IX.

History of Banking

A.

Origins of Banking

Many of today’s banking services were first practiced in ancient Lydia, Phoenicia, China, and Greece, where trade and commerce flourished. The temples in Babylonia made loans from their treasuries as early as 2000 bc. The temples of ancient Greece served as safe-deposit vaults for the valuables of worshipers. The Greeks also coined money and developed a system of credit. The Roman Empire had a highly developed banking system, and its bankers accepted deposits of money, made loans, and purchased mortgages. Shortly after the fall of Rome in ad 476, banking declined in Europe.

The increase of trade in 13th-century Italy prompted the revival of banking. The moneychangers of the Italian states developed facilities for exchanging local and foreign currency. Soon merchants demanded other services, such as lending money, and gradually bank services were expanded.

The first bank to offer most of the basic banking functions known today was the Bank of Barcelona in Spain. Founded by merchants in 1401, this bank held deposits, exchanged currency, and carried out lending operations. It also is believed to have introduced the bank check. Three other early banks, each managed by a committee of city officials, were the Bank of Amsterdam (1609), the Bank of Venice (1587), and the Bank of Hamburg (1619). These institutions laid the foundation for modern banks of deposit and transaction.

For more than 300 years, banking on the European continent was in the hands of powerful statesmen and wealthy private bankers, such as the Medici family in Florence and the Fuggers in Germany. During the 19th century, members of the Rothschild family became the most influential bankers in all Europe and probably in the world. This international banking family was founded by German financier Mayer Amschel Rothschild (1743-1812), but it soon spread to all the major European financial capitals.

The Bank of France was organized in 1800 by Napoleon. The bank had become the dominant financial institution in France by the mid-1800s. In Germany, banking experienced a rapid development about the middle of the 19th century with the establishment of several strong stock-issuing, or publicly owned, banks.

Banking in the British Isles originated with the London goldsmiths of the 16th century. These men made loans and held valuables for safekeeping. By the 17th century English goldsmiths created the model for today’s modern fractional reserve banking—that is, the practice of keeping a fraction of depositors’ money in reserve while extending the remainder to borrowers in the form of loans. Customers deposited gold and silver with the goldsmiths for safekeeping and were given deposit receipts verifying their ownership of the gold deposited with the goldsmith. These receipts could be used as money because they were backed by gold. But the goldsmiths soon discovered that they could take a chance and issue additional receipts against the gold to other people who needed to borrow money. This worked as long as the original depositors did not withdraw all their gold at one time. Hence, the amount of receipts or claims on the gold frequently exceeded the actual amount of the gold, and the idea that bankers could create money was born.

A.1.

History of Banking in the United States

A.1.a.

Bank of North America

The first important bank in the United States was the Bank of North America, established in 1781 by the Second Continental Congress. It was the first bank chartered by the U.S. government. Other banks existed in the colonies prior to this, most notably the Bank of Pennsylvania, but these banks were chartered by individual states. In 1787 the Bank of North America changed to a Pennsylvania charter following controversy about the legality of a congressional charter. Other large banks were chartered in the early 1780s by the various states, primarily to issue paper money called bank notes. These notes supplemented the coins then in circulation and assisted greatly in business expansion. The banks were also permitted to accept deposits and to make loans.

Because there were no minimum reserve requirements on deposits, bank notes were secured by the assets of the issuing banks. Most assets took the form of business loans. The only restraint on a bank’s ability to extend loans was the public’s unwillingness to accept its notes. Acceptance of a bank’s notes usually was determined by the bank’s record in exchanging the notes for coins when called upon to do so. Since most of them were able to do this, the early banks enjoyed wide latitude in granting loans.

In 1791 the federal government chartered the Bank of the United States, commonly referred to as the “First” Bank of the United States, to serve both the government and the public. One-fifth of the bank’s capital was supplied by the federal government. The bank was a repository of government funds and a source of loans for individuals and the federal and state governments. The charter of the “First” Bank of the United States was allowed to lapse in 1811, in part because half of its stock was owned by foreigners but also because of opposition to the bank by more than 80 state-chartered banks. The main reason for the conflict between state banks and the “First” Bank of the United States was that the public preferred the notes of the Bank of the United States because of the bank’s excellent reputation. This made it difficult for state banks to attract customers.

A.1.b.

Second Bank of the United States

During the War of 1812, hard currency (coins) became scarce and many state banks stopped redeeming their notes for coins. This brought into question the underlying value of bank notes and limited their use as money. At the same time, however, banks began increasing the amount of notes they issued. This rapid increase in paper money caused prices to rise and created inflation. These developments created a demand for establishing the “Second” Bank of the United States, which was chartered in 1816. The bank had a stormy career. Many local bankers who had to compete with this government-sponsored bank opposed it, as did President Andrew Jackson. As a result of Jackson’s opposition, the federal government withdrew its deposits in 1833, and three years later, when the bank’s charter was not renewed, it went out of existence.

