Banking System

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The first financial institution created in the United States was the Pennsylvania Bank (1780–1781), founded at the behest of Philadelphia's merchant community with the ardent support of pamphleteer Thomas Paine and Continental Army colonel Alexander Hamilton. The need for such a bank was acute. The new nation, still fighting for its independence, was burdened with expenses and unable to supply or pay its soldiers. A scarcity of silver and gold specie (money in coin) made it impossible for states to effectively collect taxes; their treasuries were nearly empty. Meanwhile, the paper currency printed by the colonies and the Continental Congress proved to be wildly inflationary, driving merchants to trade bills of exchange among each other rather than use actual money.

The Pennsylvania Bank, it was hoped, would solve this problem by circulating a reliable currency, aiding both the war effort and the nation's commercial stability. However, the bank proved inadequate, never becoming anything more than an institution for purchasing military goods. The Pennsylvania Bank was soon absorbed by the Bank of North America, which Congress created on 31 December 1781, shortly after British forces surrendered at Yorktown in October. With offices in Boston, Philadelphia, and Virginia, the new bank was expected to unify the country by circulating a national currency and aiding commerce along the Atlantic coast.

Though new to the United States, the Bank of North America was hardly a novel creation in the Atlantic economy. It mirrored its British and European predecessors in many ways: it was incorporated, enjoying a government charter that permitted it to issue shares of ownership (stocks), assemble a board of directors who would govern its actions, and act as an actual (corporate) person in court, allowing the bank to take part in lawsuits and exist as a legal entity. The bank could both accept deposits and make loans, and was required to hold a reserve of its deposits in coined specie. It was also limited in the amount of capital that it could accumulate ($400,000), preventing the bank from exercising undue influence over the affairs of government or becoming a powerful concentration of wealth in the new Republic. Thus, while a legislative charter vested a bank with public authority, it was also a regulatory device that limited its activities.

Even some of its Congressional supporters, however, questioned the national government's powers to create a bank. There also remained widespread public mistrust of banks in general; people often viewed banks as vestiges of aristocratic authority. These concerns led the Connecticut, Massachusetts, New York, Pennsylvania, and Rhode Island legislatures to pass laws of their own to authorize and supervise the Bank of North America's operations. With the support of the bank's new directors, Massachusetts, New York, and Pennsylvania granted the bank a charter of incorporation to fully ensure its legitimacy.

bank "discounts" in the early republic

Economically, the Bank of North America proved a stunning success, rewarding its shareholders with annual returns of nearly 10 percent and proving popular among local merchants. But with only three offices, the bank's reach was limited. Headquartered in Philadelphia, the bank's directors were the object of suspicion among many Boston merchants who preferred to have a locally controlled institution in their city. In New York, an economic center where credit and capital were in growing demand, the Bank of North America's absence only highlighted the city's financial needs.

The personal nature of banking in the early Republic made local banks preferable to larger, multicity institutions. The purpose of a bank, as stated by Treasury Secretary Alexander Hamilton in a 1791 letter to President George Washington, was straightforward. "The simplest and most precise idea of a bank," Hamilton wrote, "is a deposit of coin or other property as a fund for circulating a credit upon it which is to answer the purpose of money."

The short-term loans, or discounts, offered by banks were usually made for thirty days at an interest rate of 6 percent. These discounts were personally approved by bank directors, not the managers and cashiers who comprised the banks' small staffs. Because the bank's note, once issued, could be used as cash to pay merchants, other banks, or state taxes, it was essential that the bank closely guard its reputation. The decisions to grant loans or exchange notes for cash were therefore made in secret and often seen as arbitrary. Lending involved risk, however, and directors hesitated to chance their bank's capital on persons with whom they were unacquainted. Although some accused directors of favoring a select group of merchants and "monied elites," there was no other mechanism to protect bank depositors and shareholders from the risks of lending.

reaction to the bank of north america

Attempting to emulate the Bank of North America's success and create financial networks of their own, merchants in Baltimore (1782), New York (1784), and Boston (1784) pressed to establish banks in their cities.

