Alan M. Taylor

Gerardo della Paolera

English

Research Papers in Economics

This PDF is a selection from an out-of-print volume from the National Bureau
of Economic Research
Volume Title: Straining at the Anchor: The Argentine Currency Board and
the Search for Macroeconomic Stability, 1880-1935
Volume Author/Editor: Gerardo della Paolera and Alan M. Taylor
Volume Publisher: University of Chicago Press
Volume ISBN: 0-226-64556-8
Volume URL: http://www.nber.org/books/paol01-1
Publication Date: January 2001
Chapter Title: Appendix 2 The Law of National Guaranteed Banks
Chapter Author: Gerardo della Paolera, Alan M. Taylor
Chapter URL: http://www.nber.org/chapters/c8849
Chapter pages in book: (p. 240 - 243)Appendix 2 
The Law of National Guaranteed Banks 
At the end of 1887, a new monetary experiment was underway, the Law of National 
Guaranteed Banks, commonly referred to as the “free banking law.” This law allowed 
any banking organization to issue national paper notes when adequately backed with 
government gold bonds.  The wide use of the term  “free banking law” reflects the 
conventional historicalview, one  which sees the experiment as a monument to the laissez 
faire political ideology that was supposed to hold sway in Argentina at that moment. 
To temper this view with some empirical evidence, we might observe that, from the 
time of its inception, the provisions of the new law were for the most part adopted only 
by government-related  (national and provincial) banks.  Private financial institutions 
rarely acquired government bonds as a means to issue notes. This raises the question of 
whether the technical provisions of the law discriminated among institutions, making 
the note issue business profitable only for government related banks. 
The major provisions of the law are presented inTable A2.1. Under those provisions, 
the official transactions allowing a banking organization  to become a bank of issue 
operated as follows. 
Suppose that a potential bank sought authorization to emit paper peso notes.  To 
receive, say, 100 paper pesos in bank notes, the bank had first to deposit 85 gold pesos 
at the Banco Nacional in exchange for a 100 gold peso bond. But the bank also had to 
maintain the equivalent of 10 percent of the received paper notes as specie reserves. The 
remaining paper notes, only 90 paper pesos, would be issued into circulation in exchange 
for other assets: to buy more gold to issue more paper, to lend out, to replenish the bank‘s 
reserves, and so on. It is important to emphasize here that gold had a 35 percent premium 
with respect to paper in the market at the time. At that rate of exchange, the potential 
banker had to surrender the equivalent of 115 paper pesos to put into circulation only 90 
paper pesos, net of the required reserves. That is, 25 paper pesos were tied up by such an 
operation, and would earn no interest. The typical balance sheet of a guaranteed bank 
was as in Table A2.2. 
With this background we can evaluate the profitability of being a bank of issue.’ 
Define, 
NPV  = 
B  = 
net present value to a guaranteed bank of the issue; 
paper peso value of government bonds acquired at the Banco Nacional; 
PAR  =  nominal value of the bonds; 
R  =  yearly interest payments on the bonds; 
N 
i  =  the rate of return on alternative assets. 
=  size of issue in paper notes, net of specie requirements; 
1. We  draw on the seminal work by Cagan (1965) and Rockoff (1972). 
240 The Law  of  National Guaranteed Banks  241 
Table A2.1. Provisions  of the Law ofNational Guaranteed Banks 
Date law passed  November 1887 
Eligible bonds to secure paper notes  Government bonds specially created for that purpose. 
Nature of the financial operation 
Capital requirement 
Specie reserve requirements 
Note volume limitation 
Interest on bonds to the bank 
Exceptions to the above provisions 
Each bank had to deposit 85 gold pesos for a 100 gold 
peso bond and would receive 100 pesos in paper notes. 
Realized capital > 250,000 pesos. 
10% of the received paper notes notes had to be 
maintained as reserves. 
For each Bank, notes < 90% of 250,000 pesos. For all 
banks, total issue < 40 million pesos. 
4.5% annual interest and 1%  annual amortization at 
par and payable in gold. 
Banks that already had in circulation inconvertible 
notes at the date of the promulgation of the law could 
adhere to it by acquiring the public bonds at a 
specified rate each year. 
Sourcex Agote (1887, pp. 414-24);  Lorini (1902, pp. 431-34). 
Note that B is the effective value of the bond. The value of the bank charter is 
T.  zN+R  PAR 
(1 +  i) 
NPV = -B + C  + ___ 
(1 + ijT ’ 
t=l 
If T is assumed to be large, one arrives at a measure of profitability 
NPV = -B  + (iN  +  R)/i  = (N -  B)  + (R/ij. 
It follows that the project is profitable, NPV > 0, if and only if 
R/(B -  Nj > i. 
The final expression tells us that the rate of return from issuing notes is the ratio of the 
income from the bonds securing the notes R,  to the bank capital tied up (B -  N).  If 
this were greater than the average return on alternative assets i then one should expect 
to see many banks seeking rights to issue paper notes. Only a computation of the rate 
of return can tell us if this were a likely outcome. 
By the provisions of the Argentine law, the capital tied up (defined as the difference 
between the value of bonds acquired in guarantee and the value of paper notes net of 
reserves) necessary to obtain 100 pesos in paper notes was 25 pesos.  The state gold 
bonds provided an interest of 4.5 percent a year at par and payable in gold. Assuming, 
only for the purposes of this exercise,  a steady exchange rate of 1.35  paper pesos for one 
gold peso, the yearly payments on the 100 gold peso bond would amount to 6.1 paper 
pesos. Thus, the rate of return on note issue may therefore be estimated at 24.4 percent 242  Appendix 2 
Table A2.2. Balance Sheet of  a Guaranteed Bank 
Assets  Liabilities and Capital 
Government Bonds  115  Paper Notes  100 
