All Commentary
Monday, June 1, 1987

Banking Before the Federal Reserve: The U.S. and Canada Compared

The government was meddling with banks long before the establishment of the Fed.

The recurring financial panics in the U.S. during the 19th and early 20th centuries led Congress to establish the National Monetary Commission in 1908 to study the problem and recommend a solution. After several years of study and debate, Congress passed the Federal Reserve Act in December 1913. Even though the Federal Reserve did not prevent the Great Depression, and even though it has permitted substantial inflation since World War II, many observers still believe that some Federal control over private banking is needed to prevent the bank suspensions and failures that brought such instability to the economy in the pre-1914 years.

The purpose of this paper is to show that it was only government interference into banking before 1914 that prevented the U.S. from having a stable monetary system. Restrictions on banknote issuance, severe limits on branching, and regulations forcing banks to hold useless, idle cash reserves made the American banking system vulnerable to panics while other nations, such as Canada, avoided these crises. It also will be shown that even though Canadian banks were allowed more freedom of action, the few restraints that did exist led the Canadian government to intervene further into banking to undo the harm that otherwise would not have existed.

U.S. Banking Before 1863

Only two quasi-governmental banks were allowed to establish interstate branches in this period, the First United States Bank (1791-1811) and the Second United States Bank (1816-1836). The federal government owned one-fifth of the capital of each bank, causing political resentments which resulted in neither bank’s twenty-year charter being renewed.

When the charter of the Second United States Bank was not renewed, all banks were either chartered by the various states or given permission to operate without a charter under the so-called “free banking” laws. No banks were allowed to branch across state lines, and some states prohibited branching altogether. This prevented a natural system of nationwide clearinghouses from developing to exchange banknotes and later, deposits. Thus, when these banknotes ended up at great distances from their point of issue, they often fell to a discount. Banknote reporters tried to keep the public informed about the value of these various notes, but some fraudulent issuers were able to take advantage of the lapse of time until this information was disseminated (Rolnick & Weber, p. 14).

Some banks, particularly in cities along the eastern seaboard, were able to maintain a stable Value of their notes. The best known was the Suffolk system, which operated in the Boston area. The Suffolk Bank was able to keep smaller regional banks from overissuing by means of a clearinghouse. Banks that refused to join the Suffolk system had their notes collected and immediately presented for payment in specie; those that joined were able to count on their notes being received at par.

One problem with the so-called “free banks” was the requirement that they hold a number of state bonds equal to the banknotes they issued. These bonds often proved to be an illiquid investment for the banks, preventing them from holding the desired amount of specie to redeem their notes on demand. Since this requirement usually specified par rather than market value of the bonds, these securities in many cases were an inadequate protection for the note-holder (Rolnick & Weber, p. 16). Six states attempted to ease public fears about irredeemable banknotes by establishing a note guarantee system (FDIC, 1953, pp. 45-46)—which might not have been necessary had banks been free to branch and to hold the type of assets they preferred.

The National Bank System

Two of the methods used to finance the Civil War involved money manipulation. One was the issuance of a fiat currency (greenbacks) which was given legal tender status, and the second was the establishment of the National Banking System as a convenient place to sell low-interest bonds. The war led to the federalization of the U.S. currency because national banks were the only issuers of banknotes after Congress taxed the state banknotes out of existence. These new, uniform national banknotes were almost a government currency because they were printed by the Bureau of Engraving and the banks were forced to hold $100 of these 2 percent government bonds for each $90 of notes they issued.

This system proved to be no improvement over pre-Civil War banking; it was just as prone to panics and to suspension of cash payments. The three main weaknesses of this new system, which were avoided in Canada, were: lack of branching, forced holding of a specific cash reserve, and a government bond-backed banknote. These governmentally imposed restrictions put the U.S. banking system in a straitjacket, making it vulnerable to shocks.

