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posted on 11 September 2016

The Free-Banking Era: A Lesson For Today?

from the Philadelphia Fed

What would happen if anyone could open a bank at will? What if you or I could hang a sign in a storefront or create a website and start attracting borrowers and depositors with competitive interest rates? What if any sort of firm, big or small, could venture into the banking business in the U.S. with no official charter required? For a time in U.S. history, entry into banking in some states was thrown wide open.

The so-called free-banking era from 1837 to 1864 was also a time of numerous bank failures in those states. But exactly what lesson does this colorful yet costly period hold for us today? At a time when too-big-to-fail banks remain a concern and technology seems to point toward a freewheeling future of "cloud" lending and private electronic currency, insight into how to foster stability in the financial system is especially relevant. But as I will show, the main lesson of the free-banking era may not be the one you would think.

WHAT IS FREE BANKING?

A brief history of free banking in the U.S. After the charter of the Bank of the United States was allowed to expire in 1836, several states adopted free-banking laws. The widespread adoption of free-banking laws was part of a political movement led by Jacksonian Democrats to reduce the economic and political power of large banks in the financial centers. In the 1830s, Michigan, Georgia, and New York adopted free banking. By 1860, 15 other states had adopted free banking.1 Economic historians largely agree that Michigan's early experience was a complete failure and that New York's overall experience was a solid success. In Michigan, bank liability holders suffered large losses in 1837 - 1838 as a result of unsound banking practices. In contrast, losses were negligible in New York over the whole free-banking period in that state. The available historical data for the other free-banking states show various degrees of success when it comes to the stability of the banking system.

Free banking ended in 1864 when Congress passed legislation that provided bankers with strong incentives to obtain a national charter. During the debates over the National Banking Act, proponents cited the large number of failures of banks with state charters in the free-banking states and the need to establish a uniform, nationwide currency system.

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