The US Banking System: Origin, Development, and Regulation
by Richard Sylla
Currency note of one shilling, six pence, printed in the colony of New Jersey in 1776. (Gilder Lehrman Collection)
Banks are among the oldest businesses in American history—the Bank of New York, for example, was founded in 1784, and as the recently renamed Bank of New York Mellon it had its 225th anniversary in 2009. The banking system is one of the oldest, largest, and most important of our industries. Most adult Americans deal with banks, often on a fairly regular basis. Nonetheless, banks and banking seem rather mysterious. What do banks do? Why have they for so long been an integral part of our economy? Why, ...view middle of the document...
The intermediation function of banks is extremely important because it helped to finance the many generations of entrepreneurs who built the American economy as well as the ordinary businesses that keep it going from year to year. But it is inherently a risky business. Will the borrower pay back the loan with interest? What if the borrower doesn’t repay the loan? What happens to the banking system and the economy if a large number of borrowers can’t or won’t repay their loans? And what happens if, in the pursuit of profit, banks do not maintain levels of reserves and capital consistent with their own stability?
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There were no modern banks in colonial America. Colonial Americans gave credit to each other, or relied on credit from merchants and banks in Great Britain. Money consisted of foreign coins and paper money issued by the governments of each colony.
There were no American banks as late as 1781, when young Alexander Hamilton, who would become the most financially astute of the founding fathers, wrote to Robert Morris, Congress’s superintendent of finance, that “Most commercial nations have found it necessary to institute banks and they have proved to be the happiest engines that ever were invented for advancing trade.” Hamilton recommended that a bank be founded, and a few months later Morris persuaded Congress to charter the new nation’s first bank, the Bank of North America located in Philadelphia. Three years later, Boston merchants founded the Massachusetts Bank and Hamilton became a founder of the Bank of New York. When George Washington became our first president under the Constitution in 1789, these were the only three banks in the United States. They were local institutions, not part of a banking system in which banks routinely receive and pay out one another’s liabilities.
Washington tapped Hamilton to be our first secretary of the treasury. In his first two years in office Hamilton moved quickly, and often controversially, to give the United States a modern financial system. He implemented the federal revenue system, using its proceeds to restructure and fund the national debt into Treasury securities paying interest quarterly. He defined the US dollar in terms of gold and silver coins; these would serve as reserves backing bank money as banks proliferated. And Hamilton founded a national bank, the Bank of the United States (BUS), a large corporation capitalized at $10 million, with 20 percent of its shares owned by the federal government and with the power to open branch banks in US cities.
Hamilton’s policies induced others to fill out the other major components of a modern American financial system. The BUS prompted state legislatures to charter more banks—there were about thirty of these by 1800, more than 100 by 1810, 500–600 by the 1830s, and 1500–1600 on the eve of the Civil War. These banks were corporations, and the states also chartered many non-bank business corporations....