All national banks were forced to be unit banks except for those state banks that convened to a national charter were allowed to retain their intrastate branches. Nationwide branching would have been more stable and efficient, permitting safer bank portfolios through geographical and industrial asset diversification. Unit banks in farm states were at a special disadvantage during agricultural depressions, whereas Canadian banks could carry a non-per-forming loan to a farmer much more easily (Beckhart, p. 450). Branch banks can be opened more easily in new areas without the trouble of acquiring a new charter and establishing a separate board of directors (Dunbar 1904, pp. 195-197). In addition, branch banks can move reserves to where they are needed more quickly, and at lower cost, since they are held within the same institution and no other bank need profit on the transfer of these funds (Breckenridge, p. 377).

Secondly, national banks were forced to hold a fixed cash reserve against their deposit liabilities, even though any reserve that must be held is no reserve at all since it cannot be used. The law mandated that country banks hold two-fifths of their 15 percent reserve in vault cash while the rest could be on deposit in a reserve city bank. These reserve city banks were required to hold half of their 25 percent reserve in vault cash while the other half could be deposited in a central reserve city bank in New York, and after 1887, Chicago or St. Louis. The latter banks were forced to hold all their 25 percent reserve in vault cash, which meant gold, greenbacks or other treasury currency. Only state-chartered banks could count national banknotes as part of their reserve.

Since banks could not use these required reserves, they had to carry an excess amount in order to operate; in a crisis, banks often had to suspend cash payments precipitating financial panics. The pyramiding of reserves in a unit bank system aggravated the problem. When faced with an increased demand for cash, each bank had to think of itself first and would pull its deposits from its correspondents. By contrast, each Canadian bank held its own reserve in whatever amount it felt adequate, with the one provision that government-issued Dominion notes had to consist of 40 percent of whatever cash reserve the bank chose to hold (Breckenridge, p. 242). The pyramiding of reserves in the U.S. made American bank runs contagious; in Canada, a bank failure did not cause the public to distrust other banks.

The third restriction on national bank behavior that weakened the system was the requirement that each bank deposit with the Comptroller of the Currency $100 worth of 2 percent government bonds for each $90 of banknotes they issued. (In 1900, banks were permitted to issue notes equal to the number of bonds deposited.) Since these notes were printed by the Bureau of Engraving and were uniform in appearance, they were received and paid out by banks throughout the country. This system failed to test the ability of each bank to redeem its own notes as did the Canadian system with its distinctive banknotes (Dunbar 1917, p. 228). Yet underissuance rather than overissuance was the problem with national banknotes because of the government bond restriction.

Liquidity Crises

The value of these special bonds, rather than the demand for banknotes, became the constraint on banknote issuance. Some national banks never issued notes at all while others charged higher interest rates to borrowers who demanded loan proceeds in banknotes instead of deposits. The reduction of the Federal debt in the 1880s intensified the problem as evidenced by a decrease in banknotes outstanding from $325 million in 1880 to $123 million at the end of 1890 (Dunbar, 1917, p. 232). This underissuance of banknotes led to several liquidity crises which only U.S. banks suffered because they could not exchange one liability for another—banknotes for deposits- -as the public demanded. Instead, they had to pay out legal tender cash from their assets, thus depleting their reserves, which often led to suspension of cash payments.

By contrast, Canadian banks have not suspended cash payments since the late 1830s. All banks were allowed to issue their own distinctive banknotes without holding a legally mandated asset to back them. These notes were subjected to the daily market test of public acceptance as each bank sought to get its own notes into circulation while simultaneously driving home rival notes to their respective issuers through note exchanges. Furthermore, these banknotes were an inexpensive till-money because they were not a liability until issued (Beckhart, p. 377). This reduced the cost of establishing branches in newly developed areas.

Canadian banknotes also had excellent elasticity, expanding and contracting as the demand for them changed. This was especially evident during the autumn when crops were moving to market and the demand for banknotes sometimes increased as much as 42 percent of the yearly minimum (Curtis, p. 20). During the Panic of 1907, some Canadian banknotes even circulated in parts of the U.S. after American banks suspended cash payments (Johnson, p. 78).

