Banking Crises - Part 2.

Free banking, a view supported by Hayek among others, was for a long time seen as the progressive way forward in Western finance. By the early 2000’s it was popular amongst not only bankers but also politicians and academics. This can be illustrated in a quote from Gordon Brown in a speech he delivered to the CBI (Confederation of British Industry) in 2005 where he described his view on regulation as “not just a light touch, but a limited touch”.

So we can only assume that free bankers would have been in full support of the laissez faire system that second life’s banks were operating in. However, as described in the previous post, the financial system turned out to be anything other than stable. Following the collapse of Ginko bank many of the games other banks took losses on investments, particularly in real estate, that they had made. Following the losses, the banks struggled to meet the high rates of interest they had promised and second life experienced another round of bank runs.

According to the free banking view this should have resulted in the transfer of deposits from weak banks to strong banks. While the system was struggling some banks, like SL Bank, were comfortably earning enough to pay depositors interest, and so should have received the transferred deposits. However, depositors couldn't distinguish the strong from the weak and all the banks suffered from the lack of confidence. There was a problem of contagion.

Second Life, famously free from rules was forced to accept very strict regulation on the banking industry. Linden Labs banned all institutions from offering interest on deposits unless they could produce a banking charter that is applicable in the real world. At this stage no banks have applied. Although it is always tempting to believe that the market will regulate itself there is little evidence that they do and in an industry like banking, it is not worth the risk to find out.

Linden Lab's announcement can be found here:
http://tinyurl.com/LindenLab