Switzerland under free banking -1851-1906.. (what about India’s free banking phase?)

The ongoing crisis is pushing more and more economies and economists to look at their economic and financial history.  As most modern eco and finance is failing, it is time to look at history. Atleast we wont be wrong with our predictions.

Stefan Gerlach and Peter Kugler analyse Swiss banking in the period – 1851-1906. This was a period of free banking as there was no Swiss National Bank. The banks were free to issue notes and manage the monetary system by themselves:

The financial crisis that started in 2007-2008 is seen by many observers as the implosion of an overblown financial system, caused by a combination of weak financial regulation, ineffective supervision, and a long period of low policy-controlled interest rates. Given the subsequent regulation boom and the too-big-to-fail problems, it is of interest to study historical experiences of the behaviour of highly competitive and only weakly regulated banking systems.  

In a recent paper, we study monetary and banking dynamics in Switzerland before the foundation of Swiss National Bank in 1907 (Gerlach and Kugler 2015). At that time, banknotes were issued and deposits accepted by private banks, under a regime of free banking. Under this regime, an increase in the money supply may occur at the extensive margin through an increase in the number of banks, or at the intensive margin through an increase in the money supply by existing banks. These conditions raise the important issue of what factors determined the size of the banking sector and, in particular, whether it responded to interest rates.

Explicitly analysing the size of the banking sector is also important for interpreting income elasticity of money demand. Baltensperger and Kugler (2015) estimate an income elasticity of 1.62 before WWI. After the war, however, the income elasticity is not significantly different from one and exhibits an impressive stability over time. Since the growth of the banking system – which ended in the 1880s – occurred in a period of strong income growth, one obvious possibility is that high income elasticity results from the fact that the authors do not incorporate the growth of the banking system in their analysis. As a consequence, its importance for money demand is instead attributed to income growth.

There is a nice summary of the Swiss monetary system

Nice bit of mixing history with modern econometric tools:

In Gerlach and Kugler (2015) we study the demand for money and incorporate the number of banks as a demand factor. We consider the number of banks endogenous, and assume in the empirical analysis that it depends positively on economic activity, and the profitability of banking, as captured by the spread between the lending and deposit rates.

We draw two main conclusions.  First, the money stock M1, the number of banks, the mortgage rate, real income, the price level, and the saving rate are all connected by three co-integrating relations. Apart from nominal income (with unit elasticity) and the savings rate, the number of banks enters the equations for long-run money demand with an estimated elasticity of 0.81. Moreover, we note a strong positive long-run impact of real income (elasticity estimate is 0.79) and the interest rate spread (mortgage minus savings) on the number of banks. The change in the mortgage rate is indicated to be roughly 1.65 times that of the savings rate in the long run.  

Second, the estimates show that an excess money stock (deviation from long run money demand) is corrected by a decline in the mortgage rate, real income, and in interest rates. A positive deviation of the number of banks from long-run equilibrium corrects itself gradually by a decrease in the money stock and leads to a fall in interest rates and an increase in real income. Finally, a too-high mortgage rate corrects itself quickly and leads to a temporary increase in real income and a temporary fall in the price level. Moreover, structural break tests indicate that monetary dynamics were not strongly affected by the Federal Banking Law of 1881.

Hmm…First rising income drives number of banks and then falling interest rates lead to their decline.

There is hardly any interest on matters pertaining to Indian monetary and financial history. For us Indian eco and finance history only matters from 1991 onwards as before this we only did wrong things. And as we know what happened post 1991, there is no history to figure out.

India also had a phase of banking before its central bank. It was not free banking as British introduced a uniform currency in 1861. So banks did not issue their own notes, which is one of the key features of a free banking system. But their other operations were much like free banks of other countries. They had to figure out the money supply and liquidity themselves as there was no lender of last resort. The system could not be competitive as seen in other countries. This was because Presidency Banks dominated the landscape thanks to their highly privileged position. How Indian banks came up and tried to work their way is quite a story by itself.

Then before 1861 we also had a free banking system and banks issued their own notes. The first case of such a bank was Bank of Hindoostan in Calcutta in 1773. Then the three Presidency Banks issued also issued their own notes in their jurisdictions. Presidency Banks were actually like Local Area Banks of today operating largely in their areas. However, as there was no limited liability accorded to firms, the free banking era was fraught with problems. Any shock made the promoters liable beyond their ownership share. This made banking a scary proposition. However, the Presidency Banks had limited liability accorded and you know why? Because the British govt owned a part of these banks and did not want unlimited liability onto itself. So, the govts were very smart even back then.

There are all these stories of how banks tried to compete with Presidency Bank of Bengal but there was no such competition for Bombay and Madras Presidency Banks. In Bombay, the local traders and merchants held sway over all matters of finance. Infact, this is the reason why Bank of Bombay came so late in 1840 whereas Bank of Bengal had started in 1806. In Madras, the economic activity was much weaker and as a result there was not much space for more banks. Bank of Madras actually opened more branches as Madras alone did not provide enough. One such key branch was in Ceylon which helped the bank considerably.

In Bengal both the reasons were not there. The landed gentry was not as powerful and ofcourse the region was doing well. One of the chief competitors to Bank of Bengal was Union Bank (not the Union Bank of today) floated by Dwarkanath Tagore (grandfather of Rabindranath Tagore) in 1829. This bank folded in 1848 due to poor management and getting into bad loans (this aspect of banking is universal, most banks fail due to poor loans).

Then there are stories of organisation of these banks. They were all agency banks managed by the powerful British managing agencies. Banks were actually like departments for most of these agents and there was little clarity over flow of funds. Money moved easily from one business of the agency to bank and vice-versa. This also was one of the key reasons why banking in India did not pick up both before 1861 and after 1861. This frustrated both Indian politicians and policymakers once we embarked on development post independence. The banks were not willing to go beyond their promoters and some key cities. Ironically, it was the Bank nationalisation which finally killed the nexus between powerful businesses and their owned banks.

So, there is fair bit of things to figure about our history as well, even if want to ignore the period from 1947-91..


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