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Free Banking and Information Asymmetry

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  • Chu, Kam Hon

Abstract

A traditional argument against free banking is that it will collapse because of information externalities: it is impossible for depositors to tell whether a high deposit rate offered by a bank is due to its high efficiency or risky lending strategy. This paper shows that in a separating equilibrium a higher-quality bank offers a lower deposit rate and holds a smaller proportion of risky loans than a lower-quality bank to signal its underlying quality. Hence, free banking is not inherently unstable. The empirical results for the Hong Kong banking system during 1964-65 are consistent with the hypothesis of a separating equilibrium.

Suggested Citation

  • Chu, Kam Hon, 1999. "Free Banking and Information Asymmetry," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 31(4), pages 748-762, November.
    • Handle: RePEc:mcb:jmoncb:v:31:y:1999:i:4:p:748-62
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    Cited by:

    1. Ignacio Briones & Hugh Rockoff, 2005. "Do Economists Reach a Conclusion on Free-Banking Episodes?," Econ Journal Watch, Econ Journal Watch, vol. 2(2), pages 279-324, August.
    2. Eriko Naiki & Yuta Ogane, 2020. "Bank soundness and bank lending to new firms during the global financial crisis," Review of Financial Economics, John Wiley & Sons, vol. 38(3), pages 513-541, July.

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