Bank failures were commonplace in 19th century America but it would be wrong to presume no concerted effort was made to cure this epidemic. State governments grappled with the challenge of creating an environment conducive to bank formation and yet protected customers and others from the effects of a bank’s collapse. New York’s solution was to create an insurance scheme for bank liabilities, most notably banknotes and deposits, centered around a reserve called the ‘Safety Fund’. The model was copied by other states but ultimately failed to survive a financial panic in the 1840s.
The Safety Fund
In 1809, Farmers Bank of Gloucester, Rhode Island became the first bank to fail in the independent United States. The following decade saw a wave of bank failures. Banking then was an opaque activity; it was difficult to tell a sound bank from a troubled one and this meant even a single failure could trigger a wave of bank runs.
Bank failures were a great risk to holders of paper banknotes, issued by private banks, often as their primary source of funding. Someone who happened to be holding banknotes may have acquired them by chance in trade and often did not get to choose which banks they had exposure to. The failures of the 1810s got some thinking of solutions, but meaningful reform, undertaken by individual American states since regulating banking was then largely a state prerogative, would take time.
In New York, a wave of bank charter renewals and applications in the late 1820s forced action. Reform of the system would need to accompany such a great expansion in banking. Among the reforms proposed, New York settled on the creation of a banknote and deposit insurance scheme.
In 1829, a ‘Safety Fund’ was established in New York, part of a broader reform of the state’s banking system. This system of coinsurance was suggested by Joshua Forman, a businessman from Syracuse, New York and was advocated by the governor of New York, and future American President, Martin van Buren. It was the first bank-liability insurance scheme in the United States. Forman was inspired by the regulatory system of Hong Kong merchants who were required to insure one another’s debts should they hold a special charter allowing them to trade with foreigners.
Since the most significant liability of most banks were banknotes, this was the primary focus of the insurance program, rather than deposits; the value of banknotes in circulation was twice that of deposits. Still, the system initially covered both banknotes and deposits. In payment for this insurance, the Safety Fund required each member bank to pay into the fund 0.5% of its capital each year until the sum of those payments equaled 3% of its capital. The Safety Fund would then cover losses following a bank failure in full, with payment made once the liquidation of the failed bank was completed.
Following a loss, annual contributions would recommence until the fully funded status was restored. New York’s state comptroller would manage the fund. The money would be invested and net earnings from the fund returned to the banks.
Other States
By 1858, five other states had implemented their own insurance programs for banks. They were Vermont, Indiana, Michigan, Ohio, and Iowa. Michigan’s used the same contribution formula as was devised in New York but not all the schemes closely followed New York’s model. Indiana’s, for example, did not feature an insurance fund at all but rather a simple mandate that participating banks mutually guarantee each other’s liabilities.
Supervision
Following the introduction of bank-liability insurance programs, tighter supervision went hand-in-hand with insurance. Supervision was used to limit the losses that would be sustained from more frequent bank failures, thereby depleting insurance funds or resulting in losses to other member banks. Controls were meant to reassure safer banks that they would not simply be rewarding others’ recklessness by participating in the insurance programs.
Under New York’s regulatory framework, three new bank commissioners were appointed. Between 1829 and 1837, one was appointed by the state’s governor and two by the banks themselves; after 1837, all three were appointed by the governor. The commissioners were responsible for a quarterly inspection and audit of each insured bank. In practice, this meant the commissioners would receive a balance sheet, visit the bank, and question officers under oath. They were required to close banks that acted fraudulently, violated the state’s usury laws, or which were insolvent.
New York’s regulatory regime also imposed leverage limits on banks. Their volume of loans was limited to 2.5 times their equity capital and a bank’s note issuance was capped at twice their equity. In a compromise to gain acceptance from bankers, which could have simply withdrawn their applications for charters in response to these new rules, liability of bank shareholders for losses resulting from failure was reduced.
It is noticeable that, at least for a few years, representatives of the banking industry constituted a majority of the commissioners. Across American states at this time, giving banks a role in supervision was not unusual. Especially for those states like Indiana, which used a mutual guarantee scheme rather than an insurance fund at the core of their insurance program, allowing banks to supervise their peers seemed a logical concession. This was even thought to strengthen a program by putting in charge of bank supervision those that would pay most if bank failures were allowed to occur, namely the surviving and therefore presumably more prudent or well-managed banks.
Supervisors had broad powers in some states. In addition to forcing an insolvent bank to close, in Ohio and Iowa they could issue cease-and-desist orders requiring that a bank reduce its note circulation or liabilities. In Indiana, they could regulate dividends and establish their own ratios, within limits, on loans-to-capital for any or all banks. Indiana’s tough approach to bank supervision helped the state avoid bank failures altogether during its bank-liability insurance scheme’s thirty-year existence. This was a record not matched by other states with such a long-lasting program.
