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July 2024
19min read

Banking as we’ve known it for centuries is dead, and we don’t really know the consequences of what is taking its place. A historical overview.

For the last several years congressional committees and presidential task forces have been nattering back and forth about what should be done to change the legal order that establishes and specifically empowers and regulates the nation’s banks. They have dealt with their subject as a collection of technical problems they could solve: a bit of oil here, a tightened bolt there, a replacement for a blown gasket—and the old machine will be as good as new. But, in fact, our banking problems are systemic: we need a new machine. Changes in the technology of data processing have made it easy for businesses that are not banks to perform the functions that—until recently—only banks could even attempt, let alone fulfill. And changes in the cost and speed of communications have demolished the barriers that once gave a decidedly local character to the money and credit Americans used in their getting and spending. A uniquely American institution is changing—not only on its face but also in its very innards; a significant factor in our history has come to the end of its time.

Banks have been a major force in forming the character of American economic—and, indeed, political—life. No nation in Europe has more than a few score corporations that conduct a banking business on the foundation of deposit taking; the United States has forty thousand. American history is replete with fights in the legislature over the nature and function of banks and the role of the government in creating and controlling the money supply; in Europe such matters have been left in the hands of technocrats. From Shays’ Rebellion to Jackson’s war on the Second Bank of the United States to Bryan’s crusade against gold to Woodrow Wilson’s fight for the Federal Reserve and Franklin Roosevelt’s intensification of bank regulation, all radical reform movements in the United States proclaimed a central mission to do something about the banks. Yet at the same time there has been, across the political spectrum, a protective feeling for the local bank as a community service—an enterprise formed, as George Washington’s friend and financier Robert Morris put it, by men “clubbing a capital together” to promote the prosperity of their neighborhood.

Banking came to Europe as part of a mercantile revolution: it was the manufacturers and traders in the cities who needed credit to sell their wares. They had access to gold coins —the specie that formed an international currency, for gold was accepted everywhere. Rather than keep such hoards sterile or take the time and risk of making loans themselves, they were willing to leave their balances in the safekeeping of bankers who interposed their guarantee of safety between depositor and borrower.

In colonial America an agrarian society had little need for money and did not see much of it. The colonial balance of trade was heavily negative, which meant that specie was forever draining out of the New World to pay for imports from the mother country. As late as 1813 Thomas Jefferson wrote of neighboring tobacco farmers who drew supplies from regional merchants all year, on the strength of the tobacco crop they consigned to the same merchants after the harvest, and never saw or needed a dollar in cash. And the merchants themselves lived in a credit economy where all sums were book entries: their London suppliers shipped them goods on the strength of the merchants’ promises to ship tobacco later in the year.

The banks formed in the Colonies —and there were some, usually called loan offices—backed their issue of bank notes with pledges of the land that was the real wealth of the new society. Such notes could not be circulated at anything like their face value outside the town where they were issued. Even locally there was, in effect, no way to redeem them, as the notes had neither specie nor mortgages behind them and the land itself was not readily divisible. Bray Hammond, the long-term assistant secretary of the Federal Reserve Board, who in his spare time became the great historian of American banking, pointed out that these were almost always merchants’ banks. The essentially self-sufficient farmers had little need for credit and disliked the idea of being paid for produce in paper money. Not until a hundred years after the Revolution did farmers become agitators for inflationary monetary policies that would raise the price of their crops and thereby make it easier for them to pay the debts they had incurred in buying the newfangled machinery of the nineteenth century and to expand their land holdings.


The first bank actually begun with specific government approval in the United States was the Bank of North America, chartered in 1781 by the Continental Congress to Robert Morris, a rich, English-born, Philadelphia patriot who would be able to multiply his contribution to the cost of defeating Cornwallis by issuing the notes of such a bank. (These were much more likely to be accepted by purveyors to Washington’s army than were the notes of the Continental Congress itself, already selling at a severe discount and on their way toward evoking the disgust embodied in the longused cliché that something is “not worth a Continental.”) The war would end before this bank actually got into operation, but there was still plenty of work for it to do in managing the debts of the Revolutionists and in establishing a national currency—paper that would be accepted not only by farmers and businessmen but also by as many as possible of the sovereign states themselves.

