Free banking in the U.S: the forerunner of the stablecoin

In political fora, discussions of stablecoins (as privately issued dollar equivalents) often lead to invocations of the so-called “free banking” era in the United States, where banks privately issued their own currency equivalents. The comparison is generally negative.

Elizabeth Warren:

“This is not the first time [she said] that we’ve had private-sector alternatives to the dollar. In fact I’m going to go back further than you did. In the 19th century, “wildcat notes” were issued by banks without any underlying assets. And eventually, the banks that issued these notes failed and public confidence in the banking system was undermined. The federal government stepped in, taxed these notes out of existence and developed a national currency instead. And that’s why we’ve had the stability of a national currency.”

Lael Brainard, Vice Chair at the Federal Reserve:

“The inefficiency, the fraud, the instability in the payments system that was associated with active competition among issuers of private paper banknotes….led to what eventually was a uniform form of money backed by the national government."

Given this political context, some understanding of the free banking era and its eventual demise may prove a useful historical framework for understanding the governance and regulatory problems that modern stablecoins face. It may, of course, also prove politically useful to be able to engage in a sophisticated discussion of the free banking era in high-level discussions with regulators, politicians, or even the general public more broadly, should this comparison be made.

The Origin of Free Banking and its Vital Features

Antebellum banking, at its core, was based around gold and silver (known collectively as “specie”) the now-famous greenback not yet being in existence. Gold and silver were, so to speak, the real money, and the dollar equivalents issued by the various banks were promises that one could redeem the note at the bank for a given quantity of specie. Banks, however, benefited from redemptions being as infrequent as possible: lower redemption rates allowed them to hold lower specie reserve, though states did impose minimum reserve requirements: 5% of issuance in Maine, for instance, but 15% in Massachusetts. It was, therefore, in their interest that the bank notes they issued be accepted as de facto currency. In this sense, antebellum banks were closely analogous to today’s stablecoin operators: both were/are in the business of issuing private money that can be redeemed for “real money”, but that the issuer hopes will be treated as a currency equivalent.

The free banking era began from 1836, after Andrew Jackson’s successful campaign against the Second Bank of the United States led to the non-renewal of its charter and the distribution of federal funds held at the Bank to state chartered banks. It ended with the National Banking Acts of 1863, 1864, 1865, and 1866: the 1865 Act, in particular, sounded the death knell for the free banking era, as it imposed a 10% tax on all non-federal banknotes, driving the state banks out of the issuance business. For this relatively brief stretch of a few decades in the antebellum era, however, the federal government was out of the banking business.

As of 1837, the banking system across America was composed of approximately 17 state monopoly banks, and, in the other states, “chartered banks” that held a license to bank within a given state. This chartering process, however, was notoriously corrupt and widely loathed. In response to this (justified) public opinion and the deregulatory opportunities opened up by Jacksonian reforms, in the years between 1837 and the commencement of the Civil War in 1861, 18 out of 34 states did pass “free banking” laws (Michigan did so twice). The free banking laws allowed for anyone with sufficient capital and the ability to meet the regulatory requirements to open a unit bank, without a charter. States typically required that while free banks did not have to back their issuance 1-1 with specie, they held equivalent collateral of state or federal bonds (in some cases railroad bonds were also accepted): these collateral requirements themselves became a serious source of trouble for banks exposed to Southern state bonds as the Civil War approached. State-chartered banks were typically allowed to hold a wider variety of assets as collateral, such as mortgages.

The free banks, accordingly, more closely resemble today’s stablecoin issuers, who can also issue their own money with no license and face very little barrier to entry. Then, as now, the main regulatory focus was protection of ordinary consumers. While the requirements for setting up were very low, the regulatory protections for noteholders were extensive in many places: specie had to be paid out on demand and at par, and failure to pay any amount of specie when requested would generally bring about the state-mandated closure of the bank. The exception was times of general panic, when states frequently responded by passing laws allowing banks of all kinds to suspend redemption and avoid closing due to simple liquidity crises. In most places, the noteholders had first claim on the assets of the bank: there were relatively minimal attempts to protect the interests of depositors and shareholders.

In one crucial respect, however, free banking was not actually free, and there are good reasons to think that although the system worked well, it could have worked much better and modern equivalents could do much better. Unlike in Scotland – the clearest example of the merits of free banking – American banks (free or otherwise) were not allowed to operate nationally. In fact, banks that lacked state charters could not even open branches: they were accordingly known as “unit banks”. A small minority of the state-chartered banks could and did open branches, but did not typically operate across state lines. Weber finds only 54 banks with branches out of the 2332 in his dataset, and virtually all of these were in the South, the location of nearly all the 14 states that permitted branching. This regulatory restriction severely limited the ability of the banks to diversify their holdings, with predictable consequences for heightened bank failure risk at times of local economic downturns.

All this said, the antebellum banking regime performed fairly well, and the free banks performed best of all. Weber finds that the free banks were on average the smallest but had the lowest failure rates. Although they opened and closed at high rates - considerably higher than the chartered banks - actual losses to noteholders were lower. Weber finds losses to noteholders occurred at just 15.5% of free banks against a percentage of 22.5% at the state chartered banks without branches (not including the free banks with heavy Southern state bond exposure that failed just before the outbreak of the Civil War, in which case the free bank and state chartered failure rates are equivalent), and the losses to noteholders were lower in percentage terms at the free banks that failed compared to the failed chartered banks.

