The National Bank Note Puzzle Reinterpreted
Author(s): Phillip Cagan and Anna J. Schwartz
Source: Journal of Money, Credit and Banking, Vol. 23, No. 3, Part 1 (Aug., 1991), pp. 293-307
Published by: Blackwell Publishing
Stable URL: http://www.jstor.org/stable/1992747
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PHTTT TP CAGAN
ANNA J. SCHWARTZ
The National Bank Note Puzzle Reinterpreted
THE NATIONAL
BANKNOTEPUZZLE,as previously interpreted,is that the conditions for the issue of notes by nationalbanks provided a
high rate of returnafter the late 1890s, yet the quantityissued never reached the
maximum allowed. Cagan (1965) showed that the quantityof notes issued up to
1897 correspondedto changes in the rate of return.Thereafter,note issues became
extremely profitable and expanded, but did not approachthe maximum allowed
until the 1920s. That banks had more attractive alternativeinvestments or that
redemptioncosts made note issues unprofitableare explanationsproposed in the
literature.These explanations, however, are not satisfactory.The real puzzle, we
show, is why the marketprices of some of the eligible bonds did not reflect their
value for securing note issues. l
THE RATE OF RETURN
The National Bank Act of 1863 with subsequent amendments authorized
federallycharteredbanksto issue notes afterdepositingeligible U. S . bonds with the
We completed much of this researchmany years ago, but put it aside in the expectationthat we could
discover some feature of U.S. bonds that would explain the puzzle. We are now convinced no such
featureexists. We are indebtedto Milton Friedmanfor commentson our earlierdraft. We also thankthe
editors and anonymousreferees for their suggestions.
lWe reply here to Goodhaxt(1965) and James (1974, 1976), who commentedon our version of the
puzzle in Friedmanand Schwaxtz(1963, pp. 20-24) andCagan(1963, pp. 22-23, and 1965, pp. 86-95).
A recent paper by Champ (1990) explains underissuanceby reference to risk features that lowered
measures of expected rate of retum on note issue. We also comment on this explanation.
PHILLIP CAGAN is professorof economics,Columbia
University.ANNA J.
researchassociate,NationalBureauof EconomicResearch.
Journalof Money,Credit,andBanking,Vol. 23, No. 3 (August 1991, Part
Copyright
<B)199l
by The Ohio State University Press
SCHWARTZ
l)
is
294
: MONEY, CREDIT, AND BANKING
Treasuryfor security.Notes could be issued up to 90 percentof the par value of the
bonds, and after 1900 to 100 percent. A quantitylimit stipulatedthat individual
banks could issue notes up to only 90 percentof their paid-in capital,2 raised after
1900 to 100 percent.OtherconditionsafFectingthe profitabilityof note issue were a
small tax on notes outstandingand a small paymentfor the Treasurer'sexpense in
printingthe notes.
Since the public treatedthe notes as equivalentto Treasurycurrency,banks could
readily pay out the notes ahead of Treasurycurrencyand preferredto do so, since
the latterbut not the notes satisfied reserverequirementsfor deposits. When a bank
purchasedan eligible U.S. bond, the note issue thus replenishedthe bank'sloanable
funds by 90 percentof the bond'sparvalue and after 1900 by 100 percent.Although
the law requireda 5 percentredemptionfund behind notes issued in additionto the
deposited bonds, the fund could be counted toward deposit reserve requirements
before 1914 and so did not add to the capital tied up. The FederalReserve Act of
1913 later removed this provision.
The profit in acquiringbonds and issuing the notes thereforedependedupon the
interestfrom the eligible bonds, the taxes and costs of issue, and the capitaltied up.
Usually the eligible bonds sold at a premium,so capitaltied up equalledthe price of
the bond P minus the notes issued. For a $100 par bond, this was P - 90 before
1900 and P - 100 thereafteruntil 1914 when it increasedto P - 100 + 5.
Table 1 shows the prices of three representativesof the eligible bonds3 and the
annualrates of returnthroughpurchasesfor note issue in each year from 1895 to
1920. The denominatorof the rates is the capital tied up as described above. The
numeratoris the yield to maturityin dollarsof a $100 parbond minus an annualfee
of 6.25 cents reportedby the Comptrolleras expenses of producingand issuing the
notes and a tax, 50 cents per year for notes securedby bonds with 2 percentcoupons
and $1 by all other eligible bonds.4 Thus for 1900 and after,
rateof return= (yield-tax-
.0625) . P-
100 or P-100
+ 5
if P-100, otherwise0 or 5. Before 1900 the denominatoris P - 90. These rates
were locked in so long as the conditions of note issue did not change. The only
2Initiallythis percentagewas lower for largerbanks, but an act of 1882 made it 90 percent for all
banks. Also the ResumptionAct of 1875 eliminatedan early limitationon the aggregateissue of notes.
3Fourotherbonds not representedin Table 1 were eligible in the periodcovered:the Ss of 1904, 4s of
1907, 3s of 1908-18, and 2s of 1918-38. The price andreturnof the last one behavedsimilarlyto the 2s
of 1916-36, representedin the table. The other three had higher premiumsand lower rates of returnto
note issues, and were called or callable in the early l900s.
4Dollaryield is the productof the marketprice of the bond times the rate of return.The rate of return
is the rate that makes the present value of the future coupon payments and returnof par principle at
maturityequal to the currentprice (see source notes to Table 1).
