Canada’s Banking Stability in the Early 20th Century and the 1930s

Austrian, libertarian and free banking myths about Canada’s banking system persist.

Two myths are (1) that Canada’s alleged free banking system with its extensive branch banking was the only or the major reason why the Canadian financial system did not experience mass bank failures from 1929–1933, and (2) that there was no significant government intervention in the financial sector in the 1920s and 1930s before 1935.

Some typical statements of these ideas can be found here:

“Canada’s experience during the Great Depression also gives us reason to doubt the wisdom of monetary intervention. Canada has historically had low levels of government intervention and an unregulated banking system. Professor White noted that people did not run on Canadian banks in the same way that they ran on American banks during the Great Depression. In part, this was due to the absence of branch banking restrictions that prevented American banks from diversifying their risks. The Canadian banking system adjusted to new market conditions and did not undergo the protracted crisis that occurred in the United States.”
Art Carden and Christina Magrans, “A Free Market in Money?” Mises Daily, July 21, 2009
http://mises.org/daily/3548/

“Thousands of U.S. banks failed during the panics of the 1930s, most in states with unit banking laws.

In contrast, Canada allowed branch banking and experienced zero bank failures during the Great Depression. According to Milton Friedman and Anna Schwartz, in Canada ‘10 banks with 3,000-odd branches throughout the country did not even experience any runs,’ even though Canada experienced the same decline in its quantity of money as the United States did.” (Murphy 2009: 126).

“No episode illustrates more dramatically the weakening effect of anti-branching laws than the Great Depression. Between 1931 and 1933 several thousand US banks—mostly small unit banks—failed. In contrast Canada’s branch-banking network did not suffer a single bank failure even though in other respects Canada was just as hard hit by the depression—it could hardly have escaped all of the adverse effects on Canadian business of a 33 per cent fall in the US money supply. (The Canadian money supply fell by about 13 per cent.) Ironically the United States at the time did have a lender of last resort, whereas Canada did not.” (Selgin 1996: 209).

Now, while it is entirely reasonable to accept that a branch banking system in Canada spread risk in a better way than in the United States, and that this branch banking system was one reason why Canada had a more stable banking system, it is simply wrong that Canada had no “lender of last resort” in these years. The fact is that, despite having no formal central bank until 1935, Canada did have a lender of last resort via the discount window that was created by the Finance Act of 1914. Nor was it true that Canada’s banking system was unregulated.

This and other government interventions – and not just the branch banking system in Canada per se (although it did no doubt have some role) – are much more plausible reasons why Canada’s banking system from 1914 to 1935 had reasonable stability.

The crucial points which discredit the libertarian position on Canada are as follows:

(1) Canada did not have a classical gold standard after 1914: legal tender in the Canadian system was either gold coin or Dominion notes, which were issued by the Canadian government (Shearer and Clark 1984: 278).

(2) Haubrich (1990: 226) reports that chartered banks in Canada even in the 1920s and 1930s were “heavily regulated” by the Bank Act of 1871 and subsequent revisions of that act, which “specified (among other things) audits, capital requirements, directors’ qualifications, and loan restrictions, including a prohibition against holding mortgages.”

In particular, the Bank Act of 1871 had prohibited banks from lending on real estate (see Darroch 1994: 277–278, with a list of revisions; see also Anonymous 1900), which would presumably have checked debt-financed asset bubbles in property and real estate speculation – all major sources of instability in capitalist systems.

(3) in 1907 the Canadian government lent $5 million in Dominion notes to the private sector banks during a banking panic, which averted a serious financial crisis.

And the “Canadian Bankers Association” (formed in 1891) – which in 1900 became a public corporation – also provided stability by organising bank mergers to deal with insolvent banks.

(4) in August 1914 the Canadian government suspended the gold standard and Canada only returned to the gold exchange standard for a brief period from 1 July, 1926 to January 1929, when in the latter year it was unofficially suspended (Shearer and Clark 1984: 277) and permanently and officially suspended in 1931 (Dowd 1992: 90).

