As all dedicated Alt-M readers know, I am a big fan of the Canadian banking and monetary system that flourished between Canada's Confederation in 1867 and the outbreak of the First World War. Besides thinking it was a darn good system, I also regard it as the best example, together with Scottish banking during the first half of the 19th century, of a "free" (that is, largely unregulated) banking system.

But was the pre-WWI Canadian banking system really a "free" banking system? Although Canada's commercial banks were free from many sorts of regulatory restrictions imposed on banks elsewhere, during its "free banking" era, all of Canada's banks were "chartered" banks, where, as Stephen Williamson observed in a recent twitter exchange, Parliament had to approve each charter. "To me," Stephen wrote, "that seems like a severe entry barrier."

And so it may seem to most people. Yet a closer look at the facts suggests a different and changing picture. Despite banks' need to secure Parliamentary charters, entry into Canadian banking was relatively free until at least 1890, when stiffer bank capital requirements made it harder for prospective new entrants to qualify for a charter. Canadian bank mergers were in turn made easier by the Bank Act of 1900. As a result of these two changes the number of Canadian banks fell dramatically over the course of the first quarter of the 20th century, making it increasingly less appropriate to treat Canada's banking system as an example of "free" (in the sense of "laissez-faire") banking.

Charters before and After Confederation

Although prior to Confederation the chartering of any sort of corporation in Canada was technically a Royal Prerogative, British authorities were generally inclined to ratify charters granted to banking companies by Canadian authorities, provided those charters conformed to certain regulatory provisions the British authorities favored (see Shearer 2005). But it wasn't until the 1840 Act of Union, uniting the colonies of Upper and Lower Canada into a single Province of Canada, that uniform regulatory provisions were first settled upon, which were to be imposed both on newly-formed banks and on established ones as conditions for having their charters renewed.

It was while these terms were in effect, in 1854, that the Canadian-American Reciprocity Treaty was signed, giving a big boost to Canadian trade, and generating a corresponding increase in applications for bank charters. According to Byron Walker, General Manager of the Canadian Bank of Commerce and former president of the Canadian Bankers Association, between 1855 and 1866, inclusive, "more than twenty-five charters were granted," with fifteen new banks actually coming into business.

Confederation in 1867 brought with it the necessity of framing a general bank act for the newly established Dominion of Canada, a version of which was adopted in 1870, and then revised in 1871. The revision made the Canadian Parliament responsible for both the granting and decennial renewal of bank charters.

The necessity of a charter certainly distinguished the Canadian system from its Scottish counterpart, for although three chartered banks took part in the latter system, it also included over 30 unchartered banks, most of which issued notes, and many of which were joint-stock companies. However, as Walker explains in his 1896 History of Banking in Canada, the distinction wasn't as important as one might think:

In Canada, we have had one section of the people who have been so enamored of freedom that they have desired to see banking as well as other privileges reduced to the mere necessity of applying for incorporation under a general act, together with subscription of the smallest amount of capital which seemed possible to propose. But, as a rule, people of British origin want merely all the liberty which is compatible with freedom from license. So that while, in the main, Parliament has clung to its prerogative of refusing a charter if it chose to do so, during 50 years at least, it would not have dared to exercise the power except in the event of a clearly fraudulent application for a charter. Nor would it dare, although it has the power, to give special privileges to any one bank.

To drive home the point, Walker compares the Canadian situation to that of the U.S., where the National Bank Acts allowed banks to be established anywhere without need for a special charter.

In the United States, a certain number of individuals having complied with certain requirements — more numerous and complicated, by the way, than the Canadian requirements — became thereby an incorporated bank, if we regard the consent of the Comptroller of the Currency as a matter of form. In Canada, when a certain number of individuals have complied with certain requirements, they are supposed to have applied for a charter, which Parliament theoretically might refuse, but which, as a matter of fact, would not be refused unless doubt existed as to the bona fide character of the proposed bank. Then, as in the United States, on complying with certain other requirements and obtaining consent of the Treasury Board (performing in this case the same function as the Comptroller of Currency in the United States), the bank is ready for business.

