Banking today is much the same everywhere. And, at the broadest level, today’s banks are not much different from banks hundreds of years ago. Philadelphian Thomas Willing, America’s first banker and life insurer, and a marine insurance pioneer, would likely understand the functioning of today’s largest, most complex banks and insurance companies with little trouble.^[112] (He’d certainly understand interest-only mortgages because he used them extensively as early as the 1760s.) Despite broad similarities, banking and other aspects of the financial system vary in detail over time and place, thanks in large part to innovations: new ideas, products, and markets. Innovation, in turn, is driven by changes in the financial environment, specifically in macroeconomic volatility, technology, competition, and regulation. (We’ll discuss the economics of regulation in detail in Chapter 11, The Economics of Financial Regulation. Here, we’ll simply mention regulations that have helped to spur innovation.)

The first U.S. commercial bank, the Bank of North America, began operations in early 1782. For the next two centuries or so, banking innovation in the United States was rather glacial because regulations were relatively light, pertinent technological changes were few, and competition was sparse. Before the Civil War, all but two of America’s incorporated banks were chartered by one of the state governments rather than the national government. Most states forbade intrastate branching; interstate branching was all but unheard of, except when conducted by relatively small private (unincorporated) banks. During the Civil War, Congress passed a law authorizing the establishment of national banks, but the term referred only to the fact that the national government chartered and regulated them. Despite their name, the banks that came into existence under the national banking acts could not branch across state lines, and their ability to branch within their state of domicile depended on the branching rules imposed by that state. As before the war, most states forbade branching. Moreover, state governments continued to charter banks too. The national government tried to dissuade them from doing so by taxing state bank notes heavily, but the banks responded nimbly, issuing deposits instead. Unlike most countries, which developed a few, large banks with extensive systems of branches, the United States was home to hundreds, then thousands, then tens of thousands of tiny branchless, or unit, banks.

Most of those unit banks were spread evenly throughout the country. Because banking was essentially a local retail business, most unit banks enjoyed near-monopolies. If you didn’t like the local bank, you were free to do your banking elsewhere, but that might require putting one’s money in a bank over hill and over dale, a full day’s trek away by horse. Most people were reluctant to do that, so the local bank got their business, even if its terms were not particularly good. Little regulated and lightly pressed by competitors, American banks became stodgy affairs, the stuff of WaMu commercials.^[113] Spreads between sources of funds and uses of funds were large and stable, leading to the infamous 3-6-3 rule: borrow at 3 percent, lend at 6 percent, and golf at 3 p.m.

Near-monopoly in banking, however, led to innovation in the financial markets. Instead of depositing money in the local bank, some investors looked for higher returns by lending directly to entrepreneurs. Instead of paying high rates at the bank, some entrepreneurs sought cheaper funds by selling bonds directly into the market. As a result, the United States developed the world’s largest, most efficient, and most innovative financial markets. The United States gave birth to large, liquid markets for commercial paper (short-dated business IOUs) and junk bonds (aka BIG, or below investment grade, bonds), which are high-yielding but risky bonds issued by relatively small or weak companies. As noted in Chapter 8, Financial Structure, Transaction Costs, and Asymmetric Information, however, markets suffer from higher levels of asymmetric information and more free-rider problems than financial intermediaries do, so along with innovative securities markets came instances of fraud, of people issuing overvalued or fraudulent securities. And that, as we’ll see in Chapter 11, The Economics of Financial Regulation, led to several layers of securities regulation and, inevitably, yet more innovation.