Empirical Evidence for Free Banking

Opponents of the fractional reserve free banking usually wonder why free banking systems no long exist today. A widely spread belief is that central banks have been established because free banking has failed to work. Central bank is not the unavoidable result of the natural evolution of the banking system but the outcome of political arrangements, given the government’s need to finance their ever increasing expenses. For example, the main reason for Colombian government to establish a central bank was to ensure the access to American loans (p. 99). Also, the French episode of Free Banking ended precisely because the authorities judged that the banks were not enough inflationist (pp. 130-131). Canada, Scotland, Ireland and other countries ended free banking because of political arrangements.

The Experience of Free Banking (Kevin Dowd, 1992)

Chapter 3: Free banking in Australia (Kevin Dowd)

The Early History of Money and Banking in Australia

Branching enabled banks to economize on operating costs (e.g., by holding fewer reserves per branch, and operating an inter-branch reserve market) and enabled them to provide specialist services (such as the provision of foreign exchange) at lower cost. Branch banks were also likely to have a more stable capital value because branching enabled them to protect themselves against adverse conditions in one locality or region by diversifying their risks.

Australian Banking From The 1850s to the 1880s

“The eight trading banks operating in Australia when gold was discovered, had grown to fifteen by the end of the fifties. At the end of 1850 there was a total of twenty-four branches (including head offices); at the end of 1860 there were 197.” (Butlin 1986:8)

Interest rates were lower in Britain than in Australia, so deposits in Australian banks were attractive to British investors and a comparatively cheap source of funds for the banks. […]

1. The banks formed a hierarchy. By 1892 there were 7 large banks with 100 branches or more spread across at least 2 colonies, there were 5 intermediate banks which tended to be concentrated in a single colony, and which had 50–99 branches each, and there were 11 small banks which tended to be concentrated in a single region, and to have less than 50 branches each (Schedvin 1989:3; Merrett 1989:73).
2. Concentration rates were very high — four banks issued about half the deposits throughout this period (Pope 1989:29) — but no one of these banks ever looked as though it would win the others’ market shares. There was therefore no tendency towards natural monopoly. […]
3. The note-issuing banks accepted each others’ notes from a relatively early stage, and mutual acceptance seems to have facilitated the reflux mechanism whereby notes were returned to issuers, but clearing was often carried out on a bilateral basis. A (multilateral) clearing-house was established in Melbourne in 1867, but Sydney only followed suit at the comparatively late date of 1895. The explanation appears to be that the small number of banks involved implied that the gain from moving from bilateral to multilateral clearing was relatively unimportant.
4. Profit rates appear to have fallen over this period, presumably because of increased competition (Pope 1987:7–8). […]
5. […] Note too that Australian interest rates were only about half as volatile as interest rates in the UK or the USA (Pope 1989:24–5), and the most obvious cause of this greater interest stability would seem to be the comparative freedom of the Australian banks from disruptive government or central bank interference.

An interesting feature of the Australian free banking system is that the note issue was never particularly important for Australian banks except in their very early years. The bank note/deposit ratio was 26.1 per cent in 1851, and fell subsequently to 7.4 per cent in 1881, 4.5 per cent in 1891, and 3.9 per cent in 1901 (Pender et al., 1989:8). These figures are well below contemporary note/deposit ratios for the UK or the USA, and seem to indicate a more mature banking system in which greater use was made of cheques and deposits.

“There is … in England and Wales a banking office for every 12,000 persons; in Scotland, one for every 4,000; and in Ireland, one for every 11,000 of the inhabitants. Now in Victoria … we have a branch of a bank for every 2,760 colonists.” (Quoted in Pope 1988:2)

The Depression of The 1890s and The Bank Crash

The Australasia, the Union and the Bank of New South Wales had all received substantial deposit inflows since late 1892 — so many deposits flowed in, in fact, that the two Melbourne banks were embarrassed by this ‘sign of public confidence’ (Butlin 1961:305) — and this ‘flight to quality’ was to continue until the final bank failures later in May (Blainey 1958:145, n. 1). For the weaker banks, however, an agreement was tantamount to the provision of a credit facility at interest rates generally below what they would have had to pay on the market. An agreement was thus equivalent to a transfer from the stronger banks to the weaker ones, and the stronger banks were naturally reluctant to consent to it. […]

The suspensions were also prompted by government intervention. In Victoria the government imposed a five-day banking holiday from 1 May. […]

The two banks’ willingness to remain open shored up public confidence in them, and the withdrawals they faced soon abated. The Bank of New South Wales re-opened the next day, and also stood the storm, but the remaining banks that had closed had effectively lost public confidence and were consequently unable to reopen (Butlin 1961:303–4). […]

One of the key issues here is the banks’ liquidity and Merrett goes on to argue that the ‘inescapable conclusion is that the long decline in liquidity standards seriously undermined the banks’ ability to cope with the growing problem of higher risks’ (1989:77). However, as George Selgin points out

