The importance of intragroup funding – The 19th century US experience

This is a follow-up post to my previous one on banks’ intragroup funding.

Financial and banking historians have known for a long time what the BoE believes it has ‘discovered’. A prime example of the importance of being able to move funds around (whether under the form of capital or liquidity) is the experience of US banking in the 19^th century.

In the 19^th century, the US was plagued by recurrent banking crises. This was mostly due to strict limitations on the development and growth of banks that basically isolated banks from each other. The result was known as ‘unit banking’. I am not going to enter into all the details (and this post mainly refers to the North of the US) but I strongly advise you to check the references at the bottom of this post.

The US’ political arrangements made it very difficult for the federal government to charter banks on a national basis, as the experiments of the First and the Second Banks of the United States demonstrate. States, on the other hand, could charter banks of issue within their borders to help finance the states’ expenditures. They also tended to forbid interstate branching in order not to leak out sources of funds to other states and artificially limit competition within their borders, as banking monopoly rents led to more abundant funding resources for the states (taxes could account for close to a quarter or even a third of total state financing). Many large cities ended up having a single bank at the very beginning of the 19^th century.

The race for financing led states to charter increasingly more banks. However, new laws divided states into districts and allowed only a very limited number of banks to be chartered within each of them. Banks also did not have the right to open branches throughout the states. In the end, the whole banking system was completely fragmented in a myriad of small banks that enjoyed local monopolies.

From the 1830s, ‘free banks’ started to appear, a trend that accelerated following the 1837 banking crisis during which many banks failed throughout the country. This prompted a movement to increase competition in banking and access to credit for those who could not access the traditional, restricted, banking system. Free banks could be opened without any approval by state regulators. They still came to the funding need of state governments as the free banking laws required the full-backing of banknotes with high-quality securities, mostly government debt. Crucially, free banks were not allowed to branch. The previous system of larger banks that were constrained in their growth by their inability to open branch in other states, or simply in other districts, was progressively replaced by a system of a multitude of tiny ‘unit’ banks. In the end, the number of banks massively grew but unit banks often retained local monopolies. The federal government eventually tried to find ways to increase the number of nationally-chartered banks, but in the end those banks faced the same legal constraints that prevented free banks to branch.

There was political power behind those unit banks: because they couldn’t expand, unit banks were incentivised to lend to their local community even when times were tough (if they didn’t, they wouldn’t make any money and would fail anyway…). Banks were numerous (there were more than 27,000 banks in the US early-20^th century, 95% of which had no branches…) but geographically isolated. As a result, they suffered from high levels of concentration in their loan books and deposit base, and were particularly badly hit by local economic problems. Liquidity risk was high and banks could hardly get hold of extra funds to face bank runs when they occurred.

Some banks tried to organise themselves into holding companies, owning several unit banks. However, the law prevented any financial or operational integration between various banks. The only thing they ended up sharing was a common ownership structure. A partial solution came up with the setup of clearinghouses, which basically settled interbank transactions, but also played the role of coordinator during local crises.

As a result of this poorly-designed banking structure, financial crises were recurrent: there were 11 of them between 1800 and 1914.                 Post-clearinghouses crises were nonetheless milder as clearinghouses allowed some liquidity to circulate.

Where does this lead us?

I described in my previous post how intragroup funding allows banking systems to remain more stable by allowing liquidity to circulate from stronger entities to weaker ones (this also applies to capital).

The 19^th century US is an extreme example of what happens when you prevent this free movement of funds: a few banks fail and indirect contagion weakens even the stronger banks, leading to a systemic collapse. When banking groups are larger and free to move funds around, on the other hand, they have an incentive to reinforce their weaker links. Think about those 19^th century ‘bank holdings’, which could not operationally integrate their various unit banks: the collapse of one of their ‘unit bank subsidiaries’ could potentially endanger the existence of all unit banks owned by that holding company through economic and financial contagion. Wouldn’t it be simpler to allow the transfer of funds from one unit bank to another to prevent any failure in the first place and actually reassure depositors that their banks are solid?

Unfortunately, current regulations aims at fragmenting and isolating national banking systems (and types of banks). This is likely to transform our globalised banking system into a mild version of what happened in the US, rather than into the stronger and more resilient systems that regulators hope to build. In the US, each unit bank had to maintain relatively high levels of capital and liquidity given their inherent weakness and lack of diversification. Was it enough to prevent crises? Not at all. This is in contrast with the Canadian experience, whose banking system comprised a few, very large, lightly regulated, branching banks. The Canadian banking system remained very stable throughout the period (and later).

More on 19^th century Canada in a subsequent post.

Recommended readings:

• Charles A. Conant, A History of Modern Banks of Issue
• Charles Calomiris and Stephen Haber, Fragile by Design
• Christopher Whalen, Inflated: How Money and Debt Built the American Dream
• Milton Friedman and Anna Schwartz, A Monetary History of the United States

Update: I added one very important and great book to the list…