Howard Bodenhorn notes that banks allowed for supplying residents with a local currency and a source of credit.
Howard Bodenhorn, A History of Banking in Antebellum America: Financial Markets and Economic Development in an Era of Nation-Building (New York: Cambridge University Press, 2000), 17-20, 46-47
Besides creating prices and creating liquid forms of investment, there were direct and not inconsequential social savings arising from the appearance of bank-issued currencies. One benefit of the arrival of financial institutions was that individuals could release their holdings or hoards of relatively unproductive precious metals whose value in exchange typically reflected their true opportunity costs (that is, $100 in gold exchanged for $100 in cattle). In the alternative, once money-creating institutions arose, precious metals could be replaced by paper certificates with far lower resource costs (that is, less than 1 cent in paper and ink exchanged for $100 in cattle), which carried promises to be exchangeable into specie at their stated value. This process freed up metals to be used in alternative productive uses, whether religious icons, yachting cups, jewelry, or the settlement of foreign exchange claims.
Clearly, the resource costs of fractional-reserve currency carrying a redemption guarantee did not reduce the resource costs of banksupplied currency to zero as does a fiat currency issued by a central bank. Transactions were still based on specie convertibility and banks were forced to hold bullion and coin to meet redemption demands. But a fractional reserve system remained a cheaper way to provide a given volume of money than did a pure specie basis. Additionally, the use of specie was not reduced to its theoretical minimum because many people remained wary of banks because some banks occasionally failed to meet their redemption promises.
That redemption guarantees were not always honored does little to change the essence of the argument. Occasional reneging on the redemption guarantee may have diminished the use of paper money below its socially optimal level in a risk-free world, but even contemporaries new that such a place was not and could not be. “Every one knows,” wrote one, “that the banking system, wherever and however pursued, is not unattended with the possibility of loss. ... [But] [i]f our policy is to be founded on indefinite apprehensions, let us extinguish the banking system altogether, and when we have returned to a pure metallic currency, we shall find that the perils of false brethren, of thieves and counterfeiters, of negligence and accident, are yet to be encountered.”
Whatever the risks of a bank-supplied currency, it was apparent that most Americans were willing to accept them. They could have done away with banks at any time had the perceived risks and expected costs of bank-supplied currency outweighed the social savings it generated. That Americans chose not to and that they, in fact, continued to accumulate ever larger bank-supplied currency balances should tell us something about their perception of the utility of banks.
Money creation by banks, however important it may have been, was incidental to their most fundamental task — that of intermediating between borrowers and lenders, savers and investors. What is the business of financial intermediaries generally? Early Americans, like Nathan Appleton, believed that banks acted “merely as convenient brokers between the owners of capital, and the persons employing it.’ One could quibble with his choice of words, but he understood the basic point, that financial intermediation involved a redirection as well as a transformation of funds — twin functions that distinguished intermediaries from other types of economic units. They redirected funds by taking them from the hands (or hoards) of savers and placing them in the hands of investors. And they transformed those funds by taking up one kind of debt instrument (primary debt
issued by the ultimate investor) and offering their own debt instruments (banknotes and deposits) in return.
Modern research has laid out a number of reasons why banks were called on to perform these coincident tasks. Scholars such as Eugene Fama, Ben Bernanke, and Mark Gertler, among others, have argued that banks supplied critical intermediary roles to overcome information asymmetries with their resulting agency problems, to minimize monitoring costs, and to resolve differing preferences for maturity, liquidity, and divisibility between savers and investors. Though modern research has offered formal and sophisticated models to support their claims, the basic intuition underlying them was not unknown to nineteenth century Americans. One, writing in the North American Review in 1827, noted that “individuals with loanable funds would hardly know who merited their confidence . . . and would frequently allow their funds to lie idle were it not for the intercession of banks. These institutions ‘assume the responsibility of the debtor; they relieve the creditor of his anxiety and doubt; they enable him to divide into small portions and transfer some of his risk to those with whom he deals.’”’ In other words, through their intermediation services banks allowed individuals to lend relatively small sums in relatively liquid form. In addition, banks assumed a greater part of the risk even while reducing it substantially through broad diversification and performed the critical monitoring of the borrowers’ behavior. By pooling the funds of hundreds of small savers, banks were able to perform these tasks at a much lower aggregate cost than had each of these individuals attempted to lend on their own.
. . .
The arrival of financial institutions, therefore, represents a fundamental and important innovation in the saving-investment process. At its most fundamental level, credit money, such as banknotes and deposits, facilitates economic growth by economizing on the stock of idle specie and, by varying liquidity and leverage ratios, makes the supply of money more elastic than it would otherwise be. No longer tied directly to inflows and outflows (though to this point international influences have been ignored) the money supply can expand and contract in response to internal macroeconomic circumstances, while the stock of specie can be employed in settling international debts or industrial uses. In addition, depending on the state of a country’s coinage, the substitution of bank-issued money for commodity money can facilitate transactions. One feature of most western countries on the verge of developing was the rather sad state of the domestic coinage. It was notoriously bad in England and Scotland, and Rondo Cameron claimed that it was equally bad in Germany, Belgium, and Japan. North America, too, labored under the weight of a poor coinage that increased transaction costs at least until the mid-nineteenth century.
Intermediaries, however, play a more important role than simply replacing a poor currency with a better one — though that role should not be minimized as the search for alternatives may lead to imaginative improvisation out of which original credit instruments develop.* More importantly, financial institutions permit households and businesses to move resources through time to better meet their temporal consumption preferences. In a world in which each economic unit took in exactly the same amount as its desired expenditures there would be no role for financial intermediaries. No enterprise would require external financing, nor would any unit have a surplus searching for investment. But, it is indeed rare that consumption preferences are perfectly synchronized with income flows. Merchants require funds for inventories prior to sale. Farmers demand funds for seed and fertilizer before the crop is harvested. Manufacturers demand funds to pay for labor and raw materials before production is complete. Households want homes before they have the full purchase price. In the end, meeting these differing temporal consumption preferences gives rise to financial intermediaries.