Inherent Instability In Banking: The Free Banking Experience

• Most of the free banks were not short-lived.

          Большинство свободных банков были долгожителями.

          not short-lived-антонимический перевод;

 

    Переводческая конверсия,  или изменение морфологического  статуса формы, обычно применяется  в тех случаях, когда имеет место традиционное несовпадение степени эксплицитности элементов сообщения или стилистическая неуместность экспликации.

 

• The evidence we have gathered on the Free Banking Era indicates that the problem of this period are not consistent with the view that banking is inherent unstable.

Данные, собранные по Эре Свободного Банковского Дела, означают, что проблемы этого периода  не согласуются с мнением о  том, что банковская система обладает врожденной нестабильностью.   

 we have gathered-конверсия.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

                                                          ГЛОСАРИЙ

• inherent instability in banking-врожденная нестабильность банковского дела;
• free banking experience-опыт свободного банковского дела;
• staunchest proponents of laissez-faire-стойкие сторонники политики невмешательства;
• government intervention-государственное посредничество;
• periodic runs and failures-периодические банкротства и разорения;
• unpredictable decisions-непредсказуемые решения;
• substantial losses-существенные убытки;
• extrinsic uncertainty-внешняя нестабильность;
• to withdraw funds-изымать вклады;
• intrinsic uncertainty-внутренняя нестабильность;
• bank assets-банковские активы;
• chartering system-уставная система;
• free banking laws-законы свободного банковского дела;
• to issue own currency-пускать в обращение(выпускать) собственную валюту;
• state bonds-государственные облигации;
• state auditor and treasurer-аудитор и казначей штата;
• specie-звонкая монета;
• limited liability companies-общества с ограниченной ответственностью;
• investment-вклад;
• to cover banks losses-покрывать банковские убытки;
• balance sheet-ведомость;
• additional liability-дополнительная  ответственность;
• safe assets-безопасные средства;
• liabilities-пассивы;
• debt-долг;
• subsequent-последовательный;
• to distinguish good banks from bad one-отличать надежные банки от ненадежных;
• mortgages-закладные;
• state legislature-государственное законодательство;
• free entry-свободный вход;
• double liability-двойная ответственность;
• to get into circulation-входить в денежное обращение;
• loan-заем;
• initial capital-первоначальный капитал;
• stockholder-акционер;
• demand for bank notes-спрос на банкноты;
• to suffer losses-потерпеть убытки;
• on a bank-by-bank basis-на основе банк-банку.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

ПРИЛОЖЕНИЕ

 

INHERENT INSTABILITY IN BANKING:

                                      THE FREE BANKING EXPERIENCE

                                        Arthur]. Rolnick and Warren E. Weber

   INTRODUCTION 

Historically, even some of the staunchest proponents of laissez-faire have viewed banking as inherently unstable and so requiring government intervention. According to this view, left to unfettered market forces, banks are prone to periodic runs and failures simply because of unpredictable private decisions about the form in which individuals hold their money.

This view arose not from any explicit theory that points to an inherent problem with  a  laissez-faire banking system, but from experience with U.S. banking that goes back at least 150 years. In particular, the Free Banking Era (1837-63) is often cited as an example of what would happen if banking were unregulated. It was a period when banks were subject to few restrictions, fewer than any other period in U.S. banking history. And it has often been characterized as chaotic, with many different kinds of paper money, with numerous bank runs and failures, and with substantial losses and inconvenience to holders of bank notes. Some even claim that the U.S. economy would not have grown as robustly as it did late in the 19th century if the free banking system had been left in place (Cagan 1963).

    In this paper we reexamine the view that banking is inherently unstable by taking a closer look at the free banking experience. Based on rather extensive empirical evidence recently accumulated on this experience, we find that the problems with free banking were not caused by anything inherent in banking. Rather, we find that the problems were caused by economic shocks that caused many banks to fail but did not lead to bank runs or panics.