“the facts tell a different story. Merrett (1989, p. 75) reports that the aggregate reserve ratio … fell from .3217 in 1872 to .2188 in 1877; but his figures for later five-year intervals show no further downward trend … . Even the lowest figure compares favorably to those from other banking systems, both regulated and free. It is much higher than Scottish bank reserve ratios for the mid-nineteenth century … and about the same as ratios for free Canadian banks in the late nineteenth century and for heavily regulated US banks today.”
(Selgin 1990a: 26–7)

He also notes that

“Pope’s annual data, presented graphically … are more plainly inconsistent with [the falling reserve] hypothesis … in the seven years preceding the crisis … the average ratio of the thirteen suspended banks rose steadily from about .15 to .16 … . Pope’s reserve figures also show a minor difference only — perhaps two percentage points — between the reserve holdings of failed Australian banks and those that weathered the crisis. This also suggests that ‘overexpansion’ was not the root cause of the banking collapse.”
(Selgin 1990a: 27)

The other key issue is capital adequacy. The figures given in Butlin, Hall and White (1971: table 2) show a fall in the capital ratio from about 20 per cent in 1880 to 12.5 per cent in 1892, but these figures ignore the uncalled liability attached to bank shares, and a number of banks also had a contingent reserve liability which took effect if the bank went into liquidation (Merrett 1989:82). Merrett himself estimates that this extra capital resource amounted to ‘nearly 45 per cent of the conventional measure of shareholders’ funds’ (p. 81) which suggests that these capital ratios give a considerably understated impression of the ‘true’ capital adequacy of the banks. … The claim that the banks had allowed their capital ratios to fall to reckless levels is also difficult to defend in the light of Pope’s chart (1989: figure 8) on core capital adequacy. If this hypothesis were correct, we would expect the capital ratios of failed banks to show a distinct downward trend in the period before they failed, we would expect a model of bank failures to show that the capital ratio had a negative and statistically significant coefficient, and we would also expect there to be a major (and growing) difference between the capital ratios of failed and non-failed banks. In fact, the capital ratio of failed banks appears to rise in the two years prior to failure, and their capital ratio reaches a low point five years before failure and then recovers. Pope’s logit model of the probability of failure also shows that capital adequacy has a ‘correctly’ signed coefficient in only one out of four cases, and even that is only significant at the 10 per cent level (1989: table 1), so there is little evidence that capital adequacy ‘matters’ in the way that this hypothesis predicts it should. And note, finally, that the difference between the capital ratios of banks that were to fail and banks that were not is relatively small — under 3 percentage points, and usually considerably less — and shows no tendency to grow as the dates of the failures approach (1989: figure 8). […]

One might note too that there was no indiscriminate running of financial institutions; there was instead a ‘flight to quality’ in which depositors withdrew funds from institutions perceived as weak to re-deposit them in stronger institutions such as the big banks, and it is significant that at no time were the big three banks — the Australasia, the New South Wales and the Union — ever in serious danger. […]

The bungling attempts of the Victorian Treasurer to pressurize the Associated Banks in to bailing out the weaker banks backfired at a critical point and needlessly undermined public confidence. The Victorian banking holiday had a similar impact. […]

8. … the claim that banks’ risks were becoming more concentrated only receives very weak support. Pope’s figure 8 indicates only a barely perceptible increase in the suspended banks’ risk-concentration, and the fact that the risk-pooling variable always has an insignificant coefficient in Pope’s estimates (1989:20) indicates that it had little effect on the bank failures anyway.

Chapter 4: Free banking in Canada (Kurt Schuler)

The Beginnings of Free Banking, 1817–67

Banks that refused to accept notes and cheques from rivals found such a policy self-defeating, because if the rivals accepted their notes, they had no offsetting claims to present when rivals demanded redemption in gold or silver. ‘Note duelling’ tactics also proved unfruitful, because they increased the reserves that all note duelling banks needed to hold without giving any particular bank a strong competitive advantage. Note duelling by rivals never made any Canadian bank fail. […]

Banks accepted locally issued notes and cheques of all banks at face value, but sometimes charged commissions on notes and cheques from distant areas of the same province, even those from their own branches. Discounts on notes and cheques issued elsewhere within a province seem not to have exceeded 1 per cent (cf. Denison 1966: vol. 1, 150; Shortt 1986:304). The discounts reflected transportation costs and interlocal exchange rates, much as today’s foreign exchange rates do. For instance, bank drafts on Quebec City were frequently at a slight premium in Montreal because certain provincial taxes could only be paid in Quebec City. […] Improved transportation apparently eliminated note and cheque discounts within provinces by the 1840s. […]

Prohibitions on branching across provincial lines kept Canadian banks, except the Bank of British North America, from developing nation-wide branch networks until the 1870s, which delayed the advent of the lowest-cost clearing methods. […]

