When it comes to free banking, the era from 1837 to 1865 in the United States may be called in this way, however even the most orthodox monetarists could hesitate to call this system as an ideal one. Therefore, this period of currency issues without appropriate supervision received the name “Wildcat Banking”.
Introduction – environment in 1830s
As we all know, the major issue for the client – bank relationship in case of banknotes was the question if such banknotes could be redeemable. In the event the bank issues notes in confidence that they can be redeemed, following the original promise, it’s simply about contract enforcement. However, otherwise, the question of fraud arises.
There are number of stories in the history, when financial entities had a free space, lacking any supervision or insufficient one, they tended to use fraudulent manners resulting in non-redeemable banknotes. Let’s take a look at some examples of the U.S. states during this era.
In the United States, the 1830s were known for the existence of the Second Bank of the United States with charter expiring in 1836. At that time, couple of American states have already established a legal framework for banking business. There was no federal regulation or legal rules for this purpose, therefore it was up to respective states to regulate banking within their own territory.
Before, certain entities with limited liability (LL) could issue notes if the legal rules allowed respective charter for this purpose. However, free banking era opened the possibilities for LL entities to issue notes without any approval based on the legislature or regulatory action (as it was implemented later).
As this was an appropriate environment to develop free banking system, different states were gradually adopting the legislature to allow such business. First three U.S. states, adopting free banking framework in 1830s were: Michigan, Georgia and New York.
Most of the states adopted free banking in 1850s, when the system was little more developed, however still missing sufficient supervision.
How should the system work – legal background
This was a period when anyone could open a bank, subscribing minimum capital, but there could be also securities used like “loans to stockholders,” meaning that capital subscribed was not paid in (liability to pay was set).
Moreover, the banks could issue banknotes, free for circulation. To do so, banks had to make a security deposit with the state banking authority, which signed the notes and returned them back to the bank. Such deposit could be made in bonds (known as state stocks that time) and U.S. government bonds, both traded on the New York Stock Exchange.
Such merchantability helped to make the valuations of bonds easier, helping their extensive use. The bonds deposited worked as an asset of the bank, while the notes were a liability. The requirement of states was that the value of bonds was lesser than their face value.
In the event the security deposit value dropped below the value of notes, banks were obliged to add bonds or reduce their outstanding notes. In the event of not meeting this obligation, bank was closed and its security deposit was used to pay noteholders on pro rata basis.
Another legal requirement was the obligation of banks to convert the notes into specie on demand, therefore certain amount of specie was held in the balance of such banks (however, only fraction). In the event of not meeting this requirement, banks were penalized.
Such notes had to be converted at zero discount at the issuing bank, while in case of banks in different state, a discount could be applied (for example for a $100 note from Michigan, the noteholder could receive $98.50 in New York)
Naturally, as banks held only small amount of specie, they could not cover all the notes immediately, so there was a risk of bank runs.
How did the system work in practice?
Fiasco in Michigan (1837-38)
Although the legal framework seemed to be relatively well proposed and implemented, there were number of differences between individual states and real application.
In Michigan, the security deposits consisted of bonds or even mortgages upon real estates in Michigan. However, the first problem was the inflated appraisals and depreciated real estate values in case of large amount of real estate in security deposits. According to the bank commissioner from that era, real estate values were far below appraised values, when free banks were closing en masse.
Shortly after the adoption of free banking, suspension of specie payments occurred in this U.S. state due to reasons not connected to free banking, however according to the above mentioned legal framework, such banks had to be closed. Being aware of the situation, Michigan state amended the law in 1838, giving the banks the right to suspend specie payments.
However, the reaction was, that the number of banks doubled – therefore, the local government, unable to come up with an appropriate proposal how to solve this situation, prohibited new banks from suspending payments.
To gain some picture about the situation, in December 1837, there were eighteen banks in Michigan (probably, as even for bank commissioners it was hard to know how many of them operate), while in February 1838, there were forty banks. However, by September 1839, only nine banks remained.
Another problematic factor was the simplified capital structure that could be established to meet the legal requirements. As the owners could take advantage of the possibility not paying the capital in (so as loans to stockholders in full), but having the permit to issue notes in this way.
Result: In January 1839, bank commissioners estimated that the banks had authority to issue over $4 million in notes, however “near a million dollars of the notes of insolvent banks are due and unavailable in the hands of individuals” (U.S. Congress 1839-40).
From those 40 banks only 17 banks had sufficiently large deposits to cover their notes. According to an 1839 Attorney General’s report, approximately $2 million was outstanding toward the end of 1839 and free banks redeemed such notes at about 39 cents on the dollar. Therefore, the noteholders lost around 60% of the par value of such notes in general.