Specie Requirements  10 
Loans  90  Capital  115 
Notes: See text. 
Table A2.3. Average Bank Projts, 1885-87 
Dividend as a 
Percentage of 
Dividend as a Percentage of 
Percentage of Par Value 
Bank  Par Value Capital  Capital and Note Issue 
Bank of Italy and the River Plate  12.9  12.9 
Bank of London and the River Plate  11.0  11.0 
Banco Nacional  12.0  4.0 
Banco Provincial de Santa Fe  9.4  7.6 
Banco Provincial de C6rdoba  7.0  5.3 
Banco Provincial de Salta  6.9  5.6 
Banco Provincial de Entre Rios  1.5  1.1 
Banco Provincial de Mendoza  1.0  1  .o 
Source: Agote (1887,  pp. 115-340). 
English Bank of the River Plate  7.5  7.5 
(6.1 divided by25). This would be expected to compare favorably  with the average rate 
of return on capital from all assets of the banks (see Table A2.3)? 
On the surface, then, the scheme looked extremely profitable for any potential bank 
of issue because the income provided by the interest earned on the bonds exceeded the 
opportunity cost of the tied up capital.  But, if this were the case, what explains the 
apparent indifference of the private banks to the project? 
One plausible explanation is the private investor’s concern with the permanence of 
law’s provisions.  Since on this matter there is a lack of historical evidence, the spec- 
ulations advanced here should be taken as  tentative.  From the derivation above it is 
clear that the project’s profitability depended both on the government’s commitment to 
honor its bond service obligation and on the legal rights to issue paper notes to endure 
to a time T that is far in the future. However, there were no guarantees that the scheme 
would endure over the long run and, simply put, the investor’s fear might have been that, 
once the gold was deposited in the vaults of the Banco Nacional, the government might 
deviate from its original banking policy. What if, after a while, the government revoked 
the law and, with it, the property rights to the gold? 
Once private investors surrendered their own equity in exchange for bonds, the gov- 
ernment could be tempted to tax this capital, repudiation of the law being an extreme 
taxation scheme. Fears of repudiation were not specious. The Bank of London and the 
River Plate had suffered a bitter experience with the rights to issue notes in the Province 
of Santa Fk  in the mid-seventies when the provincial government repudiated unilaterally 
the terms of a concession to issue banking notes.’ 
Expectations  about how the law would be enforced were crucial to establish the 
2. If return to paritywas the expected near future,  the rate of return given by the  formula R/(B-N) 
3. Josh (1963) stresses that the Bank of London appealed and lost its case when the federal 
would have been a lower estimate of 18 percent, but still a profitable rate. 
courts ruled that the provincial government could properly withdraw note-issuing rights. The Law of National Guaranteed Banks  243 
Table A2.4. Balance Sheet of a Government-related Wildcat Bank 
Assets  Liabilities and Capital 
Government Bonds  115  Paper Notes  230 
Other Assets  230  Cauital  115 
Notes: See text. 
perceived life span of the project.  If an abrupt change in the banking regime, or an 
outright repudiation, were expected in the near future, the negative consequences for 
expected profits would have been very profound. How profound? That would depend, 
of course, on the hypothetical timing of the change. To give an extreme example: assume 
that two  years after the law was passed the government revoked the property rights and 
also repudiated the bond income interest; with an average discount rate of 5 percent it 
follows (from the first expression above) that the project would have lost 83 percent of 
capital invested. 
A somewhat different explanation is that investors had a less sanguine view about 
the project, decided to bid for the rights to issue the paper notes, but were denied when 
the monetary authorities preferentially allotted the rights to government-related banks. 
There is some evidence that the provincial governments had demanded a banking reform 
that would allow them to establish banks of issue? 
The newly created provincial banks did not invest already-accumulated domestic 
capital, but rather bought the “theoretical” shares with public debt contracted in the 
London money market. Thus, the scheme here became an arbitrage operation and to 
issue paper notes was profitable as long as 
i*B < iN +  R, 
where, i*  is interest rate at which the provinces could borrow in the London Market? 
In a subsequent, distinctly decadent, stage of the banking experiment, an explosion 
of “wildcat banking” occurred when the bond requirement of the law was lifted.  This 
change made the expression (N -  B) positive, so that the price paid for the rights to 
issue notes was below the value of the notes.  There is evidence that only half of the 
bonds backing the paper notes issued by the government related banks were ever paid 
with gold? The official banks overissued well above the law’s prescriptions and then the 
true leverage provided by the notes was severely affected as can be appreciated from the 
example in Table A2.4. 
4.  The  finance minister reported to Congress that “eight provincial governments are now attempt- 
ing credit operations for the purpose of founding banks, and thus satisfying necessities which 
are acutely felt; this pointedly illustrates our present situation and pushes the government to 
hasten the presentation of the accompanying bill” (Agote 1887,407). 
5. The  eight official banks that engaged in arbitrage operation had almost reached the quantitative 
ceiling prescribed in law by 1888. In addition, newly created private banks were dotted less 
than 8 percent of the stipulated sum of 40 million (Pillado 1901,60-61). 
6. Williams (1969,59) 

Straining at the Anchor: The Argentine Currency Board and the Search for Macroeconomic Stability, 1880-1935

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