We proceed as follows. Since many readers may not be familiar with the Free Banking Era, first we briefly discuss how a free bank was regulated and operated and briefly review what happened under this system. Then we discuss the concept of inherent instability in banking by contrasting two common notions of it. One is that banking problems arise because of extrinsic uncertainty; bank creditors randomly decide to withdraw their funds. Enough of these withdrawals can become contagious and lead to a run on the whole system. The other notion is that banking problems arise because of intrinsic uncertainty; local real shocks reduce the value of some banks' assets, and their creditors begin to withdraw funds.

Cato Journal, Vol. 5, No. 3 (Winter 1986 ). Copyright © Cato Institute. All rights reserved.

Arthur J. Rolnick is Senior Vice President and Director of Research, and Warren E. Weber is Senior Economist, at the Federal Reserve Bank of Minneapolis. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.

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The other notion is that banking problems arise because of intrinsic uncertainty; local real shocks reduce the value of some banks' assets, and their creditors begin to withdraw funds. Because of asymmetric information about the quality of bank assets generally, these withdrawals can become contagious and lead to a run on the whole system. Nest we present evidence from the Free Banking Era on the causes of banking problems and conclude that the free banking experience did not fit either notion of inherent instability. Finally, we examine possible reasons for these findings and discuss their implications for bank regulation.

AN OVERVIEW OF FREE BANKING

Bank Laws and Operations

    Before 1837, all new U.S. banks had to be chartered by a state legislature. Although these charters differed from bank to bank and from state to state, generally they established reserve and capital requirements for a bank and limited the types of loans it could make. In practice, the chartering system was a cumbersome and very political process that severely limited the number of banks opened.

The Free Banking Era derives its name from the free entry provision of the general banking laws passed by many states starting in 1837. (By 1860, a majority of the 33 states in the Union had passed such laws. See Table 1.) Free entry meant that a legislative charter was no longer required for a bank to be established. The free banking laws essentially allowed anyone to open a bank, issue their own currency (bank notes), take deposits, and make loans.

The Free Banking Era was not a period of laissez-faire banking, however, since banks established under the free banking laws were subject to certain restrictions. Most of the free banking laws were patterned on that passed by the New York legislature in 1838 (and amended in 1840). They thus contained its three regulations intended to insure the safety of free bank note issue:

• Free banks had to deposit designated state bonds with the state 
  banking authority (state auditor or treasurer) as security for all 
  notes issued. (Some states also allowed federal bonds.) 
• Free banks had to pay specie (gold or silver) for notes on demand. Failures to redeem even one note meant that the state banking authority would close the bank and sell all of the assets deposited with it to pay off noteholders. Further, in many states, noteholders had preference over other bank creditors in terms of legal claims on

FREE BANKING

     the remaining assets of the bank.

• In general, free bank stockholders were liable for bank losses in an amount up to the value of their stock even though free banks were limited liability companies. This double liability provision meant that, if a bank failed, someone with, say, $25,000 of free bank stock not only might lose this investment, but also would be liable for an additional 325,000 of personal wealth to cover bank losses (including those on notes).

 

 

 

TABLE 1

States with and without Free Banking Laws by 1860

States with              Year                             States without        Free Banking               Law Passed                         Free Banking Laws                                                                            Laws

Michigan   1837                              Arkansas Georgia                           1838                              California New York                       1838                              Delaware Alabama                         1849                               Kentucky New Jersey                     1850                               Maine Illinois                     1851 Maryland Massachusetts   1851 Mississippi Ohio   1851 Missouri Vermont   1851 New Hampshire Connecticut   1852 North Carolina Indiana   1852 Oregon Tennessee   1852 Rhode Island Wisconsin   1852 South Carolina Florida   1853 Texas Louisiana   1853 Virginia Iowa   1858 Minnesota   1858 Pennsylvania   1860

    Under these laws, a prototypical free bank would be established and operate as follows. Suppose that a potential banker had 850,000 of capital. To establish a free bank, that person would buy state bonds with this capital and deposit them with the state auditor. In exchange, the person would receive 850,000 of notes that the new bank could issue. Presumably, these notes

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would get into circulation by being exchanged for other assets (loans, specie, or more state bonds, for example).

