The free banking in Belgium during the 19th century

Until now, there was no account of any episode of free banking in Belgium. I was only aware of a brief narrative in chapter 2 (by Schuler, 1992) of The Experience of Free Banking (edited by Dowd). Recently, Mardini & Schuler (2014) reported a detailed story of the belgian banking system in the 19th century.

Mardini, P., & Schuler, K. (2014). Free banking in Belgium.

Paper for the conference "Free Banking systems: diversity in financial and economic growth" Lund University School of Economics and Management, September 4–5, 2014

The somewhat free banking period occurred between 1835 and 1850. The country had two major banks established in Brussels, where the status of incorporated companies with limited liability was only granted to banks at the discretionary verdict of the government. They are the "Société Générale" (banking license in 1822) and "Banque de Belgique" (obtained in 1835). Henceforth SG and BB. Both are said to be incorporated banks. These so-called incorporated banks were fierce competitors. They did not collude so as to earn extraordinary profits. Each of them wanted to be the government's fiscal agent (e.g., the Fed is the fiscal agent of U.S. government). The Société Générale obtained this status but not Banque de Belgique. It should be noted that BB bank constantly refused any type of examination from the Court of Auditors. The two banks were allowed activities such as discounting and industrial/commercial loans, but their activities were concentrated more on investment banking rather than commercial banking. Their note issue could not exceed their amount of capital, which amounted to 20 million French francs (about 3,048,980 euros). They both accepted the bank notes of the other bank, until the 1838 crisis arrived.

They are other banks, i.e., the so-called provincial banks with unlimited liability, and they also could not issue notes greater than their amount of their capital, but the restriction does not seem to have been binding, as no bank reached that limit. And there were no reserve ratios. However, other kinds of restrictions undermined bank note issue. One important restriction was the prohibition of discounting (i.e., the right to delay payments to a creditor, for a defined period of time, in exchange for a charge or fee).

The major banks heavily invested in illiquid assets. Loans were collateralized with the companies' stocks. So, if a crisis happens, the banks suffer losses on the loans and the collateral simultaneously.

Belgium had two banking crises. One in 1838, and another in 1848. The first was due to the fact that the Netherlands had launched a military campaign in an attempt to take Belgium back, while the second was related to the anti-monarchist revolution in France and France's suspension of the gold standard.

Banque de Belgique was unable to redeem bank notes in 1838. It was due to bad management of note issuing and illiquid assets. The authors suspected that BB was inexperienced. It is easy to understand why. BB came into the market in 1835. So it was still relatively young.

Free banking theory predicts that free bankers should be able to meet the public's demand for money (Selgin, 1988). If the demand for inside money is in excess relative to what the bank has supplied, it would be more profitable to expand. On the other hand, a reduction in demand for money, for whatever reason, must be followed by a reduction in credit supply of the bank. An increase in interest rates will encourage the savers/investors to lend their cash to the bank. Another possibility would be to attract more notes of competing banks, so as to have them for clearing. This can be done, for instance, by offering merchants favorable terms for this part of their business, such as free cash management services, or accepting these notes for deposit on favorable terms or at a small premium to face value. Of course, these strategies won't work in case of a bank panic. Actually, three elements should have prompted BB to reduce its note supply, namely, the 1837-1838 economic crisis taking place in England and France, the strong possibility of war with the Netherlands, and the slowdown in the domestic metallurgical industries. In light of this, they argue that BB did not know how or when to decrease the supply of notes. The bank did not expect the drop in bank notes' demand, did not keep enough bullion in reserve, relied on very liquid liabilities (deposits and savings bank) to finance illiquid assets, and did not take proper collateral for lending.

If Banque de Belgique had increased its interest rate, it would be able to satisfy the interbank clearing. However, BB was not able to fully pay SG bank through the interbank clearing; the BB bank settled the note clearing with 1.125 million francs even if the request amounted to 1.2 million. The Société Générale then knew about the difficulty encountered by BB. The SG bank sent an employee to the counter of BB during business hours by requesting redemption of the notes in the presence of other clients. This strategy is probably aimed to generate distrust regarding BB. But BB was still hoping for a government bailout, which did not come. At the end, BB had to suspend the payments. After 1838, the two banks refused each other's notes. It was only in 1839 that the bailout was accepted.

At that time, the SG bank also committed the same errors as the BB bank, but avoided suspension of payments for two main reasons. First, it had a huge buffer of implicit government subsidies, i.e., the bank collected government taxes, sold government lands, and provisioned cash for potential settlement with the government, and so it is natural to expect that the bank would use some of those funds in times of crisis. Specifically, by liquidating its French treasury bonds and withdrawing its deposits in French banks. The bank thus reacted promptly by getting 20 million francs in 5-franc pieces from French bankers to be able to meet withdrawals; this was possible because the crisis was located in Belgium. Second, it restricted the discount activity, accepting only bills maturing in a maximum of six weeks, and at some points completely stopped discounts. Third, the bank issued a press release declaring its willingness to respect the contract signed with the government, fully guaranteeing all funds deposited at its savings bank. In reality, no contract was ever signed with the government relative to the savings bank. It was only a measure to restore public trust.