The Comptrollergives 6.25 cents as the unchangingannualexpense for all denominationsof a $100
note issue. The amountcovered the expense of printingnotes. Champ(1990, Table7) estimatescosts of
shipping lawful money to the TreasuryDepartmentto maintainthe 5 percentredemptionfund and the
foregone income on these funds duringthe assumedtransitperiodof one to two weeks, in additionto the
costs representedby the Comptroller'sfigure. He gives a changing semiannualexpense, amountingto
between $1.12 and $1.45 on notes taxed at one percent, and 72 cents to 95 cents on notes taxed at onehalf percent. We discuss below the shortcomingsof Champ'scost estimates of maintainingthe redemption fund.
PHILLIPCAGAN AND ANNA J. SCHWARTZ : 295
TABLE 1
PRICES AND RETURN TO CAPITAL TIED UP FOR SELECTED BONDS TO SECURE NATIONAL BANK
NOTES PURCHASED IN JULY OF YEARS 1895TO 1920
4s of 1925
1895
1896
1897
1898
1899
1900
1901
1902
1903
1904
1905
1906
1907
1908
1909
1910
1911
1912
1913
1914
1915
1916
1917
1918
1919
1920
2s of 1930
2s of 1916-36
Price of
$100 par
Return
annual %
Prlce of
$100 par
Return
annual %
Prlce of
$100 par
Return
annual %
$124.00
114.84
125.41
125.34
130.22
134.13
138.88
134.36
135.88
132.95
133.12
129.94
128.80
122.75
120.57
115.71
115.22
115.10
112.98
110.76
111.29
110.87
105.41
107.16
107.37
106.38
7.2
10.7
6.7
6.6
5.3
5.7
4.3
5.2
4.6
5.2
4.8
5.2
5.7
8.2
9.3
13.5
13.7
13.2
15.9
13.1
12.3
12.0
23.3
17.1
15.1
15.9
$103.98a
107.82
107.78
106.78
104.97
104.02
104.03
105.53
103.94
101.55
100.71
100.33
100.96
97.97
97.58
97.08
98.59
97.06
98.08
97.01
100.85
33.6
15.7
15.7
18.3
25.9
32.7
32.3
22.4
32.8
89.0
198.7
427.5
146.0
OOC
31.5
32.2
30.7
32.9
31.8
33.7
23.9
$105.15b
104.98
102.32
101.55
101.11
100.79
101.16
97 94
96.75
97.42
98.46
96.42
98.41
99.54d
101.17
25.7
26.6
60.2
91.6
128.9
181.4
122.1
OOc
31.0
31.2
30.5
32.3
30.7
29.8
22.3
Source:Annual Report of Comptrollerof the Currency, 1902, p. 166, 1911, p. 823, and successlve years thereafter.
Bond first Issued In 1900.
Bond first Issued in 1906. Flrst quotationIS for October.
c The infinlte rateof retum for 1913 reflectedzero capitaltied up for the bonds selling below par (the 5 percentredemptlonfund until 1914
satisfied deposit reserve requirements).
d October (no quote for July).
a
b
NOTE:Pnce is some (unspeclfied)averagefor the month. ReturnIS based on yield to maturltyof the bond, annualexpense of note issue of
$0.0625 and tax of $0.50 for 2s and $1.00 for others, and beginnlng 1914 a $5 redemptlonfund
These figures differ slightly from those in Cagan (1965) which used Januarydata.
change, other than the expiration of the note issue privilege in 1935, was the
addition beginning in 1914 of the 5 percent redemptionfund to capital tied up.5
The rateof returnvariedinversely with the premiumon the bonds, but after 1900
the ratebecame quite high for the newly issued 2 percentbonds. When the prices of
these bonds fell below par in 1913, the Comptrollerof the Currencycould have
requiredbanksto deposit additionalfunds equal to the shortfallfrom par,6since the
law authorizedhim to do so. (The banks still received notes to issue equal to the
sThe authorityof national banks to sell, and consequently of FederalReserve Banks to purchase,
bonds bearingthe circulationprivilege expired, by the termsof Section 18 of the FederalReserve Act of
1913, twenty years after December 23, 1915. On March 11, 1935, the Secretaryof the Treasurycalled
for redemptionon July 1 and August 1, 1935, the only bonds of the United States bearingthe circulation
prlvl ege.
Section 20 of the Federal Reserve Act repealed the provision in the Act of 1874 that permitted
counting the 5 percent redemptionfund for national bank notes as part of a national bank's lawful
reserve.
6No makeupdeposit is included in the calculatedrates of returnof Table 1. It would not have been
large even had the Comptrollerdemandedthe shortfallfrom par.
.
.
296
: MONEY, CREDIT, AND BANKING
TABLE 2
NATIONAL
BANKNOTESIN CIRCULATION;
CALLDATESNEAREST
JUNE30, 1896-1920
Year
$ millions
Percentageof
Paid-in Capital
1896
1897
1898
1899
1900
1901
1902
1903
1904
1905
1906
1907
1908
197
198
190
199
265
319
309
359
400
446
511
548
614
31.1
31.1
30.5
32.9
42.7
49.4
44.0
48.3
52.1
56.3
61.8
62.0
66.8
Year
$ milllons
Percentageof
Paid-in Capltal
1909
1910
1911
1912
1913
1914
1915
1916
1917
1918
1919
1920
641
676
682
709
722
722
723
676
660
682
677
688
68.4
68.4
66.0
68.6
68.3
68.1
67.6
63.4
61.0
62.0
60.5
56.2
Source:Annusl Report of Comptrollerof the Currency, 1920, p. 155.
