Free Banking: The Scottish Experience as a Model for Emerging Economies

Scotland's nineteenth-century experience with free banking offers lessons to inform contemporary policymakers. A relatively unregulated banking system may be a wise option for emerging markets, if high liability limits can be enforced.
The notion of free banking is at least as difficult to define as the notion of central banking. Instead, Kroszner focuses on a relatively unregulated banking system that operated in Scotland in the eighteenth and nineteenth centuries. (Sweden adopted a similar system.) Kroszner argues that a relatively unregulated system is a wise option for emerging markets today, which exhibit many features of the eighteenth and nineteenth century Scottish economy.
In terms of private institutions and monitoring (typically thought to be a central bank responsibility:
° A private clearing system is feasible.
° So are private development and enforcement of capital and liquidity standards.
Financial institutions have strong private incentives to create their own clearing system, to benefit both banks and the public. In creating such a system, the institutions develop standards for capital, liquidity, and prudential management that will become requirements for membership in the system. Modern examples: the Chicago Board of Trade and Chicago Mercantile Exchange.
Competition is generally compatible with prudence and coordination (although the excessive note issue by the Ayr Bank demonstrates that the system did not eliminate all rogues). The Ayr Bank is the only major exception to the smooth operation of Scotland's private clearing and monitoring system in more than a century, and the system helped to contain the problems from this bank's collapse --- fulfilled a role typically considered to belong to a central bank.
There are private alternatives to deposit insurance or to a central bank to maintain confidence in and foster the stability of the financial system.
° Sophisticated note and deposit contracts are feasible.
° Free entry is important to encourage innovation.
° Branching and portfolio diversification can substitute for deposit insurance, to stabilize the banking system. So can extended liability (beyond simple limited liability of the shareholders), to give depositors and note holders some assurance that a bank could withstand a negative shock. Another alternative to deposit insurance is theoption clause or other contingent or equity-like contracts, which can solve or minimize the problem of bank runs.
Is any role left for a central bank as lender of last resort? An explicit central bank may not be needed, but rather mechanisms to provide added liquidity, perhaps through the clearing system, in times of trouble.
This paper --- a joint product of the Finance and Private Sector Development Division, Policy Research Department, and the Financial Sector Development Department --- was presented at a Bank seminar, Financial History: Lessons of the Past for Reformers of the Present, and is a chapter in a forthcoming volume, Reforming Finance: Some Lessons from History, edited by Gerard Caprio, Jr. and Dimitri Vittas.