National Bank Act - Background

Background

For most of the nineteenth century, the American banking system consisted of state chartered banks. The paper currency issued by state chartered banks had to be redeemable. Depending on the state, the capital requirements for banks, set forth in the bank charter, differed. If a bank could not redeem its bank notes for money (gold or silver), the bank had committed fraud and was subject to proscecution. Most of the state chartered banks in the North and East created redeemable currency against Bills of Exchange (Real Bills) under the Real Bills Doctrine set forth by Adam Smith. (See "The Wealth of Nations", 1776 by Adam Smith). Real Bills were negotiable instruments, payable in 90 days, which banks discounted. Real Bills were a means of financing production of consumer items moving to market. Banks created uniformly denominated redeemable bank notes against the value of the Real Bills in their inventory.

If redemption demands exhausted their gold or silver reserves, these banks could rediscount the Real Bills to obtain gold or silver. The discounting of Real Bills by banks was particulalrly suited to the banking business in the industrial states of the North and the East of the country. As to the state-chartered banks, predominantly located in the West and South, many practiced fractional reserve lending for lack of availability of Real Bills to discount. Fractional reserve lending depended on low demand to redeem the paper currency. Fractional reserve lending amounted to the issuance of multiple demand receipts for the same amount of gold and silver held by the banks. Holders of this kind of paper currency could redeem it only at the bank's branch office.

Though each and every state chartered bank issued its own redeemable currency, because of its denomination in US dollars, each bank's currency was nominally the same as any other banks currency. The difficulty lay in judging the ability of an issuing bank to be able to promptly redeem their currency for gold or silver. It was therefore extremely difficult for currency to serve as a means of exchange for inter-regional parties. In 1816, the Second Bank of the United States was chartered by the U.S. Congress for a twenty year period to create irredeemable currency with which to pay for the costs of the War of 1812. The creation of congressionally authorized irredeemable currency by the Second Bank of the United States amounted to taxation by inflation. The Congress did not want state chartered banks as competition in the inflation of currency.

Because fractional reserve banking does amount to inflating a currency, the states agreed to curtail fractional reserve banking engaged in by the "wildcat" banks by tying the amount of currency these banks could issue to the amount of gold and silver coin they held. When the charter for the Second Bank of the United States expired in 1836, "wildcat" banks resumed unsound and unregulated lending. As Americans began to head West, these institutions began to issue more and more currency as a means of facilitating land speculation. This at-will adjustment of the money supply caused all forms of currency to fluctuate wildly in value. The issuance of currency by multiple banks also led to a nationwide counterfeiting problem that left the public wondering not only how much their money was worth but whether it was real. To solve the problem, the Jackson administration passed an order that voided paper currency in the eyes of the national government, agents of the government were allowed to accept gold or silver only as a means of payment for land. Note holders ran to banks to redeem their currency only to find that banks' stocks of gold and silver were depleted and banks were no longer extending credit.

Currency notes could be redeemed for only a fraction of their nominal value and land investors began to rely on loans from abroad. A wave of bank failures ensued, eventually leading to the Financial Panic of 1837 which included a six year depression. Some banks remained open and continued to issue notes, signaling no distinct end to the paper currency problem. Notes issued by solvent institutions circulated along with currency of insolvent institutions and notes of some smaller, unknown banks even traded at a discount. The currency problem eventually became so bad that a magazine was issued that included photos and descriptions of the various bank notes and information about whether the issuing bank was sound.