On March 31, 1980, a major piece of legislation was
passed by Congress to deregulate commercial banks and other deposit-type
financial institutions. This deregulation took the form of phasing out
interest rate ceilings on various types of time deposits and of
extending the type of assets thrift institutions were authorized to
hold. However, this act took three steps in the opposite direction: it
required all banks, member and non-member, and all thrift institutions
offering checkable deposits to hold the same percentage of these
checkable deposits as non-interest reserves, either in vault cash or on
deposit with the Federal Reserve; it increased federal deposit insurance
to $100,000 per account; and it allowed all these institutions to borrow
from the Federal Reserve.
It is apparent that Congress did not intend to unleash
the forces of competition on the financial system. If this had been
Congress1 intention, it would have phased out, rather than
increased, deposit insurance and would have left the amount and location
of reserve holding to the individual institutions.
The purpose of this paper is to explain how a
completely free banking system would operate. Under free banking, all
financial institutions are subject only to the general laws of
incorporation and against fraud. They would not be restrained by the
rules of a central bank and not be audited by any government agency, nor
be protected by any government deposit guarantee. The first part of this
paper hypothesizes how individual banks would thrive in this competitive
environment, while the second part shows how the most serious problem
this economy faces - inflation - can be controlled without any
government agency doing the controlling.
The Individual Financial Institution in a Free Banking
Environment
In a free banking system, any firm can enter the
banking business by acquiring funds in any non-fraudulent manner and can
put those funds to any legal use it wants. A bank may attract funds by
offering banknotes (currency) or deposits convertible on demand to
specie (gold or silver coin). The bank's success would depend upon its
gaining public confidence for holding its banknotes and other bank
liabilities, and on the probability that it can use its funds
profitably. No bank would have any special privileges, like those
currently enjoyed by central banks, such as a monopoly of the note issue
or the protection of a legal tender law, giving its notes forced
currency. There would be no government agency or central bank on which
the bank could rely as a lender of last resort; it would have to borrow
in the private market at a rate consistent with the risk involved.
Under free banking, both notes and deposits would be
promises to pay on demand some generally accepted medium, such as gold
or silver.1 The particular combination of notes and deposits issued in
lending by each bank would be determined solely by public preference.
The bank would be indifferent between the two, but the total amount of
sight liabilities would be limited by its reserves of specie. No
government regulation would specify that a bank had to hold certain
assets, such as low-yielding government bonds, as backing for its
banknotes, as was the case under the National Bank Act.
Not only free entry, but freedom of exit is a necessary
condition of free banking. Banks unable to redeem their demand
obligations, and unable to obtain private credit, would be forced to
liquidate. This market pressure, along with the knowledge that there is
no central bank acting as a lender of last resort, would force banks to
act prudently.
Without a central bank, the check clearing process
would be privately operated at its true cost, to the mutual benefit of
banks and the public. Any cost reductions resulting from innovations
would, by force of competition, be passed along to the public. Banks
would have total freedom to branch anywhere. They would extend their
operations nationwide, as have banks in Canada, England and other
countries.
The unit bank system was not a natural development but
a result of restrictive legislation. The unit bank system led to
correspondent banking, not only for holding reserves, but also for
performance of services which small unit banks found too expensive to
undertake individually. In the United States, these reserves tended to
accumulate in financial centers, where they were subject to the
fluctuations of speculative markets. But with a branch banking system,
even if a remote bank's reserves did find their way to financial
centers, they would be held at a branch of the remote bank, which would
retain total control over the funds. Each bank's own liability structure
would determine how these funds were invested and in what maturities, in
order to maintain adequate liquidity. With no need for a correspondent
relationship, non-bank corporations could have a single banking
connection nationwide as in Canada.
Branch Banking
Evidence from the depression clearly shows that branch
banking was safer than unit banking, but that safety increased with the
widening of the geographical area over which a bank could branch.
Without branching, few banks could grow to a size large enough to handle
the more desirable accounts. One study showed that 80 percent of the
bank closings were in unit bank states, 2 and furthermore,
that two--thirds of the branch banks that did fail were those that were
restricted to a City.3 Canadian branch banks gained millions
of dollars of American deposits, especially in border cities like
Windsor, Ontario.
Another study on California banking in the depression
demonstrated that the diversity of California's economy, accompanied by
statewide branching, enabled that state to achieve one of the lowest
bank failure rates in the country. Again, the two small branch bank
systems that failed in that state were those that restricted branches to
one City.4 This study also pointed out that the strong branch
banking system in California also strengthened that state's unit banks
by competitive example.5
Under a free banking system, it might be possible for a
well-run unit bank to prosper, but it would have to do so without the
currently available privilege of issuing government-guaranteed
liabilities. The FDIC coverage is probably responsible for making the
deposits of many small banks acceptable at par whereas they might not be
so acceptable in a free market.
The specialized financial institution would be unlikely
to exist for very long under free banking. Investment banking was part
of commercial banking until forcibly separated by the Banking Act of
1933. Many activities of one-bank holding companies are merely tactics
for circumventing laws which restrict banks to a narrow line of
business. Thrifts, such as savings and loans, mutual savings banks, and
credit unions, may have developed because banks were not interested in
some particular lines of lending at first, but whenever those activities
became profitable, it would have been the natural course of events for
thrifts and banks to have merged.