NOTE:
Circulationwas limited to 90 percentof paid-ln capital of individualbanks until 1900, when the Gold StandardAct of March 14,
1900, raised the limit to 100 percent.
par value.) We have seen no indication that he ever did.7 If he didn't, any bank
purchasinga bond below par received an additionalprofit.
THE LIMITEDVOLUMEOF NOTE ISSUES
Nationalbanksrespondedslowly to the dramaticrise in returnon note issues after
1900. Table 2 shows the notes outstandingas a percentageof paid-in capital from
1896 to 1920. The maximumin the table was 68.6 percentin 1912, even though 100
percent was allowed. Let us consider the suggested explanationsfor this puzzle.
1. Have we miscalculatedthe rate of returnby underestimatingthe capital tied
up? Successive Comptrollersof the Currencywrongly calculatedthe capitaltied up
as the cost of the bonds P. They assumedthatbanks lent out the issued notes at the
going interestrate (in theircalculationsabout6 percent).The annualreturnwas thus
the intereston the bonds plus $6 interestfrom lending the notes, divided by P. To
show the extraprofit on notes versus other investments,the Comptrollersubtracted
from the annualreturnso calculatedthe amountthe banks would have received had
they lent the sum invested in bonds. This gave extra profits around 1 percent per
year, hardly worth the efFort. Spurgeon Bell (1912) noted that the Comptroller
exaggeratedthe capital tied up, though Bell gave no alternativecalculation.
James (1974, 1976) arguedthat note issues were no longer profitablewhen the
going rateon loans exceeded about 10 percentper year.8This was truefor the period
7Forexample, in Comptroller,
1913, p. 131, calculationsof the profit on issuing notes are given for
bonds selling below par. The calculationsdo not include any deposit to make up for the shortfallfrom
par.
8James(1976), by takingnote issues at 90 percentof par (as before 1900), bond yields at 2.5 percent,
costs of issue at 1 percentand assumedaverage(unissued)notes on handat 5 percentof par, calculateda
rate of returnof (2.50-1)
. (100-85) = 10 percent. Whetheror not many bank loans exceeded 10
PHILLIPCAGAN AND ANNA J. SCHWARTZ
297
3
2 PERCENT
TABLE
BONDS OF 1930HELD TO SECURE NATIONAL BANK NOTES
AS PERCENTAGE OF THESE BONDS OUTSTANDING
End of June
Percent
End of June
Percent
1900
1901
1902
1903
1904
1905
1906
1907
1908
1909
1910
77.4
70. 1
68.6
70.6
75.2
82.5
83.4
81.8
85.5
88.7a
89.3
1911
1912
1913
1914
1915
1916
1917
1918
1919
1920
90.1
92.9
93.5
93.9a
92.9
89.2
92.6
93.7
94.2
95.1
Source:Annual Report of Comptrollerof the Currency, vauiousyears, and Secretaryof the Treasury,AnnualReport of Flnances, vauious
years.
aEnd of October (numeratorfor end of June apparentlynot published).
before about 1900 when the bonds sold at high premiums and interest rates on
commercialloans were around 10 percentor more. In supportJames showed that
note issues were proportionatelysmallerby banks in regions where loan rates were
higher. But all interest rates fell drasticallyafter the late 1890s, when loan rates
were not high enough to matchthe handsomereturnon securingnote issues with the
2 percent bonds.
2. Were there eligible bonds available for the banks to purchase?The most
popular bonds for the banks were the 2s of 1930. In 1900 these comprised 90
percent of the bonds on deposit to secure notes. This percentagerose to 97.8 in
1904-05, and only graduallyfell, as more of these bonds were issued, to 82 percent
in 1912 and 80 percentin 1920. Table3 shows thatbankshad initially acquiredmost
of these bonds upon their issue in 1900.9 The other2s, though attractivebecause of
small premiums,were callable by 1916 and 1918. The banks did graduallyacquire
nearly all of the attractiveeligible bonds outstanding.Perhapsthe banks were slow
in taking until 1920 to acquire most of them for note issue, but such a lag in
response is not a majorpuzzle.
The real puzzle, as we see it, is why the marketprices of most of the eligible
bonds were not bid up until they were no longer attractivefor securingnote issues.
An individualbank could lock in an attractivereturnby buying the 2 percentbonds
percentbefore 1900, the calculationwas irrelevantfor the periodjust after 1900, when the corresponding
= 30 percent.This far exceeded loan rates, thoughdata
rate of returnwould be (2.50-1)-(100-95)
1910, p. 776), the higheststateare scarce: Among averageloan rates collected for 1910 (Comptroller,
wide averagewas 12.6 percentfor Oklahoma.In 1915, a surveyreportedthatonly 1,022 nationalbanks,
1915, p. 230, as noted by
13 percent of the total in existence, chargedover 10 percent (Comptroller,
James[1974], p. 109). Any ratesas high as 30 percentwould have been extremelyrareand in many states
illegal as usury.
9Most of the remainderwere also held by banks as eligible securityfor governmentdeposits. In June
1900 banks held 19.9 percentof the outstanding2s of 1930 to secure deposits; these holdings fell to 10
percentin 1907 and below 2 percentby 1913. Thus upon their initial issue these bonds were nearly all
taken by banks.