Unfortunately another use of the notes from Morris’s bank was to pay for hundreds of thousands of acres of land in western Virginia and Kentucky that he bought. One of the relatively few signers of the Declaration of Independence who was also a member of the Constitutional Convention (and a senator in the first Congress after the adoption of the Constitution), Morris ran out of indulgent creditors in the late 1790s—though his bank, which had quickly retreated to the status of a Pennsylvania institution, remained solvent and survived into this century. Among Morris’s visitors in debtors’ prison, where he spent three years (from 1798 to 1801), was Thomas Jefferson, who had a low opinion of banks and bankers—and thought nationally chartered banks were flatly unconstitutional—but remained grateful for the financier’s services during the war. One notes in passing and without comment that today’s national association of bank lending officers, the second largest bankers’ organization in the country, perpetuates Morris’s name, even though he went bust.

Banks create new money by making loans, though many bankers will deny it.

The earliest state charter for a bank went in 1784 to Alexander Hamilton for the Bank of New York, which continues to this day and still honors Hamilton. This was to be the most conservative bank imaginable, lending only for thirty days, essentially a device to help wholesalers carry their inventories. But before the century was out, the bank was financing the Society for Establishing Useful Manufactures in the construction of a factory at the waterfall in Paterson, New Jersey. The inevitable had occurred: once the agency was there to create new money by making loans—which is what a bank does, though a surprising number of bankers will deny it—even the most prudent directors will see reasons to help the growth of industry.

The first golden age of bank chartering was the 1790s, when the states needed help with their own budgets and the federal government established the Bank of the United States, with a twenty-year license, to clean up the new nation’s indebtedness, collect taxes, borrow abroad, and be reponsible—as the Bank of England was—for the operation of a national currency. The federal government put up $2 million of the necessary $10 million in capital, but the bank was to be run as a private institution (again like the Bank of England, in which George Washington himself was a stockholder). Among those who became shareholders were Harvard College, the state of New York, and thirty members of Congress. It was perhaps the most successful new issue ever to hit an American market: within months the twenty-five-dollar subscription price for the four-hundred-dollar par value shares rose to three hundred dollars.

The headquarters for the new bank was a superb, two-story Greek revival structure, completed in 1797 and located two blocks from Independence Hall in Philadelphia. Still a feature of every tourist’s trip to the nation’s first capital, it set a style for bank buildings that persisted until after the Second World War.

To Hamilton’s dismay, the Bank of the United States almost immediately began opening branches, an arrangement he thought would create insurmountable management problems. Moreover, one of the branches competed for business with his own Bank of New York.

Allowed to lapse with the end of its first twenty-year charter in 1811, the bank was rechartered in 1816 as the Second Bank of the United States, its purpose to clean up the fiscal mess following the War of 1812. This new bank gave rise to one of the most important of Chief Justice John Marshall’s constitutional decisions (he carefully sold off his stock in the bank before writing it): McCulloch v. Maryland established the immunity of federal institutions from state taxation. Shortly after Marshall handed down his opinion, it became known that James McCulloch, treasurer of the bank’s Baltimore branch, against whom the suit had been brought by the state, with two other conspirators, had embezzled nearly $1.5 million, very much more than Maryland had tried to assess in taxes, and had nearly broken the bank.

More important than the federally chartered bank was the proliferation of state-chartered banks, institutions to serve local needs—especially the needs of the states themselves, for these banks were required to buy state bonds as part of the price of a franchise. Soon banks were competing for business, restrained in their competition by the fact that on a normal day they held each other’s notes in their vaults as part of their own assets. The power to award bank charters was among the most early solicited privileges of state legislators, and a great source of corruption, with bribes paid both by people hoping to start a bank and by already established bankers hoping to lock out competition. Eventually these scandals would be diminished by the passage of “free banking” legislation, authorizing the state registrars to incorporate banks as they did any other kind of business. But there was always a lot of politics in banking, if only because decisions about who would and who wouldn’t get a loan were often influenced by political affiliations in a period when Americans took their politics much more seriously than they do today.