The Bank of New York, Massachusetts Bank, and Bank of Maryland replicated the Bank of North America by adhering to Hamilton's vision; they provided credit and currency to those engaged in commerce. They followed, in form and function, the Bank of North America. Perhaps inadvertently, this first bank had established a model of behavior among early financial institutions. Though denied a charter by the state legislature, the Bank of New York operated under a constitution drafted by Hamilton that made it both effective as a financial instrument and consistent with principles of republicanism.

Funded with both public and private capital, and owned by private shareholders and state governments, banks were mixed-economy enterprises in that they attempted to reconcile the public good with private interests. Hamilton expressed his hope that they would "increase public and private credit … [for] the former gives power to the state for the protection of its rights and interests, and the latter facilitates and extends the operations of commerce among individuals." "Industry is increased," he continued, "commodities are multiplied, agriculture and manufactures flourish; and herein consists the true wealth and prosperity of a state." Although only a few might directly participate in banking, Hamilton reasoned, its benefits would be shared by all.

reaction to the bank of the united states

Even after the successes of the first state banks, most people remained suspicious of them, leading bank directors to vigilantly safeguard their institutional reputations. Nearly all agreed that bank competition could have a disastrous effect on the nation's fragile economy; thus the first banks held de facto monopolies in their home cities.

This structure was challenged, however, when Hamilton introduced a plan to establish a federal Bank of the United States with branches in the nation's largest cities. To state bank advocates, Hamilton's agenda favored industrial and big commercial interests over farmers and small merchants. Hamilton and his allies dismissed the objections of James Madison and Thomas Jefferson, who believed that a national bank was unconstitutional and instead supported an expansion of state banking.

Intended to be local engines of commerce without national ambition, state banks were created in response to local needs for capital and credit. Proponents feared that the Bank of the United States and its branches would absorb state banks. They harbored concerns that the circulation of more currency would cause inflation and speculation, potentially disabling the economy.

Confronted with federal competition, states embarked on a bank-chartering boom. There were just five state banks prior to the 1792 opening of the Bank of the United States, thirteen by the end of the year. By 1801 the number had grown to twenty-eight.

Once again, the most active proponents of these banks were merchants and members of the "monied elite"—the attorneys, financiers, and industrialists with the greatest need and use for capital. Even after this new generation of banks was established, banking privileges remained exclusive. Few people needed access to the typical bank's small office suite, often located above street level in a city's mercantile district. Regularly elected by shareholders, bank directors were at the nexus of politics and finance; each director could create a subsidiary network of credit among his peers and associates.

As the number of banks grew to accommodate credit demands, they began to reflect nascent political divisions. Among all but the most elite citizens, the act of patronizing a particular bank could be a declaration of political allegiances. Such was the case following the founding of the Bank of the Manhattan Company (1799), which played an essential role in delivering a Republican victory in New York City for Thomas Jefferson during the election of 1800.

Instead of making banks irresponsible, partisan banking normalized banking practice, bringing heightened scrutiny to banking activities and deterring interference from politically hostile legislatures. As chartered banking became the norm, legislatures created new banks at a staggering rate. By the time Congress created a second Bank of the United States in 1816, there were more than 246 state banks spread across the nation.

enthusiasm for state banks

There were two chief reasons for this enthusiasm on the part of state legislatures. First, banks had proven their utility as commercial financial instruments, assuaging many legislators' anxieties about their economic propriety. This partial legitimization was quickly followed by the discovery that taxes levied on banking activities could provide lucrative public revenues. Additionally, states were more inclined to exercise options to purchase bank shares, allowing the government to collect dividends and appropriate those funds toward state projects.

