Thomas F. Cargill

English

Research Papers in Economics

FRBSF WEEKLY LETTER
April 18, 1986
Is Competitive Banking Stable?
Despite the frequent refer~nce to the term
"deregulation", used to describe the financial
regulatory reforms and innovations ofthe past
several years, the current reforms are not
designed to remove all types of government reg-
ulation. In fact, many depository institutions are
now subject to more of some types of regulation
than before.
The recent reforms are designed primarily to
remove or relax key constraints on the competi-
tive behavior of depository institutions. The
depository system is undoubtedly more competi-
tive now than before 1980, and it is likely that
deregulation will continue and further increase
this competitiveness.
The benefits of deregulation have been substan-
tial. However, many have expressed concern
about further efforts to increase competition
among depository institutions. Some argue that
deregulation has been pursued too aggressively
and, as a result, has induced depository institu-
tions to engage in portfolio activities that are
inconsistent with their role in the national pay-
ments system.
The issue has been intensified by recent events
such as the sharp increase in the bank failure
rate since 1980,the well·publicized difficulties
of Continental Illinois Bank, the increasing num-
ber of banks listed as "problem banks", and the
Ohio S&L crisis. Whether these events are
related to the deregulation process is open to
debate. The events themselves, however, have
renewed concerns about the stability of compet-
itive banking.
This Letter explores three related issues. First, I
discuss the meaning of a competitive unregu-
lated banking system and indicate that "con-
tagion" effects are critical to rendering such a
system unstable. Second, I review recent studies
oftwo historical cases when banking was sub-
ject to little or no government regulation. And
third, I draw some implications from these his-
torical cases for the deregulation process ofthe
1980s.
An interpretation of banking instability
To determine whether banking is inherently
unstable, one must distinguish between econ-
omy-wide and local shocks. Large numbers of
bank failures spread over a wide geographic
area as a result of an economy-wide shock is not
proofthat the banking system is inherently un-
stable since by definition such a shock would
affect the majority of banks. Inherent instability
is characteristic of a banking system in which
local shocks, which affect only a few banks,
threaten the continued operation of other banks.
Contagion is thus a necessary condition for the
concept of inherent instability in banking.
Unregulated banking has traditionally been
viewed as subject to contagion effects, and
hence, inherently unstable, for four reasons.
First, banks operate under a fractional reserve
system in which only a small percentage of
reserves are available to meet deposit with-
drawals. Thus, banks are unable to convert large
amounts of outstanding deposits into currency
should depositors wish to withdraw funds on
short notice. Second, depositors have
incomplete information about the ability of
banks not affected by a local shock to remain in
operation. Hence, they are not sure whether the
other banks will be able to convert deposits into
currency at par. Lick of knowledge induces
depositors to withdraw funds from the
unaffected banks and thereby possibly force
them to close.
Third, competition among banks presumably
forces each bank to accept riskier portfolios of
assets and liabilities than is prudent for institu-
tions whose liabilities (deposits) constitute part
ofthe nation's money supply. Fourth, competi-
tive unregulated banks may resort to fraud and
deliberately misinform the public about their
operations. They thus generate public distrust of
banking and raise the probability that banks will
fail.
The view that banking is inherently unstable has
had significant public policy implications. Pol-
icies designed to monitor bank portfolio opera-FRBSF
tions, limit individual bank risk, and provide
lender of last resort services have been strongly
influencedby the view that unregulated banking
is unstable. At the same time, even an inherently
stable banking system may benefit from some
types of regulation to protect the system from
economy-wide shocks and/or to provide the
public with sufficient information to judge the
quality of individual banks.
Evidence from two banking eras
The view that unregulated competitive banking
is inherently unstable has been difficultto test
empirically because there have been few peri-
ods in recent history when banks functioned in
an unregulated environment. At a minimum, the
following conditions must hold to define such
an environment: banks must be subject to little
or no government regulation that restricts their
portfolio opportunities; there must be a large
number of banks; and entry into and exit from
the banking industry must be relatively easy.
The banking conditions ofthe Great Depression
do not qualify because banks were then subject
to government regulation, In addition, the bank-
ing system experienced a series of economy-
wide shocks that make it difficult to isolate con-
tagion effects. We must turn to earlier historical
periods for examples of unregulated competitive
banking.
Two interesting periods appear to satisfy the
institutional requirements of unregulated com-
petitive banking: the "Free Banking Eras" in the
u.s. from 1837 to 1863 and in Scotland from
1800 to 1845.
The Free Banking Era in the u.s. has tradi-
tionally been regarded as strong evidence that
competitive banking in the absence of extensive
regulation is unstable. Highrates of inflation in
the late 1830sand a sharp recession in the early
1840s, which has been compared to the first few
years ofthe Great Depression in its intensity,
were regarded as the outcome of unstable bank-
ing. Accounts of the period emphasized the high
number of bank failures, bank panics, andthe
large number of bank notes that circulated at
various rates ofdiscount as evidence of unstable
banking that destabilizedthe economy.
Perhaps the most oft-cited facet of unstable
banking during this period consists of the so-
called "wildcat banks", which many observers
claimed dominated the banking scene. Wildcat
