Alchemy and ambitious Yankees

Insider Lending
January 27, 1995

At the beginning of the 19th century, New England was the most economically developed region of the new United States, opportunity rich but capital poor. Cheap cotton and the use of English technology to meet a buoyant demand for textiles was perhaps the most important avenue for growth, but trading, often based on abundant timber, grain, and fish, followed closely. The perennial question was how to develop these opportunities when credit was cripplingly scarce and expensive? The response of ambitious Yankees was to create banks. In 1784 New England -- as defined in Insider Lending -- boasted but one bank. By the time of the cyclical economic peak of 1837, the region possessed no less than 320 banks.

While a handful of important banks were established by wealthy merchants with more resources than attractive investment outlets, most were founded by men with a deep hunger for credit, who viewed a bank as a kind of alchemist's engine to create wealth. Having secured a state charter to form a bank -- a charter the elite merchants who owned the region's oldest and most secure banks believed to be scandalously easy to obtain -- these credit-hungry owners deposited in their new institution, for the sole benefit of state bank examiners, the liquid funds pledged in their charter application. Some of these funds might have come from the incorporators themselves, but often the funds were borrowed on a short-term basis; indeed, sometimes all the funds were borrowed on the strength of the collateral of the new bank's shares. As soon as the bank examiners certified the bank for operation, the borrowed funds were repaid. This left the new bank with an operational charter, some kind of an address, but few, if any, resources. These the incorporators invariably now tried to raise by selling to a wider public more equity shares in their fledgling enterprises.

But why would anyone, except in a fit of madness, buy shares in enterprises often consisting of little more than an empty shell? The attraction rested on the reputations and future prospects of the incorporators rather than on their current resources. In Insider Lending, Naomi Lamoreaux convincingly argues that many of New England's banks in the first half of the 19th century were not really banks at all in the modern sense, but rather investment clubs whose expected profitability depended upon the diversified investment opportunities possessed by the incorporators, the bank's "insiders". Lamoreaux demonstrates this argument by noting the very high proportion of all loans made by such "banks" to the corporate insiders of the new institutions. Insiders frequently borrowed from the bank to the point where "outsiders" could obtain nothing. If the loans were duly paid off, as they had to be for the insiders to maintain their original reputations, the bank (and hence all shareholders, both insiders and outsiders) received generous interest in addition to the return of principal, which was often at least partially secured on insiders' assets (including, but not exclusively, bank shares).

Insider lending was surprisingly successful. Many of the new banks flourished and in time came to rival, if not surpass, the established elite. A variety of incentives and constraints were responsible for this. The directors monitored each others' borrowings closely -- for excesses or errors by one could ruin them all. Moreover, because of the active involvement of the directors, they could make know- ledgeable judgements of each others' investments. And because bank charters were relatively easy to obtain, outside borrowers excluded by banks lending only to insiders, always had the option of forming their own bank.

The very success of insider lending hastened its decline. Vigorous enterprises generated cash flows so strong that not all the cash could be reinvested usefully. The balance began to swing -- slowly at first, then increasingly swiftly after the end, in the mid-1870s, of the great post-Civil War boom -- from a situation of more opportunities than loanable funds to the opposite situation.

The number of new banks fell sharply, and established banks began actively to seek deposits in order to leverage capital. But as deposits grew and insiders' demands for loans fell, much greater care had to be exercised in making loans: after all, deposits could be withdrawn at short notice, particularly during a cyclical downturn. Moreover, as personal know- ledge of the borrowers declined, it became harder for the banks to evaluate requests for loans.

Their response was to devise and formalise rules which restricted loans either to well collateralised projects or to short-term, (presumably) self-liquidating transactions.

The next step was to attack the banks' cost base through merger and rationalisation. In this manner the close links between banks and local industry that had existed for most of the 19th century were progressively weakened. The enlarged banks, especially in Boston, the financial centre of New England, increasingly separated their lucrative and growing security operations from their day-to-day lending decisions. Security operations were effectively controlled by the elite investment banks in New York, while Boston banks practised increased care in making conventional loans to local firms.

Lamoreaux argues that the main losers in this transformation were new manufacturing enterprises, notably in new or rapidly evolving industries, with few liquid assets yet unusually promising prospects. Such enterprises were often considered too risky for loans and too small for security flotations. This development in the financial system, Lamoreaux suggests, froze New England's industrial structure in the form of cash-rich but prospect-poor industries, just as surely as it had in Britain.

Such a hypothesis, while intriguing and not implausible, lacks the persuasive documentation characteristic of the author's narrative of the rise and triumph of insider lending. Lamoreaux fails to explain why the earlier tradition of discouraged borrowers starting their own banks did not continue. Why, at the end of the century, was New England's banking elite more secure against upstarts than at the beginning? Some of her own evidence undermines her case. She offers none, in marked contrast to the earlier part of the book, for the profitability of neglected industries, although she does refer to the preliminary, but unpublished, findings of a research project she has conducted with Kenneth Sokoloff, which should yield such information. However, that must be deferred to another book.

William P. Kennedy is a lecturer in the department of economic history, London School of Economics.

Insider Lending: Banks, Personal Connections and Economic Development in Industrial New England

Author - Naomi P. Lamoreaux
ISBN - 0 521 46096 4
Publisher - Cambridge University Press
Price - £30.00
Pages - 170pp

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