Free banking is an establishment where note-issuing banks are allowed to set up in the same way as any other type of business. It is a system in which unregulated banks can issue currency and transferable deposits redeemable in common base money. It is a monetary arrangement where banks are free to issue their own paper currency (banknotes) while also subject to no special regulations beyond those applicable to most enterprises. The total supply of banknotes and deposits is determined by free-market sources. A free bank adds to its gross income by enlarging its holdings of interest-earning assets. But it can only do this by either attracting more depositors and noteholders or by losing some of its reserves.
In free banking, banks are regarded as the same as other commercial enterprises. It refers to the competing issue of redeemable currency notes (and transferable deposits) by unrestricted commercial banks. No special rules or privileges are available to banks. In a free banking system, market forces control the supply of a total quantity of banknotes and deposits that can be supported by any given stock of cash reserves, where such reserves consist either of a scarce commodity (such as gold) or of an artificially limited stock of fiat money issued by a central bank. The market is left free to determine what commodity would be accepted as money. Historically, in England and Scotland, free banking resulted from laissez-faire economic theories that called for limited government intervention into markets. It is important to keep in mind that free banking is not the same as laissez-faire banking, in which there is no government interference of any kind. In free banking, banknotes are issued in the form of paper and metal tokens. Banks mutually accept each other’s notes.
Free banking simply means that no charter or permission is needed from a government body to start a bank, unlike the current chartered banking system in the U.S. In the strictest versions of free banking, however, there either is no role at all for a central bank, or the supply of central bank money is supposed to be permanently “frozen.” The free-banking laws specified that a state banking authority determined the general operating rules and minimum capital requirement, but no official approval was required to start a bank. There is, therefore, no agency capable of serving as a “lender of last resort” in the usually understood sense of the term. Nor is there any government insurance of banknotes or bank deposit accounts.