Keeping order in the chaos of proliferating state banks fell to the Second Bank of the United States under its new leader, Nicholas Biddle, a Philadelphia aristocrat who had been a lawyer, a poet, and an editor before becoming a banker. At the age of twenty-one, following a trip to Greece, he had conversed with dons at Cambridge University in England on the difference between ancient and modern Greek, to the delight of James Monroe, then the American minister to London; and it was Monroe who later, as President, nominated Biddie as a director of the Second Bank. Biddle wrote (though he did not sign) the standard account of the Lewis and Clark expedition, based on the explorers’ journals. Biddle was, simply, a man of parts, just the sort of person the Kitchen Cabinet around Andrew Jackson most distrusted.

Congressmen whose constituents complained of the shortage of money —which meant, then as now, most congressmen—found Biddle and his bank a natural target, made easier to hit by the fact that the Second Bank (unlike today’s Federal Reserve) was a profit-seeking enterprise, in competition with other banks, as well as a central bank with quasi-governmental responsibilities. With the attack on Biddle and the Second Bank by the Jackson administration, banking briefly became the central issue in American politics.

There was, of course, no contest: though Biddle responded as central bankers will when under political attack—by inflating the currency—Jackson won. Bray Hammond notes the delightful fact that the administration’s charge against Biddle was led by Amos Kendall, a self-made Kentucky businessman in Jackson’s original Kitchen Cabinet, who while still an undergraduate at college had submitted a poem to a prize contest in a magazine Biddle edited, failed even to receive honorable mention, and years later still remembered the snub enough to mention it in his autobiography.

With the destruction of the Second Bank, many of the states went wild in chartering local banks, all of which issued bank notes. The economy responded to the great outrush of new money with the immense investment programs that made the United States an industrial power. By the Civil War there were more miles of railroad laid in this country than in all of Europe, then six times as populous. All this was done—had to be done—on borrowed money, and the nation’s thinly capitalized banks were prone to failure if even a tiny proportion of their loans went bad. Some banks, in addition, had been designed to fail: they issued their bank notes against trivial or even nonexistent holdings of specie, protecting themselves by means of their out-of-the-way location. It was said that people who wanted to cash in the paper of the Michigan banks would have to travel out “among the retreats of wild cats,” coining a phrase still in use, though now for oil wells rather than for banks.

It was a system calculated to benefit the slick Kansas trader, to multiply the profit of the land speculator who knew enough to pay with depreciated paper money and sell only for good money. Some states would have none of it: as late as 1850, either through legal restriction or public pressure, banks could not be incorporated in Arkansas, California, Florida, Illinois, Iowa, Texas, or Wisconsin, and banking was a state-controlled monopoly in Indiana and Missouri. When Illinois, Indiana, and Wisconsin moved to free banking, the excesses were remarkable—of the ninety-four new banks opened in the first three years of Indiana’s permissive law, fifty-one failed before the third anniversary. Much of this was due to incompetence, amateur banking by people who had no notion of how much they had to keep in cash and how much they could lend, much was due to dishonesty, and some was the result of plain bad luck. Even good, honest bankers could get into trouble if something happened in New York or London that denied them funds from their accounts or their lines of credit in the metropolitan centers.

Before the Civil War, American enterprise raised its long-term money in London, and between the bond selling and the financing of imports and exports, the network of American banking became dependent on the vagaries of international trade. These years saw the arrival of truly international banking, with firms like the Philadelphia-based Brown Brothers (now Brown Brothers, Harriman in New York, still a “private” bank with partners rather than stockholders) and London’s Baring Brothers (who married Americans—sisters, in fact).

But more important than any of these more publicized situations was the solid establishment of hundreds of small, locally owned, highly independent “country banks.” These were to a significant degree co-ops: their directors, who were liable for an additional call on their own resources up to the extent of their original investment in the bank, were the business leaders of the town and the larger farmers in the surrounding countryside. It was the banks that made enterprise possible, freeing the local manufacturer from the need to finance his customer’s inventories and allowing the farmers to concentrate on cash crops and the storekeepers to stock merchandise from all over.