banks were established in remote areas (where
only wildcats roamed) and issued bank notes in
excess of the value of their assets. The remote
locations made it difficult to convert notes into
specie.
This traditional view has been challenged by
economists Arthur J. Rolnick and Warren E.
Weber (1983) in their detailed study of state
auditor reports for New York, Indiana, Wiscon-
sin, and Minnesota. They found evidence that
local failures were not contagious, that many
banks did notfail, thatfailed banks frequently
redeemed notes at par, that total losses to note-
holders resulting from bank failures were much
smaller than originally thought, and that wildcat
banking was not a major part of the banking
scene.
Rolnick and Weber havenot, however, demon-
strated unambiguously that banking in the
absence of any regulation was stable. While
there was no federal regulation during this
period, banks were subject to varying degrees of
regulation at the state level. State regulation was
minimal, but its existence leaves us uncertain as
to whether a competitive and completely unre-
gulated banking system would be stable or not.
The Free Banking Era in Scotland offers stronger
support for the hypothesis that competitive
banking can be stable. During the first half of the
nineteenth century, Scotland had no central
bank; bank entry and exit were unrestricted; and
note issuance was universal and unregulated.
Unlike u.s. banks, which were subject to some
government regulation, Scottish banks were free
of government regulation for all practical pur-
poses.
Lawrence White (1984), economist, has pre-
sented convincing evidence that unregulated
banking in Scotland was stable, competitive,
and supported significant economic growth. He
found that local shocks and local bank failures
did not spread, banks held adequate reserves,
bank notes circulated at par, banks that failedfrequently compensated the majority of note-
holders fully, and the widespread use of
extended liability provision for bank share-
holders ensured that banks were conservatively
operated. In addition, Scotland experienced no
problem with the kind of wildcat banking that
played a role in the u.s. experience.
Together, these two studies challenge the tradi-
tional view that competitive banking in the pres-
ence of minimal or no government regulation is
inherently unstable. Both studies suggest that
contagion was not a characteristic ofthe bank-
ing system, that individual banks had strong eco-
nomic incentives not to "overissue" bank notes
or deposits, and that the public had adequate
information on which to judge the quality of
individual banks.
Implicationsforthe1980s
The reinterpretation oftheu.s. experience and
the new evidence regarding Scotland appear to
refute the instability hypothesis. However, the
evidence must be regarded as only suggestive at
this time. The data are not detailed enough in
either case to provide strong empirical tests of
the instability hypothesis. Furthermore, both sit-
uations lacked highly integrated interbank and
financial markets that might have increased the
degree of actual contagion. And both banking
systems used a commodity-based, rather than a
fiat-based, monetary standard that may have
been responsible for the apparent stability.
Historical re-evaluations ofthe two periods will
surely generate debate and further research.
Assuming that these recent historical studies are
correct, what lessons can we draw?
First, efforts to remove constraints on competi-
tive behavior should not be held back by fears
that increased competition will generate
instability in the banking system. While some
individual banks will cease to exist in a more
competitive environment, their passing will not
destabilize the banking system. Competitive
banking is not necessarily unstable and con-
tagion is not necessarily characteristic of com-
petitive banking.
Second, while the studies are consistent with the
view that competitive banking was stable over
100 years ago, this does not mean that govern-
ment regulation cannot improve the perfor-
mance of a competitive banking system. Deposit
insurance, audits, and financial disclosure
requirements are ways in which regulation
could improve the performance of a competitive
banking system.
Thomas F. Cargill
Opinionsexpressed in this newsletterdo not necessarily reflect theviews ofthe managementofthe Federal Reserve Bank ofSan
Francisco,orofthe Board ofGovernorsofthe Federal Reserve System.
Editorialcommentsmaybeaddressedtotheeditor(GregoryTong) ortotheauthor....FreecopiesofFederal Reservepublications
can beobtainedfrom the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.uo~6U!450m 40~n U060JO OpOA0U
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Amount
Outstanding
3/26/86
Change
from
3/19/86
Change from 3/27/85
Dollar Percent?
Loans, Leases and Investments1 2 200,725 -1,455 11,201 5.9
Loans and Leases1 6 182,224 -1,398 10,336 6.0
Commercial and Industrial 52,440 - 670 - 696 - 1.3
Real estate 66,472 3 3,846 6.1
Loans to Individuals 38,9]7 - 4 5,806 17.5
Leases 5,651 3 328 6.1
U.S. Treasury and Agency Securities2 10,568 - 9 - 123 - 1.1
Other Securities2 7,934 - 49 988 14.2
Total Deposits 199,322 - 777 5,648 2.9
Demand Deposits 46,710 - 843 2,458 5.5
Demand Deposits Adjusted3 32,048 - 269 3,338 11.6
OtherTransaction Balances4 15,204 - 122 2,098 16.0
Total Non-Transaction Balances6 137,408 188 1,093 0.8
MoneyMarket Deposit
Accounts-Total 45,903 - 47 2,012 4.5
Time Deposits in Amounts of
$100,000 or more 37,750 205 - 1,313 - 3.3
Other Liabilities for Borrowed MoneyS 26,564 649 8,060 43.5
Two Week Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+)/Deficiency(-)
Borrowings
Netfree reserves (+)/Net borrowed(-)
Period ended
3/24/86
135
10
125
Period ended
3/1 0/86
22
30
8
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading accountsecurities
3 Excludes U.s. government and depository institution deposits and cash items
4 ATS, NOW, Super NOW and savings accounts with telephone transfers
S Includes borrowingvia FRB, TT&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
7 Annualized percent change

Is competitive banking stable?

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Is competitive banking stable?

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Research Papers in Economics