Free banking: an option for today’s banking system?

Maria Ferraz                                                                                    
Market Monday December 18th 2023


Free banking consists of a competitive market-driven system where private banks efficiently manage money and credit creation without central bank (CB) monopolization or extensive government oversight. Proposing the complete abolition or significant reduction of the CB’s duties challenges traditional monetary policy (MP) implementation in a way that government regulation will typically focus on enforcing contracts, preventing fraud, and protecting property rights, it is an alternative to central banking. Free banking existed in the 18th and 19th centuries, for example, in Canada, Scotland and U.S.. But is it feasible nowadays?

First, analyzing superficially the theoretical part of free banking. In fact, daily CB intervention could lead to unnecessary deflation/inflation. Concerning the behavior of the money supply, the freedom of note issue can eliminate undesirable changes in the money stock caused by shifts in the public’s preferred currency-to-deposit ratio. This freedom, combined with the absence of statutory reserve requirements, can help stabilize nominal spending by adjusting the bank reserve multiplier, potentially making them unnecessary and reducing the risk of unwanted price fluctuations in fiat money systems.
In this scenario, theoretically the reserve ratio would be predetermined, preventing collective decisions by banks to expand their balance sheets, as this would raise safety reserve needs and, consequently, increase clearing transactions. Banks balance loan revenue and liability costs, avoiding over issuance for profitability. Attempts to gain market share via increased issuance may lower asset values and raise deposit interest rates, impacting profit margins. Excessive banknote issuance could also induce individuals to deposit surplus currency, incurring additional costs for the bank.
Deposit insurance and the lender of last resort, CBs common roles, may be less crucial than thought. Private-market solutions, like option clauses on bank notes can help shield banks from spillover effects and avoid moral hazard, as they manage risks, boost transparency and simplify lending. Mutual funds that primarily invest in easily assessable market assets have the potential to strengthen overall financial stability. While certain financial intermediaries may not require CB regulation, inspections remain vital to prevent fraud. Even to manage riskier assets, banks could legally separate into two entities to protect clients from risk. It would be possible to impose restrictions on a bank’s portfolio so that it would be unnecessary to have CB oversight, at least for that constrained part of the bank. Addressing redemption uncertainty involves improving financial markets, enhancing the market valuation of private sector debt could reduce reliance on CB oversight.
Clearing houses, present in USA, Scotland and Canada, enhanced banking stability by providing a centralized platform for efficient settlement. During crises, loan certificates issuance secured against clearing-house assets supplemented specie shortages. The enforcement of specie payments acted as a control mechanism on bank note issuance, ensuring solvency.
However, free banking may not mean laissez-faire system. In U.S. there were rules, namely limited stockholder liability. Also, Scottish banks engaged in London bill discounting where these correspondents played a vital role. In Canada, there was union between the chartered banks, United Province of Canada, with uniform coinage and unrestricted branching.
So why did it ended? In Scotland and Canada, it was linked to international MP trends, mainly in England, leading to public disbelief in the system. U.S. bankruptcies were mainly caused by state bond devaluation, linked to fiscal and political factors, leading to chronic bank runs. In response, banks suspended convertibility, causing further trust loss in the system.
E-money may be a way to implement free-banking. It enhances payment efficiency, transforms monetary base management, and diversifies currency options if not overly regulated or prohibited. However, if introduced independently, detached from conventional currency, e-money could revolutionize and ease competition among monetary policy frameworks. It offers a platform for alternative monies to compete effectively, challenging conventional currency backing. This competition goes beyond national currencies, as seen in the Euro and US Dollar competition. Also allowing for the issuance of multiple currencies, national and private, expanding users’ currency choices.
E-money’s emergence minimizes panic in financial crises and removes the necessity for a systemic lender of last resort, since it smooths individual decision-making and personalized financial institution relationships with end-users.
The quality and quantity of available information is enhanced, e-money lowers entry barriers in financial services, allowing for the mitigation of systemic risks, through individual assessments of financial institutions’ safety and accuracy.
Furthermore, e-money issuance offers technical means for free banking implementation, its electronic nature facilitates revision or alteration of currency representation, easing entry and exit from monetary unions and inter-currency switching.
Uncontrolled e-monies extend free banking by endorsing independent clearing systems, reducing reliance on CB money, and enabling non-bank credit expansion. Independent e-money issuers can choose between diverse backings like money market funds or stock exchange indexes, preserving trust and integrity. Though major world currencies currently are viewed as trustworthy, e-money offers flexibility for new arrangements if there’s demand for alternative backing.
E-money is a growing trend in today’s world, the compound annual growth rate of the mobile wallet and mobile payment markets are, respectively, 18.5% and 14.5% (2023-2032). The growth rate of the number of e-money purchases transactions in the EU (2018-2021), is also high (82.45%), showing the potential of e-money for banking industry revolution and free banking implementation.
Indeed, free banking faces challenges in today’s world, needing a planned transition. This system has potential benefits for economic growth and banking stability. Yet, regulatory uncertainties, security issues and consumer protection challenges exist, urging policymakers to balance oversight and liberalized banking, unlocking the full potential of e-money in fostering free banking principles. An adaptive regulatory framework would be a possible solution for today’s inflation crises, with the recognition of the advantages to foster a thriving and stable environment where financial institutions can thrive while safeguarding their solvency and the system’s stabilit.

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