Local banks were not “people” banks—they did not write mortgages or make personal loans in the early days—and they provided working capital rather than long-term investments. But the creation of a bank was the fundament of progress, and the failure of a bank was a disaster far beyond the immediate losses of the depositors. How well the banker made decisions was a key element in the growth or stagnation of a county. Indeed, it still is: driving into a rural town, especially in the Midwest and the mountain states, an experienced observer can make a judgment on the quality of the local bank after about five minutes of looking through the windshield.

The system of local banks fell apart in 1857 in a cascading series of failures that rapidly contracted the nation’s money supply—nothing is more useless than a bank note from a failed bank. The institutions that survived were not strong enough to arrange the financing of the Civil War for the Union government. Unwilling to sell treasury notes for less than their face value and unable to sell them on any other terms, the Lincoln administration was driven to issue “greenbacks”—paper money that was not backed by anything but would have to be accepted on the same terms as gold coin because the government had declared it to be “legal tender.” This was unquestionably unconstitutional—the secretary of the Treasury who shudderingly acquiesced in the issuance of the paper, Salmon P. Chase, later, as chief justice of the United States, voted to disallow these paper dollars (and the Supreme Court had to be packed by President Grant—expanded from seven members to nine—to keep the U.S. government from repudiating its own pledges). At the same time the greenbacks were being issued, Lincoln moved, more cheerfully, to establish a series of nationally chartered banks that would replace the state banks and buy government bonds at par.

Among those opposed to the new measures was Hugh McCulloch, president of the State Bank of Indiana, which had moved smoothly from state ownership to private ownership when the laws changed in the early 185Os and had been run ever since on the most conservative principles. It had twenty branches, all built in Greek revival style, rivaling the courthouse in each town as the most important structure. Chase listened to McCuIloch’s arguments and then, to the latter’s amazement, offered him a job that would be created by the new national legislation—the job of comptroller of the currency, with the responsibility of chartering the new banks. To his own amazement, McCulloch accepted, although,like Paul Volcker today, he had to take a large cut in income to accept a federal job. His “Advice to Banks,” issued with the first charters in 1863, remains to this day the best statement of how commercial banks should run. You can get a copy of it, printed on parchmentlike paper and suitable for framing, at the Bank Regulation Office of the Bank of England: “Let no loans be made that are not secured beyond a reasonable contingency. Give facilities only to legitimate and prudent transactions. Make your discount on as short time as the business of your customers will permit, and insist upon the payment of all paper at maturity, no matter whether you need the money or not. … Every dollar that a bank loans above its capital and surplus it owes for, and its managers are therefore under the strongest obligations to its creditors, as well as to its stockholders, to keep its discounts constantly under control. … ‘Splendid financiering’ is not legitimate banking and ‘splendid financiers’ in banking are generally either humbugs or rascals.”

Partly because this conservatism dominated the administration of the national banks, the state-chartered banks held on. At the beginning the state institutions were helped by the lunatic requirement in the federal law that a bank changing from a state to a national charter would have to drop its old name and call itself the First (or Second, or Tenth, depending on the order of applications) National Bank of its headquarters location. Banks with established names and reputations were unwilling to sacrifice their goodwill for the inconsiderable advantages that came with a national charter.

Later there were real advantages in switching to national status, for national banks were permitted to count among their required reserves only those interbank deposits they kept at other national banks, depriving the state-chartered banks of important “correspondent” business. For a while toward the end of the nineteenth century it appeared that the system of state-chartered banks would indeed fade away. What saved it, finally, was the greater flexibility (one might say, malleability) of state regulation. State-chartered banks could write mortgages and offer trust services, which nationally chartered banks could not.

As structured in Lincoln’s day, the national system was flawed in a way strange to modern bankers. The purpose of the new national banking system had been to provide purchasers for the government’s bonds. Nationally chartered banks were allowed to issue bank notes only to the extent of their holdings of treasury paper. Through the later years of the nineteenth century, the federal government steadily ran a surplus and reduced the national debt. As the quantity of government bonds in the hands of the national banks diminished, their note-issuing power was reduced.

