d63edbdf_brary_of_Economics_and_Liberty__ast_Highlights_HIDE_HIGHLIGHTS
[Time] 21:17
Would there be fractional reserve banking in a free banking system? Yes. Going back to the Scottish case, about 1820, not a lot of modern devices; typical Scottish bank held gold reserves of 1-2%, in an arrangement where everybody had the right in principle to convert a Scottish bank note into Scottish gold. Such was the faith in the banks that nobody every did it, which is why the reserves were so low. Quote: The first thing anyone in Scotland would do if someone paid him a gold guinea would be to get rid of it quick by depositing it in a Scottish bank and receive paper. So, only 1-2% could show up at a time, though they didn't. Bank run: if depositors did lose confidence, there wouldn't be enough. How do banks in a free reserve system do in that kind of system? Do they have to shut down? Remember that the 1-2% figure evolved through trial and error. If there had been a run and banks had no other recourse, they'd have to shut down as soon as they ran out of gold reserves. However, that doesn't mean that remaining depositors would get nothing. Bank would be liquidated and assets and capital used; often would be a complete payout to depositors. Recourse the banks themselves had until a law was passed preventing them from using it was called the Option or Optional Clause, that banks put on their notes. Clause said they reserved the right to suspend payment on notes and gold, but if they exercised it, then during the period of suspension they had pay the maximum allowed rate of interest of 5% to the note-holder. Note gets converted to a little bond. Note raids used by rival banks against each other were the only occasion of using this Clause, not runs from their own customers. Would have been a useful device had a run happened, but one never really happened. Problem as an insurance system--many such private contractual arrangements in today's economy--if a bank was profligate and made bad loans, the likelihood that the assets would cover the costs is even smaller because of the delay. Beauty of the Optional Clause: if designed right with proper rate of interest, incentive-compatible. The only time it would pay for a bank to use the Option Clause instead of winding up, going bankrupt, would be if in fact it was solvent, and people were panicking even though nothing was wrong--pure panic, imperfect information. If a bank has instead been profligate, it doesn't pay to invoke the Clause--simply shut down. But the shut-down would be disastrous for the depositors. If you do business with a profligate bank, you do badly. Could be a takeover. Bottom line is, a bank customer faces a positive probability of losing your money. Every government scheme for trying to do away with that aspect of free banking has ultimately given rise to a less safe system of banking in which though the depositors don't face losses, the taxpayers do. Losses become systemic.
Selgin on Free Banking | EconTalk | Library of Economics and Liberty