Instead of allowing the free interplay of market forces to determine the relative values of the various coins, most provinces established statutory ratings that overvalued some coins relative to their metallic content. […] Undervalued coins vanished from circulation, giving rise to frequent complaints about shortages of them, and, less often, gluts of overvalued coins (Chalmers 1893:402–12; Ross 1920: vol. 1, 458; Redish 1984). […]

Canadian banks suffered not at all during the US financial panic of 1819. The English panic of 1825 caused one small, frail Canadian bank to fail and imposed foreign-exchange losses on other banks, but it did not shake the banking system as a whole. However, the panic of 1837 caused a system-wide banking crisis. The panic was clearly of foreign origin: it began in England in late 1836. The Bank of England’s refusal to lend at any price to firms importing cotton from the United States led to failures in the cotton trade on both sides of the Atlantic early in 1837. An internal drain on gold and silver by apprehensive customers made New York City banks suspend gold and silver payments on 10 May in that year. […]

The banks suspended payments in violation of their contracts with noteholders and depositors and without government approval. Even so, suspension was popular and officially tolerated because it seemed the least painful course of action. Suspension gave banks a breathing space to liquidate assets in an orderly fashion, avoiding ‘fire-sale’ losses. The exception occurred in Upper Canada, where the governor threatened to close down banks that suspended. Banks there suffered severe reserve drains, and had to contract loans more than banks in other provinces. The effect of the panic was said to be worse in Upper Canada than anywhere else in North America, and all banks there except the tiny Bank of the People eventually suspended payments with government approval in March 1838 (Shortt 1986:344–50). […] The panic of 1837 was the only system-wide peacetime banking crisis that Canada ever suffered. Comparing it with later years of stress on Canadian banks, the difference seems to have been that prohibitions on interprovincial branch banking kept the banks from being as large and as solid in 1837 as they later became.

The Heyday of Free Banking, 1867–1914

The Bank Act’s main provisions were: every bank was to have a government charter; at least $100,000 of paid-in capital was required; note issue was not to exceed the amount of paid-in capital; stockholders bore double liability for a bank’s debts if it should fail; banks could not engage in non-banking business or mortgage lending; they were to accept their own notes at face value at all branches; and they had to hold an average of half of their total reserves in government legal-tender notes (to force a demand for government notes), although there was no minimum reserve ratio. […]

Almost every autumn, the demand for notes and coins rose because many farmers were paid in cash for crops. Bond-collateral requirements prevented bank note circulation from accommodating the increase in demand, because they made the profitability of note issue dependent on bond prices, and not just on demand for notes. In Canada, note circulation was usually about 20 per cent higher in the autumn than at the seasonal low of note demand in mid-winter, whereas in the United States, it showed no seasonal variation. Interest rates, on the other hand, had no seasonal pattern in Canada and a strong seasonal pattern in the United States. American banks could not easily expand their note issues to meet the increased seasonal demand for notes, and the effect spilled over into interest rates.

The United States suffered minor credit stringencies almost every autumn from the 1870s until 1908, and major shortages in 1873, 1893 and 1907. During the major shortages, notes and coins went to a premium over bank deposits, and regular hand-to-hand currency virtually disappeared from circulation. […]

The only notable adverse events for Canadian banks in this period were limited runs on some small banks in Montreal in 1879, local banks in Prince Edward Island in 1881, and both local banks in Newfoundland in 1894. All the runs had readily identifiable causes and did not spread to large banks or to other small banks with dissimilar loan portfolios. Only in Newfoundland did a run on one bank cause another bank to fail. […]

Since 1867, bank-note issue had increased more rapidly than bank capital, and the legal limit on note issue finally threatened to become binding. The most logical remedy would have been to abolish the requirement that note issue should not exceed the amount of paid-in capital. […]

The one respect in which Canada imitated American note issue arrangements to some degree was in establishing a bank note guarantee fund by the Bank Act revision of 1890. […] Like present-day deposit insurance, the bank note guarantee fund had moral hazard risks and would have been exhausted by any large bank failure, but by 1890 notes were a small proportion of total bank liabilities, so the moral hazard risk was small, and the fund stayed solvent because the largest loss to depositors from any single bank failure from the beginning of Canadian banking (1817) to 1914 was just $3.3 million, in the 1908 failure of the Sovereign Bank.

Central Banking Comes To Canada, 1914–35

The Great Depression gripped Canada as tightly as it did the United States. GNP statistics show similar percentage declines for both countries. (A floating exchange rate did not insulate Canada’s economy, which depended heavily on trade with the United States, from real declines in American demand for Canadian products.) The number of banking offices also fell by roughly the same proportion in both countries. However, Canadian banks weathered the Great Depression much better than American banks.

