How well would the banking system work if there were no
government regulation? One way to begin answering this question is to
examine the historical record. In the nineteenth century many countries
had relatively unregulated banking systems with few or none of the
restrictions that face American banks today: legal barriers to new
entry, deposit insurance, geographic and activity restrictions, reserve
requirements, and protection of favored banks from failure. Because
these systems were so different from today's, they throw valuable light
on the possible consequences of completely deregulating banking in the
future.
A useful source of historical information is the
recently published volume entitled The Experience of Free Banking,
edited by Kevin Dowd (London: Routledge, 1992). The book's contributors
(of which I am one) investigate relatively unregulated banking systems
in nine different countries during the nineteenth century: Australia,
Canada, Colombia, China, France, Ireland, Scotland, Switzerland, and the
United States. An overview chapter by Kurt Schuler shows that there were
another fifty episodes that might also be investigated in detail. Fresh
historical evidence, of the sort provided in this book, usefully
complements the several other studies of free-market money and banking
that have been published in recent years. I
Three Lessons from History
What can we learn from historical episodes of
relatively unregulated banking? I will try to summarize three main
lessons concisely, without all the details, footnotes, and minor
qualifications that might be mentioned. I hope my fellow academics will
forgive me for breaching our professional etiquette in this way.
First lesson: Unregulated banking does not cause
inflation of the money supply or of prices.
Because reserve requirements constrain banks today,
economists have sometimes feared that banks without reserve requirements
will face no constraint against oversupplying checking deposits or
banknotes. But the fear is historically groundless. A competitive market
compels unregulated banks to fix the value of their deposit and note
liabilities in terms of the economy's basic money, by offering
redeemability at par (full face value) in basic money. In the past, the
basic money was gold or silver coins. The "dollar" was originally a
silver coin. To avoid embarrassment, in the absence of government
protection, a bank could not issue too many liabilities in relation to
its reserves of metallic money.
Under redeemability, the value of money falls (price
inflation occurs) only when the supply of the economy's basic money
grows faster than the real demand for basic money. Under the gold and
silver standards of the nineteenth century, inflation of prices in any
single year was minimal by modern standards. Over the long run of
generations, price inflation was virtually zero.
Second lesson: Unregulated competition among banks
does not destabilize the banking system.
Instability is often the fear of those who think that
"free banking" laws in some parts of the antebellum United States led to
irresponsible or "wildcat" banking. It turns out that "wildcat" banking
is largely a myth. Although stories about crooked banking practices are
entertaining - and for that reason have been repeated endlessly by
textbooks - modern economic historians have found that there were in
fact very few banks that fit any reasonable definition of "wildcat
bank." For example, of 141 banks formed under the "free banking" law in
Illinois between 1851 and 1861, only one meets the criteria of lasting
less than a year, being set up specifically to profit from note issue,
and operating from a remote location.2
The so-called "free banking" systems in a number of
antebellum American states were actually among the most regulated of all
the nineteenth-century systems of competitive note-issue. Instability
was experienced in a few states, not due to wildcat banking, but due to
state regulations that inadvertently promoted instability. "Free
banking" regulations in some states made it easier to commit fraud; in
other states the regulations discouraged or prevented banks from
properly diversifying their assets. Banking was more stable in the less
regulated systems of Canada, Scotland, and New England.
How was stability possible in banking systems with
neither deposit guarantees (nothing like FDIC insurance) nor a
government lender of last resort (nothing like the Federal Reserve)?
Depositors were more careful in choosing banks, and banks
correspondingly, in order to attract cautious customers, had to be more
careful in choosing their asset portfolios than banks are today in the
presence of deposit guarantees and a lender of last resort. Banks did
sometimes fail. But bank failures were almost never contagious, or prone
to spread to sound banks, for several reasons. Each bank tried to
maintain an identity distinct from its rivals, and was able to do so
when it was not compelled by any regulation to hold a similar asset
portfolio. Depositors then had no reason to infer from troubles at one
bank that the next bank was in trouble. Banks were generally well
capitalized, so that fear of insolvency was remote. In some cases banks
had extra capital "off the balance sheet" in the sense that shareholders
contractually bound themselves to dig into their own personal assets to
repay depositors and note-holders in the event that the bank's assets
were insufficient. Banks diversified their assets and liabilities well,
being free of line-of-business and activity restrictions.
Banks were careful to avoid excessive exposure to other
banks, which means that they minimized the risk of being stuck with
uncollectible claims on other banks. Some degree of exposure is
unavoidable in any system in which a bank accepts deposits from its
customers in the form of checks written on, or notes issued by, certain
other banks. A bank has exposure until it clears and settles those
claims through the clearinghouse. Private clearinghouses, particularly
in the late nineteenth-century United States, lowered the risks of
inter-bank exposure by making banks meet strict solvency and liquidity
standards for clearinghouse membership. Clearinghouses were a vehicle by
which reputable banks as a group voluntary regulated themselves.
Clearinghouse associations pioneered techniques for monitoring and
enforcing solvency and liquidity, such as balance sheet reports and bank
examinations. Clearinghouse associations also did some "last resort"
lending to solvent member banks that were experiencing temporary
liquidity problems. The Federal Reserve System did not introduce but
simply nationalized bank regulation and the lender-of-last-resort role.
Third lesson: Banking is not a natural monopoly.
Historical experience shows that there are some
tendencies for larger banks to be more efficient, but not beyond a
certain size. Nationally branched banks do tend to out-compete smaller
banks in many areas of the banking business, but not in all areas. Banks
must be large enough to diversify their assets and liabilities
adequately, but this does not require being large relative to the entire
banking market. Recent developments in the financial technologies of
loan syndication and securitization may have reduced the size at which a
bank becomes large enough in this respect. In the absence of government
regulations that currently favor the largest banks, particularly the
pursuit of the "too big to fail" doctrine by the Federal Reserve and the
Federal Deposit Insurance Corporation, a stable and deregulated
financial structure would result that would likely include both large
and small banks.
At the time of the original publication, Dr. White,
Associate Professor of Economics at the University of Georgia, was a
Contributing Editor of The Freeman.
1. Hans Sennholz Money and Freedom (Spring Mills, Pa.:
Libertarian Press, 1985); Kevin Dowd, Private Money: The Path to
Monetary Stability (London: Institute of Economic Affairs, 1988); George
A. Selgin, The Theory of Free Banking (Totowa, N.J.: Rowman and
Littlefield, 1988); Kevin Dowd, The State and the Monetary System (New
York: Philip Allan, 1989); David Glasner, Free Banking and Monetary
Reform (Cambridge: Cambridge University Press, 1989); Lawrence H. White,
Competition and Currency (New York: New York University Press, 1989);
Richard Salsman, Breaking the Banks: Central Banking Problems and Free
Banking Solutions (Great Barrington, Mass.: American Institute for
Economic Research, 1990); Steven Horwitz, Monetary Evolution, Free
Banking, and Economic Order (Boulder, Colo.: Westview Press, 1992).
2. This statistic, from a study by Andrew J.
Economopoulos, is cited by Kevin Dowd, "U. S. Banking in the 'Free
Banking' Period," in Dowd, ed., The Experience of Free Banking (London:
Routledge, 1992), p. 218. Pioneering modern work on the U. S. experience
with "free banking" laws, which is the source for the information in the
next paragraph of the text, has been done by Hugh Rockoff and by Arthur
J. Rolnick and Warren E. Weber.
Reprinted with permission from The
Freeman, a publication of the Foundation for Economic Education, Inc.,
October 1993, Vol. 43, No. 10.
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