remain, relatively small. Result is alternative source of funding. • 1901 -1912: Corporations obtain $18 billion in outside funds – Bank loans 24% – Stocks 31% – Bonds 45%

Problem: • How to market securities when there is little reliable financial information • Accounting profession in early stages of development. Financial documents hard to compare and interpret. • New industries were very difficult to analyze. • WHO ARE YOU GOING TO CALL?

The Money Trust: Condut • Several dominant investment banks: J. P. Morgan, Kuhn Loeb, Kidder, Peabody, and Lee, Higginson and Company • They assist companies with the sale of large issues of new securities in the primary markets • Leading investment bankers also sit on the Boards of Directors of large industrials, commercial banks and insurance companies • Conflicts of Interest: Critics charged that these bankers colluded to force these firms to use their services to issue securities and then force banks and insurance companies to buy them---raising profits of the investment banks J. P. Morgan

Money Trust: Evil Bloodsucking Monster (Vampire Squid? )* or Agent of Modern Capitalism? • Muckraking journalists and politicians denounced the conflicts of interest that caused investment banks to prosper at expense of clients and investing public. • Pujo Commission 1912 -1913: Congressional investigation into money trust • John Moody, founder of Moody’s argued in 1904 that control of corporations by financiers Rep. Arsene Pujo was necessary to direct funds to them and let investors know which firms were worthy of investment. *Rolling Stone: “The world's most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood. . . ”

Did the Money Trust Exploit Conflicts of Interest or Overcome Asymmetric Information? • De Long offers case studies – International Harvester – AT&T • Econometric Analysis – If conflicts of interest are dominant then presence of Morgan partner should lower stock prices – If monitoring and signaling are dominant then presence of Morgan partner should raise stock prices.

Conclusion? • On balance, De Long concludes that the monitoring and signaling effects were dominant. • Why did the Money Trust decline?

What changed securities markets? • Financial markets can only thrive with the development of standardized accounting methods that began to be developed in the late 19 th century. • For securities markets to flourish investors must have a means to compare investments-----these are provided today by the credit rating industry. • The earliest credit agencies like Dun’s or Bradstreet’s responded to the need of suppliers of goods to judge how much trade credit to extend to customers. • But, these are qualitative assessment—lawyers, other businesmen.

The Arrival of the Rating Agency • Investors require cheap available information on changing quality of bonds. • 1890 Poor’s Publishing Company first published Poor’s Manual, which analyzed bonds. • Its competitor Moody’s Manual of Industrial and Miscellaneous Securities followed in 1900. • Notice the timing….

The Rating Agencies: Aaa, A, Baa, Ba, and so on… • How to rank investments? • Innovation in 1909. John Moody introduced the rating system by letter as a means to combine all the statistical information on credit quality into a single easy to interpret symbol. • First applied to Railroads----they protested--but eventually a good rating meant that it was easier to raise money. • This innovation allowed investors to subscribe to a service and purchase bonds, thereby decreasing the demand for intermediation. • But, note, this was a 20 th century development.