No Canadian banks failed, nor did Canada suffer bank runs or impose ‘bank holidays’. The extensive branch networks of Canadian banks had enabled them to spread lending risks across regions and types of borrowers (Chapman and Westerfield 1942:108, 122, 357–8). Total losses to depositors and noteholders during the whole period up to the establishment of a central bank in 1935 were probably less than $30 million (cf. Beckhart 1929:337), far less per capita than in the United States. No Canadian banks failed from 1923 to 1985, while the United States suffered thousands of failures during the 1920s and 1930s.

Chapter 5: Free banking in Colombia (Adolfo Meisel)

These years are rich in events for the students of monetary and banking history: there was a period of free banking (1871–86); a near hyperinflation (1899–1902); a monopoly of note issue (1887–1909); and a period in which there was no institution which could issue bank notes (1910–22).

The Free Banking Era, 1871–86

The economic prosperity of the 1870s produced by the booming export sector helped the newly established Banco de Bogotá to prosper. The notes issued by the bank increased rapidly from 132, 165 pesos in June of 1871 to 606, 898 pesos by June 1874. In the next few years banks were established all across the country. Although the period under consideration (1871–1922) was characterized by the creation of banks, the number established in the era of free banking (1871–86) was larger than in subsequent subperiods (see Table 5.1).

The Experience of Free Banking (Kevin Dowd 1992) Table 5.1

[…] A good example of the spirit of laissez-faire that predominated in Colombian legislation of the time is provided by the banking laws of the State of Bolívar. This legislation gave ample space to private initiative and permitted only a minimum of government intervention. As the basic banking law of the State of Bolívar declared in its first article, ‘The establishment of banks of issue, deposit, and discount and mortage banks is free in the state and their activity is only subject to those duties that the laws impose on commercial companies and merchants’. Equally there were no barriers to the entry into the banking business. No charters were necessary and there were no minimum capital requirements.

Perhaps the most difficult crisis faced by Colombian banks during the experience of free banking occurred in 1876 as a result of the civil war of 1875. The largest bank of the country, the Banco de Bogotá, suspended the convertibility of its notes from November 1876 until May 1877, because of problems involved during the civil war in transferring funds from one town to another. […]

One of the main characterictics of the Colombian banking system up until 1923 was the co-existence of many regional banks and the virtual absence of branch banking. Although branch banking was allowed, it did not develop, possibly due to the enormous difficulties of communication as a result of Colombia’s rugged topography and rudimentary transport system.

Chapter 6: Free banking in Foochow (George A. Selgin)

From the beginning of the nineteenth century until the second quarter of the twentieth, Foochow’s banking and currency system was entirely private and free from all legal restrictions […] banking failures were restricted to very small banks; noteholder losses were minimal; free banks were an important and relatively low-cost source of loanable funds; there were no serious outbreaks of inflation or deflation; and counterfeiting was rare.

Kinds of Bank

Local banks were usually single-office firms involved in local lending and exchange only. Some, however, belonged to a distinct class — they were the ‘big’ local banks or tso piao tien. These issued the bulk of Foochow’s monetary assets, including demand notes current throughout the city. They were also members of the local bankers’ guild and clearing association. The remaining, ‘small’ local banks issued notes current only within their immediate vicinity and trading elsewhere at varying discounts. Small banks did little lending, concentrating on the exchange of different kinds of money. Consequently they were also known as ‘money shops,’ ‘cash shops’ or ‘exchange shops’ (chien yang tien). […]

Native bank notes, and copper-backed notes especially, were widely preferred to coin in local transactions; as early as 1853 the Governor-general of Fukien could report that 80–90 per cent of all transactions in Foochow were being settled with them (Wang 1977:13).

Growth of The Industry

Promissory notes of more reputable firms were often assigned and circulated. This led to banks issuing bearer notes, which were often cashed on demand. […]

Foochow’s most serious banking crisis occurred in 1922. In that year Cantonese (Nationalist) troops occupied Fukien, causing many local banks temporarily to close their doors and suspend payments as a precaution against having forced loans exacted from them by the occupying forces (Tamagna 1942:21). Though most of the banks recovered, four of them, including the large Bank of Fukien (banker to the provincial government and therefore a special target of invading warlords) failed, leaving $1,200,000 (Dai-Fook) of unredeemed notes (Chinese Economic Bulletin, 27 June 1925:145). Responsibility for these notes was taken by the remaining tso piao through a new agency formed by them expressly for the purpose called the Association for the Maintenance of the Money Market, which replaced notes issued by the Bank of Fukien with its own, redeemable, notes.

Organization and Operation of Local Banks

Local banks were unlimited-liability firms, usually of two to ten partners, though some were individual proprietorships (Anonymous 1932:441; Chang 1938b:27). […]

Of the two kinds of native orders only demand notes issued by tso piao circulated widely, the rest being sometimes limited to their street of issue. This suggests that the public did discriminate among various note-brands, as hypothesized in Selgin (1988:42–7). […] the local banks had discovered that refusing to cash their notes on demand (even when the notes were immature time-notes) could seriously erode public confidence in them (Wagel 1915:136).