The balance sheet of a prototypical free bank would look something like Table 2. This table assumes the free banker exchanged the initial S50,000 of notes for $25,000 of state bonds and $25,000 of loans. These additional S25,000 of bonds were then deposited with the auditor for another 825,000 of notes which were finally exchanged for another $15,000 of loans and S10,000 of specie.

 

TABLE 2 BALANCE SHEET OF A PROTOTYPICAL FREE BANK

Assets                                     Liabilities and Capital

State Bonds   $ 75,000        Liabilities: Notes Outstanding       $ 75,000 Loans                40,000 Specie               10,000        Capital                                                50,000

Total              $125,000         Total                          $125,000

As Table 2 clearly illustrates, the profitability of free banking was due to the leverage provided by the bank notes. Here the free banker obtained $115,000 of earning assets with only 350,000 of capital.

This example also shows that the double liability provision did not assure the safety of a free bank's notes. Here the value of the bank's assets plus the $50,000 additional liability of stockholders would be insufficient to pay off noteholders if the value of the bank's state bonds and loans fell below $15,000.

    Bank Failures

In a previous study (Rolnick and Weber 1983) we presented detailed evidence on the free banking experience of four states: New York, Indiana, Wisconsin, and Minnesota. Our evidence, which was based on state auditor data, indicated that, although free banking in these states had problems, the problems were not as severe as has been thought. These were our major findings:

• Very few free bank closings involved losses to noteholders; that is, by our definition, very few failed.¹ Between 1838 and 1863, 709 free banks operated in the four states and 48 percent of them closed. However, only about one-third of the closings resulted in any losses to noteholders.
• Free bank notes were quite safe. For most years and most states, the expected loss from holding a randomly selected bank note for one year was zero. Further, when noteholders suffered losses, they ranged from an average of about 25 cents on the dollar in New York and Wisconsin to an average between 10 and 15 cents on the dollar in Indiana. (We exclude Minnesota here because we think our earlier loss calculations for that state are far too high. We explain why in Rolnick and Weber 1985.)
• Most of the free banks were not short-lived. Between 1838 and 1863, New York, Wisconsin, and Indiana free banks were in business a mean of 6.3 years. To put this calculation in perspective, note that Wisconsin and Indiana did not pass free banking laws until 1852. (Minnesota, excluded here too, did not pass a free banking law until 1858.)

INHERENT INSTABILITY IN BANKING

There is*no agreement on a precise definition of inherent instability in banking. However, the conventional view is that inherent instability means that bank runs and panics can occur without economy-wide real shocks. There seem to be two general explanations for how this can happen.

One explanation depends on some extrinsic uncertainty in the economy causing individuals to randomly change their demand for bank notes relative to specie for apparently irrational reasons (attributed to, for example, sunspots or animal spirits). If the direction of the demand switch is from bank notes to specie, then even good banks (banks with assets greater than liabilities) will have trouble meeting the demand for specie because only a fraction of their notes are backed with perfectly safe assets.² This trouble spreads as noteholders begin to worry about other banks, and this contagious effect (the bank panic) leads to widespread bank failures.

'1We define a free bank failure as a closing with losses to noteholders because a major intent of the free banking laws was to provide a safe currency. The laws made no attempt to insure depositors or stockholders against risk.2We define a perfectly safe asset as an asset with the same price in all possible states of the world. By definition, therefore, perfectly safe assets are also perfectly liquid.

 

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An explicit model that incorporates this view of inherent instability is Diamond and Dybvig's (1983).

An alternative, but closely related, explanation for bank runs and panics relies on intrinsic uncertainty in the form of local real shocks and on asymmetrically informed noteholders.³ According to this explanation, a local real shock to the economy causes the value of the assets of some banks to fall below the value of their liabilities and thus causes individuals to want to redeem the notes of these banks. The desire of these noteholders to switch to specie or to notes of other banks is quite rational, and if noteholders have full information no panic or run will result. Since the real shock is local, it does not affect the assets of some banks, so informed noteholders will not withdraw funds from them.

