Free Banking

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21 Aug, 2024

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Free Banking refers to a monetary system in which the government has minimal or no involvement in regulating or controlling the currency issuance or monetary deposits and withdrawals. In such a system, private banks relish a high degree of autonomy, and the banking activities are subject to market forces and competition.

It was an experiment first conducted by the US Government to have a decentralized and unregulated banking system where the state-chartered banks or private banks were free to issue their currency. However, without a standardized system and centralized control, there was a tremendous rise in fraudulent practices such as counterfeiting.

What Is Free Banking?

Free banking is a monetary system with minimal government intervention and regulation, allowing private banks to compete in a free market without significant restrictions.
This banking system aims to promote fair competition in the banking industry, facilitate prominent services, foster economic stability, curtail costs, encourage innovation, and promote fair market practices.
It was a period of experimentation in the banking sector that necessitated improved financial regulation and the establishment of a more standardized currency. The National Banking Act of 1863 laid the groundwork for a more stable and regulated banking system in the US.

Free Banking Explained

A free banking system allows banks to freely issue their own currency without the monitoring or intervention of government authority. It has often been a point of debate due to its contribution to balancing free market principles and necessary regulations to protect consumers and maintain financial stability.

Although nations like Scotland and the US have temporarily adopted this system, it is not entertained by all the nations. This is because they perceive the threat of monetary instability. The key objective of free banking is to encourage healthy competition among banks. This can lead to better services, lower costs, and innovation in financial products.

Some of the critical characteristics of free banking are stated below:

Limited Government Intervention: The government does not heavily regulate or control banks. This allows the banks to decide interest rates, lending practices, and financial products.
Competitive Market: Multiple banks can operate freely, fostering competition. Customers have a vast list of banks and banking services per their needs or choices.
Private Banks Issue Currency: In some free banking systems, private banks can issue their currency notes. These notes circulate alongside the official government currency.
Self-Regulation: Banks get incentives to self-regulate and maintain their reputation and customer trust. The fear of losing business due to poor practices can encourage responsible behavior.

Here, the market forces determine interest rates, fees, and banking practices. Therefore, it can lead to a more efficient allocation of resources. It best meets the consumer needs by offering numerous banking options and the freedom to choose the services and banks. Moreover, a competitive banking system, without excessive government interference, can contribute to overall economic stability.

History

The era spanning from 1837 to 1863 in the history of American banking is referred to as the free banking period. It followed unsuccessful attempts to establish central banks, such as the First Bank of the United States and the Second Bank of the United States. During this period, the power shifted away from federalists to proponents of states' rights, leading to the chartering of banks by individual states. This resulted in many banks, each issuing banknotes, which varied in value and were susceptible to counterfeiting.

Michigan was the first state to embrace free banking in 1837, but it encountered challenges, including inflated mortgage appraisals and excessive issuance of banknotes. This led to the failure of many banks and significant losses for note holders. Consequently, Michigan repealed its free banking law in 1839 but reinstated it in 1857.

In contrast, New York's experience with free banking was more successful, with noteholders facing minimal losses. The success of New York's free banking system served as a model for other states that sought to reduce the influence of politically connected individuals in the banking sector and ensure that qualified applicants could establish banks.

In the free banking system, banks had to meet specific capital requirements, issue banknotes redeemable for specie (precious metal), and deposit government bonds to provide a safety net. Overall, the free banking period was characterized by experimentation, with some states achieving success while others faced failures. This resulted in varying degrees of stability within the banking system across the United States during that time.

The National Banking Act of 1863 imposed regulations and oversight on the banking industry and required banks to hold federal bonds as collateral for issuing currency. Many state-chartered banks chose to convert to national banks to benefit from the perceived stability of the national currency. By the end of the Civil War, the free banking era effectively ended as national banks became the dominant banking institutions in the United States.

