Readers Question: In early American banking history, banks would issue banknotes to patrons that were supposed to be backed by gold and silver. My questions is, what did the patrons give the banks to get the bank notes, and why were many banks unable to make payment on demand when the patrons tried to exchange their notes?
Banknotes have evolved over time. Initially bank notes were issues in lieu of precious metals and were essentially I O U’s. A more technical term is that bank notes were ‘promissory’ – Rather than give gold to customers, banks gave a credit note saying they promised to exchange this credit note for an equivalent sum of gold or silver.
Over time, gold and silver were no longer used in the monetary system, thus bank notes became effective credit notes.
It was the banks who were most keen to use promissory notes rather than deal in precious metals. Bank notes had the advantage that is was easier to transport, lower costs and, most importantly, enabled the banks to make better use of their assets.
Therefore, to gain bank notes I think that the patrons merely had to have an account with the bank.
My issuing notes, banks were able to use there assets to much better effect.
The basis of the Banking system is that banks only keep a small percentage of their deposits and then lend out the remainder to borrowers. Banks can charge a higher rate to the borrowers than it pays to savers and this is how the bank can make profit.
If people deposited £100 million and the bank had to keep £100 million in gold, then the deposits at the bank would be unprofitable because it couldn’t lend anything out.
Therefore, if a bank has deposits of £100 million. It may only keep 1% £1 million in actual cash. Therefore if people come to the bank wanting to withdraw all their money, the bank is stuck. It cannot give all the bank customers their money because the money is tied up in the form of loans to other businesses.
In the Great Depression of the 1930s, people lost confidence in the banking system and so went to withdraw their money. But small and medium sized firms soon ran out of liquid cash and this led to the bankruptcy of many banks.