What it means
A Federal Reserve note on the history of bank notes describes the free banking era as the period from 1837 to 1863. In many states, a new bank could be established freely if investors raised a certain amount of equity and met other registration requirements.
All banks were chartered by state governments. Bank notes were redeemable in specie, meaning gold or silver coin, or other legal tender.
Redemption could happen at the issuing bank or at a correspondent bank in a financial centre, called the redemption agent. Banks in financial centres typically exchanged specie for another bank's notes, but often at a discount to face value.
The Fed note says the discounts were not constant: they varied by place and over time, and local merchants had to keep track of which notes their banks would take and at what discount. In financial stress the differences widened.
Notes backed by better collateral or issued under better regulation, such as in New York, saw smaller increases in discounts than notes from states such as Michigan. A 1998 speech by Federal Reserve Chairman Alan Greenspan adds the historical correction, saying that free banking was not as free as commonly perceived and was not nearly as unstable.
The picture of an era of wildcat banking, with widespread losses to noteholders, turns out to be exaggerated. Recent scholarship showed that free bank failures were not as common, and noteholder losses were not as severe, as earlier historians had claimed.
The speech also says banking strength varied by state, and regulation and supervision were uneven. After the panic of 1837, the public knew banks might be unable to redeem their notes, and discounting became widespread.
Note brokers published periodicals listing discounts on thousands of banks. The National Bank Act of 1863 kept key elements of free banking, including free entry and collateralized bank notes.
This history is a US example, and the term is now used loosely for any lightly regulated issuer of money.
In practice
Real-world examples.
Example
A fictional merchant in 1850 receives a note from a distant state bank. The local bank will take it only at a discount to face value. The merchant must check which banks' notes are accepted and at what price.
Example
A fictional traveller holds notes from two banks. One bank is in a state with strict collateral rules, and the other is in a state with weak rules. During a panic, the second note is discounted far more.
Example
A fictional note broker publishes a bi-weekly list of discounts for hundreds of banks. Merchants use it to decide what to pay for notes. The list is a market price for the bank's perceived strength.
Formula
Calculation
Accepted value of a note = face value x (1 - discount rate).
Worked example with assumed figures: a note with a face value of $100 trades at a 4% discount.
Accepted value = $100 x (1 - 0.04) = $96.
If the discount widens to 15% in a panic, the value falls to $100 x 0.85 = $85.
The figures are assumptions, since real discounts varied by place and bank.Case study
Seen in the real world.
This case study is fictional and illustrative. A store owner in a frontier town takes payment in notes from several state banks. The notes of a bank in a state with strong collateral rules circulate near face value. The notes of a distant bank trade at a discount, and a panic widens it. The owner reads a note broker's list each week to see current discounts.
The owner accepts only notes that the list prices near par, and asks for specie on large sales. When one bank suspends, the owner holds a few notes of it. The owner redeems what the redemption agent accepts and writes off the rest. The lesson is that a note was only as good as the issuer and the ease of redeeming it. The owner spent time and money tracking it.
Watch out
Common mistakes.
- Treating every free bank as a fraud, when recent scholarship says failures and losses were less common than older accounts claimed.
- Assuming all notes passed at face value, when discounts varied by bank, place and time.
- Treating the era as unregulated, since banks were chartered by states and had to meet registration and collateral requirements.
Questions
People also ask.
What is wildcat banking?
It is the popular label for the loosely regulated state banking of the free banking era, from 1837 to 1863. It suggests reckless note issuers.
Was it as bad as its reputation?
A 1998 speech by Fed Chairman Greenspan said the reputation is exaggerated. Free bank failures were not as common, and noteholder losses were not as severe, as earlier historians claimed.
How did the system change?
The National Bank Act of 1863 kept free entry and collateralized bank notes. Later changes made notes more uniform and easier to redeem.
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