Examples

The following historical examples showcased elements of the free banking period and the encountered challenges such as bank failures and currency instability:

Example #1 - Scotland (18th And 19th Centuries)

The conventional perspective on Scottish banking before 1844 is often described as free banking. This term implies that the regulatory framework during that period mirrored laissez-faire principles, resulting in a monetary system with minimal government intervention. This viewpoint was endorsed by free banking proponents in various countries, including Britain, America, and France, who considered the Scottish banking system a model to emulate.

During this period, Scottish banks received the liberty to issue their currency. This resulted in a diverse and competitive banking environment. It is evident in early accounts of Scottish banking, such as Andrew Kerr's work from 1884. Furthermore, the Scottish banking experience has been employed as evidence countering the legal restrictions theory of money.

Example #2 - Canada (19th Century)

The pre-World War I Canadian banking system is often described as free banking because it had more freedom from regulatory restrictions compared to other countries. However, it wasn't entirely unrestricted as Parliament had to approve each bank charter, creating a barrier to entry. Entry into Canadian banking was relatively open until around 1890 when stricter capital requirements made it more challenging for new banks to qualify.

The Bank Act of 1900 also made bank mergers easier, leading to a significant reduction in the number of banks. So, while Canada's banking system enjoyed relative freedom, it wasn't entirely laissez-faire due to the charter approval process and subsequent regulatory changes impacting entry and industry consolidation.

Free Banking vs Central Banking

Free and central banking are two distinct systems of managing a country's monetary and banking affairs. Here are some key differences between them:

Basis	Free Banking	Central Banking
Definition	It is the banking system that allows private or state-chartered banks to operate without much intervention from the government.	It is the government-regulated monetary system where the central banks control the operations of the commercial banks.
Nature	Decentralized	Centralized Authority
Objective	Fair competition, economic stability, innovation, cost reduction, and better resource allocation	Provide stability to the financial system and control the money supply, reducing the risk of bank failures and currency instability.
Ownership and Control	Banks are privately owned and operate independently	It involves a central bank, owned and controlled by the government, which has significant authority over the banking sector to set monetary policy, regulate commercial banks, and issue currency
Monetary Policy	Determined by market forces, with interest rates and money supply being influenced by supply and demand in the financial markets	Central banks have the authority to set and implement monetary policy. They can adjust interest rates, control the money supply, and use various tools to influence the economy.
Currency Issuance	Banks can issue their currency, leading to various banknotes in circulation.	Central banks have a monopoly on issuing currency, and they regulate the money supply by controlling the issuance of legal tender.
Competition	Fair competition among different private banks where customers have the freedom to select the currency issued by their preferred bank	Limited competition
Government Intervention	The government's role in the banking system is minimal, and banks operate independently of political influence.	Government policies often influence central banks and may be subject to political pressures, which can impact monetary decisions.
Deposit Insurance	Depending on the specific regulatory environment, deposit insurance may or may not be available.	Many countries with central banking systems offer deposit insurance to protect individuals' bank deposits up to a specific limit.
Financial Stability and Crisis	More susceptible to financial crises and bank failures	Ensures financial stability, regulating banks, and providing lender of last resort support during economic crises

Frequently Asked Questions (FAQs)

1. Who offers free banking?

Nations like Canada, the US, and Scotland have previously adopted the free banking system; however, their economic model faced various issues and failures, resulting in a more regulated and centralized banking system. However, some have adopted a mixed banking structure with central and free banking features.

2. Would free banking work in the US?

The feasibility of implementing free banking in the United States is a subject of ongoing debate and discussion. Though the system entails minimal government regulation of banks and the ability for them to issue their currency, the US banking sector is subject to significant regulatory oversight aimed at ensuring financial stability and safeguarding consumers.
While proponents argue that a less regulated system could foster innovation and competition, critics express concerns about potential risks like bank failures and fraudulent activities.

3. What were the problems with the free banking era?

The free banking period's primary issue was the convertibility of the bank notes at their par value. The banks during this era issued banknotes against risky bonds, and these instruments were callable at par value on demand.