Free Banking in the United States

Free Banking in the United States : Wildcat Banking, Banking Panics, and Free Banking in the United States 

Free Banking in the United States : In 1837, after two attempts to establish a central bank in the United States, the federalists lost the power struggle to state’s rights advocates, causing the federal government to no longer be responsible for chartering banks, rather it became the responsibility of individual states. 

This transition marked the beginning of the Free Banking period in the United States, from 1837 to 1863. 

During this period, close to half of all banks failed, and their average lifespan was five years. To understand the implications of Free Banking in the United States, Gerald Dwyer, a 1 Professor at Clemson University, examines the whether the Free Banking System was so bad that people would have been better off with no banking system at all, in his paper Wildcat Banking, Banking Panics, and Free Banking in the United States. 

Nationally, Free Banking was a Fractional Reserve banking system that allowed any person or group to open and operate a bank if they met their state’s requirements. However, the overarching national requirements were: 

● In order to open a bank, subscriptions for a minimum amount of Capital Funds were required. 

● In order to issue notes, banks were required to have a security deposit equal to the value of notes. If the security deposit’s value fell below the notes’ issued value, banks were required to add bonds to the security deposit within a limited time, or they would be closed. 

● Banks must convert all of their issued notes into specie at par value on demand; if banks could not within a limited period of time, the bank was closed, and the security deposit was used to repay noteholders. 

● Banks must submit a report of their activities to the state banking authority at least once a year.2 

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Although all banks had to follow these requirements, there were significant discrepancies among states regarding what assets bank owners could use as a security deposit, causing states’ banking 

systems to have varying levels of success. However, there is a significant correlation between the success of a state’s Free Banking system and the amount of liability bank owners held to noteholders. 

New York and Michigan are excellent case studies to understand the relationship between an owner’s liability and the bank’s success because they had drastically different requirements and levels of success. 

The state of Michigan was one of the first states to adopt the Free Banking system in 1837. Under Michigan’s system, security deposits consisted of either bonds and mortgages upon real estate within state lines or in bonds executed by resident freeholders of the state. 

The mortgages and personal bonds included in Michigan’s security deposits presented 3 significant issues, as speculators appraised properties well above their actual values, and personal bonds did not create any liability for bank owners. 

As a result, some individuals opened banks with no intention of redeeming their notes because Michigans’ regulations enabled them to make substantial profits from opening and quickly closing a bank. 

Using the reports of State Bank commissioners, experts estimate that noteholders lost $1-1.2 million in the state of Michigan. In stark contrast to Michigan, experts regard New York as a successful Free Banking system.

Adopted in 1838, New York’s policy required that bank’s security deposits consist of New York state government bonds or bonds and mortgages on real estate, (New York’s real estate 4 appraisals were not significantly inflated). Under these conditions, bank owners were significantly more liable to noteholders in the case of a bank closing.

As a result, the annual loss rate on New York notes was only 4% in the early 1840s and eventually fell to .01% by the 1860s. 

As shown in this comparison, when bank owners were more liable to noteholders, the banks 5 were significantly more successful. 

To further investigate the Free Banking System, Dwyer examines the role of infamous Wildcat banks, or banks that were believed to have been set up in remote locations where “wildcats roamed,” to prohibit noteholders from ever redeeming their notes.

These banks were commonly believed to have been set up in states such as Indiana, Wisconsin, and Illinois; three states where the system failed. 

However, in addition to their remote location, Dwyer includes banks that were were opened and then quickly closed, and banks that were opened through using high amounts of leverage in his characterization of Wildcat Banks.

Although many Free Banks 6 did fit these criteria, Dwyer determined that their downfall was largely a result of external episodic events rather than a remote location or recklessness. 

Furthermore, these banks were not as reckless as commonly perceived because, in a bank failure, security deposits often covered noteholders’ losses. 

In concluding his analysis of the Free Banking system and Wildcat banking, Dwyer claims that it was not as disastrous as commonly depicted, but rather Michigan was the only state where Free Banking may have been worse than no banking system at all as noteholders experienced substantial losses.

Furthermore, although noteholders experienced significant losses when the system was first implemented, as state governments tightened regulations, the performance of the Free Banking system improved to mitigate losses. Ultimately, Free Banking in the United States did not end because of dissatisfaction of citizens, but rather it was taxed out of existence by the federal government in 1865.

Free Banking in the United States by Michael Slattery

1 Chaudhuri, Ranajoy. 2014. The Changing Face of American Banking. Palgrave Macmillan, 7.2Information on Bank requirements found in, Dwyer, Gerald P. 1996. “Wildcat Banking, Banking Panics, and Free Banking in the United States.” Economic Review, Vol. 81, Nos. 3-6, 1996. 2-7. 

3 Dwyer, Gerald P. 1996. “Wildcat Banking, Banking Panics, and Free Banking in the United States.” Economic Review, Vol. 81, Nos. 3-6, 1996. 6.

4 Dwyer, Gerald P. 1996. “Wildcat Banking, Banking Panics, and Free Banking in the United States.” Economic Review, Vol. 81, Nos. 3-6, 1996. 7. 

5 Dwyer, Gerald P. 1996. “Wildcat Banking, Banking Panics, and Free Banking in the United States.” Economic Review, Vol. 81, Nos. 3-6, 1996. 9.

6 Dwyer, Gerald P. 1996. “Wildcat Banking, Banking Panics, and Free Banking in the United States.” Economic Review, Vol. 81, Nos. 3-6, 1996. 9-10. 

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