The Mystery of Banking

central reserve city
, which was then only New York; 
reserve
city
, for other cities with over 500,000 population; and 
country
,
which included all other national banks. 
Central reserve city banks were required to keep 25 percent
of their notes and deposits in reserve of vault cash of 
lawful
money
, which included gold, silver, and greenbacks. This provi-
sion incorporated the reserve requirement concept which had
been a feature of the free banking system. Reserve city banks, on
the other hand, were allowed to keep one-half of their required
4
See Bray Hammond, 
Sovereignty and an Empty Purse: Banks and Pol-
itics in the Civil War
(Princeton, N.J.: Princeton University Press, 1970), pp.
289–90.
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Central Banking in the United States III
225
reserves in vault cash, while the other half could be kept as
demand deposits in central reserve city banks. Finally, country
banks only had to keep a minimum reserve ratio of 15 percent to
their notes and deposits; and only 40 percent of these reserves
had to be in the form of vault cash. The other 60 percent of the
country banks reserves could be in the form of demand deposits
either at the reserve city or central reserve city banks. 
In short, the individualized structure of the pre-Civil War
state banking system was replaced by an inverted pyramid of
country banks expanding on top of reserve city banks, which in
turn expanded on top of New York City banks. Before the Civil
War, every bank had to keep its own specie reserves, and any
pyramiding of notes and deposits on top of specie was severely
limited by calls for redemption in specie by other, competing
banks as well as by the general public. But now, all the national
banks in the country would pyramid in two layers on top of the
relatively small base of reserves in the New York banks. Further-
more, these reserves could consist of inflated greenbacks as well
as specie. 
The national banks were not compelled to keep part of their
reserves as deposits in larger banks, but they tended to do so.
They could then expand uniformly on top of the larger banks,
and they enjoyed the advantages of having a line of credit with a
larger “correspondent” bank as well as earning interest in demand
deposits at their bank.
5
Furthermore, in a way pioneered by the free banking system,
every national bank’s expansion of notes was tied intimately to its
ownership of U.S. government bonds. Every bank could issue
notes only if it deposited an equivalent in U.S. securities as collat-
eral with the U.S. Treasury. Hence national banks could only
expand their notes to the extent that they purchased U.S. govern-
ment bonds. This provision tied the national banking system
closely to the federal government’s expansion of public debt. The
5
Banks generally paid interest on demand deposits until the Federal
Government outlawed the practice in 1934.
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226
The Mystery of Banking
6
See Smith, 
Rationale of Central Banking
, p. 48.
7
See ibid., p. 132.
federal government had an assured, built-in market for its debt,
and the more the banks purchased that debt, the more the bank-
ing system could inflate. 
The pyramiding process was spurred by several other provi-
sions of the National Banking Act. Every national bank was com-
pelled to redeem the obligations of every other national bank at
par. This provision erased a severe free market limit on the circu-
lation of inflated notes and deposits: depreciation increasing as
one got farther away from the headquarters of the bank. And
while the federal government could scarcely make the notes of a
private bank legal tender, it conferred quasi-legal tender status on
the national banks by agreeing to receive their notes and deposits
at par for dues and taxes. And yet, despite these enormous advan-
tages granted by the federal government, national bank notes fell
below par with greenbacks in the crises of 1867, and a number of
national banks failed that year.
6
While national banks were required to redeem the notes and
deposits of each other at par, the requirement was made more dif-
ficult to meet by the government’s continuing to make branch
banking illegal. Branch banking would have provided a swift
method for banks calling on each other for redemption in cash.
But, perhaps as a way of blocking such redemption, interstate,
and even more, intrastate, banking continued to be illegal. A bank
was only required to redeem its own notes at its home office, mak-
ing redemption still more difficult. Furthermore, the redemption
of notes was crippled by the federal government’s imposing a max-
imum limit of $3 million a month by which national bank notes
could be contracted.
7
In addition, limits which had been imposed
on the issue of national bank notes were removed in 1875, after
several years of the banks’ straining at the maximum legal limit. 
Furthermore, in June 1874, the structure of the national
banking system was changed. Congress, in an inflationist move
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