Working Paper | HBS Working Paper Series | 2004

Regulation and Reaction: The Other Side of Free Banking in Antebellum New York

by David A. Moss and Sarah Brennan

Abstract

Free banking, which first appeared in the United States in the late 1830s, comprised two essential features: general incorporation for banks and rigorous security requirements for note issue. Because the general incorporation feature is what allowed free entry, it has typically been heralded as the centerpiece of the institution, leading some scholars to characterize free banking as laissez faire banking. Far from allowing free bankers complete freedom of action, however, free banking laws actually prohibited the most common form of intermediation of the time. By requiring that bank notes be fully backed with high-grade securities, these laws prevented banks from intermediating between liquid notes on the one hand and illiquid loans on the other. The purpose for this paper, therefore, is to explore the other side of free banking—the regulatory side which banned the use of notes as a source of funds for non-marketable lending. After tracing the intellectual and legislative history of free banking in New York State (the first state to adopt an enduring free banking statute), we show that New York's 1838 law placed significant constraints on note issue, which ultimately helped to transform the nature of bank money throughout the state. We find, in particular, that these constraints led to a significant reduction in the issue of bank notes and a concomitant increase in the relative importance of demand deposits. This effect is visible not only by comparing note-to-deposit ratios in free versus chartered banks, but also by tracking changes in this ratio among a sample of chartered banks that were forced to convert to free banks when their charters expired (at scattered moments throughout the 1840s and 1850s). We conclude that the rise of free banking not only enhanced competition in the market for banking services (as a result of free entry) but fundamentally transformed bank balance sheets as well (as a result of the strict security requirement for note issue).

Keywords: History; Law; Competition; Financial Liquidity; Money; Market Entry and Exit; Financing and Loans; Banks and Banking; Banking Industry;

Citation:

Moss, David A., and Sarah Brennan. "Regulation and Reaction: The Other Side of Free Banking in Antebellum New York." Harvard Business School Working Paper, No. 04-038, April 2004.