Reputation formation in early bank note markets

  • Gorton G
  • 29

    Readers

    Mendeley users who have this article in their library.
  • 53

    Citations

    Citations of this article.

Abstract

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 corre- sponds to the formation of a "reputation," a valuable asset that pro- vides 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 stud- ied consists of new banks issuing bank notes for the first time during the American Free Banking Era (1838-60). The presence of a repu- tation effect in note prices is confirmed: the notes of new banks are discounted more heavily than the notes of banks with credit histo- ries. 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 techno- logical improvements in information transmission, namely, the in- troduction 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").

Get free article suggestions today

Mendeley saves you time finding and organizing research

Sign up here
Already have an account ?Sign in

Find this document

Get full text

Authors

  • Gary Gorton

Cite this document

Choose a citation style from the tabs below

Save time finding and organizing research with Mendeley

Sign up for free