VoxEU Column Economic history Financial Regulation and Banking

Switzerland under free banking, 1851-1906

The Swiss franc was created in 1850, but the Swiss National Bank wasn’t founded until 1907. The interim was a period of free banking, marked by two successive phases: one of free, unregulated note issue; and then one of strictly limited banking freedom. This column studies the Swiss banking market over this time. The number of banks is found to play an important role in determining the long-run money demand, and in the monetary adjustment process. Further, problems with harmonisation and common regulation created the incentives for monopolisation and centralisation.

The financial crisis that started in 2007-2008 is seen by many observers as the implosion of an overblown financial system, caused by a combination of weak financial regulation, ineffective supervision, and a long period of low policy-controlled interest rates. Given the subsequent regulation boom and the too-big-to-fail problems, it is of interest to study historical experiences of the behaviour of highly competitive and only weakly regulated banking systems.  

In a recent paper, we study monetary and banking dynamics in Switzerland before the foundation of Swiss National Bank in 1907 (Gerlach and Kugler 2015). At that time, banknotes were issued and deposits accepted by private banks, under a regime of free banking. Under this regime, an increase in the money supply may occur at the extensive margin through an increase in the number of banks, or at the intensive margin through an increase in the money supply by existing banks. These conditions raise the important issue of what factors determined the size of the banking sector and, in particular, whether it responded to interest rates.

Explicitly analysing the size of the banking sector is also important for interpreting income elasticity of money demand. Baltensperger and Kugler (2015) estimate an income elasticity of 1.62 before WWI. After the war, however, the income elasticity is not significantly different from one and exhibits an impressive stability over time. Since the growth of the banking system – which ended in the 1880s – occurred in a period of strong income growth, one obvious possibility is that high income elasticity results from the fact that the authors do not incorporate the growth of the banking system in their analysis. As a consequence, its importance for money demand is instead attributed to income growth.

The Swiss monetary system before the Swiss National Bank

In 1850, Switzerland created the Swiss franc as the national currency of the new federal state founded in 1848 with common coins. Switzerland stuck to a competitive solution for bank note issue until 1907, when the Swiss National Bank started operating. The authorisation of banks and their regulation remained with the cantons and differed widely until 1881, when banknote issue was heavily regulated by the new Federal Banknote Act. As far as the creation of money in the form of bank deposits is concerned, Switzerland, like virtually all other countries, has stayed with a competitive system until today.

After its introduction, the Swiss franc was quickly established as the national currency. Legally, Swiss banks were still allowed to issue notes denominated in foreign currencies as was often done before 1850. However, the dominance of the Swiss franc led to a termination of this practice.

The period from 1850 to 1881 thus can be characterised as a period of free, unregulated note issue, but now with a common currency. The cantons were liberal in permitting new banks and in regulating their business. As a consequence, a large number of note issuing banks competing with each other entered the market, some private and some public, the latter in the form of cantonal banks established by the cantons themselves. In 1880, there were no less than 36 note-issuing banks.

This system provided banknotes with stable purchasing power while (almost) avoiding financial turbulence and bank failures (Weber 1988, 1992).  The issue of banknotes involved considerable costs for production (printing), banknote clearing, personnel to provide bank counter service and – particularly important – for the metal reserves necessary for confidence and trust. The demand for banknotes was dependent on their acceptance at full value, which led to the formation of clearing networks including entire groups of banks. For all these reasons, banks’ note issue business remained small and of limited importance throughout most of this period. Complaints about the complicated nature and the inefficiency of the payments system remained frequent. Several authors (e.g. Jöhr 1915 and Ritzmann 1973) stressed this sense of dissatisfaction and the inefficiencies causing it.

The period from 1881 to 1905 was one of strictly limited banking freedom – the Federal Banknote Act of 1881 prescribed currency denominations for banknotes, and heavily regulated and harmonised note issue businesses, but still without a centralised government monopoly over note issuance. Banks were severely constrained with regard to their liquidity reserves, their equity capital, their banknote redemption, and their issuing policies. The regulatory standardisation and mutual acceptance of notes issued by different banks improved the efficiency of the monetary and payments system. However, it undermined competition as it introduced an externality that created incentives to over-issue banknotes, which led to a tendency towards monetary and currency weakness. This state of affairs would ultimately lead to full nationalisation of the issue of banknotes and the foundation of the Swiss National Bank.