298
: MONEY, CREDIT,AND BANKING
at the quoted market prices and could do so at premiums up to about $16.l°
Actually, the low marketpremiumgraduallydeclined even further,mainly because
interestrates rose from the low levels of the early l900s and in small partbecause
the bonds moved closer to maturity.
While there might be some possible expense in withdrawingnotes upon retirement of the bonds on deposit, it could not have amountedto much. Certainlythe 2s
of 1930 ofFereda long period to amortize any final cost of note withdrawal.
At one time we thought that the puzzle might reflect some special unattractive
featureof the eligible bonds, particularlythe 2s of 1930, such as an early call date.
But we have confirmedthat the 2s were not callable before 1930 and did not have
any other unattractivefeatures.
3. Were there other costs to issuing notes that our calculations miss? Some
references suggest that banks had troublekeeping the notes in circulation. A contraryview appearedin the Commercial
andFinancialChronicle(1900, p. 505):
There never was a time when the issuing banks could not find employmentfor their
returnednotes....
[N]ationalbanks feel no uncertaintyabout getting their notes out
again whenever returnedto them by the redemptionbureau and keeping them out
without intermission.
The denominationsof nationalbank notes supposedlyposed a problem. The law
specified thatonly one-thirdof the notes could be $5 bills, the remainderlargerbills
($1 and $2 notes were discontinuedin 1879). But this could not have been a major
problem. Of total U.S. currencyoutstandingin 1900, only 29.5 percent in value
represented$1, $2, and $5 bills. In 1910 the percentagewas 33 percent. National
banknotes comprisedonly abouta thirdof the currencyin circulation.Nevertheless,
to satisfy this requirementthe banksmay have issued fewer $5 bills thanthey would
have liked.
Goodhart(1965) arguedthatthe costs of redeemingand continuallyreissuingthe
notes subtractedsignificantly from their profit to the banks. We examine the redemptioncosts in the next section and do not find them a satisfactoryexplanation.
THECOSTSOF REDEMPTION
TheProcessof Redeeming
Notes
The National Currency Act authorizingthe issue of national bank notes, as
amended in 1874, provided for redemption of the notes by the Treasurer.The
Treasurerredeemedin U.S. currencyall nationalbank notes presented,whereupon
he requested reimbursementin U.S. currency or its equivalent from the issuing
l°In 1900a hypothetical
priceof $116 on the 2s of 1930wouldhaveprovidedan annualyield to
maturityof 1.35 percentor $1.57. Subtracting
56.25 centsfor taxesandprintingcosts, the implied
annualrateof returnon noteissueswouldbe just over6 percent,the rateassumedfor loansby the
Comptroller
in his calculations.
After1913thepremium
allowinga comparable
rateof returnwouldbe
lowerbecauseof the5 percentredemption
fundandtheshorteramortization
period,butstillwell above
zero.
PHILLIPCAGAN AND ANNA J. SCHWARTZ : 299
bank. At the same time, he returnedredeemednotes to the issuing bank, which in
the course of daily operationspaid them out again over the counter. The issuing
bank in turnforwardedto the TreasurerU. S . currencywhich depositorspaid in over
the counter.
For the issuing bank, the redemptionprocess reduced the quantity of notes it
could keep continuouslyin circulation.In additionto the capital tied up in paying
for the premiumon the bond acquiredas collateral,it had to contributefrom its own
capital a sum equal to the quantityof redeemednotes on hand and not reissued. To
allow for redemptioncosts, that sum shouldbe includedin the capital tied up in the
denominatorof the profit-rateformula. Table 1 does not allow for these costs.
Goodhart also argued that banks incurredan additional cost in receiving and
disposing of the notes issued by otherbanks. When the seasonaldemandfor currency ebbed, it was often difFicultto pay out national bank notes over the counter.
Banks sent surpluscurrencyeither to reservecity correspondents,where the deposited funds earnedinterest, or to the Treasurerfor redemption.In principle, redemption by the Treasurerinvolved a cost because of the time lapse between shipmentof
the notes and receiptof paymentfor them in U. S . currencyby the redeemingbanks.
Practice, however, difFeredfrom principle, as we discuss in what follows.
A nationalbank could avoid only a negligible partof the cost of redeemingnotes
of other banks by not issuing its own notes.l l By all accounts nationalbank notes
and Treasurycurrencywere interchangeableto the public;consequently,the fraction
of currency flowing into any bank which was its own issue roughly equaled the
fractionof total notes in circulationwhich it had issued-a very small fractionfor
all banks, even for those issuing the legal maximum. No bank need expect, therefore, that the inflow of national bank notes over its counters would increase if it
issued more of its own notes. If all banksdid issue more notes, of course, the return
flow would increase;but the individualbank had no control over what other banks
did, and could not influencetheirbehavior.The cost of redeemingthe notes of other
bankswas thereforeirrelevantto a bankin deciding whetherto expandits own issue
and should not be counted as part of the redemptioncosts of its own notes in
figuringthe profit. Goodharterredwhen he arguedthat redemptioncosts made the
marginalcost of issuing notes a sharplyrising curve; marginalcosts were constant
and equal to the averagecost.
