The Free Banking Era How should banking be regulated? The U.S. Post 1837/1843? Monetary policy regime: Bimetallic System No central bank: No lender of last resort No fiscal agent. The U.S. government uses system of sub-treasuries to collect and disburse funds. Federal debt declining. No big wars and no large projects. Damaged reputation on international capital markets slowly recover. No federal regulation of banking---regulation of banks left completely to the states and a new period of experimentation begins---the Free Banking Era The Free Banking Era, Beginning in 1838 (New York), many states abandon chartered banking where the state legislature needed to vote to give a charter. Many businessmen angry about favoritism and corruption. Lightly regulated but not laissez-faire banking Key features of general banking laws. Freedom of Entry. Meet minimum rules, entrepreneurs free to open banks Bond-backed banknotes. To issue banknotes, bank must buy state bonds and deposit them with state agency to as security. And two more common features Banks must pay out specie for notes on demand Bank stockholders liable for losses up to value of investment (double liability). New York and the Birth of Free Banking Why is Incorporation Valuable? Corporate charters protect the collective ownership of property and encourage the accumulation of capital, limit investor risk and facilitate access to the courts Between 1790 and 1810 corporate privileges were reserved for a few large business---before 1800, only 28: 13 turnpikes, 4 banks, 3 canals, and others. But restriction of number meant they were valuable---elicited bribes and corruption. (e.g. Schwartz (1947) The Albany Regency In 1821, state constitution requires a 2/3 majority of both houses for a new bank charter to control corruption. Limits growth--- only 12 new banks chartered Crisis as old charters are expiringno renewal no banks, NY lose out in competition with Pennsylvania and Massachusetts. Elected governor in 1828, Martin Van Buren creates a machine, arrives in state senate and builds a machine, the Bucktails or Albany Regency of NY Democrats. Promotes young men on rise to legislature and patronage through state officials and judges. The Albany Regency Van Buren elected governor 1828three problems (1) chartering logjam (2) protect public against failures (3) keep chartering under Regencys control Safety Fund Act: requires all newly chartered banks to contribute 6% of capital to a fund plus annual contributions to reimburse note holders and depositors of failed banks. A mutual guarantee system. Sets common regulations and a state bank supervisorthe first. No worries about bank qualitylegislators can focus on quantity---64 de novo charters and 29 re-charters Big rewards. State Assemblyman Erastus Root: no one would hesitate, from motives of delicacy, to offer a member [gratis] shares in a [proposed] bank. Most of benefit is channeled to benefit of Albany Regency. Reward loyalty. State administrators decide who will receive new shares allocated to friends of Regency. Number of banks still limited. By 1837, this gross corruption angering the public. Regency hurt by panic of Eleven banks fail and exhaust the Safety Fund. Whigs defeat Democrats in New law orders all shares to be sold at public auction not allocated. New York Free Banking New NY Law in Free Banking Act--- stripped the government of source of revenue by allowing free incorporation. Allowed for all business---greater freedom of opportunity. Although Van Buren an ally of Jackson---- general movement of Jacksonian democracy was towards greater opportunity of equality for all, especially small scale enterprise. The bond-security provision aims at solving the safety problem. Start bank with $100,000 capital and coin reserves of $100,000 Print up $75,000 in banknotes. Buy bonds worth $75,000 in coin to back banknotes. Make $75,000 in loans Keep $25,000 in specie reserves. Banknotes protected but losses still possible if huge decline in value of loans and bonds. Banks also had depositsnot shown here Assets Liabilities Coin ReservesCapital $25,000 $100,000 BondsBanknotes$75,000 Loans $75,000Total$175,000 EXAMPLE: FREE BANK BALANCE SHEET Market Discipline Big Questions for the Free Banking Era and 2010 How do owners of bankthe shareholders---discipline the managers (President and other officers) How do depositors discipline the managers? Banking Issue A question of financial architecture---is this lightly regulated system inherently unstable. Can incompletely informed depositors distinguish between sound and unsound banks (sufficient reserves)? Can they penalize (provide incentives) so that banks will behave? Will banknote holders and depositors be unable to monitor banks and suffer key losses? Will panics and losses be endemic? Will this produce a small banking sector not conducive to growth? Traditionally historians not friendly Discounts or transaction costs? Rise in Crises. Explicit cost of monitoring banks at a distance Rolnick and Weber (1993): Conventional Wisdom Free bank failures were numerous Free banks were in business for a relatively short period Free bank notes were not safe and free bank failures produced substantial losses for their noteholders. TRUE? Rolnick and Weber (AER, 1983)a closer look at troubled states Most banks in troubled states do not go out of business. Many that do redeem at par. Otherwise What were the losses to noteholders? Total $1.9 million only.01% GNP Many states no losses, some it was highMichigan, Indiana where there were defective systems and New York where there were problems that were corrected later Not pure losses but transfers. Social cost if people avoided bank notesdemand for money. But what caused failures? Major problemwildcats and failures appear when state bond prices tumble because can issue notes based on par value of bonds not market value Consequently Illinois banks could use Tennessee bonds In many states, banks collapse at the outset of War The Civil War: the Second American Revolution New challenge Huge war-----bimetallic standard, low taxes, no central bank, state regulated banking system collapses But the South is out of the picture---long opposed to strong central government.