A.1.c.

Free Banking and the Safety Fund System

In 1838 New York State passed a free banking law. Before this date all incorporated banks had been chartered by states and had been granted the note-issuing privilege. Under free banking, charters could be obtained without a special act of the state legislature. The main requirement for new banks was that they post collateral of government bonds equal in value to the notes to be issued. In principle, noteholders were protected because, if the bank failed, proceeds from the sale of the collateral would be used to reimburse them. Free banking was soon adopted by other states. Because there was little regulation of new banks, many banks failed and bank fraud occurred. The free-banking years of 1837 to 1863 are also known as the Wildcat Banking era.

In New England, however, the Suffolk Bank in Boston, Massachusetts, had redeemed bank notes of out-of-town banks only if they kept on deposit amounts large enough to cover the redemptions. Since Boston was a trade center, the pressure was great on all New England banks to accept this system, known as the Suffolk banking system. Practically all New England banks had joined the system by 1825.

In the early 1800s New York State also developed the safety fund system, under which each member bank contributed a small percentage of its capital annually to a state-managed fund. The purpose of the fund was to protect noteholders in the event of bank failure. In 1842 Louisiana enacted legislation to limit the number of banks and to require them to maintain one-third of their assets in cash and two-thirds in short-term obligations.

A.1.d.

The National Banking Act of 1863

The Civil War (1861-1865) brought about the National Banking Act of 1863, and with it a fundamental change in the structure of commercial banking in the United States. Originally named the National Currency Act, but later amended and renamed, the National Banking Act created the system known as dual banking, in which banks could have either a state or federal charter. This system still exists in the United States. The act established the Office of the Comptroller of the Currency in the Department of the Treasury and gave it the power to issue national bank charters to any bank that met minimum requirements. The philosophy of relatively “free banking” continued until 1935 when Congress made it more difficult to obtain a bank charter. The 1863 act allowed nationally chartered banks to issue a uniform bank note backed by U.S. government bonds. The amount of the notes was not to exceed 90 percent of the value of the bonds. Officials hoped that the issuance of uniform bank notes backed by the U.S. government would guarantee the value of bank notes and thereby produce a useful nationwide currency, while also inducing state banks to take out national charters. However, because the regulations accompanying a national charter were much stricter than state charters, a movement toward federal charters did not happen as planned. In 1865 the U.S. Congress enacted a 10 percent tax on any bank or individual paying out or using state bank notes. As a result of the tax, many banks converted to national charters, but many others simply stopped issuing their own notes. Instead, these state banks began to issue their customers demand deposit money—that is, checking accounts, instead of bank notes.

By the 1870’s, deposits were well established as a substitute for paper or coin currency, and state banks experienced a revival. State charters contained several advantages over federal charters. State-chartered banks were allowed to hold lower cash reserves relative to deposits, and less capital. State-chartered banks had more flexible branching opportunities and fewer restrictions on the types of loans that could be made.

The National Banking Act was successful in correcting some failings of the pre-Civil War commercial banking system. It produced a unified national paper currency consisting primarily of national bank notes. Bank crises, however, did not disappear. Panics occurred in 1873, 1884, 1893, and 1907, although the causes of these crises varied. Between 1873 and 1907, demand deposits far outweighed bank note circulation. At times some banks were unable to make immediate payment of demands on these deposits. Consequently these banks failed, and their depositors suffered losses of all or part of the money in their accounts.

A.1.e.

Federal Reserve Act of 1913

The financial panic of 1907 resulted in the Federal Reserve Act of 1913. This act went further than any earlier legislation in recognizing the importance of stable money and credit conditions to the health of the national economy. Under the Federal Reserve Act, a central bank was reestablished for the United States, the first since the “Second” Bank of the United States. The new bank was charged with maintaining sound credit conditions. To achieve this goal, the Federal Reserve System was given control over the minimum amount of reserves that member banks must hold for each dollar of deposits. It also obtained the power to lend money to member banks and regulate the types of assets they can hold. Members of the Federal Reserve System include national banks, whose membership is required, and state banks, whose membership is optional. Membership requires a bank to buy stock in the Federal Reserve System. Most large banks under state charter have joined the system.

World War I (1914-1918) brought about inflation and a sharp postwar recession (economic slowdown). Although the banks had bought large quantities of U.S. government bonds during the war, they also lent large amounts of money to individuals engaged in stock market speculation. By investing in bonds, banks helped finance government expenditures during the war and the attendant expansion of American productive resources in the decade following World War I. By lending money to speculators, they became a major factor in the climb of stock prices and the wave of speculation that resulted in the crash of 1929.

A.1.f.

