Michigan Act (1837)
In the early and mid nineteenth century the supply of gold and silver coins was insufficient to serve as the only form on money as is prescribed by a literal interpretation of the Constitution. For this reason and despite its inherent risks, state banking thrived as a means of augmenting the money supply. To further facilitate the growth of banking, the 1837 Michigan Act was adopted as the first of the nation's free banking laws. Literally, a free banking system is one without any form of government restriction on banking activities, save the enforcement of legal contracts and prohibitions against fraud (Sechrest, 3). The Michigan Act did not achieve this pure definition, but it and the other free banking laws enacted in subsequent years constitute the closest the U.S. has come to literal free banking.
The Michigan Act granted a banking charter to any person or group that satisfied established criteria, rather than requiring an act of the Michigan legislature each time a new group petitioned to open a new bank. Specifically, the bank's owners had to purchase at market value state bonds and then deposit those bonds with the state auditor as collateral. However, the bank could issue banknotes up to the marketvalue of the bonds, so the performance of the bond market directly affected the system's ability to issue notes. Banks were also required to redeem their notes on demand in gold or silver coin. Failure to do so resulted in the bank being closed by the state, and the bank's assets being liquidated. The state's bank examiners were in charge of enforcing this specie reserve requirement, but the banks were always one step ahead. Consider this account given by Galbraith:
At the outer extreme of compliance, a group of Michigan banks joined to cooperate in the ownership of reserves. These were transferred from one institution to the next in advance of the examiner as he made his rounds. And on this or other occasions, there was further economy; the top layer of gold coins in the container was given a more impressive height by a larger layer of ten-penny nails below. But not all of the excesses of leverage were in the West. In the same years, in the more conservative precincts of New England, a bank was closed up with $500,000 in notes outstanding and a specie reserve of $86.48 in hand (Galbraith, 63-64).
In addition, depositors were granted a lien on the bank's assets. Other than these conditions, there were no significant restrictions on a bank's activities in the free banking system (Sechrest, 96-100).