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“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.” Read more.

“Free Banking and Information Asymmetry”
Kam Hon Chu
Journal of Money, Credit and Banking, Vol. 31, No. 4 (Nov., 1999), pp. 748-762

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