The best proof that SG has also been impacted is that it has drastically diminished its savings deposits, in favor of demand deposits. The reason is obvious. Demand deposits bear no interest, can be withdrawn at demand, can be used in daily transactions. Savings deposits thus are more costly. Due to the 1838 crisis, the SG bank apparently needed to reduce its costs by lengthening the advance notice required for withdrawal to 45 days (instead of the usual 8 days) and later (apparently in 1842) by raising the advance notice to 60 days and by restricting the 4% interest rate to the first 1,000 francs on savings deposits (instead of the usual 4% on the first 2,000 francs, or 305 euros). For this reason, the shift in current liabilities, in favor of demand deposit, took time and occurred in the middle of the 1840s.

The Banque de Belgique also reacted the same way. The bank witnessed an increase of savings deposit between 1835 and 1838, and then a decline in 1839, and a large increase in 1841-1843. The bank added several restrictions on savings deposits in 1843 so as to decrease them, probably due to cost burden as well.

An interesting feature of the 1838 crisis is that it could have been smoothed. In this year, a reputable group of english investors applied to create a Banque Anglo-Belge, but the charter was never granted. The capital would have been subscribed in England but the bank would have operated in Belgium. The bank would have been permitted to engage in all banking operations, including note circulation. The bank's proposers envisioned a capital of 25 million francs (about 3,811,225 euros) and several branches in the provinces. The potential bank's director was even received by the king. Even so, the government denied the application for unknown reasons although Belgium was then in a serious financial crisis and fresh capital was desperately needed. Some members of parliament were outraged by the decision and some newspapers accused the government of bending to the will of SG bank. The bank was suspected of scheming to preserve its dominant position in the market, especially after the difficulties of the momentary failure of BB bank. The same group of english investors was forbidden to buy stock in the bank. They finally obtained a license in 1840 to create a bank in Ghent, where they established the Banque des Flandre in 1841 under the patronage of the SG bank. It was SG that issued the shares of the Banque des Flandre for subscription, just as it did for the companies under its patronage.

On March 19, 1839, the lower house of parliament approved a treaty with the Netherlands and war tensions vanished. On June 20, a final payment to creditors was made and confidence was restored.

The 1848 crisis had probably more consequences than the 1838 crisis. It seems to have been linked to the 1844 railway boom (which has brought optimism in industrial activities such as metallurgy). The spillover of the 1847 british and french financial crises, related to the end of railway mania, made things worse. In 1848, the outbreak of revolution in France created a panic in Belgium. Given the strong political, economic, and cultural ties between France and Belgium, the belgian people considered the revolution a prelude to chaos and possibly war. They wanted their paper to be converted into bullion. The panic calmed down when the French government made its peaceful intentions known. But public concerns reemerged when belgian laborers working in Paris were armed and sent back to their home country to foment revolution and when the troubles started in Liège and Hainaut provinces. A second round of bank runs and market crashes started, fueled by the French government's adoption of a fiat currency regime on March 15. belgian banks were experiencing a liquidity squeeze and they asked the government to follow France off the bimetallic standard. In the same year, 1848, the government introduced a bill (law) in favor of legal tender for SG and BB bank notes. The bill allowed the two big banks to suspend the convertibility of their notes except for those of 50 francs (7.6 euros) or less. A maximum of 20 million francs and 10 million francs in new notes were allowed to be issued respectively for SG and BB. The notes were guaranteed by the government, which in turn asked the banks for collateral (shares, real estate, government bonds, etc.).

This crisis had no bailout because the government lacked the needed resources. But the government helped the SG bank by allowing for 20 million francs of inconvertible notes guaranteed by the government, under certain restrictions (e.g., offer collateral as counterpart of the guarantee, pay the government a 4% interest on the amount issued, government administrators would supervise the bank, etc.).

To better understand the difficulties of SG bank, we must look again at the earlier crisis. After 1838, BB bank restructured its balance sheet. Between 1838 and 1848, the short-term financial loans in % of total assets diminished from 56% (but was 38% in 1837) to 32% while at the same time the short-term economic loans in % of total assets increased from 9% (but was 19% in 1837) to 37%. On the other hand, SG bank did not restructure its balance sheet, probably because it did not encounter a lot of troubles in 1838. As a result, the % of short-term financial loans has increased between 1838 and 1848, from 40% to 49% while the % of short-term economic loans remained stable at around 4%. For this reason, the SG bank took a bigger hit than BB bank in the 1848 crisis. The SG bank apparently encountered similar problems in 1848 that BB bank had to face in 1838; that is, it did not raise interest rates enough to reduce its note supply.

After the 1838 crisis, some economists believed that private issuing of notes is a risky task; some requested that the banks should redirect their activities toward discounting instead of financial services but some asked for the creation of a central bank. This demand was answered only after the 1848 crisis. In 1849, the government negotiated with the banks the creation of a monopoly note issuing bank owned by the Société Générale and the Banque de Belgique. This central bank, called the Banque Nationale de Belgique, was created in 1850 and opened in 1851.

One would notice the period almost began with a crisis and almost ended with a crisis as well. In both crises, however, the connection with external political shocks is obvious. We cannot tell if a centralized banking system would have performed better. Other examples (e.g., Britain; see White's Free Banking in Britain) suggest it won't. In conclusion, there is no clear evidence that the banking system in Belgium during this period was a success, but there is no evidence that it had failed.