Asymmetrically informed noteholders, however, can turn the local shock into a bank run. If noteholders are ill-informed about the value of bank assets, then they cannot perfectly distinguish the sound banks from the unsound ones. Thus, they interpret the runs at some banks as a signal that other banks may be in trouble. That is, here as in the other explanation, bank runs are contagious because noteholders use the observation of runs at some banks to revise their views about the safety of others.

The following quotation shows that this type of explanation of bank runs corresponds to that of Friedman and Schwartz (1963, p. 308) for the events of 1930:

A crop of bank failures, particularly in Missouri, Indiana, Illinois, Iowa, Arkansas, and North Carolina, led to widespread attempts to convert demand and time deposits into currency. ... A contagion of fear spread among depositors, starting from the agricultural areas, which had experienced the heaviest impact of bank failures in the twenties. But such contagion knows no geographical limits.

An important additional aspect of the inherent instability which is attributed to asymmetric information is that the general fear can turn some financially sound banks into insolvent ones. Obviously, the local real shock will cause the value of some assets to fall because some banks will have to liquidate assets. With complete information, depositors with rational expectations would be able to determine the new level of asset prices, and banks with assets sufficient to cover liabilities would not be run.

  With asymmetric information, however, asset prices can be lower than their full information level because the specie demands of fearful depositors will cause more banks to have to liquidate assets. And at these lower asset prices, fewer banks will have assets sufficient to cover liabilities.⁴

INHERENT INSTABILITY IN FREE BANKING

Here we examine the empirical evidence from the Free Banking Era for its implications about the inherent instability of banking. First we examine whether the problems free banks experienced seem to be traceable to "sunspots" or to local real shocks. Then we examine whether free bank failures were contagious.

Extrinsic versus Intrinsic Uncertainty

To determine whether free bank failures were due to extrinsic or intrinsic uncertainty, we first identify periods when many free bank failures occurred. We restrict our attention to such periods because a cluster of failures would seem to be necessary for inherent instability. Next we attempt to determine whether or not a local real shock occurred before these time periods. If such a local real shock can be identified, then these failures can be assumed to be due to extrinsic uncertainty. Otherwise, the intrinsic uncertainty explanation may be more appropriate.

In a previous study (Rolnick and Weber 1984) we identified 104 free bank failures in New York, Indiana, Wisconsin, and Minnesota, and we obtained reasonably precise closing dates for 96 of these banks. In Table 3 we show these free bank failures grouped by time period. Our previous study found that most (76 of the 96) free bank failures occurred during periods of falling asset prices, as measured by large declines in the prices of either Indiana or Missouri state bonds. The breakdown of these failures by period is reproduced at the top of Table 3. At the bottom of the table are grouped the remaining 20 failures, which occurred during periods of steady or rising bond prices. Since these periods were generally longer than those of price declines, they are subdivided to exclude lengthy intervening periods when no failures occurred.

The results in Table 3 show that 80 of the 96 free bank failures seem to fall into four major clusters. (The remaining 16 failures did not occur in large groups.) Further, we are confident that three of these clusters (a total of 68 of the 80 failures) can be

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associated with local real shocks:

TABLE 3

Free Bank Failures During Periods of Falling and

Stable or Rising Asset Prices, 1841-61

                               Number of Bank Failures in

Periods When Four Asset Prices Were               N.Y.       Ind. Wis. Minn. States

Falling Jan. 1841-April 1842 20          -*                 -          -  20 May 1844-July 1846 2            -                    -                -                     2 July-Dec. 1854                    1           11                0               -                   12       March-Oct 1857                 1            0                 0               -                    1    June 1860-Jime 1861           1            1                  37             2                    41     Total 25          12                  37              2                      76

Stable or Rising May 1842-April 1844           3             -                    -               -                       3 Dec. 1847 1            -                    -               -                       1  Oct. 1851 2             -                    -                -                        2 Jan. 1853-June 1854 2            1                  0              -                      3 Jan. 1855-June 1856 0            3                  0             -                      3 Jan.-Dec. 1858 1            0                  0             0                     1 June-Sept. 1859 0            0                  0             7                     7   Total 9            4                  0              7                    20