The ‘Free Banking’ in Hong Kong

Among the numerous successful episodes of Free Banking, the Hong Kong episode is rarely cited as a relevant one. Not surprisingly, because the austrian economists (the free bankers) themselves seem to consider the period of free banking (1935-1964) has never been free at all. Schuler (1992, p. 39) is an illustration of that belief :

Hong Kong ended free banking in 1935 in the wake of China’s unexpected decision to abandon the silver standard, which disrupted the basis of their trade. The government confiscated the banks’ silver, and tied the Hong Kong dollar loosely to the British pound, which itself was no longer convertible into gold at a fixed rate. (The Experience of Free Banking, ch. 2)

According to the Hong Kong Museum of History, the Hong Kong dollar was legal tender :

Under the Currency Ordinance of 1935, banknotes in denominations of 5 dollars and above issued by the three authorised local banks, (the Mercantile Bank of India Limited, the Chartered Bank of India, Australia and China and the Hong Kong and Shanghai Banking Corporation) were all declared legal tender.

Why should we focus our attention on the Hong Kong episode ? The regulations in place were likely to foster a huge credit expansion and other bad banking practices but despite of these bad incentives, the free banking episode in question was spared from banking or economic crisis.

Kam Hon Chu published an enlightening article (1996) for the Cato institute. He compares the bank failures rate of Hong Kong, Canada and United States. The US banking system is a regulated one with deposit insurance. The canadian banking system is a regulated one but it had no deposit insurance until 1967. The chinese banking system was the freest and the less regulated of the three in study. He comes to the conclusion that the canadian and chinese banking system were less prone to bank failures, as illustrated by the table below (see pp. 4-5 for an explanation of the results displayed in the table) :


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. [7] 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 first Banking Ordinance was passed in 1948. But except an annual licence fee of HK$ 5,000, banks were not subject to any restrictions, such as minimum capital-asset ratios, reserve ratios, or liquidity ratios. More stringent banking regulations were not imposed until the Banking Ordinance of 1964 was passed on October 16, 1964. …

The downtrend in the number of banks in Hong Kong over the 1948-58 period (see Table 1) was due to both economic and noneconomic factors. [9] Nonetheless, this downtrend did not result in any reported losses to depositors or turmoil to the financial system, so banks that left the industry are not counted as failed banks in this study. While there were no bank failures during this period, there was a short-lived run on the Liu Chong Hing Bank, a medium-sized local bank, in June 1961, partly due to the liquidity squeeze arising from the oversubscription of rights and new issues on the local stock market and unfavourable clearings suffered by small banks. It ended after the Liu Chong Hing Bank had reportedly used its real estate holdings on a purely commercial basis to secure advances from the two largest note-issuing banks (Jao 1974: 238-40). …

Both Hong Kong and Canada were, and still are, major trading partners of the United States, and the business cycles of these three economies moved closely together.

At first glance, the above table suggests that the regulated banking (without deposit insurance) is just as stable as the free banking system. But regulations is likely to reduce economic growth and the efficiency of intermediation. In other words, growth would have been higher without regulations. Concerning the US banking system at that time, the fact that “fixed” deposit insurance leads to more frequent and serious financial crisis is well informed by Kam Hon Chu (2011). In addition, Kam Hon Chu (1996) noted :

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 Saving Bank and 70 other thrifts insured by the Ohio Deposit Guarantee Fund following the Home State’s reported loan loss of $140 million, exceeding the fund’s $136 million in reserves. [6]

[6] … the state governments would have been more credible insurers only if they had been perceived as ready and able to finance (by borrowing or taxing) whatever amount was necessary to replenish the insurance fund. The same is true of federal deposit insurance.

Even though economic downturns are related to bank failures, the period under study is relatively stable. Hong Kong and Canada experienced higher growth rate, but Kam Hon Chu notes that bank failures occurred in United States regardless of economic cycles. Another critical point is to consider that the causality is likely to run in the opposite direction : a good banking system leads to higher economic growth.

Soon after the Banking Ordinance of 1964 was passed, a banking crisis occurred, precisely at the beginning of 1965. As we shall see, it were the Banking Ordinance and the government intervention that caused the crisis, not the so-called “overbanking”.

During the period of free banking it seems that nevertheless one bank “failed” in 1952, according to Catherine Schenk (2006). Unfortunately, she did not provide any detail about the closing yet it does not threaten the banking system as a whole. It was of little importance.

One bank closed in 1952 after it ‘was besieged by its creditors when it failed to open its doors’ after the New Year holiday.

She also notes the closure of the Chiu Tai Bank in 1963. But its cause stems from fraudulent operations, not overexpansion :

One case in the early 1960s (between the two banking crises, when it must be assumed that public confidence was fragile) was Chiu Tai Bank, whose offices were raided by the police in November 1963 because of allegations of fraud associated with a series of dishonoured cheques. 50 The bank came under scrutiny by the Deputy Economic Secretary, TD Sorby, in October 1961 when the Registrar General alerted him that the balance sheet for 1960 suggested the bank might be insolvent. … The incompetent or perhaps fraudulent operation of a small bank was not sufficient to cause systemic problems.

