The Rise of the Clearinghouse Certificate
Bank clearing house associations were a distinctive form of private financial regulation that emerged in the second half of the 19th century. Beginning with the New York Clearing-House Association (NYCHA) in 1853, these associations came into being first and foremost to more efficiently settle (or “clear”) interbank debts owed among banks within a certain business area. Although modeled on the London Clearing House founded some eighty years earlier, the American version was perhaps more functionally similar to the Suffolk System of New England (1824-1858) that regulated banknote issues in that region.
The growth of clearing houses was primarily a consequence of the spread of check-writing against deposits. Rather than presenting checks to each other bilaterally for settlement, it proved far more efficient to convene a single session where representatives of each bank could redeem each other’s checks, resulting in a single net balance (positive or negative) for each bank with the other clearing house members. Specifically, the clearing house interposed itself between each member bank, and all the other member banks, for the purposes of settling net balances due or owed. This not only spared the tedium and danger of physically delivering specie between banks, but also stimulated the innovation of three different financial instruments: (1) large-denomination coin and currency certificates; (2) clearinghouse loan certificates, and (3) small-denomination clearinghouse certificates.
Coin and Currency Certificates
Very early on in the history of American clearing houses, member banks adopted the device of replacing cash settlement via actual coin and currency with large denomination certificates ($500 and up). These instruments, internal to the clearing house, increased the efficiency of multilateral clearings. Rather than settle balances with piles of small-denomination currency or bags of gold coin subject to abrasion, banks would use these certificates, which represented coin or currency held in escrow by a designated member of the clearing house. The federal government not only approved of the use of these certificates but very quickly supplemented them with its own issues of large-denomination coin and currency notes. While not intended for general circulation and not a legal tender, these certificates counted as part of the legal reserves of banks under the National Banking System (NBS).
Clearinghouse Loan Certificates
As early as 1857, the NYCHA developed a second financial instrument, the clearinghouse loan certificate, which was superficially similar to coin and currency certificates but had a much greater policy significance. Faced with increased depositor demand for cash during times of financial stringency, banks could economize on their supplies of coin and currency by settling among themselves with loan certificates instead. Doing so freed up cash that could be used to meet withdrawals. These certificates were issued against approved collateral (portfolios of high-quality loans) deposited with the clearing house up to a certain safe proportion (usually 75%) of the collateral’s value.
The issuance of clearinghouse loan certificates, along with the pooling of reserves by member banks (thus allowing strong banks to protect their weaker brethren), were two ways that these private banking associations in the pre-Federal Reserve era were able to temporarily expand the money supply during financial panics in order to meet the public’s liquidity demands without breaching their minimum reserve ratios.
First adopted by the NYCHA in 1857, the use of clearinghouse loan certificates had become a common practice among bank clearing houses by the Panic of 1873.
Small-Denomination Clearinghouse Certificates
The next step in the development of clearing house media was logical, if somewhat more controversial from both a legal and public-relations point of view. This was the issue of small-denomination clearinghouse certificates, backed by the large-denomination loan certificates, which would circulate as hand-to-hand currency for ordinary transactions outside of clearing houses. Legally, this was a problematic development since one basic purpose of the NBS was to standardize the nation’s currency by suppressing private banknote issues in the first place. In producing their own money, banks were, in effect, reverting to antebellum practices. From a suspicious public’s perspective, this emergency private bank money faced the danger of being rejected as “funny money”, as indeed it was when workers went on strike or rioted rather than accept their wages in bank scrip. The very need for it would serve to draw the public’s attention to design flaws in the country’s financial system, especially after the fiasco of 1907.
Creating small-denomination clearinghouse certificates as a cash substitute not only followed the example of their larger counterparts, but reflected the structural tendencies of late 19th century American finance. In the absence of branching, individual banks adopted to the rules of the NBS by creating correspondent relationships with reserve and central reserve city banks. Since the rules allowed banks to hold a portion of their reserves in interest-bearing deposits, the result was the well-known ‘pyramiding’ of bankers’ balances in central reserve cities (St. Louis, Chicago, but especially New York City).
Under the NBS, central reserve banks did have to maintain higher reserve ratios than other banks, but they found themselves custodians of those other banks’ balances from across the country that could be called upon at any time. Even more ominous was the practice of lending these balances into the call loan market, where they financed speculation on the stock exchange. In this way, the nation’s resources of financial liquidity were concentrated into an inherently unstable arrangement that could break down if any shock precipitated sudden and large-scale withdrawals of correspondent balances. Two characteristic signs of stress in this arrangement were when the public started hoarding cash (notoriously, held in safety deposit boxes rented from the very banks from which the cash was withdrawn), as well as the emergence of a premium on physical cash (selling for more than its face value) over the equivalent in bank deposits.
The first examples of small-denomination clearinghouse certificates emerged during the Panic of 1893, mostly in certain Southern states, although the use of company payroll checks as a circulating medium occurred elsewhere in the country. It was during the Panic of 1907 that the issue of cash substitutes exploded on a national scale, as banks, bank clearing houses, and private corporations all around the country issued circulating media to remedy the acute shortage of official money.