No interest was paid on demand notes.

Note Exchange and Clearing

Although small banks sometimes paid out notes of larger banks, or used them to redeem their own notes, large banks issued only their own notes, returning all others immediately on receipt in exchange for their own notes collected by rival banks or for cash. Thus, bank notes played only a limited role as high-powered money, with specie being the most important bank reserve medium. This was an important reason accounting for the inability of local banks to overissue independently of their rivals or to engage rivals in a system-wide overissue.

Failures and Panics

Banks that failed usually did so just before the Chinese New Year, when many debts had to be settled, causing exceptional withdrawals of cash and bullion and bringing to light the existence of bad loans. This put a heavy strain on weaker, poorly managed banks. […]

The insolvency of a single bank (especially at the end of the year, when other banks were also at greatest risk of default) often triggered runs on other banks suspected of being low on cash or specie (King 1965:103).


In an exceptional case local bankers put a stop to a particularly intransigent forger by hiring him as an expert detector of other forgeries! (Parkes 1852:185–6).

Chapter 7: Free banking in France (1796–1803) (Philippe Nataf)

Competitive Banking: Spontaneous Expansion and Monetary Stability

With 20 per cent of its assets financed by its own funds, the bank was well sheltered against normal business risks. However, an unusual disaster befell the Caisse on 17 November 1797 when thieves stole FF2.5 million — representing 10 per cent of the bank’s assets. Today, such a loss would destroy almost any bank. 6 But its strong equity position and its liquidity enabled the Caisse des Comptes Courants to avoid failure and successfully to face the run that followed. If solvency avoided total failure, the liquidity of its assets permitted immediate redemption when the run began. […]

After only one day of suspension of payments, the stockholders pledged to reimburse every note, the bank reopened its doors and confidence was rapidly restored. The run stopped and no failure occurred. […]

The Caisse d’Escompte du Commerce was founded on 24 November, 1797. […] Apparently this bank also received time deposits bearing high interest as a result of its use of short-term loans and was very stable. Its strength, noticed by Du Pont de Nemours stems also from its high solvency and liquidity. He wrote that in June/July 1802, ‘one of the managers of the Caisse d’Escompte stole FF800,000; but it still held, in addition to its portfolio, more than sufficient assets in écus [metallic money] and other assets in buildings … Its payments have been neither suspended nor slowed down. Its notes did not lose any value’ (Du Pont de Nemours 1806:36). […]

The documents of the period show that, in spite of difficult times (wars, theft, embezzlement), banks suffered no failures. They functioned ‘freely, smoothly and to the high satisfaction of the public’ (Courcelle-Seneuil 1867).

Chapter 8: Free banking in Ireland (Howard Bodenhorn)

Free Banking Gone Awry?: The Irish Experience 1797–1820

The charter gave the Bank of Ireland a ‘semi-monopoly’ privilege in that no other body exceeding six partners could legally issue bank notes. […] This ultimately led to a multiplicity of poorly capitalized ‘private’ banks that were ill-prepared to meet their obligations when the frequent crises came. […]

All partners in a banking partnership were to be bankers only. By forbidding merchants from banking, the Parliament had effectively barred from the business the people who would most benefit from a stable banking system and the people with the wherewithal to form well-capitalized banks. That the Act was restrictive is demonstrated by the fact that only two new banks were formed in Dublin between 1760 and 1783 (Hall 1949:13).

The Second Free Banking Period, 1824–45

In May of 1821 agreement was reached whereby the Bank of Ireland’s monopoly as a bank of issue with more than six partners was restricted to a radius of 50 Irish miles (65 English miles) from Dublin. […]

The result was the Irish Banking Act passed in 1824. This Act repealed the residency requirement of the 1821 Act and allowed any citizen of the United Kingdom to be a shareholder; it repealed the ban on merchants being partners or shareholders; and it allowed the names of shareholders to be registered in the Court of Chancery instead of appearing on all notes. […]

For forty years, the Bank of Ireland had refused to open branches despite numerous petitions to do so. […] But just eleven days after the announcement by the Provincial that its first branch would be opened in Cork, the Directors of the Bank of Ireland met to discuss the expediency of opening country agents (Barrow 1975a: 85). […]

As Table 8.4 shows, despite the loss of some of its monopoly privileges, the Bank of Ireland continued to out-perform the interlopers who paid annual dividends of only 4 or 5 per cent until the mid–1830s. […]

The Experience of Free Banking (Kevin Dowd 1992) Table 8.4

One of the arguments against free banking is that competitive pressure induces bankers to issue notes beyond their capacity to redeem them. A cursory glance at Table 8.3 might give the impression that such was the case with banking expansion in the 1830s. Twelve banks entered between 1834 and 1837, but only six of them continued to operate in 1845. Most of the banks closed with a whimper. Of the five that closed in 1839, they dissolved for reasons other than ‘failure’. [16]

[…] The ratio of small-notes (less than £5) to total note issue during the Restriction period was variable but averaged about 25 per cent. But with the advent of the joint-stock banks, it increased from 28 per cent in 1824 to 39 per cent in 1828; thereafter following a slow increase until it reached 48 per cent in 1844. Small denomination notes were important for merchants and linen exporters who often travelled from town-to-town buying small webs of linen or small quantities of produce from local weavers or growers. Most of these transactions were in small amounts, usually £5 and less, and since notes were more easily carried than specie most of these purchases were made with bank notes. Therefore, as competitive pressures forced the Bank of Ireland to deal more with the public and less in government securities, it found it increasingly necessary to supply smaller denomination notes.

