A strong pattern among banks in four states doesn’t prove a theory, of course. But another banking system in the antebellum period, the Suffolk Banking System of New England, offers further support for the importance of exposure to loss and authority to restrain risky banking activity. The System provides an example in which a motivated party (the Suffolk Bank of Boston) could and did take action to curb risktaking by (and improve survival of) interconnected banks (those who joined Suffolk’s noteclearing system) whose potential losses would negatively affect its interests.*
Suffolk was a regional note-clearing system—not a bank liability insurance scheme—run by the Suffolk Bank of Boston from 1825 to 1858. By the early 1830s, most banks in New England belonged to the Suffolk Systembecause it enabled them to hold smaller levels of coins and other reserves than would otherwise be required to redeem the notes they issued. Banks could borrow fromthe Suffolk Bank and pay off the Suffolk loans when their own loans and other assets matured. Another benefit: Notes issued by member banks exchanged at par throughout New England, increasing value and convenience for bank customers. In exchange for these benefits, the Suffolk Bank required its members to keep an interest-free deposit at Suffolk (or another Boston member bank) of 2 percent of bank capital.
If a member bank failed, the Suffolk Bank would be stuck with losses on the bank’s notes held on its balance sheet, as well as any overdraft advancesmade to that bank. (The losses would be borne by Suffolk alone, not mutually by all members as in a mutual guarantee system.) And potential losses could be quite substantial. In the 1830s and 1840s, observesWeber, member banks owed Suffolk about $700,000 on average, climbing to about $1 million in the 1850s. Bank notes held by Suffolk were about $450,000 in the 1830s, rising to roughly $700,000 in the 1850s. These numbers loomed large compared with Suffolk’s total capital stock of approximately $1 million in the 1840s and 1850s.
“Thus, the Suffolk Bank had an interest in monitoring the actions of banks that were members of the system,” writesWeber. “And it did.” He quotes as evidence a letter from Suffolk’s president to a Vermont member bank commenting that “too large a portion of your loan…cannot be relied upon at maturity to meet your liabilities.”
“Further, the Suffolk Bank had the power to affect the behavior of member banks,” writes Weber.Whenever it felt compelled to do so, it notified debtor banks to pay off loans due. Otherwise, the bank’s notes would be redeemed by Suffolk for gold and silver coin—solid collateral.
The Suffolk System’s apparent ability to reduce bank failure is suggested by Weber’s failure rate data from System members in four New England states (Maine, Massachusetts, New Hampshire, Vermont) compared with four other eastern states (Maryland, New Jersey, New York, Pennsylvania). In the Suffolk System, only 24 of 354 banks failed—a rate of 6.8 percent, less than half the 14.5 percent rate of bank failure (47 of 325) in the other four states.
* In earlier work with Arthur Rolnick and Bruce Smith, WarrenWeber studied the Suffolk Banking System to evaluate the claim that it was an effective and efficient privately run interbank payments system. They conclude that the System’s history of extraordinary profitability suggests that note clearing is a natural monopoly and that “there is no consensus in the literature about whether or not the unfettered operation of markets in the presence of natural monopolies will produce an efficient allocation of resources.” Rolnick, Arthur J., Bruce D. Smith and Warren E.Weber. 1998. “Lessons from a Laissez-Faire Payments System: The Suffolk Banking System (1825-58).” Federal Reserve Bank of Minneapolis Quarterly Review 22, Summer, pp. 11–21.