Most critics of the free banking fail to distinguish between a localized and a wide-scale bank failure. It should thus be clarified once more that an isolated banking failure is unlikely to threaten the banking system as a whole (Selgin, 1988, pp. 29-30, 115).

Through a clearinghouse banks can also share information concerning forgeries, bounced checks, and the like. Clearinghouses may also conduct independent audits of member banks to assure each member bank that the others are worthy clearing partners. …

Note and deposit exchange rates would reflect potentials for capital losses depending on the soundness of underlying bank loans and investments. Chapter 2 showed how note brokerage systematically eliminates note-discounting except when it is based on risk-default generally acknowledged by professional note dealers, including banks themselves. In short, note brokerage produces information on bank-specific risk. … After confirming through the newspaper that there is no discount on the notes he holds, a bank customer would feel no urge to redeem them in a hurry.

As such, isolated bank failures contribute to the efficiency of financial markets because they enable resources to be better reallocated, besides keeping the surviving banks in alert. As Kam Hon Chu (2011) explained :

As long as a run is on an individual bank but not on the banking system as a whole, deposits are just redistributed from the bank that is perceived by depositors as more risky, and hence run on, to other safer and financially sound banks.

Now, the common explanation for the banking crisis of 1965 is the collapse of the property market that had imploded in the 1950s. For instance, the difficulties of Liu Chong Hing in 1961, as well as the bankruptcy of Chiu Tai Bank in 1963, find their source in the real estate downturn. Goodstadt and Schenk jump to the conclusion that the banking system was not regulated enough to prevent the banking crisis of 1965. But they ironically provide a large body of evidence that the crisis stems from the government intervention, not from the monetary overexpansion.

By his own admission, Leo Goodstadt (2006b), despite being very hostile to free banking, recognized the role of the government in the 1965 banking crisis :

Property owners faced considerable constraints on their freedom to redevelop urban sites in the early post-war period. In 1953, the law was amended to permit owners to clear occupants from damaged or dangerous premises and to rebuild them, which led to a sharp rise in the level of activity in the property market. …

Paradoxically, it was to be government intervention in the market that first intensified the property boom and then led to a crash which was followed by the worst bank runs in Hong Kong’s history. The announcement in 1962 that building densities would be reduced from 1966 caused a rush to start new projects. These were planned on the basis of completion schedules that proved increasingly difficult to achieve. The situation was aggravated by further controls introduced in 1964 to limit the hazards created by demolition and redevelopment of existing buildings. These regulations slowed down the rate at which construction could proceed and increased the risk of breach of building covenants.

Catherine Schenk (2003) admits that the Banking Ordinance of 1964 depressed the banks’ sale of property assets :

Near the end of 1964, property prices began to fall after a spurt of speculative building. The market was also depressed by the banks’ sale of property assets to conform to the new Banking Ordinance. This left many banks (especially Chinese banks) overexposed as the demand for cash associated with the Chinese New Year approached.

The 1964 Banking Ordinance consists of “imposing minimum liquidity requirements and restricting the freedom to lend to related parties” (Goodstadt, 2006b). Catherine Schenk (2006), while being a promoter of a regulated banking scheme, gives further evidence that the 1965 banking crisis was not due to overbanking.

The impact of the 1965 banking crisis was a redistribution of deposits rather than an overall decline. In 1967, however, there was a flight of capital out of the colony and an absolute reduction in bank deposits.

Using archive data for the 1965 crisis it is clear that there is no correlation between size of deposits in December 1964 (a month before the second bank crisis) and the proportional fall in deposits during January and February. Figure 19 plots the relationship, leaving out HSBC to enhance the scale (HSBC’s deposits were $2.2b at the end of 1964 and increased by 8% during this period). The correlation coefficient for size of deposits at the end of 1964 and liquidity ratio at the end of February 1965 is -0.04.

There is a slightly higher correlation for local banks (other than HSBC) between size of deposits and change in deposits during the first round of the crisis but it is still low at -0.18 (compared to 0.06 for the banking system as a whole). …

Foreign banks would have been vulnerable to changes in sentiment about the Hong Kong banking prospects of their foreign depositors, but the data show that there was not a large overall decline in deposits like there was when international confidence in Hong Kong was rocked by the Communist disturbances of 1967. 55 These multinational banks were not threatened by the local withdrawals, and they tended to rebound by the end of the second phase of the crisis in April 1965.

55 Overall, deposits fell only 1.8% from the end of 1964 to 25 February 1965

The evidence for the increase in banking activity is clear, but the link between this trend and systemic instability as exhibited in the banking crises of 1961 and 1965 is not. … If there was a time of ‘over-banking’ it was arguably the 1950s when there were 133 banks rather than the 1960s when there were 74.