The only government restriction on the issuance of Canadian banknotes was an unnecessary one that proved to be harmful in the early 20th century. No bank was permitted to issue notes in excess of its paid-in capital, which excluded the surplus account. When passed in 1871, no bank had approached that limit, but by 1908, some had. But instead of removing this unnecessary restriction, Parliament passed a special law that year permitting banks to issue notes to an amount 15 percent over their combined capital and surplus accounts during the crop moving season if banks paid a 5 percent tax on this excess issue. Banks obviously disliked this tax so, in 1913, Parliament passed another law which allowed banks to avoid the tax if their excess issue were fully banked by deposit of gold in the newly-created Central Gold Reserve in Montreal (Neufeld, p. 108). Banks in Canada had only about a year’s experience operating under these new provisions before World War I broke out which saw the Canadian government undertake inflationary wartime measures, such as suspending the gold standard and permitting banks to borrow fiat base money from the Minister of Finance.

Emergency Currency: The Illegal Clearinghouse Loan Certificate

In times of crisis when U.S. national banks were forced to suspend cash payments, these banks cooperated through their respective clearinghouses to issue a free market money which, though illegal, worked quite well in preventing the contagious runs that were to implore the whole system in the early 1930s. The clearinghouse allowed unit banks to put up a united front in times of panic by marshaling the resources of all the members, thereby stretching the scarce supply of currency. The clearinghouse would authorize the issuance of loan certificates which banks with deficits could use instead of regular currency to settle their balances after these banks pledged acceptable securities as collateral. Banks holding surpluses accepted these loan certificates as payment to earn the 6 percent interest that was paid on them (Timberlake, pp. 4-6). If a deficit bank failed and the collateral was insufficient to cover the loan certificates, the members of the clearinghouse had to share the loss.

During the Panics of 1893 and 1907, clearinghouses used small denomination certificates for hand-to-hand currency in addition to large denominations to settle their balances (Noyes, pp. 20- 22). The public obviously preferred legal currency to these small certificates as evidenced by the fact that the makeshift currency usually fell to a discount until suspension of cash payments ended (Andrew, pp. 507-509). Yet these free-market arrangements mitigated each panic by preventing the fractional reserve collapse that was to occur after the Federal Reserve was in operation. On the other hand, it is possible that these crises would not have occurred at all if U.S. banks had been allowed to issue banknotes without restrictions, to branch where they wanted, and not made to hold a useless cash reserve.

Emergency Currency: The Legal Aldrich-Vreeland Banknote

In the aftermath of the Panic of 1907, Congress passed the Aldrich-Vreeland Act of 1908 which authorized national banks to issue a legal emergency currency until a permanent solution could be found. This law, which was to expire on July 1, 1914, attempted to overcome two of the three shortcomings of the national bank system: the lack of branching and the rigid restrictions on issuance of banknotes. Any ten or more national banks with an aggregate capital of at least $5 million could form a national currency association to issue notes backed by commercial paper or other securities, rather than just the 2 percent government bonds to which banks had been restricted. These new banknotes, for which all banks in the association would be liable, could not exceed 75 percent of the market value of the securities backing them and, in addition, could not be issued until the banks in the association had regular government bond-backed banknotes outstanding equal to 40 percent of their capital stock. Congress further imposed a 5 percent tax on this emergency currency for the first month of its circulation and this tax was to increase by 1 percentage point a month until it reached a maximum of 10 percent (Comptroller 1908, pp. 73, 75).

Even though 21 national currency associations were formed during the next 6 years, no emergency currency was issued, either because the tax was considered to be excessive, or no occasion warranted it. Congress passed the Federal Reserve Act on December 23, 1913, but the new System did not begin operating until November 16, 1914. However, the Federal Reserve Act extended the provisions of the Aldrich-Vreeland Act for one year, until July 1, 1915. Ironically, had it not been extended, the Act would have expired before the need to use it arose. Congress also reduced the tax on the emergency currency to 3 percent for the first 3 months it was outstanding, after which the tax was to rise by half a point each month until a maximum of 6 percent was reached (Comptroller 1914, p. 12-13).

The occasion for using the new currency was the crisis following the outbreak of World War I in August 1914. Foreign holders of American securities tried to liquidate them for gold, and depositors tried to convert their deposits into currency, both of which put extreme pressure on bank reserves (Sprague, p. 517). Before banks could issue the new currency on demand, however, Congress had to repeal the restriction that banks could only issue it if they had bond- backed banknotes outstanding equal to 40 percent of their capital. Congress responded quickly, even increasing the aggregate amount of notes that could be issued (Wall Street Journal, August 5, 1914, p. 6).

