Free banking : the Scottish experience as a model for emerging economies

The notion of free banking is at least as difficult to define as the notion of central banking. The author focuses on a relatively unregulated banking system that operated in Scotland in the eighteenth and nineteenth centuries. He argues that a relatively unregulated system is a wise option for emerging markets today. In terms of private institutions and monitoring: 1) a private clearing system is feasible; and 2) so are private development and enforcement of capital and liquidity standards. Financial institutions have strong private incentives to create their own clearingsystem, to benefit both banks and the public, and will develop standards for capital, liquidity and prudential management by doing so. Competition is generally compatible with prudence and coordination. There are private alternatives to deposit insurance or to a central bank to maintain confidence in and foster the stability of the financial system: 1) sophisticated note and deposit contracts are feasible; 2) free entry is important to encourage innovation; and 3) branching and portfolio diversification can substitute for deposit insurance to stabilize the banking system. So can"extended"liability. Another alternative is the"option clause"or other contingent or equity-like contracts, which can solve or minimize the problem of bank runs. Therefore, an explicit central bank may not be needed, but rather mechanisms to provide added liquidity, perhaps through the clearing system, in times of trouble.