Chapter 2The First Narrowing of Bank Lending

To address these constant panics, the first set of changes began, as it always would, with a crisis – in this case, The Civil War. The Civil War forced the Union to finance itself, and a patchwork of thousands of state banknotes was an obstacle to both war finance and commerce. So, the National Banking Acts of 1863 and 1864 were written to create the OCC and allow banks to get a federal charter instead of a state charter. The intent of the acts was to create incentives that limited funding of state banks and direct more funds to national coffers to fund the war effort, and a follow-on law in 1865 imposed a 10% tax on state banknotes that pushed banks toward national charters. National banks, in turn, were required to buy U.S. government bonds to back the notes they issued.

With a federal charter came, for the first time, rules on what a bank could do. Unlike state-chartered banks, nationally-chartered banks faced minimum capital requirements. They could lend no more than 10% of their capital to a single borrower, and they were prohibited from lending against real estate.¹ The logic was there - a bank funded by deposits payable at any time should hold assets that convert quickly to cash, and land does not. This is the first time we see a rule that would govern American banking thought, which held that appropriate bank lending meant making short-term, self-liquidating loans – e.g. finance the merchant’s inventory and get repaid when it sells - and never fund anything whose payoff takes years.

Everything the early banks had funded (for better or worse), like the mill that took five years to pay off, the land that becomes a town years later, the venture that is nothing but a capable man and an idea, was now, by definition, improper. Not illegal for everyone; merely improper for banks. The initial infinite pool of investments available to banks had its first drawn boundary.

Projects that needed funding that fell outside this new boundary did not disappear, they just had to find new sources of funding. This is where the pattern mentioned in the Prologue and that repeats itself throughout this paper makes its first appearance. That pattern is:

Sometimes that less regulated source of capital catalyzed the next crisis, but in most cases, it worked to fill a gap that was left when banks were forced out of a market. In this case, a capital gap formed around farm credit, which was starved by the real estate prohibition, and the gap was filled in part by state-chartered banks, trust companies, life insurance companies, farm mortgage companies and land brokers which could do what national banks could not. Some loans were financed by individual private lenders, as well as local merchants and storekeepers, with merchants fronting supplies to the farmers who claimed the farmer’s unharvested crop as collateral.

In some cases, the needs of some industries were too big for the banking system altogether. In those cases, a gap was created naturally rather than through regulations. The greatest capital need of the age, the railroads, outgrew banks entirely and was funded instead by the “investment house.” J.P. Morgan’s firm and its peers syndicated railroad bonds to investors across two continents, launching the American version of the merchant banking system prominent in Europe. While the railroad’s financing needs were larger than what banks could offer, some argue that the emergence of these investment banks was invented from necessity, as the long-term nature of building out railroad systems would have disqualified them from the banking system anyway.