But even more important was the Finance Act of 1914. This allowed Dominion banks to borrow notes directly from the Canadian Department of Finance: such notes were issued at the request of the banks with no gold-reserve requirement (Shearer and Clark 1984: 279).

This meant that from 1914 onwards Canada had a lender of last resort in the form of government issued money:

“The Finance Act, passed in 1914 to facilitate wartime finance, provided the chartered banks with a liberal rediscounting facility. By pledging appropriate collateral (this was broadly defined) banks could borrow Dominion notes from the Treasury Board. The Finance Act clause, which was extended after the wartime emergency by the Amendment of 1923, provided a discount window/lender of last resort for the Canadian banking system.” (Bordo 2005: 292).

Thus the Finance Act (1914) allowed the Canadian government the power to expand the money supply by creating dominion notes unbacked by gold (Bothwell, Drummond, English 1987: 183–184). This Finance Act of 1914 was amended and made permanent by the legislation of 1923.

Moreover, the use of this system continued long after the war:

“… the Finance Act provided a ‘discount window’ for the chartered banks as early as 1914, and … this mechanism had extensive use during the 1920’s. In a sense it was Canada’s answer to the Federal Reserve System of the United States.” (Bond and Shearer 1972: 402).

The private banks in fact had lines of credit with the discount window at the Department of Finance which they could access on demand through advances at a posted interest rate.

These lines of credit were definitely used and used in a significant way:

“Between 1920 and 1935, on average, advances amounted to only 16 percent of aggregate lines of credit, and in 100 of the 180 months, to less than 15 percent. Borrowing reached 25 percent of aggregate lines of credit in only 30 months, and the maximum usage was 39 percent (November 1929). At no time did the banking system have less than 60 percent of authorized lines of credit available for immediate use.” (Shearer and Clark 1984: 279).

“To a bank, an unused line of credit was a costless liquid asset that guaranteed almost instant access to legal tender. In principle, control over lines of credit was like control over cash reserves.” (Shearer and Clark 1984: 283).

The Finance Act of 1914, then, effectively made the government a “lender of last resort” and became a permanent part of the financial system (Naylor 2006: 526–527).

For example, in 1924, the Dominion and Imperial Banks experienced runs and turned not just to other banks, but to the Department of Finance for liquidity to avert a crisis (Carr, Mathewson, Quigley 1995: 1147).

And one can posit that the heaviest use of this lender of last resort facility was in the crisis years from 1929–1933 during the depression, which must have contributed to the stability of the Canadian banking system.

(5) A related point is that, while it is generally reported that no bank failures occurred in Canada during the Depression, we should note that the banking system did, however, contract:

“Although Canada’s branch banking system proved immune to runs and panics, the number of branches dropped from 4049 to 3640 between 1929 and 1933, loans and deposits fell, and bank-stock prices dropped. The interwar period showed a trend towards fewer and larger banks.” (Haubrich 1990: 224).

Even if no bank failed, nevertheless, it must have been the case that many bank branches were closed in the course of the depression.

(6) After WWI, a third of Canadian banks failed outright or were unloaded on other institutions, and it was government issued money and a continued infusion of these government legal tender notes that keep the banking system solvent (Naylor 2006: 527).

(7) another major factor was that Canada’s branch banking system had become highly concentrated by 1920. The number of banks declined from 30 in 1900 to 11 in 1920 as mergers and the acquisition of smaller banks by larger ones occurred (Bordo 1995: 10–11; Bothwell, Drummond, English 1987: 184; cf. Haubrich 1990: 225, who reports that in 1920 there were 18 banks and by 1929 this had fallen to 10).

(8) There is some evidence that successive Canadian governments from the 1920s made public statements and implicit promises to protect depositors in failed private banks, at least to some extent (Kryzanowski and Roberts 1993; with Carr, Mathewson and Quigley 1995 and Kryzanowski and Roberts 1999), as described here.