Other Perspectives

Readers may well doubt that we should take an established Canadian banker's word for it when he tells us that entry into banking in Canada was practically as open as it was in the U.S. But Byron Walker was hardly the only person who thought so. Here, for example, is the opinion of R.M. Breckenridge, a highly regarded historian of Canadian banking (he was commissioned to write the National Monetary Commission volume on The History of Banking in Canada) who, though a Canadian and a businessman, was not himself a banker. In Breckenridge's 1895 book on The Canadian Banking System, he says that

The disposal of bank charters, has never been marked by the fraud or partizanship which make the record of some of the American commonwealths so discreditable in this respect… . Yet charters have been easily obtained, too easily obtained. Since confederation forty-four charters have been granted, and only five proposed charters reported on adversely… . Twenty of the forty-four have been forfeited for non-user. … Any new bank may now be chartered as soon as the projectors convince the disinterested committee of Ministers and heads of departments known as the Treasury Board, that their intentions are honest and that they have financial backing. A favorable report by the Treasury Board or the House Committee on Banking and Currency makes the bill a Government measure and ensures its passing. The Canadian banks have enjoyed no monopoly against the entrance of new competitors bona fide into banking, nor have the shareholders profited from investments in stocks which others might not obtain.

Writing in 1910, when (as we shall see), the Canadian banking system had already begun a process of consolidation, American economist Joseph French Johnson (1910, p. 86) observed, in his own National Monetary Commission volume, that, although "Some critics insist that the difficulties in the way of establishing a new bank are so great that the existing banks practically possess a monopoly," the criticism was still "not altogether justifiable." "A dozen or more new banks have been chartered since 1890," Johnson observed, "and there is no evidence whatever that Parliament has refused a charter to any set of deserving incorporators."

The Beginnings of the End: Canadian Banking Consolidation

But while entry into the Canadian banking system may be said to have long been relatively free when Walker, Breckenridge, and Johnson wrote about it, a sea change was underway. The change was a result of two modifications to Canada's banking laws. The first was the implementation of stricter minimum capital requirements included in the the Bank Act of 1890. That provision required, not only that banks meet a $500,000 capital requirement, but that that capital be fully subscribed within a year of the granting of the charter, and that at least one-half of those subscriptions be paid in, before the Treasury Board would grant the bank a certificate authorizing it to commence business.

These provisions marked a substantial change from those of the previous Bank Acts. Although the 1871 Act had also required banks to have at least $500,000 in subscribed start-up capital, only $100,000 of that amount had to be paid up. Moreover, as John Turley-Ewert points out in his excellent dissertation on the history of the Canadian Bankers Association (p. 14, n 55), because government authorities never bothered to enforce the provisions, in practice capital requirements appear to have been "meagre rather than substantial," and especially so since the 1871 Act imposed no requirements at all on private bankers, who therefore "successfully competed with the chartered banks through the 1870s and 1880s." Besides raising the paid-in component of bank capital requirements, the 1890 Act also sought to give the law some real teeth.

Despite one notorious failure, involving the Ontario-based Farmers of Canada,[1] the new law appears to have largely achieved its intended purpose of limiting bank entry. Breckenridge himself understood the new capital requirement to be

a legal step in the direction of making the organization of new banks more difficult. No new bank has entered the field since 1885. …Of the fourteen banks chartered in 1883 to 1893 inclusive, only five could comply with the requirements of the Bank Act and actually began business; three of the five have already been put in liquidation, two in 1887 and one in 1893. It may be expected that hereafter both people and Parliament will be disposed closely to scrutinize applications for new charters. The enthusiasm for new banks…has abated… . The tendency of the number of banks to remain stationary, or even to diminish, so pronounced in English and Scotch banking,[2] is thought a factor of considerable influence in the Canadian situation.

The second modification, included in the Bank Act of 1900, was in itself a step in the direction of more rather than less freedom in banking, consisting of the relaxation of what had been a very strict policy regarding Canadian bank mergers. Before 1900, it took an act of Parliament to authorize a merger, just as it took such an act to grant charters to new banks; Parliament was not, however, inclined to approve of mergers. The 1900 revision allowed any bank to acquire another bank's assets without Parliamentary action provided the merger was approved by the Governor in Council pursuant to a recommendation of the Treasury Board. Consequently mergers become much more common: whereas from Confederation until 1900 only seven bank mergers occurred, the period between 1900 and 1926 witnessed another 27.

