Understanding The S&L Mess

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The banks in the older Eastern cities were, not surprisingly, the largest and most conservative, and the Eastern states in general had the toughest banking laws. The Eastern banks issued the least paper money, relative to their capital; many issued none at all.

Rather it was the banks located in the frontier regions of the country, where the demand for credit was greatest and the need for banks’ magical ability to create money the most intense, that cranked out the most bank notes. The value of these Western bank notes varied according to both the perceived soundness of the banks that issued them and the distance of the banks from where the transactions took place. Many people made a living publishing guides known as bank-note detectors, telling which were good and which were not. By the 1850s there were more than seven thousand kinds of more or less valid notes in circulation in the country, along with more than forty-five hundred fraudulent and counterfeit ones. It was no less than a monetary Babel.

Some “banks” were deliberate frauds from the very beginning, their sole purpose being to issue as many notes as possible, get as much for them as possible, and then disappear. These were known as wildcat banks, because their headquarters were invariably located “out among the wildcats,” where they were hard to find. Florida authorities reported that they could find no local trace of one bank, chartered by the state in 1835, but added brightly that “it is said [to be] chiefly operating in New York.” Some states were not above aiding and abetting this practice. Nebraska, for instance, forbade banks chartered in that state to issue bank notes there but allowed Nebraska banks to issue them in Iowa. Iowa returned the compliment.

Nothing could show more clearly the regulatory anarchy that was American banking in the early years. The Constitution had made the United States a single common market, but the Jeffersonian inheritance made it nearly impossible to effectively regulate banks, through which the lifeblood of the American economy increasingly ran as we evolved from an agricultural, barter-based economy to an industrial, cash-based one.

Perhaps underlying Churchill’s famous backhanded compliment to democracy is the fact that true reform, however obviously desirable or even necessary, can often be achieved only during or after a great crisis. The American Civil War certainly qualified as a crisis and placed wholly unprecedented demands on the American economy and money supply.

The cost of the war forced the government (and the banks) off the gold standard—that is, they had to stop paying their bills in gold. The government began using printing-press money, the so-called greenbacks authorized in early 1862. Greenbacks were the first paper money the United States government had ever issued. (Salmon P. Chase, Secretary of the Treasury and a chronic presidential hopeful, took advantage of a golden opportunity for publicity by placing his own face on the one-dollar greenback.)

The value of greenbacks fluctuated relative to gold according to the fortunes of the Union Army. Just before Gettysburg it took $283 in greenbacks to buy $100 worth of gold. More than $400 million in greenbacks would be issued by 1863, and this great increase in the money supply drove the wartime inflation. But at least one could determine the value of the greenbacks at any time by looking in the newspaper. And the issuer, the United States Treasury, was unlikely to disappear.

Far more important to the American banking industry than greenbacks, however, was the establishment in 1863 of a national banking system. It was designed both to help finance the war and to reform American banking. It succeeded admirably in its first goal but only partially in its second.

The legislation called for the creation of nationally chartered banks. These banks had to have at least fifty thousand dollars in capital, a relatively large sum in those days, of which thirty thousand dollars had to be invested in U.S. Treasury securities. They could issue bank notes, but only those designed and engraved under the direction of the federal government, and these notes had to be backed by pledged Treasury bonds.

The first national bank was chartered on June 20, 1863, in Philadelphia. (One can only wonder if it is pure coincidence that Pennsylvania was the home to the first commercial bank, the first central bank, the first mutual savings bank, the first S&L, and the first national bank in the country.) It had been expected that the major state banks would switch over to national charters, but they were reluctant at first. By November 1863 only 134 national banks had been chartered, almost all of them new banks.

Changes in the law in 1864 sped conversions, but they still were undertaken by only a small fraction of the old state banks. So in March 1865 Congress passed a prohibitive 10 percent tax on bank notes issued by state-chartered banks. This was designed not to raise revenue but to force the state banks to take national charters. “The national banks were intended to supersede the state banks,” Sen. John Sherman, architect of the legislation, reported. “Both cannot exist together.”