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During the free banking era of 1837-1863 the federal government divorced itself from almost all attempts to regulate the banking system. Following the demise of the Second Bank of the United States in 1836, the nation was left with state banks as its only supplier of banking services. States were left in charge of regulating the banks they chartered, and in the states that adopted the free banking laws, this meant little or no regular supervision. By the onset of the Civil War state banks numbered 1,562.
The problems with state banking were numerous, but three are conspicuous. First, the nation had no unified currency. State banks issued their own banknotes as currency, a system which at worst invited severe bouts of counterfeiting and at best introduced additional uncertainty in the task of determining the relative value of each banknote. Second, with no mitigating influence on the issuance of banknotes, the money supply and the price level were highly unstable, introducing and perhaps causing additional volatility in the business cycle. This was due in part to the fact that banknote issuance was frequently tied to the market value of the bank's bond portfolio which they were required to have by law. Third, frequent bank runs resulted in substantial depositor losses.
Prior to the return of the federal government to the business of bank regulation, the states made several attempts at solving some of these problems. The New York Safety Fund was sponsored in 1829 by the state of New York as a deposit insurance system (a century later the Federal Deposit Insurance Corporation was modeled after it). State banks in New York paid an annual premium to the state Treasury. In the event of a bank failure within the state, the Fund would be used to pay the depositors and other creditors of the bank. Without such protection, a bank run could destroy even a sound bank. The Safety Fund worked well for about 10 years until a large wave of bank failures struck the Northeast economy and bankrupted the Fund.
There were also private attempts to improve the state banking system. The Suffolk Bank system was an example of a miniature central banking system that appeared in New England. Suffolk Bank was based in Boston and was one of the larger banks serving New England, but there were also numerous small, rural banks operating in the region. Suffolk Bank had a good reputation for redeeming its banknotes, so its notes were accepted at par by the public. The notes of the rural banks were deemed riskier by the public, and were accepted at discounts of one to five percent. In accordance with Gresham's Law, the public began to hoard Suffolk's notes and circulated the rural banknotes as their primary medium of exchange. This was harmful to Suffolk because it was forced to keep more liquidity than it would like and therefor reduced its profitability. To remedy this situation, Suffolk decided to accept at par the notes of any bank that agreed to keep a minimum portion of its deposits on hand as specie reserves. The banks that did not voluntarily agree to this were "convinced" of the plan's merit when Suffolk began hoarding the notes of uncooperative banks and then presenting them in bulk for redemption. In effect Suffolk was imposing a required reserve ratio, a tool we normally associate with the Federal Reserve. By 1825 most of New England's banks were members of this system and the results were generally good. Almost all the banknotes in the region were accepted at par which eliminated the Gresham's Law problem that had plagued Suffolk originally. In addition, the money supply in the New England area exhibited less volatility than in other regions of the country.
Another private institution that evolved during the period was the clearinghouse. One function of the Federal Reserve or any central bank is to act as a lender of last resort for banks that are temporarily short of liquidity. When the Second Bank of the United States was permitted to die in 1836, the banking system was without this safety valve of liquidity. Private clearinghouses soon appeared to perform this and some other functions of a central bank. A bank in temporary need of liquidity could borrow money from these clearinghouses in the form of loan certificates. These certificates had short maturities and were backed with some of the borrowing bank's assets, usually with a portion of its loan portfolio. The clearinghouse certificates were then given to depositors instead of specie and circulated as money. During the financial panics of 1893 and 1907, the certificates temporarily increased the money supply between 2 and 4 percent. Similar provisions were incorporated into the Federal Reserve Act in 1913.