Goodhart'saccountdoes not accuratelydescribethe actualpractice. He relies on
Bell (1912), who referredto
the expense incurredbecause the notes must be sent to the redemption agency at
Washingtonin orderto secure their redemptionin lawful money. The redeemingbank
must forego the use of the funds in transit during the week or two weeks elapsing
between the time of shippingand the time of receiving the redemptionmoney. ( p. 45)
The descriptionis in accordwith the statute(June20, 1874) governingredemption
of notes of nationalbanks, which stated
llIt couldnot by law declineto acceptnotesof othernationalbanks.Nationalbanknotesdid not
so a bankhadno recourse,if it couldnotpaythemout
satisfynationalbanklegalreserverequirements,
officesor sendthemto correspondents.
over its own counter,otherthanto redeemthemat Treasury
300
: MONEY, CREDIT,AND BANKING
when the circulatingnotes of any such associations, assortedor unassorted, shall be
presentedfor redemption,in sums of one thousanddollars, or any multiplethereof, to
the Treasurerof the United States, the same shall be redeemedin United States notes.
In practice, however, as Secretaryof the TreasuryCarlisle testified in December
1894, from the very start national bank notes were redeemed at the subtreasuries
located in majorcities. To quote Carlisle, "Largepaymentsof customs duties are
made every day at New York, and the nationalbank notes are not as useful to the
banks of New Yorkas other kinds of money are. The consequenceis that the banks
send them down to the subtreasuryand have them redeemedin lawful money of the
United States . . . You see, therefore, that as the law stands now any bank-or
anybodyelse for that matter wantinglawful money in exchange for nationalbank
notes may presentthe nationalbank notes at a subtreasuryof the United States and
get lawful money for them."12
Subtreasurieswere located in nine cities. Eight of these were the centralreserve
cities of New York, Chicago, and St. Louis, and five reserve cities. Banks in these
eight cities presentedfor redemption85 to 90 percentof the total notes redeemed.
For these banks the period between presentationof notes and receipt of lawful
money was not one or two weeks, Bell notwithstanding.On the contrary, the
assistant treasurerspromptly paid out lawful money over the counter, or issued
draftson the subtreasuries,or creditson accountof the S percentredemptionfund of
the redeemingbanksor on accountof the U.S . governmentif redeemingbankswere
designatedas depositories. Only a small fractionof notes were redeemedby direct
shipment to Washington(usually mutilated notes unfit for use). The expense to
redeeming banks was thereforenegligible.
Redemptionof a Bank's Own Notes
Redeemed notes, whetherinitially delivered to subtreasuriesor shipped directly
to the TreasuryDepartmentin Washington,were countedand sortedin Washington.
Notes fit for circulationwere returnedto the issuing banks by express, and those
unfit for circulationwere delivered daily to the Comptrollerof the Currencyfor
U.S. Congress (1894, pp. 19-20). Carlisle also said (p. 20):
If we were to put a strictconstructionon the statute(which has never been done), I thinkthat the
national-banknote is redeemableonly here in Washington,because the law says thatpresentation
of the notes shall be to the Treasurerof the United States. But in practice, the differentassistant
treasurersall over the United States have been receiving those notes.
The TreasuryDepartmentdid not, however, give official recognitionor sanction to the actual practice
that Carlisledescribed. In Circularno. 162, on redemptionof currency,which it issued on Nov. 1, 1894,
a month before Carlisle testified, the following statementappears:
Nationalbanknotes are redeemablein lawful money of the United States by the Treasurerbut not
by the Assistant Treasurers.
This statementwas regularlyincluded in subsequentcirculars.
PHILLIPCAGAN AND ANNA J. SCHWARTZ :
301
destructionand replacementby new notes,l3 which were then shippedto the banks
r
-
ot lssue.
There was an elaborateritual, prescribedby law, for the destructionof currency
unfit for circulation, but it was not time-consuming.l4 Nor was there a delay in
sending blank currencyto replace the notes destroyed. A bank when first issuing
notes placed an initial orderwith the Comptrollerfor printingits notes thatexceeded
the authorizedcirculationby about50 percent, to cover redemptionsof unfit notes.
Thereafter,banks kept a recordof their blank currencyin the Comptroller'sofFice
and, as it was drawndown, requestedhim to print additionalsupplies in advance.
Currencyshipped by the Comptroller,when signed by the presidentor vice president and cashier, was ready for circulation.
If a bank's 5 percent fund on deposit with the Treasurerwere overdrawnby
redemptions, the Treasurerwithheld from shipment sufFicientnotes to cover the
overdraftuntil the fund was made good; otherwise, the Treasurershipped the redeemed notes at the same time thathe notifiedthe bankto reimbursethe fund for the
amount redeemed.
Banks were notified of the redemptionof their notes, fit or unfit, accordingto a
schedule, following an alphabeticalrotation. As Treasuryclerks came to each
bank's name on the alphabeticallist, they did nothing if the redeemednotes of that
bank totaled less than $500. If the redeemed notes totaled $500 or more, they
shipped the notes and notified the bank.15When notified, a bank was supposed to
reimbursethe Treasurerfor the notes redeemed,withoutwaiting for the priorreceipt
of notes fit for circulation, or for the certificate of the destructionof unfit notes
forwardedby the Comptroller.
Redemptionsimposed a cost on banks in proportionto the time lag between their
remittanceof U.S. currencyor its equivalent to reimbursethe Treasurerand the
reissue of their redeemed notes. Banks had an incentive thereforeto delay compliance with the Treasurer'srequest for reimbursement,since the redeemed notes
were alreadyon their way and could be issued when received. According to Carlisle, banks did not "make the fund good sometimes for two or three weeks" (U.S.
