Rohit Potaraju

ECO 322
Mr. Trinque
2/8/16

Practice Report (Lamoreaux)

In the late nineteenth century banks in New England enjoyed a specialized part in
the economy, concentrating on the provision of short term loans to commercial borrowers
and disregarding long term relations with the industrial enterprises. This particular
situation came about because of a specific mix of circumstances: an enormous
development in the number of banks, and a sudden increase in the use of deposits of
lendable funds. The latter development increased the interdependence of the banking
system, making each institution vulnerable to runs provoked by the unsound practices of
its competitors. The former made it difficult to regulate the lending practices of individual
banks. Peoples and institutions greed in the early banking practices in New England
paved the way and provided a strong foundation for todays banking system and short
term bond loans helped get the banking system in place.
Dating back to early 1800s during the civil war, the banking system was based on
the economic and political environment. The greed started here when the directors of the
banks and their close associates during this time absorbed as much as 50 to 90 percent of
the institutions lendable funds. This kind of behavior right now in this economy would

cause a huge financial crisis. Imagine if the bank directors of J.P Morgan had consumed
50 and 90 percent of the all the institutions lendable funds? The whole economy would
collapse and there would probably be another depression. But, as it turns out this extreme
degree of favoritism caused a resentment in people. So, legislators were forced to pass
legislation which allowed for more banks to be created. There were more than 500 banks
per region created which tremendously helped the economy. So we can see here how
thirst for money led to the development of an enormous number of banks.
Late nineteenth century was a time when real bills were declining in volume
relative to the other kinds of business paper. This caused the banks to move away from
the real paper which caused for favoritism to re-emerge. When a bank was supposed to
give out loans, they over valued the assets of enterprises which led to bank failures in the
1880s. According to journalists this was due to the very poor security of the loans made
by the bank officers who had a a pecuniary interest in the enterprises that received the
money (Lamoreaux). It is said that the officers well knew in most of these cases that
the securities were of a hazardous nature. And they would never accept these securities,
except for their own interest in these outside undertakings (Lamoreaux). This shows us
how the greed and thirst for money can lead to disastrous financial events. But as it
always happens these mistakes were rectified by a bunch of conservative bankers who
began to promote some new standards for loans. They needed the collateral loans to be
backed by securities that commanded ready market on the exchanges, so their values
could be easily assessed (Lamoreaux). Banks were asked to have a better check on the

financial statements as well. This credit system has minimized judgement problems
which has helped progress the banking system in America.
Financial institutions provide most external debt financing for small
businesses. Thus for most small businesses banks loom large. In fact, modern theories of
financial intermediation view intermediaries as delegated monitors and are mostly
theories about funding small, informationally opaque firms. To deal with information and
incentive problems surrounding small business finance, intermediaries use collateral,
personal guarantees, and foster long-term relationships with borrowers. Both practicing
bankers and economic theorists have long argued that bank relationships are valuable.
With repeated contracting with borrowers, banks continuously gather information and
update their evaluations of firm credit worthiness. Information is gathered through repeat
lending or the provision of deposit and other information-intensive financial services.
Theory holds that small businesses that form relationships with a principal bank secure
several advantages, including lower interest costs, greater credit availability, lower
collateral demands, and protection against credit rationing in periods of firm distress. Yet,
despite a general sentiment that firm-bank relationships are valuable, the empirical
evidence remains inconclusive.
The short term loans were the main scope of the banking operations in the late
nineteenth century. These loans were based on commercial paper and easily convertible
assets. These loans became so important because it is believed that the best means of
insuring that loans would be given according to objective criteria, such that a banker

could exercise no arbitrary discretion when he extends or refuses accommodation to the

borrower (Lamoreaux). This standard for loans were closely related to the ideal of real
commercial paper, therefore the banks could avoid the confusion between lender and
borrower which was the main cause for a week security of the banking system. So the
short term loans were not only used for liquidity but also for security purposes.
Not only were the short term banking loans useful for security reason but they
were also highly profitable. Most bankers by the end of 19th century shifter their
portfolios to short term commercial loans. Big banks used this to make huge profits.
Another reason is because of the demand for other types of loans has declined as a result
of growing availability of equity finance (Lamoreaux). Also, from a big banks point of
view, a firm seeking a long term loans were one whose capital was not sufficient to
conduct ordinary business and was on a poor credit risk. All of the above reasons made
short term commercial loans are very important part of the banking system. By
promulgating strict measures for short term commercial loans, bank reformers looked to
build the ability of executives and stockholders to monitor the choices of their banks'
supervisors and, in the same time, to restrict the harm to the banking system that deceitful
investors could cause. Comparatively issues of control emerged in the British banking
system in the same century, and might clarify the simultaneous movement toward short
term commercial loans that happened in that country. Extensive German banks could
restrict the autonomy of their competitors and subsequently the risk to the security of the
managing a banking system that they postured.

What we can learn from this analytical summary is, that the peoples greed and
thirst for money have paved the way for better banking practices. All the above
arguments show us that. Also, the short term commercial loans have come a long a way
and played a major key in the formation of standards to protect the security of our
banking system.
Works Cited
No Arbitrary Discretion: Specialisation in Short-Term Commercial Lending by Banks
in Late Nineteenth-Century New England, Naomi R. Lamoreaux, Business History
Vol. 33, Iss. 3, 1991