In 1891 a revision of the constitution – the Federal Act on the Swiss National Bank – was accepted by voters, introducing the exclusive right of the Confederation to issue banknotes. However, conflicts about the legal form of the central bank and the location of its headquarters meant the act only came into effect 14 years later, in October 1905. The SNB started its operation in June 1907.

The development of the shares of coins, banknotes, and sight deposits in M1, over the period 1851-1906 depicted in Figure 1, shows that Switzerland was a ‘coin economy’ at the time of the introduction of the Swiss franc. Approximately 87% of M1 were coins in 1851 and the remaining 13% were shared equally by banknotes and sight deposits. In the following years we observe a trend decrease (increase) in the roles of coin (sight deposits) resulting in shares of 7% and 74% in 1906, respectively. By contrast, the share in banknotes experienced a strong increase in the 1870s, in the aftermath of the liquidity crisis triggered by the inconvertibility of the French franc during the Prussian-French war. It increased again after the switch to federal regulation of banknote issue (in 1881) and reached a peak of 30% in 1891. The incentives to over-issue for banks led to a weakness of the Swiss franc at the foreign exchange market and the associated loss of monetary metal and increasing costs of banknote issue led to a decline of the banknote share to 19% in 1906. 

Figure 1. The composition of M1 in Switzerland 1851-1910

Data source: Swiss economic and social history data base, M1 (Table Q3).

Money demand under free banking

In Gerlach and Kugler (2015) we study the demand for money and incorporate the number of banks as a demand factor. We consider the number of banks endogenous, and assume in the empirical analysis that it depends positively on economic activity, and the profitability of banking, as captured by the spread between the lending and deposit rates.

We draw two main conclusions.  First, the money stock M1, the number of banks, the mortgage rate, real income, the price level, and the saving rate are all connected by three co-integrating relations. Apart from nominal income (with unit elasticity) and the savings rate, the number of banks enters the equations for long-run money demand with an estimated elasticity of 0.81. Moreover, we note a strong positive long-run impact of real income (elasticity estimate is 0.79) and the interest rate spread (mortgage minus savings) on the number of banks. The change in the mortgage rate is indicated to be roughly 1.65 times that of the savings rate in the long run.  

Second, the estimates show that an excess money stock (deviation from long run money demand) is corrected by a decline in the mortgage rate, real income, and in interest rates. A positive deviation of the number of banks from long-run equilibrium corrects itself gradually by a decrease in the money stock and leads to a fall in interest rates and an increase in real income. Finally, a too-high mortgage rate corrects itself quickly and leads to a temporary increase in real income and a temporary fall in the price level. Moreover, structural break tests indicate that monetary dynamics were not strongly affected by the Federal Banking Law of 1881.

Figure 2 provides an illustration of the determination of the number of banks according to the respective co-integrating relation. We plotted the number of banks and real GDP (index 1951=100) as well the interest rate spread. We see that strong GDP growth and a relatively large spread since the late 1850s supported the increase in the number of banks until around 1880. Then we note a strong decrease in the interest rate spread associated with a general fall in the level of interest rates which led to a levelling off of the number of banks despite continued strong trend GDP growth.

Figure 2.  Number of banks and long run determinants, 1851-1906

Data sources: Swiss economic and social history data base: M1 (Table Q3), GDP (Table Q16a, b), number of banks (Q8) and consumption deflator (H17). SNB historical series: saving deposit and mortgage interest rates, Table 2.4.3.

In sum, our empirical analysis of the Swiss experience with free banking in the 19th century points to the important role of the number of banks as a determinant of the long-run money demand as well as in the monetary adjustment process under free banking in a developing economy. Moreover, we see that harmonisation and common regulation of banking business may led to incentive problems which then in turn favour monopolisation and centralisation of the banking business.


Baltensperger, E and P Kugler (2015) “Swiss monetary history since the early 19th century”, manuscript, forthcoming.

Gerlach, S and P Kugler (2015) “Money demand under free banking: Switzerland 1851-1906”, CEPR, DP11029.

Jöhr, A (1915) Die Schweizerischen notenbanken, 1826 - 1913, Zürich.

Ritzmann, F (1973) Die Schweizer banken: Geschichte, theorie, statistik, Bern.

Weber, E J (1992) “Free banking in Switzerland after the Liberal Revolution in the 19th Century”, in K Dowd (ed), The experience of free banking, London.

Weber, E J (1988) “Currency competition in Switzerland, 1826-1850”, Kyklos, 41.

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