Early Banks and Financial Markets

What did Hamiltonian Finance Do to Encourage Financial Development?• It provided a stable macroeconomic environment

—government fiscal dilemma was solved• Large issues of tradable securities---U.S.

government bonds---useful asset for portfolios of individuals and financial institutions (In 2008 crisis, there was one safe asset—flight to U.S. bonds, their yield falls to 0.05%)

• First and Second Banks of the United States—proto-central banks—help to police behavior of other banks

The Modern Flow of Funds

BorrowersSavers

Financial Markets

Financial Institutions

Flows Returns

The Colonial Flow of Funds: Consequences for Growth?

BorrowersSavers

Financial Markets---non-existent

Financial Institutions Land Banks…..little else

Flows Returns

New Nation: New Institutions and New Markets

• Beginning in 1790, states are free to charter banks and companies

• Companies begin to issue stocks and bonds

Growth of Banks

Rapid Expansion in Early National Period

Growth of Securities Markets

Financial Markets: the appearance of organized exchanges for the

secondary market

• On May 17, 1792 a group of twenty-four traders gathered under a buttonwood tree at 68 Wall Street in NYC to determine conditions and regulations of the market. The Buttonwood Agreement, a simple, two sentence contract.

• “We the Subscribers, Brokers for the Purchase and Sale of the Public Stock, do hereby solemnly promise and pledge ourselves to each other, that we will not buy or sell from this day for any person whatsoever, any kind of Public Stock, at least than one quarter of one percent Commission on the Specie value and that we will give preference to each other in our Negotiations. In Testimony whereof we have set our hands this 17th day of May at New York, 1792.

• BUTTONWOOD AGREEMENT--Two Key Provisions

– 1) Exclusivity: the brokers were to deal only with each other

– 2) Fixed Commissions: commissions to be 0.25%.

• The New Yorkers dedicated the Tontine Coffee House in Wall Street as their exchange in 1793.

• In 1817, they formed the New York Stock & Exchange Board with its own constitution and bylaws; its name was changed to the New York Stock Exchange in 1863

Institutions and markets quickly appear 1790-1840

BorrowersSavers

Financial Markets: For government, banks, insurance and “improvement” companies

Financial Institutions: banks

and insurance companies

Flows Returns

Real GDP p.c. 2000 $1790-1840

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Real GDP growth 1790-1840= 4% p.a., It is faster than Great Britain. Growth p.c. = 1%

(population 3.9 million to 17.1 million)So does financial development matter for economic growth?

Do they do anything?

Short Answer from Sylla

1800: US had paid in bank capital of $20 million, England $35 million (U.S. had half the population)

1825:US had paid in capital of $129 million, England $46 million !!!!

Why did the U.S. develop so fast?

Bodenhorn, A History of Antebellum Banking (2000)

State Economic Development

Did Financial Development Aid Early American Growth?

Financial Institutions and Markets a Key to Economic Growth

Rapid Growth of both in first 50 years of the US

How Well did the Institutions and Markets Perform

Measuring Performance• One measure---are funds delivered to their best

possible use? Will they flow to where there is the highest return. If they do so easily---then interest differences should be minimized and we would say that the markets are integrated.

• Another measure---are there any unexploited price opportunities? Markets that work well should not have these. If they don’t exist then markets are priced efficiently.

• What evidence does Sylla give for integration of markets?

• What evidence does Sylla give for markets being efficiently priced?

Integration and Efficiency

• Integration of markets: interregional arbitrage—prices differ New York, Philadelphia, & Boston on a given day but adjust with time it takes information to travel.

• Integration is also shown (partly) in the large international capital flows.

• Market efficiently priced U.S. 6% coupon bond and 6% deferred coupon bond (no interest for 1st 10 years)….similar yields when adjust for the present value of missing interest payments

Empirical evidence for Sylla’s argument?

U.S. Long Term Bonds

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U.S. Long Term Bonds British Consols

1787 Yield on certificates was 26%, while British yield 4.08%

26%

Financial Institutions or Markets

• In this era, banks are much more important.

• Why?

• Are there any constraints on the development of bank, 1790-1840?

YES!• After passage of the Constitution, states

forbidden to issue “bills of credit.” • Many resist broad based taxes----instead focus

on chartering banks as a source of revenue.• States hold stock and received dividends.• Charter were of limited number of years—

renewal required bonus payments.• States resisted competition because this would

drive down profits of banks• Partial Solution—some states tax bank capital

and have an incentive to charter many banks• NOW…..a little chronology………

Bank of North America• First bank chartered in U.S., 1781. Approved by

Congress and State of Pennsylvania. Key promoter Robert Morris, Superintendent of the Treasury.

• [Next: Bank of New York, key promoter Alexander Hamilton, 1784, then Bank of Massachusetts, 1784]

• Office in Philadelphia, capital $400,000. • Bank makes loans and issues banknotes. When

states can no longer issue bills of credit---banknotes by state-chartered institutions provide a paper medium of exchange.

• Loans were short-term 30 to 60 day loans at 6%. Short-term to limit risk and ensure liquidity.

• Accepted deposits of specie and settled accounts through transfer of checks.

Bank of North America• Treasury officially recognized BNA bank notes

as legal tender in payments of debts and taxes to federal government.

• BNA makes loans to Treasury that help to smooth out flow of its revenues.

• First financial institution to maintain continuous specie convertibility for its banknotes---value is sustained.

• Primary lending was to merchants and especially to those directors on its boards---was there a good reason for this?

• Yet, Conservative management. Modest portfolio of interest earning loans. Earns high dividends, 1782, 8 ¾ % 1783 and 1784 are 14%

Schwartz: Banking in Philadelphia

• What evidence is there that banking was not competitive?

• How was competition blocked?

• How many banks are needed before banking becomes competitive?

Schwartz: Banking in Philadelphia

• Many merchants—especially Quakers feel excluded, propose Bank of Pennsylvania and gets charter

• BNA fearful– BP will cuts profits– Drain specie reserve from BNA as public pays

for BP shares: Robert Morris—not enough specie available

– Schwartz: fallacy because ignores only fraction of specie held by the banks—rest by the public

• Does BNA suffer? Dividend: 13 ½% 1791, 12½% 1792, and 12% for next 6 years.

Schwartz: Banking in Philadelphia

• Philadelphia Bank seeks charter 1803. PB offers large fee for charter plus $100,000 interest free loan and a subscription to its stock to the state.

• PB opposed by BP---argues that more banks will reduce value of state’s investment in BP. BP offer $100,000 interest free loan and other inducements worth $440,000

• PB offers fee of $135,000 plus $300,000 in bank stock subscribed and it succeeds.

• After PB suceeds, opposition to new rivals becomes muted. Farmers & Mechanics, 1809

The Arrival of Competitive Banking!

Other States?• Charters granted by state legislatures• Organizers petition must state legislature• Competition: in NY 1836---93 petitions for

charters but only 12 granted• Corruption

– Merchants Bank of NY (1805): legislators offered shares in bank with a repurchase at 25% over par

– Bank of Virginia (1804) state reserved right to subscribe to 20% of shares worth $300,000 and bank lends money to state to purchase.

• Why? Huge rents to be earned from limited entry or monopoly.

• Sets stage for the revolt against “chartered banking” in favor of “free banking”