While Carr, Mathewson, Quigley (1995) dispute this and argue that there was no explicit or implicit promise of 100% deposit protection, nevertheless the evidence shows that governments did pay to reimburse or protect depositors: when in August 1923 the Home Bank of Canada failed, the Canadian government in June 1925 passed legislation which eventually resulted in the government paying 22.3% of average depositors’ claims (Carr, Mathewson, Quigley 1995: 1143). Even provincial governments provided stability: for example, in 1923 the government of Quebec provided $15 million via bond issues for the merger of the Bank Nationale with the Banque d’Hochelaga to avoid a bank failure (Kryzanowski and Roberts 1993: 365; Carr, Mathewson, Quigley 1995: 1149).

These interventions and possible implicit promises were further policies that contributed to the stability of the system.

(9) Canada finally had a formal central bank in 1935 (Dowd 1992: 91), which simply took over the discount window facility from the previous Department of Finance.

It is perfectly clear, then, that Canada after 1914 and during the Depressions years – but before its formal central bank of 1935 – had significant government interventions that provided banking stability.

What is especially ridiculous here is that these basic facts are freely admitted by free banking scholars like Dowd (1992: 89–92). Yet the libertarian myths continue.

Further Reading on Critiques of Free Banking
“Selgin, Lastrapes and White on ‘Has the Fed been a Failure?,’” February 29, 2012.

“Free Banking in Australia,” May 16, 2012.

“A Tale of Two Depressions: 1930s and 1890s Australia,” May 18, 2012.

“Why Did Canada Have no Mass Banking Failures in the Great Depression?,” September 12, 2012.

“Free Banking in Scotland,” April 12, 2013.

BIBLIOGRAPHY
Anonymous. 1900. “The Canadian Bank Amendment Act of 1900,” The Quarterly Journal of Economics 14.4: 543–551.

Bond, David E. and Ronald A. Shearer. 1972. The Economics of the Canadian Financial System: Theory, Policy and Institutions. Prentice-Hall, Scarborough, Ont.

Bordo, Michael D. 1995. “Regulation and Bank Stability: Canada and the United States, 1870–1980,” Policy Research Working Papers 1532, World Bank, Policy Research Dept., Finance and Private Sector Development Division, and Financial Sector Development Dept.

Bordo, Michael D. 2005. “The Lender of Last Resort: Alternative Views and Historical Experience,” in Forrest Capie and Geoffrey E. Wood (eds.), The Lender of Last Resort. Routledge, London. 279–296.

Bothwell, Robert, Drummond, Ian and John English. 1987. Canada, 1900–1945. University of Toronto Press, Toronto and Buffalo.

Carr, Jack, Mathewson, Frank, and Neil Quigley. 1995. “Stability in the Absence of Deposit Insurance: The Canadian Banking System, 1890-1966,” Journal of Money, Credit, and Banking 27.4 (Part 1): 1137–1158.

Darroch, James L. 1994. Canadian Banks and Global Competitiveness. McGill-Queen's University Press, Montreal.

Dowd, Kevin. 1992. The Experience of Free Banking. Routledge, London.

Haubrich, Joseph G. 1990. “Nonmonetary Effects of Financial Crises: Lessons from the Great Depression in Canada,” Journal of Monetary Economics 25: 223–252.

Kryzanowski, Lawrence and Gordon S. Roberts. 1993. “Canadian Banking Solvency, 1922–1940,” Journal of Money, Credit, and Banking 25: 361–376.

Kryzanowski, Lawrence and Gordon S. Roberts. 1999. “Perspectives on Canadian Bank Insolvency during the 1930s,” Journal of Money, Credit and Banking 31.1: 130–136.

Murphy, Robert. 2009. The Politically Incorrect Guide to the Great Depression and the New Deal. Regnery Publishing, Inc. Washington, DC.

Naylor, R. T. 2006. Canada in the European Age, 1453–1919 (2nd edn.). McGill-Queen’s University Press, Montreal.

Selgin, George. 1996. Bank Deregulation & Monetary Order. Routledge, London.

Shearer, Ronald A. and Carolyn Clark. 1984. “Canada and the Interwar Gold Standard, 1920–35: Monetary Policy without a Central Bank,” in Michael D. Bordo and Anna J. Schwartz (eds.), A Retrospective on the Classical Gold Standard, 1821–1931. University of Chicago Press, Chicago, Ill. and London. 277–310.