The public would be much better served by a more
diversified financial institution than by a single-purpose lender. A
legally imposed distinction between deposit-type institutions does not
serve the public well, because it leads to further government assistance
to these single-purpose lenders, such as Regulation Q, the Federal Home
Loan Banks, the FSLIC and the NCUA. None of this intervention is
costless: funds are channeled into areas that otherwise would not
receive them except at higher interest rates, while other erstwhile
borrowers are crowded out of the capital market.
Under free banking, some of the strongest competition
for existing banks may be provided by large retailers, brokerage firms
and credit-card companies. Sears and Roebuck, Merrill-Lynch, and
American Express already have in place nationwide offices from which to
conduct a banking business. Automatic teller machines could give a
depositor instant cash anywhere in the country.
The one-bank holding company has already been
responsible for combining banking with other financial services, so free
banking would only remove the artificial restraints.
The Market Decides
The market would eventually decide which of the many
new services offered by banks would be profitable, but the chief
beneficiary would be the consumer. Not only actual competition but
potential competition from new entrants would work more to the
consumer's advantage than most of the "performance" laws that were
specifically designed for consumer protection. Under free banking, there
would be no legal requirements for "truth in lending," "equal credit
opportunity," or "community reinvestment," and no restrictions on debt
collection practices. These performance standards add substantial
reporting and regulatory costs, which are at least partially passed on
to the consumer.6
Compared to a single governmentally issued currency,
private banknotes might present a greater temptation to counterfeit.
Counterfeiting was prevalent before the Civil War when there were so
many different banknotes being used. However, a single government
currency does not guarantee a counterfeit-free economy either: today's
overdrafts and forged checks are analogous to the antebellum
counterfeiting of state banknotes. Furthermore, modern communication
technology would strongly discourage counterfeiting. At any rate,
insurance companies can underwrite any losses the public may suffer, as
they do now for stolen or forged credit cards.
With different banknotes being used, some company or
group of retailers might sell fractional coins to be used for small
purchases and plastic tokens with electronic markings to be used in
vending machines.7
How Free Banking Would Prevent Inflation
Deregulation of bank money alone will not give us an
environment free of inflation unless there is some way to stop the
unlimited creation of the money base by the central bank. When gold or
silver is the base into which all banknotes and deposits are
convertible, there is a limit on the money supply, because this base
cannot be created at will as fiat money can be issued by a central
bank.8 Central banks, being politically sensitive, use their
monopoly of the money base to help organized sectors at the expense of
the general public, often under the guise of lowering interest rates. It
was recognized long ago that free banking restricted credit expansion,
whereas central banks were tools for creating an easy-money
environment.9
The imposition of a money-growth rule on a central bank
is not the cure for inflation. Congress has never shown any inclination
to impose a fiat-money growth rule as monetarists have advocated, and
the Fed could not be trusted to follow it, judging from experience with
gold reserve requirements. In 1913, the Fed was ordered to hold gold
equal to 40 percent of its note liabilities and to 35 percent of member
bank reserve deposits. Every time the limit was reached, these
requirements were either suspended (1933), reduced (1945), or abolished
(1965 & 1968). Emergency currencies without gold backing were issued
in the depression and in World War II.
Prudent Practices Encouraged
By contrast, commercial banks in a free banking system
could never go off gold as could a privileged central bank with
legal--tender banknotes. A private bank would be forced into liquidation
if it could not convert its sight liabilities into specie. However,
there is another limit to over-expansion in a free banking system
besides exhaustion of gold reserves, and that is the reflux of
banknotes. Each bank would only pay out its own notes over the counter,
because unlike the notes in the National Banking System, these notes
would be distinctive. Therefore, a bank that expanded its lending beyond
prudent limits would have its notes and deposits presented for payment
faster than those of its rivals. If a bank wanted to protect its
"brand-name capital," it would have to curtail its lending or face the
possibility of its notes circulating at a discount. The marginal cost of
printing banknotes may be zero, but the marginal cost of keeping them in
circulation clearly is not zero.
Central banks could try and compete with private
banknotes, but the public would only hold the central bank's notes if
they retained their value relative to the private notes. However, the
central bank could not monetize government deficits at will, nor bail
out any bank or industry in trouble, because an oversupply of notes
would result in depreciation. One might envision the Fed and private
banks competing through advertising the way the U.S. Postal Service and
private package carriers do now.
At the time of the original publication, Dr. Wells
taught in the Department of Economics and Dr. Scruggs in the
Department of Finance at Memphis State University, Memphis,
Tennessee.
1. Vera C. Smith, The Rationale of Central Banking
(London: P. S. King & Son, 1936), p. 149.
2. Gaines T. Cartinhour, "Branch Banks versus Unit
Banks," Annals of the American Academy of Political and Social Science
171 (January 1934): 36.
3. Ibid., p. 37.
4. John P. Wernette, "Branch Banking in California and
Bank Failures," Quarterly Journal of Economics 46 (February 1932): 371.
5. Ibid.
6. Catherine England, The Case for Bank Deregulation,
(Washington: The Heritage Foundation, 1982), p. 24.
7. F. A. Hayek, Denationalization of Money The Argument
Refined, 2nd ed. (London: The Institute of Economic Affairs, 1978), p.
48n.
8. Lawrence H. White, "Competitive Money, Inside and
Out," Cato Journal 3 (Spring 1983): 296.
9. Ludwig von Mises, Human Action: A Treatise on
Economics (New Haven: Yale University Press, 1949), pp. 443-44.
Reprinted with permission from The
Freeman, a publication of the Foundation for Economic Education, Inc.,
February 1985, Vol. 35, No. 2.
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