Free banking is a viable banking model

I came across this article by Kam Hon Chu, entitled, “Is free banking more prone to bank failures than regulated banking?”, published in the Cato Journal; Spring/Summer 1996.

Basically it should be an eye opener to those who believe that free banking is not viable. It strongly adds evidence to the fact that banking can work without government meddling (or a minimal level of regulation).

EXTRACTS

Regulations, Deposit Insurance, and Bank Failures

The traditional, dominant view is that free or unregulated banking is inherently unstable because of market failures arising from such factors as externalities, natural monopolies, and information asymmetry. Free banking causes counterfeiting, wildcat banking, fraudulent banking, over-issue of banknotes and overexpansion by banks. Free banks therefore are prone to failures and lead to systemic banking instability. Economic and non-economic reasons have been given to justify banking regulations—such as protection of small depositors, maintenance of monetary stability, protection of the payments system, assurance of safety and soundness of financial institutions, avoidance or limitation of the effects of failed institutions, and encouragement of efficiency and competition in the financial system.’ Bank failures in Indiana, Wisconsin, and Minnesota during the free banking era (1837-1865) are cited as prima facie evidence of the instability of free banking.

This conventional view has come under increased scrutiny since the 1970s. Benjamin Klein (1974), F. A. Hayek ([1978] 1990), Lawrence H. White (1984), Roland Vaubel (1985), George Selgin (1988), David Glasner (1989), and others have provided a theoretical basis and offered historical evidence for the soundness of a free banking system. One of the major arguments is that competition in the supply of money forces banks to maintain either their brand names or convert¬ibility of their liabilities (banknotes or deposits) into specie or real commodities, which in turn prevents banks from over-issuing money. In contrast, a self-correcting mechanism does not exist under monopo¬lized supply of money by the government. Therefore, free banking is more stable than central banking.

Empirical studies of the U.S. free banking era by Hugh Rockoff (1974, 1975) and by Arthur Rolnick and Warren Weber (1983, 1984, 1988) show that that era was not as chaotic as commonly thought. Lawrence H. White (1984) uses the Scottish free banking era as historical evidence of the success of free banking in practice. Other studies of free banking outside the United States—e.g., those by Weber (1990), Eugene White (1990), Andrew Economopoulos (1988, 1990), and Kevin Dowd (1992)—also support the stability of free banking.

Some economists, though not necessarily advocates of free banking, argue that banking regulations (such as interest-rate ceilings, restrictions on loans and investments, and required reserves) can be a source of instability. The major ways in which regulations affect the stability of financial institutions are well summarized by George Benston (1991). First, regulations constrain banks’ diversification by limiting banks’ portfolio choices or by restricting branching, thus reducing the flexibility of banks to accommodate unanticipated shocks. Second, as implicit taxes, regulations reduce banks’ profitability. Third, regulations often create a moral hazard problem by encouraging risk taking. Fourth, while it may be the intention of the regulatory authorities to promote banking stability by interventions through monitoring, supervising, and preventing fraud and grossly incompetent management, it is usually the case that supervision is inadequate.’

Before the recent deposit insurance crisis in the United States started to surface, most economists had a strong faith in deposit insurance.’ Information and confidence externalities in the banking sector were believed to justify the setup of a deposit insurance scheme. The steep decline in the bank failure rate from 28.16 percent in 1933 to 0.37 percent after the establishment of the Federal Deposit Insurance Corporation (FDIC) in 1934 was regarded as evidence of the effectiveness of deposit insurance in stabilizing the banking industry.’ Formal theoretical models (e.g., Diamond and Dybvig 1983) have also been developed to justify deposit insurance.

While deposit insurance reduces or eliminates the systemic risk due to contagious bank runs, it also induces a moral hazard problem by encouraging banks to take excess risk (Kane 1985). Moreover, it is not obvious if the systemic risk is reduced when the deposit insurance fund is insufficient to cover depositors’ losses. For instance, there were runs in 1985 on the Home State Savings Bank and 70 other thrifts insured by the Ohio Deposit Guarantee Fund following Home State’s reported loan loss of $140 million, which exceeded the fund’s $136 million in reserves.

The Hong Kong, Canadian, and U.S. Banking Systems, 1935-64

During the period 1935-64, the Hong Kong banking system was virtually unregulated, whereas the Canadian system was regulated, and the U.S. system was regulated and subject to federal deposit insurance. Banking was not completely free in Hong Kong because the right to issue banknotes was restricted to only three private commercial banks, whereas the supply of coins and notes of small denominations was monopolized by the Hong Kong government.’ Nonetheless, there was free trade in banking in the sense that supplies of deposits and loans were competitive and largely unrestricted. Furthermore, Hong Kong had no deposit insurance and no central bank; neither a discount window nor an official lender of last resort existed. At the same time, banking regulations were very lenient. 

The Canadian banking system during the period under study was a regulated one without deposit insurance as the Canadian Deposit Insurance Corporation (CDIC) was not established until 1967. It had more stringent regulations than its Hong Kong counterpart. 

The U.S. banking regulations were more complicated and stringent than those in Canada. In addition, the Federal Deposit Insurance Corporation (FDIC)—a flat-rate deposit insurance system—had been set up in 1934. Because of the differences, U.S. banks in this study are limited to commercial banks insured by the FDIC. Other depository institutions such as noninsured commercial banks, mutual savings banks, and S&Ls are excluded—either because their deposits are not insured or because their business activities differ from those of commercial banks.

Conclusion

the finding that the American banking system had a higher bank failure rate than the Canadian system, though both were regulated, is consistent with Benston’s allegation that the U.S. regulatory authorities were not adequate in preventing bank failures. That the existence of regulations does not necessarily stabilize the banking industry is also supported by the Hong Kong experience.

this study is another piece of evidence to show that free banking is not as unstable as most economists believe. If a free banking system is not more prone to bank failures than other banking systems, it can be an effective alternative to banking reform. Regulatory authorities, therefore, should not assume that more regulations naturally translate into fewer bank failures.

Government regulations are not necessarily more effective and efficient than self-regulation. Furthermore, when government regula¬tions are imposed, a distinction between economic regulation and health-safety-environment regulation should be made.

Regulations are costly and distortionary; they may not necessarily achieve the goal of stabilizing the banking system, as evidenced by the U.S. experience. To achieve the goal, appropriate regulations need to be imposed, and they must be adequately and effectively enforced. 

Related posts:

1. Let’s abolish central banking and revert to free banking – an open-ended research note
2. The IMPOSSIBILITY of central banking
3. There is only way to increase wealth: free the market

Read more at Sanjeev Sabhlok’s Occasional Blog-Economics