The Question of Note Issue in American Free Banks
Howard Bodenhorn, Lafayette College
Michael J. Haupert, University of Wisconsin - LaCrosse
In 1912 Spurgeon Bell uncovered a paradox that has vexed banking and monetary historians ever since. He found that national banks failed to expand their note issues despite its apparent profitability. Subsequent writers refined BellÕs original profit calculations and most have shown that, if anything, BellÕs calculations understated the profit to be earned by banks through expanded note issues. Explanations of the paradox abound.
Bell (1912) and Goodhart (1965) argued that banks failed to increase their note issues out of fear that circulation privileges would be revoked. James (1976) argued that regional interest rate differentials in the postbellum era made it more profitable for banks in some regions to focus on lending low-cost deposits rather than engage in higher-cost note issue. Champ (1990) and Kuehlwein (1992) focused on term-structure and holding period risks. Bond-secured note issue required banks to hold long-term assets as collateral against which short-term liabilities were issued. If redemptions increased significantly, banks might be forced to sell off bonds to redeem their notes. If such sales were required in a general panic, the bank would absorb a significant capital loss. Cagan and Schwartz (1991) believed that banks simply acted irrationally. Given the profits to be earned through additional note issues, bankers should have bid the price of bonds up to a level where note issue was no longer profitable. Despite all this work, the national bank note paradox remains unsolved; some might say insoluble.
Our research pursues the question raised by a cadre of writers examining the National banking era: why did the national banks issue so few notes? We examine this issue with regard to free banks, and find that like their national bank successors, they too passed up profitable note issue opportunities. In our quest to solve this paradox, we have followed the evolution of the literature, and further refined the latest profit calculations. While these new calculations reduce the foregone profits, they do not solve the problem.
In order to get a handle on this issue we attempt to answer the problem by focusing our attention on a different aspect of the bank decision-making process. We focus on the use of bond-backed note issues as a means of signaling the credible commitment made by the bank in its operations. The use of bonds by banks acts as a signal to the market about the separation of ownership and control over bank assets. This enhances the reputation of an individual bank by signaling a reduced likelihood of ÒwildcatÓ behavior by the bank, thus increasing the value of the bankÕs stock and aiding in keeping the bankÕs notes in circulation. This work builds on the research of Fama and Jensen (1983) and our earlier examination of bank returns during this era (Bodenhorn and Haupert 1995).
Our research focuses on the free banking era, for which we feel comfortable posing this solution to the paradox raised in the national banking literature. We are inclined to believe the same answer exists for the national banks, but will hold off proclaiming so pending further research.