Reputation Formation in Early Bank Note Markets

Two hypotheses concerning firms issuing debt for the first time are tested. The first is that new firms' debt will be discounted more heavily by lenders, compared to firms that have credit histories (but are otherwise identical), and that this excess discount declines over time as lenders observe defaults. The declining interest rate corresponds to the formation of a "reputation," a valuable asset that provides an incentive for firms not to choose risky projects. The second hypothesis is that prior to the establishment of a reputation, new firms issuing debt are monitored more intensely. The sample studied consists of new banks issuing bank notes for the first time during the American Free Banking Era (1838-60). The presence of a reputation effect in note prices is confirmed: the notes of new banks are discounted more heavily than the notes of banks with credit histories. Note holders are then motivated to monitor new banks because the excess discount provides an incentive for the notes of new banks to be redeemed. As lenders learn that new banks can redeem their notes, the discount declines as predicted for surviving banks. The precision of learning increases during the period because of technological improvements in information transmission, namely, the introduction of the telegraph and the railroad. The results explain why the pre-Civil War system of private money issuance by banks was not plagued by problems of overissuance ("wildcat banking").