For the first time, national banks could issue banknotes for deposits on public demand, thereby preventing suspension of cash payments which were so characteristic of past American crises. Even though only 1,363 of the 2,197 banks in the 45 currency associations in existence at that time actually issued the emergency currency, it was the immediate response to public demand that prevented the panic (Comptroller 1915, pp. 92, 99). Only $386.4 million was taken out during the emergency that lasted into the spring of 1915, but $368.6 million, or 95 percent of the total, was issued by the peak period in October (Wall Street Journal, November 3, 1914, p. 1). By the first week of January, 60 percent had been retired; the remainder was retired by the end of June, except for $200,000 in a failed bank (Comptroller 1915, p. 101).

Less than a fourth of the legal maximum was ever issued, with banks in New York City taking out 37.5 percent of the total; these banks were the first to issue the currency and the first to retire any and all of it (Comptroller 1915, pp. 100-101). This Act allowed national banks to act as Canadian banks would under stress, issuing banknotes as demanded and saving their gold and treasury currency for use as a reserve. State-chartered banks could use the emergency currency as part of their reserves, but as often happens, once they realized this currency was readily available, they, along with the general public, stopped demanding it. Much of the emergency currency sent to the interior was later returned to New York in its original wrappings (Wall Street Journal, November 14, 1914, p. 8).


From hindsight, we know that both legal and illegal emergency currency outperformed the Federal Reserve during the credit implosion of the early 1930s. Banks can respond to market forces if they are allowed to issue banknotes, which are an “inside money” just as are deposits, but they cannot issue “outside” Federal Reserve Notes. When the public found out that currency was not available, they demanded it all the more, precipitating the fractional reserve collapse during the depression.

The problems of pre-1914 banking in the U.S. involved too many government restrictions, not too few. Politicians may have believed that private banking was unstable, but had they looked to the Canadian model as a guide, they could have concluded that market forces can give us a successful banking and monetary system just as it provides us with food, clothing, and other necessities.


Andrew, A. Piatt, “Substitutes for Cash in the Panic of 1907,” Quarterly Journal of Economics 22, August 1908, pp, 497-516.

Beckhart, Benjamin H. The Banking System of Canada, New York: Henry Holt and Company, 1929.

Breckenridge, Roelift M. The Banking System of Canada 1817-1890. New York: MacMillan, 1895.

Curtis. C- A. Statistical Contributions to Canadian Economic His-too’. Vol. I. Statistics of Banking. Toronto: The MacMillan Company of Canada, 1931.

Dunbar, Charles F. Economic Essays. New York: MacMillan. 1904.

Dunbar, Charles F. The Theory and History of Banking. 3rd Ed. New York: Knickerbocker Press, 1917.

Johnson. Joseph French. “The Canadian Banking System Under Stress,” Annals of the American Academy of Political and Social Science 36, November 1910, pp. 60-84.

Neufeld, E. P. The Financial System of Canada. Toronto: MacMillan Company of Canada, 1972.

Noyes, Alexander D. “The Banks and the Panic of 1893.” Political Science Quarterly 9, March 1894, pp. 12-30.

Rolnick, Arthur J. and Weber, Warren E. “Free Banking, Wildcat Banking and Shinplasters,” Quarterly Review, 6, Federal Reserve Bank of Minneapolis, Fall 1982, pp. 10-19.

Sprague, O. M. W. “The Crisis of 1914 in the United States,” American Economic Review 5, September 1915, pp. 499-533.

Timberlake, Richard H. Jr. “The Central Banking Role of Clearinghouse Associations,” Journal of Money, Credit and Banking 16, February 1984, pp. 1-15.

U-S- Federal Deposit Insurance Corporation. Annual Report, 1953. U-S- Department of the Treasury, Office of the Comptroller of the Currency Annual Reports, 1908. 1914, 1915.

The Wall Street Journal. August 5, 1914; November 3. 1914; November 14, 1914.

  • Donald Wells teaches in the department of economics and L. S. Scruggs in the department of finance at Memphis State University, Tennessee.