Congress 1894, p. 19). The severe punishmentto which Goodhartrefersfor "failure
to provide the Treasurywith lawful money to maintainthe 5 percent redemption
fund" (p. 517) did not exist. However, banks were not responsiblefor most of the
130f the total redeemed, 1901-14, notes fit for circulationconstitutedas little as 20 percentin some
years, as much as 45 percentin others;and unfit notes, the largerremainingpercentages.Champ(1990,
Table4) gives redemptionsas a percentageof notes outstandingannually,1875-1914. Froma low of 41
percentin 1907, the percentagerose to 93.5 in 1914. Aboutthree-fifthsof totalredemptionsin 1914 were
unfit notes that were reissued, suggesting a high rate of deteriorationof the notes.
14See
Pratt's Digest (1908, p. 313). The Digest was a contemporarycompendiumof regulationsand
proceduresfor the edification of nationalbanks.
lsWe have seen no estimate of the durationof the period duringwhich one rotationwas completed.
Since nearly 4,200 nationalbanks were in operationin 1901 (7,500 in 1914), the time for one rotation
was probablynot inconsequential.A referee, however, suggests that it might have been completed in as
short a period as one week's time.
302 : MONEY, CREDIT,AND BANKING
deficienciesin thefund,16 andslow complianceshouldnotbe overemphasized
as a
meansby whichbanksreducedtheirredemption
costs.
Goodhartarguedthatif a week or two elapsedbetweensendingofFnotes for
redemptionto Washingtonand gettingbacklawfulmoneyin return,the reverse
operationmusthavetakenequallylong. He contendedthat "Bell is surprisingly
inconsistent"in referringto a lapseof only a few daysbetweenreimbursement
of
the 5 percentfundandthe returnof notesto the issuingbank(p. 521). Bothseem
unawarethat,unlessthe 5 percentfundwereoverdrawn,the Treasurer
shippedfit
notesto banksatthesametimeas he notifiedthemto remitlawfulmoney.Shipment
of new notesby the Comptroller
to replacesoiled andwornones destroyedmay
havebeendelayeda day or so afternoticewas sent,butit seemsunlikelythatthe
time elapsedin transitfromWashingtonfor the two classes of redeemednotes
differedgreatly.
ESTIMATESOF THE REDEMPTIONCOST
As explained,the only redemptioncost incurredby the issuingbankwas the
foregoneincomeon theaveragequantityof capitaltiedup in theperiodbetweenits
reimbursement
of the Treasurer
andthe reissueof its redeemednotes. Banksincludedtheredeemednotesin transitto themfromWashington
in a memorandum
to
the Comptroller
on "ownnoteson hand,''l7whichprovidesus with a roughestimateof thecapitaltiedup at anytime.Thisitemalsoincludesthetemporary
bulge
in noteson handof banksexpandingtheirissue,whichcanbe viewedalsoas a cost
of issue. (Banksreducingtheircirculation
didnotproducean offsettingsubtraction
fromthisitem,becauseon theirbookstheyimmediately
transferred
liabilityforthe
notesto the Treasurer.)
Banks'own noteson handas a percentageof totalauthorized
circulationfor all
nationalbanksfluctuatedoverthe period1900-14 between1 and2 percent,only
16Carlislecomplained that the fund was usually 30 to 40 percent deficient (ibid.). However, as
describedin the text, the Treasurerredeemednotes up to $500 for an issuing bankbefore notifying it, and
even when he had redeemedmore than $500, he sent notice only when the bank's name was reachedin
alphabeticalrotation. That procedureapparentlyaccounts for the major part of the deficiency.
Althoughbanks creditedtheir 5 percentfund accountat the time thatthey sent funds to reimbursethe
Treasurerand he countedthe funds when received, the time lapse was short. Goodharthas the mistaken
impressionthat "the issuing bankshad to ship lawful money to the redemptionagency in Washingtonto
rebuildtheirdepletedredemptionfund" (p. 521). In fact, on the average,70 percentwas paid either "by
a check drawnon New York, payable to the orderof the AssistantTreasurerof U.S. in New York, and
collectible throughthe clearing-house,forwardeddirectlyto that officer, with instructionsto deposit the
amounton accountof the five per cent fund," or by a deposit of lawful money at one of the subtreasuries
located in nine cities; 22 percentwas paid from the proceedsof redeemednotes of otherbanks;and only
the small remainderwas either paid over the counter at the TreasuryDepartmentor shipped there by
express (see Pratt's Digest, 1908 ed., p. 310, and Comptroller, 1887, p. 83).
17These "own notes on hand" were not shown as an asset on the balance sheet, at call dates. The
circulationitem the banks showed on their balancesheets as a liability was the circulationreceived from
the Comptroller,less own notes in vault or in transitfrom the Treasurer.The banks were subject to tax
only on the net figure, not the circulationreceived from the Comptroller.
The capital tied up by redemptionsin Cagan (1965, p. 89) was incorrectlyestimatedby the amounts
"due from Treasurer,"which national banks reportedon their balance sheets. This item implied an
additionalcapitaltied up of l/2to 1 percentof notes outstanding,a little smallerthanour presentestimate
of below 1 to 2 percent.