The second reason for states' newfound affinity for banks was defensive: legislatures sought to protect their internal economies in anticipation of the 1811 expiration of the charter for the Bank of the United States. If Congress failed to renew the charter, the national bank would be forced to shut its doors. This forced legislatures to plan for a scenario in which their state banks would be forced to act as independent mini-national banks, underwriting both state and federal debts, facilitating commercial exchanges, and acting as an emergency lender if the government was beset by unforeseen expenditures.

Just as was true for the national bank, state banks were only partially controlled by their state governments and continued to be regulated by the provisions of their charters during the first two decades of the nineteenth century. Some were wholly owned by the state at their moment of incorporation, but most were partially owned. States usually bought shares in the banks but were sometimes vested with them. Both arrangements allowed states to take advantage of market conditions by timing the purchase and sale of bank stocks, raising public revenues from the profits.

Banks were typically taxed on their overall capital, but states also targeted deposits, dividends, and profits. Occasionally, banks paid the state a flat fee, or bonus, for the right to conduct business within a geographic area or industry. Although these taxes were quantitatively insignificant before the wider democratization of commercial banking in the later 1810s, they became major sources of public revenues soon thereafter. In Massachusetts, for example, a 1 percent annual tax on bank capital enacted in 1812 provided nearly one-half of all state revenues needed between 1820 and 1860, entirely eliminating property and poll tax collection in many years. Some states, such as Maryland and Delaware, dedicated bank taxes to particular expenditures, using them to fund internal improvement projects such as turnpike roads, or creating special accounts to establish free public schools that were funded exclusively by bank taxes.

The practice of owning and taxing banks by legislatures fundamentally altered the relationship between banks, the public, and the government. The advent of more liberal bank incorporation practices by legislatures, accompanied by growing ambitions for public works, led to a thirst for public revenues that relied on banking rather than public taxation. It was politically preferable to levy taxes on those who were privileged enough to patronize state-created institutions, that is, banks, that were created to generate profits. This redistributed a portion of those profits to the public en masse, which was thought appropriate given that banks, as mixed-economy enterprises, were chartered in the public's name and to serve the "public good."

Yet the lure of public revenues did not silence all bank critics, forcing proponents to sometimes devise creative ways to build legislative majorities in favor of bank charters. On occasion, some charters were outright deceptions, offering banking privileges to seemingly benign institutions by hiding the operative language deep within legislation. In the 1802 charter for the Kentucky Insurance Company, for example, "banking" is nowhere mentioned, but the legislation includes phrases that were standard in other bank charters. This episode mirrored the 1799 furor over the charter granted to the Manhattan Company in New York, which was intended primarily to function as a water utility. Yet the deception was repeated in the April 1803 creation of the Miami Exporting Company of Cincinnati by the Ohio legislature. The company's charter granted a right to "dispose of the funds of the company in such manner … most advantageous to the shareholders." These words conferred all the authority necessary for company directors to open an office of discount and deposit weeks later, much to the surprise of some legislators.

the bank of the united states expires

Increasingly during the first decade of the nineteenth century, these machinations became less necessary to win approval for bank charters as the expiration of the First Bank of the United States drew near.

Although he was willing to expand the national bank into the newly purchased Louisiana Territory with a branch at New Orleans, President Thomas Jefferson never became convinced of its constitutionality. That opinion, shared by many Jeffersonian Republicans who came to power in 1801, did not waver despite a mutually beneficial relationship between the government and the bank during Jefferson's two terms of office.

Anticipating an uphill battle for the charter's renewal in 1811, in January 1808 the Bank of the United States shareholders petitioned Congress to consider the issue. Amicable feelings for the bank, which was the government's chief financial agent, failed to move Treasury Secretary Albert Gallatin to make a recommendation to Congress until the end of Jefferson's term in 1809. His delay led Congress to defer the renewal issue until 1810; by then, enemies of the bank formed a sufficient coalition to bring about its demise. The bank's reputation was damaged by its large number of British, albeit nonvoting, shareholders, and Federalist directors. It was labeled an "English bank" just as the United States was about to embark on a second military war against Britain. Rechartering eventually failed by a single vote in each chamber of Congress, with the preceding debate principally focused on the legality of a federal bank.

a new war and a new bank

Surprising even Treasury Secretary Gallatin, the dissolution of the First Bank of the United States was accomplished with relative ease. Branches were liquidated among local bank proprietors like financier Stephen Girard of Philadelphia, who was the national bank's largest stockholder. However, without the monetary regulation of the central bank, state banks were left free to issue their own notes, causing dramatic inflationary spikes that doubled the total amount of currency in circulation between 1811 and 1816. Specie shortages, an inability to collect debts, and a lack of access to credit once again became commonplace.