These small notes had come under attack in 1826. In England the bank crisis of 1820, culminating in the failure of many of the small country banks was blamed on the overissue of small notes instead of the restrictions on capital. The House of Commons proposed to outlaw the issue of such notes not only in England, but in Ireland and Scotland as well. A committee was formed to investigate the proposal. The banks of Ireland and Scotland banded together to oppose the measure. Their common front was effective as the eventual Act included only England and Wales, and left Scotland and Ireland free to continue with the issue of small notes. The most common note issues of the joint-stock banks were those of £1, £1 5s, £1 10s, £1 15s, £2 and very few over. These issues were appropriate when transactions were small, as they were in the market towns of Ireland. Table 8.6 shows the proportion of small notes in circulation in Ireland and Scotland from 1845 to 1856. While this period is after the years under consideration here, it is doubtful whether a drastic change of regime would have taken place given the testimony of the officials. [23] What is striking is the exceedingly high proportion of small notes in Scotland. This is further evidence that the issue of small notes and bank stability are not mutually exclusive.

The final positive aspect of competitive banking to be considered is that of interest rates. Evidence from the 1837 Committee shows that competition had narrowed the difference between lending and borrowing rates.

Chapter 10: Free banking in Switzerland after the liberal revolutions in the nineteenth century (Ernst Juerg Weber)

The Liberal Regime: 1830–81

There was one note-issuing bank per 80,000 people and at least one bank in twenty of the twenty-five cantons by then. […]

The note circulation of the large commercial banks actually stagnated from 1850 to 1870, and most of the increase in the total circulation in this period was accounted for by the issues of new local banks (See Table 10.1). […]

Even the commercial banks in the industrial centres found it difficult to keep bank notes in circulation for a significant period of time. In 1855 the notes of the Bank in Basel on average returned to the bank after 36 days (Table 10.2). In 1865 they stayed in circulation for only 10.5 days, which is not much more than the time it now takes for a personal cheque to clear. In 1875, reflecting an increase in the real demand for paper money, the 100–franc notes stayed in circulation for 70 days, the 500–franc notes for 37 days and the 1,000–franc notes for 18 days. The large bank notes were less popular than the small-notes because people preferred to use cheques and bills of exchange as media of exchange in large commercial transactions. […]

The notes of the cantonal banks were usually guaranteed by the cantonal government, and they could be used at par for tax payments and other transactions with cantonal authorities. In addition, in the 1870s private banks in some cantons were subject to regulations and taxes that did not apply to cantonal banks. Yet despite these advantages, the cantonal banks were not able to drive out the private banks as issuers of paper money. The poor performance of the cantonal banks suggests that in a competitive monetary system government banks do not have a comparative advantage in issuing paper money.

The Federal Regime: 1881–1906

The revised constitution authorized the federal government to regulate the issue of paper money and provided the basis for the Federal Banking Law of 1881. Although a large number of banks continued to issue bank notes until the Swiss National Bank took over between 1907 and 1910, the free issue of paper money had ended in Switzerland by 1881. The following are the most important provisions of the Federal Banking Law.
(i) The issue of paper money was restricted to incorporated banks and cantonal banks, and private individuals were excluded. This was no longer of much importance because the private bankers, who had issued notes under the aristocrats, had already voluntarily abandoned the bank-note business,
(ii) The banks were required to hold at least 40 per cent of their bank note circulation as specie reserves. In addition, those banks whose notes were not guaranteed by a canton had either to hold the remaining 60 per cent in the form of approved domestic and foreign government securities or, under very restrictive conditions, as commercial bills. This regulation strongly favoured the cantonal banks,
(iii) The capital had to amount to at least one third of the banknote circulation,
(iv) Each bank was required to accept the bank notes of the other banks at par as long as those banks redeemed their bank notes on demand,
(v) The tax that the cantons could levy on the circulation of bank notes was reduced to a maximum of 0.6 per cent. In addition, there were federal and cantonal fees of 0.2 per cent,
(vi) The federal government provided the banks with standardized bank notes with face values from 50 to 1,000 francs. Earlier, notes with smaller face values were common,
(vii) The banks were required to submit weekly and monthly statements to the federal government and they were regularly examined by the Eidgenössische Noteninspektorat.

