Prior to 1838 bank charters in New York were granted by special act of the legislature and in many cases they were given as patronage to political favorites. As a result of the bank monopoly thus developed and the political abuses and corruption attending it, there arose a strong sentiment in favor of a "free banking" law. The free banking system established in 1838 authorized any person or association of persons to set up a bank and issue circulating notes by depositing with the state comptroller certain kinds of securities as a protection to note holders. These securities might consist of bonds of the United States, of the State of New York or other approved states, or mortgages on real estate worth double the amount of the mortgage and bearing interest at not less than 6 per cent. Not more than one-half of the securities pledged could consist of mortgages. No provision was made for redeeming the notes in specie, but when a bank failed, the securities were to be sold to redeem its outstanding notes.
Under this system anyone having the necessary securities might open a bank, and 133 new banks were organized within two years, many of them for the sole purpose of issuing notes. Of these, 26 failed between 1839 and 1844 and their notes were redeemed at an average of seventy-six cents on the dollar. These failures demonstrated that the securities deposited were not adequate to meet the notes. The law was then amended so that only the bonds of the United States and of the State of New York were acceptable as security and other faults were remedied as perience showed the weakness of the system. Under the amendment of 1840 country banks were required to redeem their notes in New York and Albany at a discount not exceeding one-half of 1 per cent (later reduced to one-fourth of 1 per cent). Even with this limitation many persons in the cities issued notes in the country towns, making a good profit by redeeming them at a discount. Later, no one was allowed to do a banking business except at the place of his actual residence, and all banks issuing notes were required to become banks of deposit. These changes in the law so strengthened the system that after 1850, failures were infrequent and the notes of failed banks were redeemed at par. But it was inelastic and unresponsive to the needs of the business community. Banks could issue notes only in proportion to the bonds deposited, which bore no relation to current business demands. This plan of note issue, however, became the model for the national banking system.
The free banking system appealed to democratic sentiment and was tried in some form in many other states. In the '50's several Western states adopted the plan of issuing notes against securities, generally without the restrictions which the experience of New York had shown to be necessary to protect the note holder. Bad management and lack of proper regulation led to failure and disaster in many of these experiments. Before they could be perfected the national banking system came in, superseding all other systems of bank note issue.