After the outbreak of military conflict with Britain, it became clear that the federal government was the party most compromised by the lack of a national bank. Forced to negotiate loans with dozens of smaller state institutions, the federal government had no ready source of funds in either paper or specie, nor could it safely convey such money to where it was most needed. Variations in state discount rates made it impossible to efficiently fund a war on different parts of the continent, and the Treasury was unsuccessful in soliciting financial support by selling shares of loans to banks and citizens in the nation's cities.

Faced with defaulting on several of these undersubscribed loans, the Treasury Department, under the helm of Alexander Dallas, petitioned Congress in 1814 to create a second federal bank. Congress first rejected the idea but then passed legislation that President James Madison vetoed because he disagreed with a few of the bill's provisions. Finally, a compromise created a bank on 10 April 1816, two years after the signing of a peace treaty with Britain to end the War of 1812. This second central bank would, in Madison's words, restore a "uniform national currency" among the state banks. Unlike previous congressional discussions about federal banking, constitutionality was accorded a minor role in the 1814–1816 debate. Instead, the extent of the bank's regulatory and monetary power was at issue, particularly in defining the relationship between the central bank and the proliferation of state banks.

the panic and the legality of the bank

That relationship faced its first test early after the opening of the second Bank of the United States, when the bank ordered the first of a series of suspensions of specie payments, assuming control of state bank deposits. Having expanded and then contracted the nation's availability of credit among a set of largely uncooperative state banks, the bank inadvertently contributed to a recession, and then panic, that struck in 1818–1819. The price of cotton and other commodities plummeted as European import demands diminished, and the migration of specie to western territories left many state banks, along with the federal bank, deeply indebted. The central bank had more than $22 million in liabilities, but just $2 million on hand, a dangerous 10:1 debt-to-cash ratio.

In this moment of weakness, many state legislatures began levying heavy taxes on the federal bank to protect their own institutions and financially punish the bank. A $15,000 tax applied to the Baltimore branch of the Bank of the United States by the state of Maryland was judged unconstitutional by the Supreme Court in McCulloch v. Maryland (1819), a decision that not only established the legality of the central bank but greatly expanded federal power in general.

the 1820s: stability and the jacksonians

Throughout the 1820s the bank, under the leadership of Nicholas Biddle, managed debt and currency circulation throughout the country as its burgeoning trade fostered interregional networks between Western agrarian interests and coastal commercial centers stretching from New Orleans to Boston. Facilitating international monetary exchanges on behalf of state banks, the bank was active in handling southern cotton as a commodity, moving it to northern and British manufacturers. Private merchants and foreign banking houses, however, retained a prominent role in trading both bank stock and federal debt, owing an unfavorable balance of trade that the United States could not overcome so long as it imported goods of greater value than it exported.

Still, despite the stability of the state and federal banks as a functioning monetary system, both state bank supporters and antibank activists found an ally in Andrew Jackson, who opposed the concept of a central regulatory mechanism in favor of a laissez faire federal monetary policy. His election in 1828 signaled a renewed opposition to the national bank, culminating in his veto of its renewal in 1832.

See alsoBank of the United States; Hamilton, Alexander; Hamilton's Economic Plan; Federalism; Federalists; Jackson, Andrew; Jefferson, Thomas; Madison, James; McCulloch v. Madison; Taxation, Public Finance, and Public Debt .


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Brian Phillips Murphy