Tuesday, December 20, 2022

Free vs Regulated Banking: Canada’s Free Banking Era – Did Canadian Free Banking Have Any Regulations? (Part 2)

Click here to read the original Cautious Optimism Facebook post with comments

6 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff discusses the Canadian government's early experiments with banking regulation in the latter decades of its lightly regulated "free banking" era.

Odd-denomination private banknote, the unintended
consequence of early Canadian banknote regulations


In Part 1 of Canadian banking regulation we reviewed the handful of provincial rules imposed on colonial banks before Confederation.

When Canada became a self-governed Commonwealth nation in 1867 the new Canadian Parliament took a longer look at the question of banking legislation.

One of Parliament’s seminal regulatory initiatives was the Banking Act of 1871 which imposed federal rules in lieu of provincial ones and also established Parliament would revisit the subject of banking regulation once every decade.

(If only U.S. Congress would wait for a decade before drumming up new bank regulations!)

However the first federal regulations weren’t much different from their predecessors – once again mostly precluding fraud and conflict of interest. 

New federal laws required banks to open their finances to shareholders and the federal government every six months, and banks agreed to comply with surprise government inspector audits (ironically, no surprise audits occurred for decades).

However one new edict in the 1871 Act authorized Canadian Parliament to intervene in the note-issuing business.

Unsurprisingly the results were negative.

First, low denomination private banknotes – which had been banned even in Scotland in 1765 – were not only prohibited in 1871, but Parliament took the further step of getting into the low denomination banknote printing business for itself. 

Private banks were prohibited from issuing notes under four dollars which became the exclusive monopoly domain of the Department of Finance.

The government’s newly dubbed “Dominion notes” had to be backed 20% by gold, but they still served as a major revenue source for Parliament. The federal government could hold, say, $1 million in gold but print $5 million in Dominion notes to pay for its expenses.

The edict led to bizarre albeit not crisis-inducing outcomes. 

Canadians may now have been forced to conduct $1 and $2 transactions using government Dominion notes, but they didn’t always have to use Dominion notes for larger odd payments.

For Canada’s private banks reacted with their own workaround: issuing odd-denomination notes with face values of $4, $6, and $7. 

A consumer could make a $17 purchase and pay with a combination of private $10 and $7 banknotes instead of needing two $1 Dominion government notes.

More illustrations of odd-denomination banknotes can be found in the comments section.

In 1880 the minimum private banknote denomination was raised to $5 and banks were banned from issuing notes in anything but multiples of $5, thus forcing Canadians to use Dominion notes to facilitate all odd payments going forward.

Soon after the establishment of the Bank of Canada in 1935, which marked the end of the free banking era, the private central bank was granted a legal monopoly on all banknote issuance and private banknotes disappeared from circulation (the Bank of Canada was nationalized in 1938). 

Still, the old private odd-denomination notes are sought after by collectors for their numismatic value.


Finally, we reach the two most consequential regulations of the free banking era: greater barriers to entry and capital requirements on note issuance.

In the late 1880’s Parliament began upping the paid-in capital requirements for new banks to receive charters. In 1890 the minimum was raised to $500,000, a significant sum at the time, with a requirement that the entire capital subscription be completed within one year of the charter’s granting (Selgin: 2018).

The government’s objective was clear: to prevent too many new competitors from entering the market.

The long-term effects were also quite predictable: a multi-decade period of bank consolidation with mergers and acquisitions reducing the number of institutions but scant few new entrants to offset the decline.

Many Canadian historians believe there was an unspoken agreement between banks and Parliament: that the government would keep the number of banks relatively small in exchange for increased competition and stability via nationwide branching.

Whether or not that was the intent, the result turned out exactly that way.

By the 1910’s Canada was served by about twenty major banks plus another few dozen thrifts—all for a country of 8 million (about the population of Oregon). Yet despite the smaller number of banks, Canadian consumers enjoyed greater competition, lower interest rates, more access to credit, and far greater banking stability than Americans with 27,000 banks!

The reason was unbridled access to markets via branches. Canadian banks could branch anywhere—and did. In the United States, most towns only had a single unit bank which was granted a monopoly by its state legislature.

Thus Parliament’s higher barriers to entry were hardly an example of laissez-faire and almost certainly unnecessary, but the legislation did not lead to banking crises the same way that American restrictions on branching did.


Lastly we examine the closest thing to a destabilizing regulation during the Canadian free banking period: the paid-in capital requirement for banknote issuance.

In the United States banks were only legally allowed to issue currency if it was backed 111% by U.S. government bonds.

Canadian Parliament placed a similar restriction on its banks, requiring the quantity of banknotes issued to never exceed 100% of the bank’s paid-in capital, a measure to secure the value of the notes should the bank fail.

For the most part the Canadian version of banknote restriction was trouble-free, something we’ll explain in a few paragraphs, but it did produce industry stresses in one year: 1907.

The effects of America's enormous Panic of 1907 were spreading into Canada, but farmers and depositors asking to withdraw cash were, like in the USA, also being told “no cash available” by their bankers since they didn’t have sufficient paid-in capital to legally issue more notes.

For that reason 1907 proved to be the worst year in Canadian history for bank failures. Hold onto your seats…

Three banks failed.

One was acquired by the Bank of Montreal and its customers never noticed any disruption, one paid all its creditors back in full, and only the last failed bank was unable to make good on 100% of its liabilities.

Parliament examined the problem shortly after and simply upped the banknote limit from 100% of paid-in capital to 115%.

The problem never occurred again and, unlike in the United States, 1907 wasn't severe enough to be considered a crisis by anyone then or ever since.

The United States took a radically different course: Congress adopted the Federal Reserve System to take over note-issuance completely and act as lender of last resort.

But the paid-in capital requirement serves as an example of Canada inching towards a financial crisis as it flirted with more and more intrusive bank regulations… just before stepping back from the brink.

Incidentally the Canadian paid-in capital requirement was always less onerous than the American bondholding equivalent, hence why Canada had just one instance of industry duress while the USA suffered six banking panics during the 1863-1914 National Banking era.

Why were U.S. banknote restrictions less flexible?

The quantity of U.S. government bonds required to back private banks’ note issuances was limited by the national debt, debt that was declining during the law's first thirty years and later, even when new bonds were floated, was still inadequate to meet the demands of the public.

But the Canadian paid-in capital requirement was far more flexible. If a Canadian banker noticed customer demand for banknotes was nearing his paid-in capital limit, he could always go to the equity markets and raise more capital to up his note issuance limit. 

A U.S. banker had no such recourse since the supply of U.S. Treasury bonds was under exclusive control of the federal government.

In the next installment we’ll discuss a few criticisms and praises of the free banking system from the handful of academics even aware of its existence.

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