The resulting deflation of the currency produced William Jennings Bryan and Populist agitation for the “free coinage” of silver. One factor and one alone makes a bank successful over time: It must have money to lend. In the desperate recession of the 189Os, a decade that was anything but “gay” for American workers and businessmen, the state banks, not shackled by the declining national debt, found money and revived.

One cannot exaggerate the importance of the local banker in the maintenance of local autonomy and diversity in a country being unified by the railroad, the telegraph, the national magazine, chain stores, nationally branded products, and then the radio networks. Because there was, in effect, a local market for money, local manufacturers of everything from beer and bread to bicycles could start out on a base of their own market. Unlike the situation in Europe, where national governments provided the funds for local improvement, American cities and towns could build their own schools and bridges, waterworks, and sewage treatment plants with bonds sold to (sometimes resold by) the local banks. Bankers were—still are—the big boosters of their communities. That New York never achieved in the United States the total dominance won by London or Paris or Berlin reflected in part the size of the country—but also the spread of financial capability through the operation of localized banks.

There was another side to the coin. Because banking is so much a matter of trust, and people trust those they consider most like themselves, banking became a bulwark of racism. There were significant Jewish investment bankers in New York from the 1870s on, and early in this century A. P. Giannini in California could build his Bank of Italy into the Bank of America (because he always had money: he built branches and solicited small deposits from people whom the established banks didn’t want to see in their palaces). But across the country, banking was white, Protestant, and dominated by old ethnic groups. No Irish need apply, and it was inconceivable that a bank would lend to a black businessman—or, for that matter, to a female proprietor.

Banking was stodgy, more a family business than most: the third generation of the manufacturing entrepreneur was supposedly back in shirt sleeves, but the bankers’ progeny stayed at the banks. And the system was monstrously inefficient in an economy rapidly growing more articulated. Just as banks in the old days had taken other banks’ notes only at a discount from their face value, the banks of the turn of this century would accept each other’s checks—unless both were in the same city and members of the same clearinghouse—only for something less than the full amount.

The method of linking the banks into a national monetary system was the “correspondent” relationship: a bank that kept its own funds on deposit with another bank in a distant city could arrange credit at that bank (and at other banks that were members of the same clearinghouse) for the checks its customers wrote on their home accounts. This arrangement was necessarily incomplete because there was a limit to the amount of money a country bank could leave idle at another bank for that purpose, and it was also a dangerous practice.

In the nature of the correspondent relationship, banks sometimes have positive balances and sometimes have overdrafts in their accounts. As the money markets concentrated in New York around the Stock Exchange, the New York banks became prisoners of the demand for funds on Wall Street. When J. P. Morgan and E.H. Harriman locked horns over the Northern Pacific Railway, the ready money of the country drained to New York; correspondents found their traditional overdrafts denied them, any balances they held from big-city correspondents drained away, and funds were very hard to come by. The result was that purely financial crises—such as the Bankers Panic of 1907—threw people out of work and left factories idle.

The Federal Reserve, created in 1913, designed to establish a national and stable banking system, was hedged with protections for the local banks. Nationally chartered banks had to be Federal Reserve members, but state-chartered banks did not (and, indeed, two-thirds of the nation’s banks did not become Fed members). The nation was divided into twelve “districts,” each of which had its own Federal Reserve Bank, charged with minding the store in its own region; and no two of the seven governors of the Federal Reserve could be drawn from the same district. In the 1920s Congress ordered federal regulators to make sure that every nationally chartered bank obeyed whatever basic regulations the states imposed on their own banks in that region. If a state forbade a bank to have branches, as Texas and Illinois and Georgia and many others did, then a nationally chartered bank would also be required to do all its business from one office.

The high point of protection for the local banker was the New Deal. The Depression had devastated the country banks, but the big-city banks had survived. President Roosevelt was happy to go with the verdict of history—small-town bankers were overwhelmingly Republican, anyway—and to see the fittest expand to fill the void. Congress rebelled and demanded deposit insurance, which would bring the funds back to the country banks, and Congress won. The package of New Deal legislation in finance was designed to shackle the banks in the metropolitan centers, and not only protect the country banks but also promote a new kind of local banking enterprise, the federally chartered savings and loan association, to assure the supply of mortgages. Rigid walls were built between the national stock market and the banks, between commercial banks and savings institutions, between insurance companies and deposit takers. With the Federal Housing Authority guaranteeing the home mortgages that were always a significant part of the state-chartered, country-bank portfolio, the local bankers only had to sit tight in order to make money.