The losses to noteholders that did occur were often not large and generally shrank dramatically over time. In general, states that passed free banking laws encountered the most problems in the immediate aftermath of regulatory liberalization, and as the years went by both citizens, regulators, and the legal systems adjusted to the new reality, with decreased rates of both bank failures and wildcats seen over time. An 1896 history of banking in Illinois finds that in its brief free banking era, from 1852 to 1861, only one bank out of fourteen that closed its doors brought a loss to the noteholders, and the loss was just three percent. In New York the loss rates on total free bank notes issued after its introduction of free banking began at 4% in 1842 but had fallen to 0.4% just six years later and thereafter were never higher than 0.1%. The loss rates on notes issued by failed New York free banks began at 42% in 1842 but fell to 3.7% by the 1850s and 0.1% by the 1860s.

Common Myths and Responses

Some common myths about the free banking era derive from little more than the technological and regulatory limitations of the time. The “inefficiency” that Brainard mentions almost certainly refers to the phenomenon that not all banknotes traded at par: supposed dollar equivalents issued with a face value of X could not always be traded for X and would only be accepted at a discount. In popular legend this phenomenon occurred due to doubts about the creditworthiness of the issuing bank (analogous to a stablecoin drifting off peg due to doubts about the collateral held by the issuer), which has been used as an argument to justify the emergence of a single currency backed by the national government. In reality, however, while this did sometimes happen, in general the size of the discount was a reflection of the geographic distance between the issuing bank and the place of the attempted trade (that is, it priced in the cost of travel back to the issuing bank for redemption). Given the limitations of the rail network of that era, and the bans on banks opening branches and/or operating between states, such discounts were virtually inevitable in many contexts. They were not, however, universal: Northeastern bank notes were typically accepted at par throughout the country, while banks would often band together to redeem each other’s notes, so it became fairly easy to trade banknotes issued by banks operating in nearby regions at par in most trade hubs.

The major critique of the free banking era, however, is the presence of the wildcat banks. Defining a wildcat bank is not an entirely precise endeavor, even with good data on how long the bank survived, its ratio of specie held to notes issued, its location (wildcats generally operated in more rural areas) and how much the noteholders were able to recover when the bank failed. In total there may have been no more than 150-200 wildcats ever in the free banking era, and perhaps as few as several dozen depending on the precise criteria used to define them. Even on the more generous estimates of wildcat presence, the absence of social media and the limited geographic expanse over which banks could plausibly operate (especially wildcats) meant that the number of affected victims was relatively small and sums lost not large, given that although bank failures were relatively common, redemption below par in the event of bank failure was less so and complete wipeouts of noteholders rarer still. Furthermore, sizable numbers of free bank failures in states such as Illinois and Wisconsin were not due to wildcat operators at all, but simply due to the fact that the banks in these states held as their collateral the bonds of states that were later to join the Confederacy. Wildcats in the free banking era can be perhaps thought of as analogous to the “flavour of the week” scamcoins that come and go today- genuine nuisances, and some people do lose money, but not causing sufficient systematic issues to warrant a regulatory clampdown.

Unfortunate timing also played a role in the difficult experiences some states encountered, the famous Panic of 1837 striking immediately after Michigan had passed its free banking law. The state then massively compounded the problem by passing a time-limited law that allowed not only established banks to suspend redemptions, but also any banks that might be set up before the expiry of the law. A more obvious incentive to unscrupulous operators is hard to imagine. Michigan abolished free banking in 1839, but permitted it again (much more successfully) in 1857 (see here for a review of Michigan’s free banking experience and its limited but real problems with wildcats). It is worth noting, however, that even at the worst of Michigan’s experience, losses to noteholders of wildcat banks were less bad than some stablecoin collapses of recent memory…

Some takeaways:

  • The free banking era does not deserve much of the opprobrium heaped on it today. Losses were relatively rare and the rapid growth of finance in this era drove economic growth. Free banking in particular had noteworthy pro-competitive effects, something that may prove to be a useful talking point today in an era dominated by “too big to fail” financial institutions and widespread fears of excessive firm concentration, both in banking and beyond (see also here). Elizabeth Warren and her supporters may not be naturally allies of stablecoins, but they are even more opposed to the big banks, deriving much of their political energy from the fallout of the great financial crisis of 2008.

  • A savvy stablecoin marketing strategy would perhaps position stablecoins as not anti-Fed or anti-dollar, but as competitors with the unloved mega-banks of today, much as the free banks competed with the chartered banks of their day (which were widely suspected of obtaining their charters by dishonest means, as indeed was often the case). Over time, it is plausible that the stablecoin issuers will look to expand their range of financial product offerings: if so, and if the market remains highly competitive, this could reduce the systemic importance of legacy banks as key “too big to fail” nodes in today’s financial ecosystem. In the free banking era, banks opening and closing seems to have been about as routine and (in the absence of Michigan-style wildcatting), as untroubling as grocery stores opening and shutting, with New York free banks staying open for on average 8 years, and just 2 years in Indiana.

  • The free banking era offers some intriguing examples of highly effective private regulatory arrangements wherein the banks policed each others’ activities in exchange for certain mutual benefits (e.g accepting each others’ notes at par). These will be explored in future posts, especially the Suffolk System in the Northeast, which revolved around the Suffolk Bank of Boston. In Ohio, a mutual liability bank network operated. The key insight here, I think, is that system insiders are actually better placed to regulate the activities of other system players than are external government regulators or indeed the general public, given their privileged access to critical knowledge about the financial stability of the institutions in question, and the trustworthiness of the persons running them. In modern financial frameworks, these system insiders generally lack the incentive to perform this role, but the free banking experience offers reason to think that a suitable institutional structure could be created where, once again, they would.

1 Like