New York success – a different story
While the events in Michigan proved that certain supervisory approach is always necessary, New York was a different example showing that there can be a balance found between supervisory approach and free space for bank business.
The security deposits could consist of state government bonds, bonds and mortgages on real estate. However, real estate proved to be less of a problem as in case of Michigan, keeping their value.
The annual loss rates on notes issued in New York were relatively high in 1840s, reaching the peak in 1842, when (in general) the loss reached 4% (however, 42% in case of failed banks, what was the cause of the higher loss rate in total). Nevertheless, in 1844 it was only 0.2%, in 1848 only 0.4%. The average loss rate in 1850s was 3.7%, while only 0.1% in 1860s, showing an improvement in banking sector over time.
Indiana’s fragile system
Indiana is another good example, how the system could get quickly into troubles in case of any external impact (this time an amendment of legislature in neighboring Ohio).
Indiana banknotes were highly circulating in other states, in particular in Ohio, whose high taxes on banks left this state unpopular for the bank organizers. Not only that Ohio was not willing to join the club of “free bankers,” but the country passed a law in May 1854 that made the use of small banknotes (large number of Indiana’s banknotes) illegal in the state since October 1, 1854.
Naturally, the result was return of such notes for redemption and a drop in Indiana bonds’ prices (making 2/3 of banks’ security deposits). To make the picture about the situation full, the discount rates on Indiana’s notes were 1.50 in 1853, while in 1854 (after the adoption of Ohio’s ban) they reached 25%.
As expected, from October 1854 to January 1856, Indiana banknotes outstanding declined by approximately 45%. The reaction was similar as in Michigan – free banks suspended payments.
Illinois and Wisconsin – Bonds’ Selloff due to Civil War coming
These two states adopted free banking little later (Illinois in 1851 and Wisconsin in 1852), therefore even the troubles related to free banking occurred in the last years of this era.
In 1861, the decrease in U.S. bond prices occurred before the difficulties hit Illinois and Wisconsin. Political tension caused a frequent occurrence – prices of bonds dropped, while yields were rising gradually.
In particular, the prices of southern and border states suffered and it was only intensified after the firing on Fort Sumter and Lincoln’s blockade and calling up of troops. Thus, the Civil War was the initial factor of troubles of number of banks in Illinois and Wisconsin, while causing problems to the financial sector in number of other states as well.
The fragile system of extremely free banking system in not yet fully-developed states like Illinois and Wisconsin was expressed by the discount rates in the same way as we could see in Indiana in 1854.
Wisconsin saw its discount rate of 2.75% in 1860 (an acceptable one) hiking to an extreme of 20% in June 1861. Illinois ended even worse, when its discount rate soared from 2.25% in June 1860 to unprecedented 60% in June 1861, eliminating number of bank entities in the state.
Subsequent contraction in the amount of outstanding notes was only a natural consequence. Wisconsin outstanding notes dropped by approximately 60%, while Illinois banknotes even 84%. Suspension of payment followed this development with 47% of Wisconsin banks closed and 87% of Illinois banks closed.
Causes of troubles
The main causes were the following: the fact that anyone could organize a free bank with only little funds. The bank owner could borrow funds, use them to buy state bonds, while subsequently, such state bonds were used as a security for notes.
Not only that this initial process is risky – it may continue further – the state banking authority sends notes back to the bank owner (as approved with stamp) and the owner may use them to buy even more bonds, thus increasing the risk.
In connection to the above mentioned, the main motivation of certain banks within this high-leverage operation was the income from interests, based on the purchase of state bonds. Therefore, number of entities was not focusing on the service for clients, but served more as investment banks investing into state obligations under the conditions of markedly high leverage.
The end of free banking
Although not trouble free, number of states avoided such panics, based on fraudulent behavior, high leverage or external effects hurting still fragile financial system in less developed U.S. states.
This era helped the United States to gain invaluable experience with financial sector, tested pretty much during the Civil War, resulting in the understanding of more extensive supervision. As shown many times in the history, freedom in business is crucial for the market development, however there is the need of certain watchdog to show the direction in case of improper behavior.
This era came to its end in 1865 by the action of federal government with the assistance of new tax system. Nevertheless, the question is, if we could expect the still developing states in the U.S. (most of the U.S. states, except for the eastern, oldest ones, had their financial system widely undeveloped) to see a different progress in the banking sector.
Top image: michiganradio.org
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Friedman, Milton, and Anna J. Schwartz. A Monetary History of the United States, 1867-1960. Princeton, N.J.: Princeton University Press, 1963
Hayek, F.A. The Denationalization of Money – The Argument Refined. 2nd ed. London: Institute of Economic Affairs, 1978