Historically, even some of the staunchest proponents of laissezfaire 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.
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.
problems were caused by economic shocks that caused many banks to fail but did not lead to bank runs or panics.
Before 1837, all new U.S. banks had to be chartered by a state legislature. In practice, the chartering system was a cumbersome and very political process that severely limited the number of banks opened.
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.
State governments were jealous of the financial favors they had garnered from their banking systems. In order to retain these favors while allowing freedom of entry into the banking business, they supported the inclusion of "bond deposit" provisions in the laws regulating bank-note issues.
• 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. Failure 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 note holders. Further, in many states, note holders had preference over other bank creditors in terms of legal claims on 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 $25,000 of personal wealth to cover bank losses (including those on notes).
• Very few free bank closings involved losses to note holders; that is, by our definition, very few failed. 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 note holders.
• 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.
• 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.
for a banking system to be inherently unstable, a run on one or more banks and their subsequent
failure must lead to the failure of other banks.
Why were free bank failures not contagious? That is, why did the bank failures in one state not spread to other states? A possible explanation is that the requirement that free banks keep a reserve of state bonds behind their notes provided some public information about free bank portfolios which helped note holders distinguish good banks from bad ones when local real shocks occurred.
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