Commercial Banking in Colonial AmericaBy Robert E. Wright
"A discussion of economic theory and practice is likely to antagonize the student of political history. To begin a political study in this manner may therefore be courting disaster. But, like it or not, certain political events are unintelligible without reference to some kind of economic framework." -- Joseph Albert Ernst, Money and Politics in America, 1755-1775, A Study in the Currency Act of 1764 and the Political Economy of Revolution, (Charlotte: University of North Carolina Press, 1973), 3.
In the decades following these first attempts in Philadelphia, New York, and Boston, commercial banking endured political attacks, economic depressions, and angry mobs. But through it all, banking so seeped into the lives of Americans that life without them is now hard to imagine. In this last decade of the twentieth century almost everyone has a bank account, a credit card, a student loan, a car loan, or a mortgage. Even those with no direct dealings with banks have received a check from an employer or the government payable "at bank."
Although most people today use banks and study about banks in school, it is necessary to describe the functioning of early banks for two reasons.4 First, some aspects of banking have changed since the Early National period. Second, the general public misunderstands or does not appreciate many of those aspects of banking that remain unchanged.5 The rest of this section, then, will describe the similarities and differences between early commercial banks and today's banks in an effort to introduce readers to technical terms and themes important to the rest of the study.
In the Early Republic there were two very distinct types of banks, commercial and savings. Today, the same bank will perform many different economic functions.6 They will accept all three types of lodged deposits: time (certificates of deposit and other high interest but illiquid7 savings), demand (checking and low interest but withdrawable or liquid savings), and special (safe deposit box).8 They will create deposits by loaning money on security of vacant land, improved land, personal property,9 or a customer's promissory note (a written promise to repay the obligation). Many offer a revolving, unsecured type of credit, at extremely high rates of interest, that customers activate by a plastic card embossed with special numbers. Today's banks will also make exchanges by allowing customers to buy and sell foreign currencies. They will make special dealings with businesses. Finally, one bank, the Federal Reserve, issues bank notes, the green pieces of fiat paper with portraits of Washington, Lincoln, Hamilton, Jackson, Grant and other statesmen that pass easily among us.
In early national New York banking functions were not integrated. Distinct institutions performed different banking functions.10 Today, it makes little difference to most people whether their money is in a savings bank, a credit agency, or a commercial bank.11 In the Early Republic, savings banks only maintained lodged time deposits for individual use.12Loans or credits to purchase unimproved land came from the land owner,13 be it an individual, a large company such as the Holland Land Company,14 or the government.15Sometimes, wealthy personal friends supplied funds. Country banks, which were nominally commercial banks, but which broke many of the rules of strict commercial banking, also loaned money for real estate.16 Insurance and Trust companies did too.17 Individuals and, as we will see, country and city banks, made personal loans backed only by promissory notes,18 though the latter usually tried to hide the fact. Unscrupulous brokers and "monied" individuals broke the state's usury laws to supply short-term unsecured credit at high interest. Merchants, brokers, and commercial banks conducted currency exchanges.19 Commercial banks accepted special and demand deposits. They also created deposits by loaning "money of account" that could be drawn on by check or draft. Finally, commercial banks, and sometimes other corporations, both public and private, used loans to issue their own promissory notes payable to the bearer on demand.20
The nature of the notes was quite different from today's Federal Reserve notes. The notes of commercial banks were redeemable in specie. By presenting the note at the bank of issue, the bearer received the note's face value in gold or silver. Merchants considered bank notes the equivalent of specie.21 A bank that could not convert its notes into gold or silver was considered insolvent and could lose its charter.22 Although physically similar to the notes of the Early Republic,23 today's Federal Reserve notes24 can be used to purchase gold and silver, but no one is under any obligation to make the sale.
Commercial loans were different from the typical consumer loan of today. Bankers called these loans "discounts" because the bank took the interest up front. A commercial bank making a $1,000 loan at 6% interest per annum payable in three months would give the borrower $985.26 At the end of the three months the borrower27 would have to pay the full $1,000.