Banking During the Great Depression

The Great Depression of the 1930s dealt a severe blow to the commercial banking industry. Many banks failed (went out of business) when their loans could not be repaid. The number of commercial banks declined from 26,000 in 1928 to about 14,000 in 1933. Total deposits in these banks declined by about 35 percent. Depositors rushed to retrieve their money, a process known as a run on the banks, and the federal government was forced to close all the banks for four days in 1933 to stem the panic. It became apparent to observers that the Federal Reserve System had not solved all the problems of bank stability.

Consequently, during the Great Depression, Congress recognized the importance of a sound banking system and created a number of agencies to restore public confidence in the banking system. Among the first of these was the Federal Housing Administration, which was created in 1934 to insure payment on home loans made by private lending institutions. The guarantee helped preserve the value of bank loans and enabled banks to continue to lend money to homebuyers.

The Banking Act of 1933, also known as the Glass-Steagall Act, created the Federal Deposit Insurance Corporation (FDIC) to insure bank deposits, increase the confidence of depositors, and therefore prevent bank runs. Federal Reserve member banks were required to join the FDIC. Membership was optional for other banks. The Glass-Steagall Act also set interest rate ceilings on deposits to reduce competition among banks, which was considered a cause of bank failures during the Great Depression. It also prevented banks from becoming too involved in investment-banking activities, such as underwriting stocks or bonds for companies. Underwriting, which typically involves selling stocks or bonds at a guaranteed price, can be risky and can cause banks to fail. The act also prevented banks from buying stock, which is a risky activity if the stock market crashes. This prohibition on investment-banking activities lasted until the 1980s.

The banking system began to recover in 1934. By 1937 deposits had reached pre-Depression levels. During World War II (1939-1945), deposits increased rapidly and more than doubled from 1941 to 1946. For the next 40 years the U.S. banking system went through a continuous expansion and modernization. In particular, there was an enormous increase in lending to consumers, through installment loans (loans for a fixed amount repaid in equal monthly payments) and credit card loans (loans for a varied amount repaid more flexibly).

A.1.g.

Banking After World War II

Some of the legislation enacted during the Great Depression and in the immediate postwar period began to have negative repercussions on the banking industry by the 1970s, according to some experts. Interest ceilings on deposits, which were required by the Glass-Steagall Act, prevented banks from competing with unregulated money market funds or even bonds issued by the U.S. Treasury. As people withdrew deposits to earn higher interest elsewhere (a process known as disintermediation), SLAs found it increasingly difficult to raise funds to make mortgage loans. Many SLAs went out of business. Disintermediation was not the only problem SLAs faced, however. Many SLAs decided to venture into business lending in the early 1980s with drastic consequences as commercial real estate markets collapsed. Many business loans went bad and forced even more SLAs out of business. In 1980, 3,998 SLAs existed in the United States. By 1992 the number had dwindled to only 2,039. There were 672 SLA failures from 1989 to 1992 alone and over 1,200 overall. The SLA crisis ultimately led to the collapse of the Federal Savings and Loan Insurance Corporation. It necessitated a restructuring of deposit insurance in the United States and a government bailout of the SLA industry that cost taxpayers an estimated $200 billion.

Restrictions on how banks could expand geographically also affected the industry. The Bank Holding Company Act of 1956 prohibited bank holding companies from acquiring banks across state lines. As a result of geographic limitations on expansions, banks were forced to operate primarily in local markets, which made banks particularly susceptible to local economic downturns. This act also restricted the activities of bank holding companies, limiting them to only those activities that were closely related to banking.

Legislation enacted in the 1980s and 1990s began to address these issues. The Depository Deregulation and Monetary Control Act of 1980 eliminated ceilings on interest rates. The 1994 Riegle-Neal Interstate Banking and Branching Efficiency Act legalized interstate banking, allowing banks to diversify geographically.

The most sweeping legislation, however, took place in 1999 when Congress removed most of the remaining provisions of the Glass-Steagall Act and replaced it with the Gramm-Leach-Bliley Act, named after Republican Party sponsors Phil Gramm, Jim Leach, and Thomas Bliley, Jr. The act also removed some of the restrictions of the Bank Holding Company Act of 1956 by permitting bank holding companies to engage in the full range of financial services, including lending, deposit taking, investment advising, insurance, stock and bond underwriting, and other investment banking services. The act did not, however, allow bank holding companies to own nonfinancial businesses. Many observers believe that the new law will increase the dominance of bank holding companies and lead to the establishment of so-called universal banks that offer a full array of financial services, including traditional banking services, insurance, investment advice, and stock and bond brokerage services. Critics of the law, however, caution that the new law, combined with the provisions of the 1994 act that ended restrictions on branching and allowed nationwide banking, may ultimately diminish competition for financial services in the United States.