Collateral Analysis:

Nineteenth century commercial banks earned their profits to a large extent by financing the inventories of shopkeepers and their supply chains. The expansion of manufacturing during the Industrial Revolution resulted in lower prices, broader distribution channels and an explosion in mercantile trade. As the first department stores were developed in the early 1850s, merchants increasingly asked for greater lines of credit to support their growing businesses. The standards used by bankers to evaluate their customers were described by J.S. Gibbons in The Banks of New York, Their Dealers, The Clearing House, and the Panic of 1857, which was published in 1858 by D. Appleton & Co. in New York.

Merchandise is sold from first hands to the jobber on a credit of eight months, more or less, for which the latter gives his promissory notes. The jobber sells in small quantities, by the piece or single package, to the retailer, on a credit of six months. The ability of the retailer to pay the jobber depends chiefly on the punctuality of the consumer in settling his bills. Thus each class of merchants is dependent on another class for the means of liquidation. A large cash capital may enable a man to pay all his notes at maturity, even if his debtors fall considerably in arrears; but the majority of traders of all classes are obliged to carry full lines of credit. This system supplies our banks with promissory notes, the discount of which is their principal source of profit.

The nineteenth century was a time of great change in banking, just as we are experiencing today. However, unlike today, this was a period of bank expansion, not contraction. Before 1838, banks could only be created in the United States by special charter granted by the state legislature. Between 1838 and the passage of the National Bank Act of 1863, the establishment of a commercial bank was permitted for any organization that met certain capital requirements and backed its bank notes with gold or silver. In essence, the precious metal acted as collateral backing the bank’s notes, which were given to the borrower as currency.

The New York City banks do not discount paper until it comes within two or three months of maturity. That which has a longer period to run is therefore unavailable for direct use. The bank, however, will admit a modification of its rules, when satisfied that the notes are good. It will receive a certain amount of them as collateral security for the merchant’s note payable within the required time, reserving in such cases what it’s called margin for contingent losses. Thus the dealer may deposit $12,000 of paper, which has from four to eight months to run, coupling with it his own note for $6,000 or $8,000 at 60 days.

The excess is the margin intended to cover loss by the possible failure of some of the drawers, and the expenses of collection and interest that would accrue, if the dealer himself should fail and oblige the bank to have recourse to the collateral notes. This is a very simple operation in appearance; but it involves the exercise of no common sagacity and discretion on the part of the bank officers. They must endeavor to maintain accurate knowledge of the affairs of the merchant to whom the loan is made, and of the responsibility of the drawers of the collateral notes.