The Case For Free Banking A Freebanking System

Imagine a laissez-faire regime in a hypothetical 'imperfect' economic environment - information is scarce and asymmetric, there are non-trivial agency and coordination problems and so on.5 These problems give rise to a financial system characterized by the presence of intermediaries that enable agents to achieve superior outcomes to those they could otherwise achieve (for example, by cutting down on transactions and monitoring costs).

Perhaps the most important intermediaries are banks, which invest funds on behalf of client investors, some of whom hold the bank's debt and others its equity. Most bank debts are deposits of one form or another, and most of these can be redeemed on demand. Many deposits are also used to make payments by cheque. The equity-holders are residual claimants, and their capital provides a buffer that enables a bank to absorb losses and still be able to pay its debt-holders in full.

The banking industry exhibits extensive economies of scale, but not natural monopoly,6 and there are typically a small number of nationwide branch banks, with a larger number of specialist banks that cater to niche markets. The industry is also competitive and efficient by any reasonable standard.7

But how stable is the banking system? With no lender of last resort or state-run deposit insurance system, depositors would be acutely aware that they stood to lose their deposits if their bank failed. They would therefore want reassurance that their funds were safe and would soon close their accounts if they felt there was a significant danger of their bank failing. Naturally, bank managers would understand that their long-term survival depended on their ability to retain their depositors' confidence, so they would pursue conservative lending policies, submit themselves to outside scrutiny and publish audited accounts. They would also provide reassurance by maintaining adequate capital: the greater a bank's capitalization, the more losses a bank can withstand and still be able to pay off depositors in full. If the bank's capital is large enough - if the bank is adequately capitalized - the bank can absorb any relatively 'normal' losses and still repay depositors, and depositors can be confident that their funds are safe. The precise amount of capital is then determined by market forces: the more capital a bank has, other things being equal, the safer it is; but capital is also costly, and depositors need to pay shareholders to provide it (for example, by accepting lower interest on deposits). Competition between banks should then ensure that banks converge on whatever levels of capital (or safety) their customers demand (and, by implication, are willing to pay for): banks will be as safe as their customers demand.8 Consequently, if bank customers want safe banks - as they surely do - then market forces will ensure that they get them.

The conclusion that banks under laissez-faire would maintain high levels of capital is consistent with the empirical evidence. For example, US banks in the period before the US Civil War were subject to virtually no federal regulations and yet had capital ratios in most years of over 40 per cent (Kaufman, 1992, p. 386). US banks were subject to more regulation at the turn of the century, but even then their capital ratios were close to 20 per cent, and capital ratios were still around 15 per cent when federal deposit insurance was established in the early 1930s (ibid.). The evidence is also consistent with the associated prediction from free-banking theory that laissez-faire banks are very safe. For example, US banks appear to have been fairly safe before the Civil War (Dowd, 1993, ch. 8) and, afterwards, bank failure rates were lower than the failure rates for non-financial firms (Benston et al., 1986, pp. 53-9). Losses to depositors were correspondingly low (Kaufman, 1988). Failure rates and losses were also low for other relatively unregulated systems such as those in Canada, Scotland, Switzerland and various others (see, for example, Schuler, 1992 or the case studies in Dowd (ed.), 1992).

Nor is there any reason to expect banking instability to arise from the ways in which banks relate to each other, either because of competitive pressures, or because of 'contagion' from weak banks to strong ones. It is frequently argued that competitive pressures produce instability by forcing 'good' banks to go along with the policies of 'bad' ones (for example, Goodhart, 1988, pp. 47-9). The underlying argument is that if the bad banks expand rapidly, they can make easy short-term profits which pressure the managers of good banks to expand rapidly as well, with the result that the banking system as a whole cycles excessively from boom to bust and back again. However, a major problem with this argument is that it is not in the interest of bank managers or shareholders to engage in aggressive expansion of the sort this argument envisages. A bank can expand rapidly only by allowing the average quality of its loans to deteriorate, and a major deterioration in its loan quality will undermine its long-run financial health and, hence, its ability to maintain customer confidence. It is therefore hard to see why a profit-maximizing bank would choose to undermine itself this way, even if other banks appeared to be doing so. Indeed, if a bank believes that its competitors are taking excessive risks, the most rational course of action is for it to distance itself from them - and perhaps to build up its financial strength further - in anticipation of the time when they start to suffer losses and lose confidence. The bank is then strongly placed to win over their customers and increase its market share at their expense, and perhaps even drive them out of business. The bank would have to forgo short-term profits, but it would win out in the long run. In sum, there is no reason to suppose that competitive pressures as such would force free banks into excessive cycling.9