Because of these changes, and as Breckenridge had anticipated, the number of Canadian banks fell rapidly. In his 1929 book, The Banking System of Canada, Benjamin Beckhart observed that "The tendency toward fewer and larger banks has been perhaps the outstanding characteristic of the banking structure of Canada within recent years." While the number of Canadian banks peaked at 41 in 1885-6, Canada still had 38 banks a decade later, when Walker and Breckenridge penned their respective histories. In 1910, when Johnson wrote, the number had fallen to 29; and he had no doubt that it would fall further:

The tendency in Canadian banking…is unmistakably toward combination. The chartered banks possess no monopoly now, but the situation is such that the large banks have a great advantage over the small ones and seem destined to get most of the new business that will be created in Canada in coming years. Their prestige assures their branches are welcome in every new community. No business is too large for their resources, and none is so small as to be despised. They are able to open more new branches than their small competitors, and can much better afford, if need be, to operate them for a time at a loss. It will not be surprising, therefore, if Canada has fewer banks ten years hence than now (Johnson 1910, pp. 134-35).

By 1914 there were, in fact, just 22 chartered banks; and by 1935, when the Bank of Canada was established and granted a monopoly of note issue, only 10 were left. Because the decline reflected both a lack of new entrants and mergers, it brought with it a greater concentration of assets in a handful of banks, with the four largest in 1929 holding 77% of the total (Beckhart p. 328).

In short, by the time the Bank of Canada took over, Canada's private currency system could no longer be regarded as an essentially "free" system, differing only in degree from the Scottish system in its pre-1845 heyday. For this reason Canada's era of (relatively) free banking is best regarded as lasting only until 1914 at the latest, when consolidation, though already underway, had as yet left the system's operating principles fundamentally unchanged.

Banking without Sin

What ultimately doomed free banking in Canada, even before the advent of the Bank of Canada, was Canadian authorities' growing unwillingness to tolerate any risk of depositor or banknote-holder losses in connection with bank failures, even when those failures posed no macroeconomic threat. The government may first have hoped that stiffer capital requirements would rule-out losses stemming from bank failures. But when three banks failed between 1890 and 1900, and two of those failures — those of the Banque Du Peuple in 1895 and of the Banque Ville Marie, in 1899 — resulted in substantial depositor losses, its hopes were disappointed. The government's subsequent decision to encourage bank mergers was supposed to serve as an alternative and more palatable means for winding-up failing banks. Until the advent of deposit insurance many decades later the combined effect of these steps was to all but guarantee a gradual move towards banking-industry oligopoly.

The lesson here seems obvious enough. In banking as in other enterprises, genuine competition is a matter of creative destruction, where the "creative" part calls for relative ease of entry, while "destruction" means that badly managed banks are allowed to fail, even if that means that creditors sometimes bear losses. The occasional liquidation of individual banking firms, and the losses suffered by those firms' shareholders and creditors, are part of the cost of having a robust and stable yet nonetheless dynamic banking system. If they go too far in their attempts to avoid such costs, regulatory authorities could end up undermining, rather than bolstering, the banking system's long-term integrity.

As the late Allan Meltzer remarked, "Capitalism without failure is like religion without sin." For a quarter century or so, Canada's banking authorities left Canada's banks and bank customers to the mercies of the old-time capitalist religion. By so doing they allowed one of the world's most brilliant banking systems ever to flourish, albeit at the cost of exposing Canada's bank patrons, not only to bank failures, but to occasional banking swindles. But Canadian authorities eventually found the trade-off impossible to tolerate, preferring to stamp out sin altogether, even if that meant transforming Canada's competitive though imperfect banking system into an immaculate banking cartel.

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[1]Established for the express purpose of advancing credit to farmers on more favorable terms than those offered by existing chartered banks, the Farmers Bank struggled to raise the necessary capital. Wishing to see the bank succeed, William Fielding, Canada's Liberal Finance Minister, first granted its promoters several extensions, and then, in 1906, instructed the Treasury Board to issue the bank a certificate to begin business solely on the basis of a sworn oath to the effect that the necessary capital had been raised, by the bank's general manager, W. R. Travers, despite having been warned by persons in a position to know that Travers' claim was false. The Farmers Bank suspended payments on December 19, 1910, its failure having been due, according to a royal commission, to its management's "gross extravagance, recklessness, incompetency, dishonesty, and fraud." Although that same commission absolved Fielding of negligence, Travers was eventually found guilty of having violated the Bank Act, for which he was sentenced to six years in prison.

[2]The consolidation referred to here was a consequence of the passage of Peel's Bank Charter Acts of 1844 and 1845, which effectively ended new entry into the banknote issuing business in the United Kingdom.

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