Results
In 1837, some New York banks became insolvent; the event was unanticipated by the banking commissioners. Since 1829, the size of the state’s banking system had grown rapidly. Per capita bank credit had risen from $6.61 to $35.11, an average annual rate of growth of over 20% between 1830 and 1837. New York’s insured banks had grown from less than $8 million of combined equity capital in 1829 to over $32 million in 1837 by which time their assets stood at over $86 million. Bank leverage had also increased to the maximums permitted by the law and reserves had decreased.
To extinguish the crisis, state agencies were mandated to continue accepting the banks’ notes and the Safety Fund was used to take preventative measures. Safety Fund money was used to redeem banknotes from threatened banks, improving their capitalization relative to their circulating notes, and the rescued banks were able to reimburse the Safety Fund at a later date.
Victims of failed banks could not make a claim against the Safety Fund until the banks were liquidated and this never happened in 1837; even the insolvent banks recovered quickly, repurchasing their notes and recommencing operations. The Safety Fund seemed to have saved the day without even incurring a single loss.
In 1841, New York’s Safety Fund made its first payment in connection with a bank that had failed, following improper conduct by its president. However, the bank failures didn’t stop there. The next year, several more banks failed and the liabilities of those were three times greater than the fund’s reserves, $2.7 million to $900,000. Included among the failed banks were those that had been narrowly saved just a few years earlier and they were among the costliest failures this time around.
To manage the situation, New York’s state legislature authorized 6% interest bonds issued by the Safety Fund against the value of its future contributions and $1 million was raised. The law was also modified so that the fund only had to make whole the holders of the failed banks’ banknotes rather than all of their creditors. A special assessment on the surviving banks was levied to support the fund. The earlier introduction of limited liability was reversed and a standard of ‘double liability’ was reimposed, making shareholders liable for losses of their bank in an amount equal to twice their entire investment rather than only the size of their investment alone.
Ten more banks had failed by 1845. In spite of efforts to save the Safety Fund, New York’s comptroller and another future American President involved in the state’s experiment with deposit insurance, Millard Fillmore, declared the fund exhausted. Other states with similar mutual insurance programs had to levy special assessments on their members to rescue failing banks.
A flaw in these insurance systems was that all banks had to make the same contribution into the system regardless of the riskiness of their management. This created a moral hazard as banks would be incentivized to engage in riskier behavior since they benefited from the protection of the insurance program without having to contribute any more towards it than any other bank. Making matters worse, reforms had allowed banks to opt out of the Safety Fund if they posted federal and state bonds with the regulator as collateral for their banknote issuances, meaning banks remaining in the Safety Fund system tended to be riskier.
It turned out the controls and oversight were not strong enough. New York’s banking commissioners would express concerns about risky loans, such as those financing land speculation, and were aware of dangerous situations at some banks but would take no action. Prior to 1840, only once did the commissioners order a bank closed. It did not help that they could not authorize any lesser action than ordering a bank to cease operations, as such it could not prohibit excessively risky loans, until of course the bank was already insolvent or getting close to it. They were no doubt overworked as well, having to inspect ninety banks at the peak, each four times a year, with no assistance.
The programs in Iowa and Ohio, the last two to be launched of those mentioned earlier, were also the only two created after the bank failure waves of the late 1830s and early 1840s. Both required that banks make an initial payment into an insurance fund before opening and then a payment of 10% of the amount of circulating notes. Such a formula made sense now since these systems only covered banknotes and not the other debts of a bank; the objective of these programs would be less ambitious, likely reflecting the poor experience in New York.
In any case, each of the existing bank insurance programs were eliminated when the banknotes of state-chartered banks effectively ceased to be legal currency in the United States during the Civil War, the result of a prohibitively high tax on banknote issuance by state banks. At the time the remaining insurance funds were wound up, two of them, that of Vermont and Michigan, had deficits. This amounted to $1.2 million in the case of Michigan, whose program never really recovered from the earlier banking crisis.
Lesson
Though insurance of bank liabilities in 19th century America was a project with only mixed success, the principle was not abandoned forever. The recognition, even in rather laissez-faire times, that banking was different, that the failure of banks ruptures basic economic infrastructure from credit to payments with indiscriminate effect, could not be ignored. When efforts to reform the banking and monetary system were undertaken in the 20th century, the example of New York’s Safety Fund was put to use, so that it was inevitable that both enhanced supervision and consumer protection would feature in that new system.
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Further Reading
1. Bodenhorn, Howard. “Chapter 7 – New York’s Safety Fund System: America’s First Bank Insurance Experiment.” State Banking in Early America a New Economic History, Oxford University Press, New York, 2003, pp. 155–182.
2. Bodenhorn, Howard. “Zombie Banks and the Demise of New York’s Safety Fund.” Eastern Economic Journal, vol. 22, no. 1, 1996, pp. 21–33.
3. Federal Deposit Insurance Corporation. A Brief History of Deposit Insurance in the United States, Washington, DC, 1998.
4. Markham, Jerry W. A Financial History of the United States. Sharpe, 2002.
Norman Clairmont