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.