Banking Without Regulation; L. White

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 fail ure. Because these systems were so differ ent 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, Scot land, 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 Dr. White, Associate Professor of Economics at the University of Georgia, is a Contributing Editor of The Freeman.

banking that have been published in recent years.! Three Lessons from History What can we learn from historical epi sodes of relatively unregulated banking? I will try to summarize three main lessons concisely, without all the details, footnotes, and minor qualifications that might be men tioned. I hope my fellow academics will forgive me for breaching our professional etiquette in this way. First lesson: Unregulated banking does not cause inflation ofthe money supply or of prices. Because reserve requirements constrain banks today, economists have sometimes feared that banks without reserve require ments will face no constraint against over supplying 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 ab sence of government protection, a bank could not issue too many liabilities in rela tion to its reserves of metallic money.

Under redeemability, the value of money 375 376 THE FREEMAN • OCTOBER 1993 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 modem stan dards. Over the long run of generations, price inflation was virtually zero. Second lesson: Unregulated competition among banks does not destabilize the bank ing system. Instability is often the fear of those who think that "free banking" laws in some parts of the antebellum United States led to irre sponsible or "wildcat" banking. It turns out that "wildcat" banking is largely a myth. Although stories about crooked banking practices are entertaining-and for that rea son have been repeated endlessly by text books-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 com petitive note-issue. Instability was experi enced 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 regu lated systems of Canada, Scotland, and New England. How was stability possible in banking systems with neither deposit guarantees (nothing like FDIC insurance) nor a govern ment lender of last resort (nothing like the Federal Reserve)? Depositors were more careful in choosing banks, and banks cor respondingly, 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 some times 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 bal ance sheet" in the sense that shareholders contractually bound themselves to dig into their own personal assets to repay deposi tors and noteholders in the event that the bank's assets were insufficient. Banks di versified 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 clear inghouse. Private clearinghouses, particu larly in the late nineteenth-century United States, lowered the risks of interbank expo sure by making banks meet strict solvency and liquidity standards for clearinghouse membership. Clearinghouses were a vehicle by which reputable banks as a group volun tary regulated themselves. Clearinghouse associations pioneered techniques for mon itoring and enforcing solvency and liquidity, such as balance sheet reports and bank examinations. Clearinghouse associations also did some "last resort" lending to sol vent member banks that were experiencing temporary liquidity problems. The Federal Reserve System did not introduce but sim ply nationalized bank regulation and the lender-of-last-resort role.