The forms of collateral security for these loans or discounts were also different from today's. Bankers made discounts on evidences of commercial transactions called "commercial paper." For centuries,28 the most common type of commercial paper was the bill of exchange.29 According to the foremost nineteenth-century authorities, "a Bill of Exchange is a written order or request by one person to another, for the payment of money."30 The use of bills arose over centuries for the convenience of merchants and for the safety of their specie. For example, suppose a New York merchant owed an English manufacturer for some goods shipped to America. At the same time, an English food importer owed the same New York merchant for flour shipped to London. It would be dangerous, costly, and unproductive for the merchant to ship specie to the manufacturer and receive specie from the food importer. Instead, the merchant could pay the manufacturer [his creditor] by drawing a bill of exchange on the importer [his debtor]. The manufacturer could get his specie from the food importer, while the latter would deduct the amount of the bill from the New York merchant's credit in his account books.31
In this transaction, the New York merchant is called the "maker" or "drawer" of the bill. The food importer, the merchant's debtor, is called the "payer," "drawee," or, after the amount of the bill has been accepted or acknowledged, the "acceptor." The debt expressed on a bill of exchange does not have to be admitted or accepted, in which case the bill is "returned" or "protested."32 The "payee," in this case the manufacturing firm, is the person or firm receiving the money. The bill is said to be drawn "in favor of" the payee. Transactions were rarely this simple, however, because the manufacturing firm was obliged to pay for the raw materials of the goods it shipped to New York. Also, bills of exchange were rarely payable "at sight" or "on demand" but had time "to run" before payment was due. Instead of waiting to get specie from the food importer, which might be payable at an inconvenient time or place, our hypothetical payee, the manufacturer, could "indorse" the bill by signing the back of it and use it to pay one of his creditors. The party taking the bill in payment is called the "indorsee." An indorsee could, in turn, become an "indorser" by signing the back of the bill and proffering it for payment to yet another party.
As the bill came close to its due date it was likely to be remitted or sold to someone able to redeem it.33 In most cases the acceptor paid the bill and this mercantile instrument served as a type of currency, helping to cancel a number of debts. If the bill was protested for nonpayment, however, a legal nightmare ensued.34 The lex mercatoria, or law of merchants, considered the payer of the bill the original and principal debtor, and primarily liable. The drawer and all indorsers were sureties.35 If the payer would not or could not pay, the bearer, the last to receive the bill in payment, could sue each of the indorsers and even the drawer of the bill.36 There was often a flurry of letters and sometimes a chain of lawsuits until all the debts, once thought cancelled, were again made good.37
Commercial banks interceded in this process, ameliorating and rationalizing the use of bills of exchange.38 Instead of holding a bill until it came due, or indorsing and passing it, merchants in towns with commercial banks could offer the bill for discount.39 If the bank felt the acceptor40 was likely to pay the bill on time without hassle, the bank would have the bearer or discounter become an indorser by signing the back of the bill, take possession of it, and give the discounter, in the bank's own notes, specie, or money of account, the face value of the bill of exchange minus interest.
Dealers offering bills for discount were willing to suffer the loss of the interest for several reasons. For some transactions, like the East Indies trade, only specie was accepted in payment.41 For other transactions, like paying one's hired help or buying a little food at market, bills of exchange were much too large. Bank notes, with their varying denominations, were ideal for making numerous, small, local remittances. Also, bills discounted by banks were somewhat less likely to come back to haunt the discounter because banks usually held on to them until they became due,42 cutting down on the number of litigants in case of protest. Most importantly, discounts made merchants more liquid, giving them cash in hand to make remittances or extend advances immediately. Liquidity, as will be shown in the next chapter, was a crucial factor in business in early national New York.
The discounting of bills of exchange and other forms of commercial paper, then, characterized and defined commercial banking.43 The issue of bank notes and the creation and maintenance of demand deposits supplemented and facilitated this special form of loan activity. Private merchants also made discounts but savings banks and land offices never did so. For a long time historians thought that discount and note issue were the only major banking functions performed by commercial banks. This erroneous assumption arose because of the prevalence of the "real bills" doctrine in the mid and late nineteenth century. The loan practices of most New York banks was far from the "real bills" ideal.