As a follow-up to my recent post on antebellum banking as a historical precedent and potential model for stablecoin issuers, this week we explore some lessons in financial governance and mutual private sector regulation from that era. In modern times, financial regulation is thought of as a core government activity, and financial system participants have less incentive to police each other and fewer mechanisms for doing so. The debate over future crypto-currency regulation is framed entirely in terms of the degree to which the administrative state should oversee the activities of token issuers and exchanges.
In reality, however, there are reasons to think that private sector regulatory networks may be both achievable and preferable, if we assume that financial market participants are likely to possess unique insider knowledge about each other’s balance sheets, knowledge that government regulators or the general public will not possess. There are also excellent reasons to think that market participants in a free banking system (or a modern analogy thereof) would have self-interested reasons to form these networks, especially in the absence of a lender of last resort.
The possibility of forming co-insurance networks that signal enhanced financial credibility, reducing the risk of bank runs started by panicking, uninformed noteholders/depositors.
These co-insurance networks would also reduce the risk of contagion and liquidity crises across the network even in the event of a run on one member
If an agreement is formed to redeem each other’s banknotes at par, each bank expands the network wherein its notes are treated as currency, diminishing the need for redemptions and allowing each bank access to a wider customer pool. In turn this allows each bank to hold lower reserves.
There is likely something of a Goldilocks size effect for these networks. If the network is dominated by one very large financial institution, the other members of the network are unlikely to be able to police it effectively. In markets dominated by giant firms with huge network effects, there are reasons to doubt the plausibility of mutual regulation. Likewise, beyond a certain point, the costs of adding extra members to the network will outweigh the diminishing benefits. Nevertheless, in competitive but somewhat concentrated markets, we can expect that if these interbank regulatory networks are allowed to form and operate, they will have positive effects on both bank resilience and profitability.
The Suffolk System, which was operated by the Suffolk Bank of Boston across New England from 1824 to 1858, is one notable historical example of such an institution. It was not the only interbank mutual regulation network of that antebellum era: in Ohio, for instance, an formal mutual liability network operated (which the Suffolk System was not). Nonetheless, the Suffolk System was one of the most effective of these interbank networks in the antebellum era, and (to the best of my knowledge) the longest-lasting. It did not begin as a public-spirited effort to furnish New England with a common currency, and nor did it continue for that reason: the system was in fact enormously profitable for the Suffolk Bank. Nevertheless, the benefits across the banking system and for the general public at large were quite sizable.
Origins and Development
In the first two three decades of the 19th century, the city banks of Boston found themselves confronted with the annoying persistence of the notes of rural banks circulating widely throughout the city. The city banks viewed this as unwelcome competition limiting their potential profits. In 1824, they accordingly formed a cartel to buy up rural banknotes at a discount and transport the notes to the issuing banks for redemption in specie at par. The discounts on country notes were available because of the cost of transport in antebellum America, and also in some cases due to the market’s doubts about the soundness of the issuing banks. This strategy, however, was unsuccessful, largely due its low profitability (the discounts on the rural banknotes being simply equal to the transport cost in most cases), and the high levels of demand in rural areas for banknotes coupled with Boston’s status as a regional trade hub (which guaranteed a constant inflow of these rural notes).
The next year, the Suffolk Bank and its allies gave up and shifted strategy, becoming a true note clearing operation. Rather than return notes to the issuing banks for redemption, the Suffolk Bank formed a system whereby banks in the network would hold permanent deposits at the Suffolk Bank, equal to 2% of their capital, as well as a further deposit which would be sufficient (on average) to clear the quantity of their banknotes that the Suffolk Bank received. In return their notes would be accepted at par at the Suffolk Bank, which net cleared all notes received from other banks in the System on a daily basis, netting them against the accounts of the banks The other Boston city banks only had to hold a single fixed deposit (initially $30,000 but later reduced to $5000). None of these deposits were interest-bearing. Banks that were not part of the network had their notes transported back to them for immediate redemption, but by 1836 the System had around 300 members - composed of virtually all the banks operating throughout New England.
The key benefit of such a system for the members has already been noted above: the Boston clearing operation lowered the frequency with with their notes would be redeemed for specie, allowing them to hold less and reducing the need to pay for specie to be transported to the bank location (an expensive operation at the time). Perhaps most attractive, however, was the chance to benefit from the interbank lending scheme that the Suffolk Bank offered to System members, which allowed banks to access extra capital when required, permitting business expansion and the opportunity to weather times of crisis more easily. With this lending, however, came their acceptance of the Suffolk Bank’s regulatory oversight. In 1842, for instance, the President of the Suffolk Bank wrote to his counterpart at the Bank of Woodstock, admonishing him that “…too large a portion of your loan is in accommodation paper [loans to industry], which cannot be relied on at maturity to meet your liabilities…”
For the Suffolk Bank itself, the permanent deposits that it required of System members were a valuable source of capital for its own operations, allowing it to retain a uniquely high assets to capital ratio (i.e operate with unusually high amounts of leverage for the time). It also became a virtual monopolist in the interbank loan market, which was likely viable because of the direct insight into the activities of other banks that the Suffolk Bank could garner through its note clearing operations, which allowed it to detect over-issuance of notes and accordingly refuse credit to overextended banks. By 1857 the Suffolk Bank had interbank loans outstanding equalling 10x the value of the interbank loan book of any other New England bank. While we do not have direct data on its profitability, during the System’s operation the Suffolk Bank consistently paid a dividend around two percentage points higher than its competitors, likely indicating that the Suffolk Bank was exceptionally and unusually profitable during this timeframe.