The Purchasing Power of The Bank Notes

Yet the banks did not provide for suspensions of payments because each faced a real demand for bank notes that was very sensitive to changes in the purchasing power of those notes. Indeed, in a competitive monetary system the issuers of bank notes cannot keep depreciating notes in circulation because people can easily substitute notes.

The Circulation of Bank Notes

The Swiss circulation of bank notes rose from 7.6 million francs in 1850 to 234.9 million in 1906 (Figure 10.1). This increase represents a rise in the real demand for paper money as Switzerland was on a succession of specie standards with no significant increase in the price level. The available price figures confirm that the inflation rate was small in the long-run. Despite large price changes in the short-term, the average price of agricultural products remained almost unchanged in the second half of the nineteenth century (Figure 10.2). […]

In the following months Swiss (and Belgian) bank notes drove out the depreciating French bank notes (certainly outside France and to some extent also in France) as the public preferred bank notes with stable purchasing power.

Bank Difficulties

The competitive issue of paper money provided a secure monetary system with only one bank failure. The Banque Cantonale du Valais failed as a result of the persistent cantonal budget deficits, thus foreshadowing the inflationary bias of modern central banks.

Chapter 11: US banking in the ‘free banking’ period (Kevin Dowd)

‘Free Banking’ in New York

The New York law allowed free entry to the industry subject to a number of conditions. Banks had to have at least $100,000 in capital, they were to observe a 12.5 per cent specie reserve requirement against notes, and their notes had to be redeemable on demand. Their notes were also to be secured by deposits of eligible assets with the state comptroller, and these assets included US bonds and the bonds of New York and other ‘approved’ states, and certain mortgages. Shareholders of ‘free banks’ were also allowed limited liability, and noteholders had first lien on the assets that were deposited to secure the note issue. The act was revised in 1840 when the reserve requirement was eliminated and US bonds and the bonds of other states were removed from the list of eligible bonds—a move, incidentally, that Knox (1969 [1903]: 418) says was expressly intended to promote the demand for New York bonds. […]

A large number of ‘free banks’ was set up immediately after the passage of the act—Hammond (1957:596) suggests that 50 were set up very soon after, and 120 within two years. The early years of New York ‘free banking’ coincided with the financial difficulties of the late 1830s and early 1840s, however, and a number of banks failed when a group of southern and western states defaulted on their debts and inflicted large losses on them (see Root 1895:20). (As an illustration, Rolnick and Weber (1985:8) note that the 17 banks that closed in the period from January 1841 to April 1842 held no less than 95 per cent of their asset portfolio in the form of bonds issued by defaulting states.)

‘Free Banking’ Laws Elsewhere

Free banking’ in Michigan (1837)

The most important factor behind the failures appears to be a suspension law that resulted from a special legislative session in June 1837–three months after the ‘free banking’ law — that authorized all banks in the state to stop specie payments. This law effectively removed the discipline against overissue […]

… nearly all the Michigan wildcats lived their brief lives during the period of general suspension. (Rockoff 1975a: 95)


… The Illinois ‘free banking’ system ‘escaped practically unscathed’ from the crises of 1854 and 1857 (Rockoff 1975a: 113), and Economopoulos reports that it ‘worked reasonably well prior to 1861’ (1988:254). He notes, too, that it outperformed three out of Rolnick and Weber’s four states during this period (1988:113). However a potential problem was highlighted in a bank commissioners’ report of 1857 which revealed that over two-thirds of Illinois banknotes were secured by bonds from the state of Missouri, and the Illinois banking system was therefore vulnerable to a fall in the price of Missouri state debt (Economopoulos 1988:253). Relatively little was done to reduce the banking system’s vulnerability to the prices of Missouri bonds, and a large number of bank failures followed when Missouri bond prices plummeted at the start of the Civil War.


Wisconsin had a ‘free banking’ experience similar to Illinois. The territorial legislature was initially very hostile to banking and did what it could to prevent it, and the prohibition on banking was continued under the constitution of the new state until it was reversed and a ‘free banking’ law passed in 1852 (Hammond 1948:8). One hundred and forty ‘free banks’ were set up, and thirty-seven eventually failed (Rolnick and Weber 1983: table 2). Wisconsin’s ‘free banking’ appears to have been relatively successful throughout the 1850s and there were no failures until 1860–1 (Rolnick and Weber 1984:280). The balancesheet data provided by Rolnick and Weber (1985: table 3) indicate that those Wisconsin ‘free banks’ that failed had secured 48.8 per cent of their note issues with the Missouri 6s that subsequently lost over half their market values in 1860–1 and inflicted such damage on the ‘free banks’ of Illinois, and an additional third or more of their note issue was secured by the bonds of other southern states that also fell very heavily in price. The failed ‘free banks’ of Wisconsin were thus the victim of the same fiscal instability as their Illinois counterparts.

