AMER.MACRO: The Question of Note Issue in American Free Banks

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                EHS Abstract Submission
                    (c) 1997 EH.Net
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              Name: Michael J. Haupert
               Email: haupert@mail.uwlax.edu
         Institution: University of Wisconsin - LaCrosse

         Co-author: Howard Bodenhorn
                           Department of Economics
                           The William Simon Center
                           Lafayette College
                           Easton, PA 18042

             Title: The Question of Note Issue in American Free
Banks

  Internet Address
of abstracted work: Not available on the Internet

           By mail:
                     Michael J. Haupert
                     Department of Economics
                     University of Wisconsin-LaCrosse
                     LaCrosse WI 54601 USA
                     
           Language: English
 
          Abstract:
   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 the
apparent profitability of doing so. Subsequent writers refined
Bell's original profit calculations and most have shown that, if
anything, Bell's 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 to 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 "wildcat"
behavior by the bank, thus increasing the value of the bank's
stock and aiding in keeping the bank's notes in circulation.
This work builds on the research of Fama and Jensen (1983) and on
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.

 
      Bibliography: Bodenhorn, Howard, and Michael J. Haupert.
"The Question of Note Issue in American Free Banks." Paper
presented at the third World Congress of Cliometrics, Munich,
Germany, July 1997.
 
                  Subject: H
 Geographical Area: 7
      Country/Region: United States
           Time Period: 7

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