PHILLIPCAGAN AND ANNA J. SCHWARTZ : 303
rarely going slightly above that range. Adding $1 to $2 to the denominatorof the
rates of returnin Table 1 would reduce them substantially,but still leave them at
quite attractivelevels.l8
Fromdataon banks'own notes on handand the quantityof notes redeemedby the
Treasurer,both as a percentageof the authorizedcirculation,we can obtain a rough
estimate of the averagetime lapse between the notificationof banks that redeemed
notes were on their way from the Treasurerand the reissue of the notes. Thus
(monthlyredemptionsat Treasury)* (time lapse) = banks' own notes on hand. As
noted, this is an overestimate of the time lapse, since part of the notes on hand
reflected an expansionof issues. Even so, monthlyredemptionsaveragedabout 3.5
percentof the authorizedcirculationin 1901 and rose to about 8 percentin 191314.19 Using 1.5 as the average percentagefor notes on hand in most years, we
derive the time lapse as 1.5/3.5 = 43 percentof a month, or about two weekss in
1901, and 1.5/8.0 = 19 percentof a month, or about one week, in 1913- 14.
Between June 1900 and June 1914, the nationalbank circulationgrew 2.4 times,
while total currencyoutside banksgrew only 1.5 times. Over the same period, there
was a marked increase in the average frequency of redemptionsof national bank
notes, from once every thirty-twomonths to once every thirteen months.20 The
conjunctionof both changes is strikinglyinconsistentwith Goodhart'sclaim thatthe
cost of redemption was a significant expense for issuing banks that drastically
reduced the profit on nationalbank notes as we have computedit.
CITY VERSUS COUNTRYBANKS
To supporthis argumentthat redemptioncosts were important,but more so for
city banks than for country banks, Goodhartshowed (see his Table 2) that, while
country bank note issues rose, note issues of central reserve and reserve city national banks declined, 1908-13, relativeto their paid-incapital. No supportfor his
argumentis found, however, in the ratiosof banks'own notes on handto authorized
circulationfor the three reserve classes of nationalbanks (see Figure 1). It is these
ratios which indicatethe cost of redemptionsto issuing banks. The ratio was higher
for city than for countrybanks, but on the average never by more than about two
percentagepoints, which still gave city banks a handsomeprofit on issuing notes.
Moreover,the averagedifferencein the ratiofor the threeclasses of banks, far from
increasingover the period 1901-14, if anything,declined. If redemptioncosts had
18Noteson hand in 1905, slightly greaterthan in most otheryears, averagedabout $1.75 per $100 of
notes. Hence the profit rate including this cost for notes and secured by the 2s of 1930 in Table 1 is
(104.02-.01803 - 0.5625) . (4.02 + 1.75) = 22.8 percentinsteadof 32.7 percentas in Table 1. Own
notes presumablyincludednotes received from customersin paymentof loans, redeemednotes received
from the Treasury,and notes not yet circulated.
19Wehave no ready explanationfor that rise (but see note 20). Likewise, we have no explanationfor
the reductionin time lapse. Possibly express shipmentsbecame faster.
20Therewas a parallelincreasein frequencyof redemptionsof U.S . currency,from once every thirtynine months to once every twenty-one months. The ratio of currency to the total money stock was
declining duringthe period, and possibly the averagedollar of currencywas graduallycirculatingfaster
because it was coming to be used less and less as a store of wealth.
Per cent
6
5
10
ll
J0ntrol
reserve
a4::XS
O_
I
1901
I
'02
I
'03
I
'04
I
'05
I
'06
I
'07
I
'08
I
'09
I
'10
FIG. 1. NationalBank Notes of Issuing Banks
on Handas Percentof Notes Received from
Comptroller,by Reserve Cl
14. Source:Computedfrom table in
Comptrollerof Currencyannualreports, 1901-14,
"Specie and Circulationof Nation
Ended . . . "
PHILLIPCAGAN AND ANNA J. SCHWARTZ : 305
been important,that decline should have led city banks to expand their circulation
relative to that of countrybanks, contraryto what Goodhart'stable shows.
The ratio of reserve city banks' own notes on hand to circulationin most years
shows a sharppeak duringthe summeror autumnmonths. The peaks imply that it
was difficult for those banks to reissue their notes without some delay in those
months. Merchantbanks, doing little business over the counterwith the public, may
well have been limited in their ability to pay out currency,2lespecially during a
seasonal low in the public's demand for currency.It was no alternativeto use the
notes for settling adverseclearings with other banks, for the recipientbanks would
immediately send most of them throughthe redemptionprocess again. For some
city banks, therefore, the likely seasonal ratio of own notes on hand to circulation
may have been high enough to discourage any issues at all, making redemption
costs prohibitively high. But that could have been true of only a handful of specialized banks, as evidenced by the relatively low ratios for all banks in the aggregate. The Commercialand Financial Chronicle stated flatly (1900, p. 505):
a bank managerdoes not exist that ever found it difficult to get out of each year 12
months' earnings for its note issues.
OTHER ALLEGEDRISK FEATURESOF NATIONALBANK NOTE ISSUE
Champ(1990) alleges thatnationalbanksfaced substantialrisk in the intermediation of governmentbonds. Accordingto him, banksfaced term structurerisk to the
extent that their note liabilities were short-termpayable on demand, and the asset
backing was long-term governmentbonds. For this reason, he asserts that government bonds that served as backing typically were not held until the maturitydate.
