What is the meaning of free banking?

A “Free Banking System” allows financial institutions including banks to operate without government intervention or very little government intervention.

Here we can see the absence of a central bank and banks have the independence to issue paper currency.

What was the free banking era also known as?

Free banking era was also known as the “lightly regulated banking” era.

What was the free banking era between 1837 and 1863?

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 1863 was also a time of numerous bank failures in those states.

Free banking Canada was between the years 1867-1914. There was little government intervention even in the free banking era in Canada.

Free banking system examples: What happened during the free banking era?

Some of the major economies have applied the free banking concept in the past. As examples, we can say Scotland, Switzerland, Sweden, the United States, Canada, and so on. (White, 2015). Among these countries, some of them such as Scotland highly succeeded by applying free banking theories. (Kroszner, 1995).

The free banking system in Scotland

Within the period of 1716-1844, Scotland applied the free banking concept. In this period government has not influenced the financial system of the country. The government applied deregulation theory toward the financial sector. For example, the government removed legal barriers when entering the particular sector. Ultimately the economy of Scotland had a higher rate of growth because of the blooming of the financial sector.

The free banking system in Canada

When we consider the free banking concept application in Canada, it was between the years 1867-1914. There was little government intervention even in the free banking era in Canada. As an example, when a bank entered the market, it had to get the approval of the parliament which was an “entry barrier”. Also, the Bank Act of 1890 applied some restrictions toward the freedom of the banking sector. (SELGIN, 2018). However, Canada was succeeded with the free banking system. Within the free banking era, the country had a higher level of economic stability and economic growth. For example, between the period of 1867-1914, the annual GDP growth rate of Canada was higher than the annual GDP growth rate in the USA. Also, there were only little inflations and deflations of the general price level within the period of 1867-1914.

But, the financial system of Canada was failed after the establishment of the Canadian central bank called, “Bank of Canada” which was established in March of 1935.  Briones and Rockoff also expressed that the Canadian financial market prevailed sustainably until the establishment of the Bank of Canada. (White, 2015). Because the Bank of Canada introduced tougher monetary policies which reduced the freedom of the financial market. But for the failure of the financial market of Canada, the bad effect great depression also influenced. (Thiessen, 2000).

But now “The Bank of Canada” is a world-class central bank that has ranked as the top 16^th central bank among other world banks in the world. (Economics rankings: Central Banks | IDEAS/RePEc, n.d.). It gives a higher contribution to the economic growth of Canada as well as world economic growth. However, at the beginning of the Bank of Canada, it failed and there was a significant decrease in the Canadian financial sector. We can see that Canada was not succeeded with the central banking system.

Which countries engage in free banking today?

In the current world, we can identify several countries that engage in free banking and do not have a central bank. As examples, we can say Nauru, Palau, Marshall Islands, Monaco, and so on. (Countries Without Central Banks 2020, n.d.). We can see several specific characteristics in a free banking system as follows.

Free banking vs central banking

• In a free banking system, financial institutions can enter the finance system with low barriers. In a central banking system, when a new financial organization enters the market, it has to follow a very lengthy process to establish itself as a legal financial institution. Financial institution has to work under the supervision of the central bank. But in a free banking system, there is no or less these kinds of barriers.
• In a free banking system, there is no statutory reserve requirement (SRR) that banks should maintain. But, normally in a central banking system, the compulsory amount of cash should be maintained as a percentage of deposits of the banks.
• In a free banking system, financial institutions can set interest rates as they wish. But in a central banking system, financial institutions can only set their interest rate within the limit that is desired by the central bank.

Advantages of free banking system

• In a free banking system, there is a huge freedom to the financial institutions. They can work with the profit maximization intention. In a central banking system market efficiency is less than the free banking system.
• In a free banking system, there is a higher level of competition between financial institutions. That leads to less cost to the customers while giving a higher level of benefits.
• The next advantage of the free banking system is less political intervention. In a central banking system sometimes government and political parties affect the banks and other financial institutions through the central bank. For example, central banks reduce the statutory reserve requirement ratio and overnight policy rate (OPR) because of the influence of the government. Since the absence of the central bank in a free banking system, government and political parties have less opportunity to influence the banking system.

It can be concluded that, although the majority of the countries of the world have a central banking system, some countries still use the free banking system. Because in a free banking system there is a higher level of freedom to the financial institutions and there is higher competition in the market that gives more benefits to the customers. In the past, Some, major countries also applied the free banking theory. Among them, the success of Scotland and Canada was remarkable.

References

Countries Without Central Banks 2020. (n.d.). Worldpopulationreview.com. Retrieved December 18, 2020, from https://worldpopulationreview.com/country-rankings/countries-without-central-banks

Economics rankings: Central Banks | IDEAS/RePEc. (n.d.). Ideas.Repec.org. Retrieved December 21, 2020, from https://ideas.repec.org/top/top.central.html

Kroszner, R. (1995). The Scottish Experience as a Model contemporary policymakers. for Emerging Economies. POLICY RESEARCH WORKING PAPER. http://documents1.worldbank.org/curated/en/719951468760530224/pdf/multi-page.pdf

SELGIN, G. (2018, May 8). Entry into Canadian Banking, 1870-1935. Alt-M. https://www.alt-m.org/2018/05/08/entry-into-canadian-banking-1870-1935/

Thiessen, G. (2000, October 17). Can a Bank Change? The Evolution of Monetary Policy at the Bank of Canada 1935–2000. Www.Bankofcanada.Ca. https://www.bankofcanada.ca/2000/10/can-a-bank-change/

White, L. H. (2015, April 28). What You Should Know about Free Banking History. Cato Institute. https://www.cato.org/blog/what-you-should-know-about-free-banking-history