Free Banking System
FREE BANKING SYSTEM
FREE BANKING SYSTEM. Historically, in England and Scotland, free banking resulted from laissez-faire economic theories that called for limited government intervention into markets. The Scottish free banking system proved remarkably resilient, and when failures occurred they were handled by the "double indemnity" laws governing directors and stockholders. In the United States, the free banking movement emerged from the large demand for banking institutions during the chartering era when every new bank had to obtain a state charter (except for the Bank of the United States [BUS], which had a national charter). State legislatures found themselves swamped with applications, and thus, beginning in New York in 1838, a new process was established called "free banking laws," which was later applied to all corporations under "general incorporation" laws.
The free banking laws required the owners or stockholders of banks to place on deposit with the stipulated authorities (usually the state comptroller or treasurer) designated bonds equal to the value of the bank's capital. This deposit then allowed the state to authorize the bank to issue banknotes equal to its total bond deposit. If a bank failed to redeem its notes upon demand, the state authorities would sell the securities and make redemption—whereas with a chartered bank, the institution would have to forfeit its charter. In reality, neither of these steps was taken often.
The American free banking system proved nearly as strong as the Scottish system. Many of the free banking principles, such as deposit of government bonds, were incorporated into the National Banking System of 1863, but gone was the central and most important aspect: free entry without intervention by the legislature, state or national.
Rockoff, Hugh. The Free Banking Era: A Re-examination. New York: Arno Press, 1975.
Rolnick, Arthur, and Warren Weber. "Inherent Instability in Banking: The Free Banking Experience." CATO Journal 5 (Winter 1986): 877–890.
See alsoBanking: Overview .