For the public, the Suffolk System furnished them with an effectively uniform currency, as all banknotes acrossed New England traded at par within itself, and at a uniform and low discount outside of New England. It was widely recognized even at the time that the discipline the Suffolk Bank imposed on System members helped to increase the resilience of the overall financial system in the face of extraordinary events like the Panic of 1837, which the New England banks weathered unusually well - so well that Vermont subsequently forced its own banks to join the System or pay a 1% annual tax on their entire capital. Unsurprisingly, all Vermont banks were System members by 1850. In the subsequent Panic of 1857 just 15 banks in the Suffolk System failed, 12 of them being extremely small banks (total capital under $200,000), and even among these failed banks the losses to noteholders were just 0.9%:. Despite two severe stress-testings, it seems the System passed on both occasions with flying colours.
The Suffolk System and Personal Liability
The Suffolk System also highlights another key feature of the antebellum banking era, which was its embrace of personal liability for bank shareholders and managers. Nowadays, employees are compensated partly in stock to align their interests with those of the company, but in the antebellum banking era this practice was a double-edged sword. Bank cashiers would often be obligated to own the bank’s stock in the knowledge that in the event of the bank failing their stock would be worthless and they could be exposed to substantial further liabilities. Notably, this extended shareholder liability was also a key feature of the highly successful Scottish free banking system that operated from 1716-1844.
The head cashier at the Suffolk Bank, William Grubb, ran their clearing operation. After some initial losses in his department at the outset of the clearing operation, he signed bonds agreeing to indemnify the Suffolk Bank against all further losses, which could in theory have been quite substantial even absent bank failures given the constant inflow of counterfeit banknotes (a longstanding issue at the time). The small losses that Grubb oversaw were inconsequential relative to his salary, which over the duration of the System’s operation rose from $720 a year in 1824 to $30,000 a year (half a million a year in 1995 dollars) in 1854, as the volume of note clearing at the Suffolk Bank exploded from $2 million a month at the start of the System’s operation to $30 million a month near its end.
1)Bank runs on stablecoin issuers are already identified in policymaking circles as one of the greatest risks of stablecoin adoption: see, for instance, Hilary Allen’s Senate testimony here, or remarks by Federal Reserve Vice Chairman for Supervision Randal Quarles:
“While these digital currencies may not pose major concerns at their current levels of use, more serious financial stability issues may result if they achieve wide-scale usage. Risk management can act as a mitigant, but if the central asset in a payment system cannot be predictably redeemed for the U.S. dollar at a stable exchange rate in times of adversity, the resulting price risk and potential liquidity and credit risk pose a large challenge for the system.
Nevertheless, history does show that private interbank regulatory networks can do much to mitigate this problem, both through lowering the risk of runs via credibility signalling and mutual portfolio management, and through providing tools to manage runs as and when they do occur. Given the right incentives these networks can and do form entirely through the self-interest of the institutions involved: no altruism or public-spiritedness is required. These networks should not be regarded as entirely sufficient tools to deal with bank runs, but they are powerful complements to other tools that were used at the time. Suspension of specie redemption sat alongside interbank networks as the other main line of defense, allowing banks suffering liquidity crises to sell their less liquid assets or wait for loans to be paid off. It should be noted in passing that even at quite aggressive and freewheeling antebellum banks, such as the Black River Bank of Watertown NY, the average loan maturity was under 90 days. In part this simply reflected the nature of the economy of the time, with plenty of demand for short-term loans from farmers to meet payroll, but it doubtless also reflected the need for antebellum banks in their role as currency issuers to avoid the risk of long-term lending.
2)In the crypto space, the risks of runs are if anything more acute than was the case in antebellum America. Social media allows panic to spread fast and no one has to physically travel to a bank’s location to redeem their notes for specie. As seen in the current crypto market conditions, both direct and indirect contagion in downturns are major risks and are likely to remain so for the foreseeable future. Moreover, within the Reserve ecosystem, there is a very direct mechanism for problems at one RToken to cause issues at all the others, even if the other RTokens have extremely conservative designs. This mechanism is simply the fact that RSR is being used to provide insurance across all the different types of RTokens, and the failure of a major RToken would almost assuredly cause the price of RSR to drop, not only hurting all RSR holders financially but also leading to a new situation where other RTokens would now be under-insured. In short, the need for meta-governance across RTokens seems inescapable, and the Suffolk System perhaps serves as a historical analogy and partial blueprint for how it could be done.