Then there is the contagion argument that the difficulties of one bank might induce the public to withdraw funds from other banks and threaten the stability of the financial system. The conclusion normally drawn from this argument is that we need a central bank to prevent 'contagion' by providing lender-of-last-resort support to a bank in difficulties (for example, Goodhart, 1989). However, this argument ignores the earlier point that good banks have a strong incentive to distance themselves from bad ones. If the good banks felt there was any serious danger of contagion, they would take appropriate action - they would strengthen themselves and curtail credit to weak banks - to help ensure that contagion did not in fact occur. Indeed, as discussed already, they would position themselves to offer the customers of weaker banks a safe haven when their own banks got into difficulties. A serious danger of contagion is thus inconsistent with equilibrium. When runs occur, the typical scenario is a flight to quality, with substantial inflows of funds to the stronger banks, and there is no evidence that runs are seriously contagious (see, for example, Benston et al., 1986, pp. 53-60). The contagion hypothesis is implausible and empirically rejected.

The Impact of State Intervention

What happens to this system if the government intervenes in it? There is no space here to consider all the ways in which governments intervene in the financial system, but we should at least consider the impact of the more important forms of state intervention - deposit insurance and capital adequacy regulation.10

Suppose then that the government sets up a system of deposit insurance. Assume, too, that this is a fully comprehensive system (that is, with 100 per cent insurance cover) along North American lines.11 Once it is established, depositors would no longer have any incentive to monitor bank management; managers would therefore have no further need to worry about maintaining confidence. And, since the main point of maintaining capital strength - to maintain depositor confidence - no longer applies, a bank's rational response to deposit insurance would be to reduce its capital. Even if an individual bank wished to maintain its capital strength, it would be outcompeted by competitors who cut their capital ratios to reduce their costs and then passed some of the benefits to depositors in the form of higher interest rates. The fight for market share would then force the good banks to imitate the bad. Consequently, deposit insurance transforms a strong capital position into a competitive liability, reduces institutions' financial health and makes them more likely to fail. It also encourages more risk taking at the margin: if a bank takes more risks and the risks pay off, then it keeps the additional profits; but if the risks do not pay off, part of the cost is passed on to the deposit insurer. The bank therefore takes more risks and becomes even weaker than suggested by its capital ratio alone.12 In short, deposit insurance encourages the very behaviour - greater risk taking and the maintenance of weaker capital positions - that a sound banking regime should avoid. Indeed, someone who observed this excessive risk taking might easily attribute it to the market itself, and falsely believe that the banking system actually needs the deposit insurance system that is, in reality, undermining it. A major cause of banking instability (that is, deposit insurance) could easily be mistaken for its cure - and, unfortunately, often is.13

The imposition of capital adequacy regulation also tends to have undesirable consequences. If the regulation is binding (that is, imposes a minimum capital requirement that exceeds the capital the bank would otherwise choose to maintain), then the bank's only rational response to it is to find ways to reduce - and preferably, eliminate - the burden associated with the capital regulation. The regulation is a burden because it would make the bank safer than its management themselves prefer, and so reduce their opportunities for profitable risk taking. A bank will therefore respond to this sort of regulation by finding other ways of increasing risk and/or reducing its regulatory capital requirement - by switching to more risky assets, such as riskier loans; by exploiting loopholes or inconsistencies in the capital regulation to reduce its capital requirement; and by resorting to off-balance sheet transactions. Off-balance sheet positions - derivatives positions especially - are very useful means for banks to increase their leverage (and hence their risk), as well as a very convenient way of getting around awkward regulatory and tax obstacles. Thus, a bank will respond to capital regulation by trying to frustrate it, and the net effect of the regulation will be very hard to assess. If there are many opportunities to avoid the regulation, as is increasingly the case, then the chances are that the regulation will become no more than a nuisance: the bank will end up taking similar risks to those it would have taken anyway, and the regulation will do nothing to make it any safer. Indeed, it is quite possible that the regulation will be counterproductive, and induce responses from banks that will make them even weaker than they would otherwise have been (see, for example, Koehn and Santomero, 1980).14

Financial End Game

Financial End Game

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