This is the system that died, dramatically and by historical standards very suddenly, during the past four years. By the end of this decade the United States will have many fewer independent banks than it had at the beginning, and the link between local enterprise and local banking will be much weaker. Nobody is fighting very hard any more to preserve the local bank. The small-town bankers themselves, scenting in the neighborhood potential purchasers come to pay them more than their businesses are worth, no longer marshal their forces in the state legislatures or Congress to keep the giant banks off their turf.

Though interstate banking is still formally prohibited, the fact is that New York’s Citibank has already begun operating in California (taking deposits as “Citicorp Savings”) and in Maryland (as “Choice,” a credit card that permits its holder to build a positive, interest-bearing balance in his account) and several years ago won a charter to start a bank in South Dakota. Early in 1984, under restrictions that prohibit the New Yorkers from offering their other banking “products” through these new possessions, the Federal Reserve Board okayed Citicorp’s acquisition of failing savings associations in Florida and Illinois. Bank of America has been permitted to buy the floundering Seafirst in Seattle; North Carolina National Bank, using a loophole in Florida’s trust company legislation, has been able to purchase banks throughout that state. Beyond that, Sears and stockbrokers led by Merrill Lynch have begun in virtually every state what are banking operations in all but legal semantics. Household Finance has already become Household Bank in California and might one day convert all its one thousand offices to banking operations, complete with checking accounts.

In part, the galloping nationalization of the banking business is the result of fecklessness in the management of the currency by a succession of administrations in Washington that did not understand the way people’s attitudes toward money and credit are warped by inflation. But the force driving America to a new pattern of financial institutions has been the change in communications and information-processing technology. Increasingly, both money and securities are no longer expressed by pieces of paper that must be sorted and stored in ways that leave a ledger and an audit trail. Instead they are electronic blips, no different in their nature from the other electronic blips that all companies with computers routinely generate and preserve in magnetic media.

Money is now moved, credit is extended, and financial purchases are consummated at the touch of a key, from almost any place on earth to almost any other place. Where once a local banker had preferential access to the funds of his neighbors, now a salesman for a money market fund can pick up a telephone and siphon away a bank’s deposit base simply by offering a higher rate of interest. Nationwide mortgage bankers, affiliated with stockbrokers or real estate brokers, can compete with local banks for that most local of loans, the home mortgage. Commerical credit companies backed by such giants as General Electric can offer local business owners the financing they require, quite possibly on terms more advantageous than those available at the local bank.

Ten years ago, when I was completing work on my book The Bankers, I kept running into counties and even states where the interest paid by the banks for funds and the interest paid by their debtors for loans were wildly different from those in the metropolitan centers. Wisconsin had a pattern of mortgage loans quite different from that in other states. Montana bankers would say that they couldn’t charge ranchers what the New York banks were charging retailers because they’d be run out of town on a rail. Returning to this business to write a sequel, I found national markets everywhere—Montana bankers who were shipping half the resources of the bank “upstream” to the money markets, where the rates were higher, and Wisconsin bankers who were offering only the mortgages the Washington-based national mortgage associations were willing to purchase from them.

Even where local bankers survive, they now perforce float in the direction of the national tide, whether they like it or not. In Texas, Florida, Iowa, and Georgia—where, for generations, the law has prohibited banks from opening branches—the great majority of the local banks are now owned by statewide holding companies.

Nobody has begun to do the social analysis of what is implied—on the ground, close to home—by the homogenization of money and of banking. We are looking once again at one of those trade-offs between efficiency and idiosyncracy that make up the long-running drama of our time, and it puzzles us. What we can say is that we have reached the end of a long era in the uniquely American history of an occupation central to this society. What we must now decide is not what we wish to preserve from a past that is gone, but what we wish to create on a green field.

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