The Causes of the ‘Free Bank’ Failures

A second major cause of the failures was the capital losses inflicted on ‘free banks’ by falls in the values of the state bonds held in their asset portfolios. A bank’s liabilities were basically fixed in value, so its net worth depended on it maintaining the value of its assets, and a sufficiently large fall in the value of these assets could wipe out that net worth. There is considerable evidence to link ‘free bank’ failures with such capital losses, and these losses, in turn, can be linked to the fiscal instability that certain states experienced at particular times.

Some evidence is presented by Rolnick and Weber using data for the states of New York, Indiana, Minnesota and Wisconsin over the years 1852–63 (1982: table 3). They use Indiana bonds as a proxy for the assets held by the ‘free banks’ in these states, and the prices of these bonds fell 25 per cent in the second half of 1854, 20 per cent from March to October 1857, and about 20 per cent from October 1860 to August 1861 (1982:16). The bonds therefore fell for a combined period of about two years out of the total sample period, and yet 54 (or 79 per cent) of the 68 known ‘free bank’ failures in these states during the sample period occurred during these two years (1982: table 3). Rolnick and Weber present comparable results for the same states over the longer period of 1841–61 (1984: table 9) — which, in effect, means the same sample plus New York over the additional period — and found that 76 out of the 96 known failures (i.e., 79 per cent again) occurred during periods of falling bond prices (Rolnick and Weber 1984:288). Economopoulos provides even stronger evidence from Illinois. He takes the whole population of known ‘free bank’ failures – 91 in all – and finds that all of them occurred in periods of falling bond prices (1988:262).


Related papers :

With these federal restrictions in place, none of the cantons experienced free banking according to the conditions laid out by Selgin and White (1994) anymore. Nonetheless, Neldner (1992) argues that free banking persisted after 1882. Neldner refers to Jöhr (1915: 191) who states that “the law of 1881 adhered to the principle of free banking” and argues that neither the specie nor the securities reserve requirements were ever binding (Neldner 1992: 752). […]

Throughout the 1870s – the decade directly preceding the implementation of the national banknote law – the average coverage had dropped to roughly 50% of the note issue. For private banks this rate had still been 71% during the 1850s. Since the Swiss free banking system had at large a tendency to become more sophisticated along the path laid out by Selgin and White (1987), I posit that in the absence of the reserve requirements brought about by the federal banknote law of 1881, the reserve ratios would have continued to fall over time [probably due “to lower costs of obtaining specie on short notice or to lower risk of substantial specie outflows”, White, 1996, and probably because “customers required lower reserves from older, trusted banks”, Erik Lakomaa, 2007]. The claim that the regulations were not binding, because the banks made sure to hold enough reserves to comply with the regulations, including a buffer stock to be prepared for unexpected events, is therefore highly questionable. Further, the regulations have had an effect on the relative competitiveness of cantonal and private note-issuing banks. As mentioned under point (2) above, cantonal banks could rely on guarantees of their respective cantons for 60% of their note circulation whereas private banks had to hold either government securities or certain commercial bills to cover the remaining 60%. […]

This requirement increased the costs for private banks to issue notes relative to cantonal banks, since it gave them less freedom concerning the composition of their portfolios. Hence, it is not surprising that cantonal note issuing banks became relatively more prominent. In 1880, there were 22 non-cantonal and 14 cantonal note-issuing banks, whereas in 1906 there were 14 non-cantonal and 22 cantonal banks that issued notes (Jöhr 1915: 191). Over the same period of time, the cantonal banks were able to raise their share of the total circulation of banknotes from 43% in 1880 to 59.5% in 1906 (Nedwed 1992: 83). It appears as if the federal regulations did in fact make a difference; they favored cantonal banks over other note issuing banks. As do Briones and Rockoff (2005: 309), I therefore agree with Weber (1992) that the federal banknote law of 1881 effectively turned the Swiss banking system into a non-free system. […]

During the period of free banking from 1826 to 1881 and the period of competitive note issue under the federal regulations from 1882 to 1906, only two banks experienced a run on them (Jöhr 1915: 92) and two banks failed, while the notes held by customers were never devalued (Neldner 1998: 289-290).

The boom was financed, not by any increase in the bank money multiplier, but by injections of high-powered money from Austra-lian gold mines and from the British capital market. [13] When injections from Britain came to a sudden end with the Barings Crisis of 1890, many Australian banks were obviously unprepared; but this did not make them guilty of having lent excessively and “irrationally” during the boom years.


Further reading :
On the So-Called ‘Failure’ of Free Banking in Australia : the Banking Crisis of 1893
On the Success of ‘Free Banking’ in Sweden
The ‘Free Banking’ in Hong Kong
Free-banking revisited: the Chilean experience 1860-1898 (Ignacio Briones)
Truth About Free Banking in Chile : Selgin versus Rothbard
On the Success of Free Banking in Scotland (1716-1844)

This entry was posted in Economics and tagged . Bookmark the permalink.