The next step taken in the progress of banking in New York was the installation of the Free Banking System. The panic of 1835 created a demand for a general revision of the private banking laws, particularly those having to do with the securing of charters. As we have seen, a bank charter was often a political gift or purchase.

Few could gain the privilege and fraud and corruption were common features of what should have been a simple business transaction. Something had to be done to mitigate the evils of the banking monopoly as held by the chartered banks. Something had to be done, also, to prevent a recurrence of the wholesale failures which were shaking men's confidence in all banking systems. Abijah Mann fathered the act of April 18, 1838, by which the Free Banking System of New York was established.

Into the twenty-six sections of this law it is hardly necessary to go. The feature of the act which made it notable as New York's second important contribution to banking was that it was the "first practical exponent of the principle of a bank circulation secured as to its ultimate redemption, by collaterals placed beyond the power of the bank, in the custody of the government." Under the law any association wishing to issue notes was required to deposit, with the State Comptroller, bonds of the United States or of the State of New York, or any other approved bonds, or certain classes of real estate mortgages, to be the security for one-half of the bank's circulation. In case of failure the State was to employ the securities to redeem the outstanding notes.

This system of free banking was the model after which the National banks set up during the Civil War were patterned. While not the first such system to be established, Michigan had tried it the previous year, it was the first that was enforced successfully and the one copied in most of its features by sixteen other States. The system was not perfect; there were too many loop-holes through which the schemer might crawl. The range of securities which could be deposited was too wide and led to losses which averaged almost a third of the par value of the notes issued by failing banks. With the door opened to everyone who could deposit the required securities, too many entered it, and failures were numerous during the first decade. Amendments were made in 1844 and 1846 which strengthened the system. In the first year it was required that every prospective banker should make a substantial deposit of specie; in the latter year a double liability was placed upon the stock-holders.

 In 1846 the Legislature was "forbidden to legalize the suspension of specie payments, or to grant special charters." The restrictions upon chartered concerns, the better standing of the "Free" banks, and the difficulties attending the renewal of a charter, led most of the banks in the State to reorganize under the free system. "In 1848 the number of free banks was fifty-three, and of individual bankers fifty-one, with an aggregate circulation of $9,993,762, against securities amounting to $10,640,182." Minor modifications in the State banking laws were made from time to time, and general revisions of all statutes in 1882, 1892, and later.

Trials of the Free Banking System

The free banking system had to have its trials before proving itself worthy. One of its severest tests came in 1857, when the "Western Blizzard," as the panic of that day was called, hit the banks of the East. There had been a war with Mexico which, while it was not followed by the customary boom, did boost business. The discovery of gold in California in 1848 with the subsequent adding to the gold supply of the country profoundly affected the economic development of the Nation. Everything seemed prosperous and speculation again lifted its head. True there was a warning given by several failures in 1854 of prominent banks including one in Buffalo. 

But another boom had been born and by 1856 had reached unusual limits. In the early months of 1857 the Nation had every appearance of extraordinary prosperity. Then came an unexpected slacking of pace; credit had again been stretched too far. Supposedly strong banks in the West failed, and immediate demands were made upon the financial resources of New York, more particularly of the city. Several of the failures had been due to embezzlements and stock gambling. 

The populace lost faith in all banks and raided them for their deposits. In September many of the large banks in the country suspended; New York tried to breast the wave. The Bowery Bank went under first, and runs were started on the other city institutions. On October 13, 1857, $4,500,000, about nine per cent of the total deposits in coin were withdrawn from metropolitan banks, and that evening it was decided to suspend specie payments. It is said that with the exception of the Chemical Bank of New York and a very few others, all the banks in the country stopped payment.

In New York the suspension lasted only sixty days. Two things were shown concerning the banking system of the State: That the reserve required was hardly enough for safety, and banking was too "free." It was too easy to issue bank notes; any individual or association could send out its notes so long as they abided by the rules. Under the system the fluctuations in the amount and value of paper currency in the United States was greater than any other country, and tended to produce too many bankruptcies and failures. 

These conditions were in a measure corrected during the Civil War by the National Bank Act, which, while in many respects founded upon the Free Banking Law of the State of New York, differed radically from it in its effect upon the promiscuous circulation of notes. One odd result of a part of the Free Banking Law was that by the section which forbade a bank to suspend specie payments under penalty of forfeiture of charter all the banks in the State were automatically threatened with loss of their charters for having done so. Favorable court decisions determined the status of the banks to the satisfaction of all concerned.