The claims that Hong Kong was ‘over-banked’ can only be substantiated if market entry reduced the profits of existing banks to the extent of threatening bank solvency, or if the competition among banks led to higher risk in lending due to competition for sound outlets for loans. Both were claimed for Hong Kong in the 1960s. There is no evidence of an overall fall in profits before 1964-65, but certainly there is evidence of an increase in profits after the moratorium was introduced.

Kam Hon Chu (1996) also made the same point :

Available bank balance sheet data reflect that over the year there was a redistribution of deposits within the banking system rather than a run on the entire system.

Leo Goodstadt (2006a) provides the following table :


In regard to the above figures, while Cowperthwaite believes that the crisis of 1965 was inconsequential, Goodstadt argues that the impact of the banking crisis had been postponed two years later (1966 and 1967). But the banking crisis occurred just at the beginning of 1965 while the real growth in this year amounts 14.5 compared to the 8.6 points of growth for 1964. Furthermore, the slow growth in 1967 is likely to be due to a decline in international confidence in Hong Kong caused by Communist disturbances, not by the 1965 banking crisis.

Since there is virtually no bank failures, one may ask : Can the lack of bank failures mean that inflation is all the more rampant ? Given the regulations in place, this is plausible. Surprisingly, when I emailed Kam Hon Chu, the last year, he told me that the data actually show that the Retail Price Index in Hong Kong rose from 108 in 1950 to 118 in 1960 (an increase of less than 1% on an annual basis). Reference : “Hong Kong Statistics, 1947-67”. Without legal tender laws, it is very plausible that inflation would have been more slow.

Finally, it should be noted that the HK banking system was quite unregulated even before 1935. Kam Hon Chu reports that the unregulated HK banking during 1864-1933 enjoyed a long period of stability with very few bank failures :

Ironically, the Hong Kong banking system enjoyed a long period of stability in the past despite the fact that it was largely unregulated. For the period 1864-1933, the Hong Kong banking system was more stable than its Canadian and American counterparts. There had not been any documented and reported bank failures resulting in losses to depositors and financial crises since the collapse of the Oriental Banking Corporation in 1884. … Its failure was due to the failure of coffee crop in Ceylon (King 1990: 16).

Berry Fong-Chung Hsu (1997) reports that the war triggered a total of six bank failures during the year of 1866. So, the HK banking system at that time should not be blamed for the bank failures of 1866.

In its early days, Hong Kong’s financial stability depended heavily on international commodity markets. In 1865, the conclusion of the U.S. Civil War caused uncertainty about U.S. cotton production, which depended largely on slave labor. The uncertainty touched off a trade depression, which was compounded by fluctuations in the price of silver and a recession in the Bombay financial market. In 1866, six of the eleven banks operating in Hong Kong went into bankruptcy. (74) Notwithstanding this instability, the government did not take measures to control banking activities. This lack of response was consistent with the laissez faire policy practiced by the Hong Kong government at the time.

Kam Hon Chu notes that regulations failed to provide financial stability. After the 1965 banking crisis, another banking crisis occurred 20 years later despite the strengthening of banking regulations :

The 1965 banking crisis in Hong Kong also shows that regulations are no guarantee for financial stability. Between 1967 and 1981, the Banking Ordinance had been amended 19 times to strengthen banking regulations. Yet they failed to prevent the 1982-86 banking crisis, during which a total of seven commercial banks experienced financial difficulties, and they were taken over either by the Hong Kong Government or other financial institutions. [19]

A final word about the unregulated HK banking system. Given the fact that the HK banking system was not a “pure” free banking, one may think that the body of evidence presented above is inconclusive, but one should not look for any pristine because such thing has never existed. We have to determine what aspects of the banking system efficiency should be attributed to freedom, and what aspects should be attributed to regulatory interventions.

Despite the bad incentives of the regulations in place, the HK ‘free’ banking system was spared from inflation and bank failures. Furthermore, Hong Kong enjoyed higher growth rates than the USA. So I consider this free banking episode as a relevant one.


Chu, K. H. (1996). Is Free Banking More Prone to Bank Failures Than Regulated Banking?. Cato J., 16, 47.
Chu, K. H. (2011). Deposit Insurance and Banking Stability. Cato Journal, 31(1).
Goodstadt, L. (2006a). Government without Statistics: Policy-making in Hong Kong 1925-75, with special reference to Financial Markets (No. 6). HKIMR Working Paper.
Goodstadt, L. F. (2006b). Painful Transitions: The Impact of Economic Growth and Government Policies on Hong Kong’s ‘Chinese’ Banks, 1945-70 (No. 162006). Hong Kong Institute for Monetary Research.
Hsu, B. F. C. (1997). Legislative Control of Hong Kong Financial Markets: Some Aspects of Banking and Securities Regulations. Law & Pol’y Int’l Bus., 28, 649.
Schenk, C. R. (2003). Banking crises and the evolution of the regulatory framework in Hong Kong 1945–1970. Australian economic history review, 43(2), 140-154.
Schenk, C. (2006). The Origins of Anti-Competitive Regulation: Was Hong Kong’over-banked’in the 1960s?.

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