Hence the possibility of capital losses on the bonds existed. He cites no evidence
that confirmsthat the prevalentpracticeof bankswas not to hold bonds to maturity,
however.
In additionChampcontendsthatthe possibility of a terminationof the circulation
privilege would have exposed banksto capitalloss on the bonds. Any risk of capital
losses, should the note-issuingprivilege be terminatedor costs of issue be substantially increased, was remote. To be sure, talk of banking reform was in the air
throughoutthe latter 1890s, and in the early l900s it intensified. Goodhartalso
suggests thatthe prospectof reformmade loss of the issue privilege a risk in holding
21Goodhartemphasizes instead the costs of redeemingnotes of other banks.
Moreover,the marginalcosts of note issue varied as between the city and countrybanks, for the
country banks could dispose of their unwantednotes by sending them off as interbankdeposits
where they paid 2 per cent. The city banksgot no interestat all duringthe transitperiodbetween
sending off excess notes for redemptionand receiving back lawful money from the redemption
fund. (p. 522)
As we have seen, for city bankstherewas, for the most part, no transitperiodat all in redeemingnational
bank notes-they simply exchanged them at a subtreasuryfor lawful money. Moreover, the cost of
redeeming the notes of other banks was irrelevantto a bank in deciding how many of its own notes to
issue.
306
: MONEY, CREDIT,AND BANKING
the bonds. He relies on a phrasein Bell's articleas evidence thatcity bankers,at any
rate, took the danger seriously. We have yet to find a shred of documentationthat
they were even concerned.In fact, when bankingreformwas legislated in 1913, the
note issue privilege itself was not changed.22It was finally withdrawnin 1935,
when the Treasurydid not extendthe issue privilegeto otherU.S. bonds when those
outstandingmatured,so that capitallosses throughsales of the low-yield bonds did
not occur and, indeed, were never likely.
But we cannot entirelyrule out the effect of this fear on banks' decisions. It may
have reinforced an attitude of bankersby which, as Bell suggested, they simply
did not want to load up with bonds because they viewed their role as commercial
lending, not passive investing in bonds.
CONCLUSION
By not bidding up the marketprices of the eligible bonds, nationalbanks did not
pursuerationalprofit maximization.There was no hidden cost. However negligent
of a profit opportunity,the banks did not give up much in total return.Given the
limitation of issuing notes up to 100 percent of capital, a representativebank
withoutreducingotherassets could have increasedits note issues by a thirdto a half
of its capital (Table 2), adding somewhat less than $1,000 to annual earnings per
$100 thousand of capital.23 Although not a road to unlimited riches, it was a
puzzling neglected source of income.
LITERATURECITED
Bell, Spurgeon. "Profiton NationalBank-NoteCirculation."American
EconomicReview2
(March 1912), 38-60.
Cagan, Phillip. "The First Fifty Years of the National Banking System." In Bankingand
MonetaryStudies,edited by Deane Carson, pp. 15-42. Homewood, Ill.: Irwin, 1963.
. Determinants
andEJ%ects
of Changesin theStockof Money1875-1960. New York:
National Bureauof Economic Research, 1965.
Champ, Bruce A. "The Underissuanceof National Banknotes during the Period 18631913." Workingpaper, University of WesternOntario, May 1990.
Commercial
andFinancialChronicle."Features,New and Old, of National Bank Notes."
March 17, 1900, 504-505 .
22Althoughthe profit on note issue was reduced by disallowing the inclusion of the 5 percent
redemptionfund to satisfy partof the banks'reserverequirementsagainstdeposits, the resultingincrease
in capitaltied up did not deterthe issue of notes, which continuedto expand. Nor did the prospectiveloss
of the issue privilege deter national banks from increasingnote issue when in July 1932 the range of
governmentbonds eligible as securitywas broadenedby an amendmentto the Home Loan Bank Act. For
a period of three years the amendmentpermittedthe use of all governmentbonds bearinginterestat 33/8
percent or less. National bank notes increased$220 million over the next year.
23Foreach $100 thousandin capital, the typical bankcould have added$30 to $50 thousandof bonds
to its assets, nearly all paid for with the expandednote issue. At net returnsof less than 2 percent, the
additionalbonds added less than $1,000 to annual earnings. With paid-in capital of $150 thousand,
aroundthe averagefor nationalbanksduring1900-20, the extraearningsneglected were at most $1,500.
PHILLIPCAGAN AND ANNA J. SCHWARTZ : 307
Friedman,Milton, and Anna J. Schwartz.A MonetaryHistory of the United States 18671960. Princeton, N.J.: PrincetonUniversity Press for National Bureauof Economic Research, 1963.
Goodhart,C. A. E. "Profiton NationalBank Notes, 1900-13." Journal of Political Economy 73 (October 1965), 516-22.
James, John A. The Evolution of the National Money Market, 1888-1911. Ph.D. dissertation, MassachusettsInstituteof Technology, 1974.
. "The Conundrumof the Low Issue of NationalBank Notes." Journal of Political
Economy 84 (April 1976), 359-67.
Pratt's Digest. Washington,D.C.: A. S. Pratt& Sons, 1908 ed.
U.S. Comptrollerof the Currency.Annual Report, various issues.
U.S. Congress. The National Currencyand Banking System. Hearings before the House
Committee on Banking and Currency.In H. Rept. 1508 (v. 1), 53rd Cong. 3d Sess.
(December 1894).