On the Success of Free Banking in Scotland (1716-1844)

Here’s some excerpts from Free Banking in Britain: Theory, Experience and Debate 1800-1845, Second Edition, by Lawrence H. White (1995).


“There were many competing banks; most of them were well capitalised by a large number of shareholders; no single bank was disproportionately large or dominant; all but a few of the banks were extensively branched. Each bank issued notes for £1 and above; most banks’ notes passed easily throughout the greater part of the country. All the banks of issue participated in an effective note-exchange system. All offered a narrow spread between their deposit and discount (loan) rates of interest.” (p. 32)

“Counterfaiting was not a significant problem in the Scottish experience. Counterfaiting was a problem for the Bank of England, however, especially during the period of the suspension of payments. The explanation is that the likelihood of undetected counterfeiting varies directly with the length of time a note circulates before returning to the issuing bank – where it passes under a teller’s discriminating gaze for deposit or payment. Coppieters (1955, pp. 64-65) points out that Scottish notes had a very brief average period of circulation, as other issuing banks would not hold them as till money, but would return them through the clearinghouse. The same could not be said for Bank of England notes.” (p. 36)

“By one account (Wenley, 1882, p. 142), all failed banks having more than nine partners were able to pay their liabilites to the public in full. The loss to the Scottish banking public from all failures to date was estimated in 1841 at only £32,000. Public losses in London during the previous year alone were estimated at twice that amount (Aytoun, 1844, p. 678).” (p. 37)

“The contrast between Scottish and English deposit practices – only the Scottish banks paid interest on deposits as small as £10 and paid interest on current accounts without charging a fee for withdrawals – may be attributed to the effectiveness of competition in the supply of bank notes in Scotland.” (p. 39)

“In the second half of the 18th century their ratios, averaged for each bank by decades, stood between 10 and 20 per cent in six out of ten cases reported, and over 20 per cent in one case. In the first half of the 19th century the ratios were substantially lower, ranging from 0.5 to 3.2 per cent. The drop may be attributed to lower costs of obtaining specie on short notice or to lower risk of substantial specie outflows.” (p. 40)

“In 1764 the government in London intervened, after receiving a memorial from the Glasgow banks and after hearing from a joint committee of the Bank of Scotland and the Royal Bank. Effective from 1765, notes bearing the option clause and notes of denomination smaller than one pound were prohibited in Scotland.” (p. 27)

“The crash of the Ayr Bank, spectacular as it was for its day, did not imperil the Scottish banking system as a whole. Other banks of issue were not dependent on the Ayr Bank’s survival for their own. They did not hold large quantities of its notes, thanks to the operation of the clearing-house. … The repercussions of the Ayr failure on the industry were short-lived (Checkland, 1975, p. 133). Private banking revived in the next few years, with new entrants in Edinburgh and in provincial towns.” (p. 29)

“Any potential erosion of general confidence in bank notes from the Ayr failure was halted by joint action of the Bank of Scotland and the Royal Bank. On the day before the Ayr Bank went into liquidation the two banks advertised that they would accept the notes of the defunct bank. The benefits of this action to the two banks are clear: it would bolster public confidence, attract depositors, and help put their own notes into wider circulation. The potential cost was surprisingly low because of one of the most remarkable features of Scottish free banking: the unlimited liability of a bank’s shareholders. Despite their magnitude, the Ayr Bank’s losses were borne entirely by its 241 shareholders. The claims of its creditors, including note-holders, were paid in full.” (p. 29)

“The system of compulsory unlimited liability for new entrants can be viewed as a potential barrier to entry, because it may have restricted new banking firms to a suboptimal sharing of bankruptcy risk between shareholders and debt-holders … It is possible, however, that the restriction was not binding. The unchartered Scottish banks chose to retain unlimited even after limited liability became available to them through the Companies Act of 1862.” (pp. 37-38)

“Scottish and English experiences may be contrasted for the crises of 1793, 1797, 1825-6 and 1837. [16] The weaknesses of the English country banks led to their frequent failure even in good times. … The slightest suspicion could touch off a run on the country banks. These smallish banks could not turn to one another for financial support in such a circumstance; neither did they appear an attractive investment opportunity to the Bank of England. The Scottish banks, by way of contrast, stood ready to lend one another liquid funds in the event of a short-term disturbance.” (pp. 40-41)

‘The fear of an invasion took place, and it led to the sudden failure of some country banks in the north of England. Other parts felt the influence of the alarm, those in Scotland, in a great measure, excepted, where, through long use, the confidence of the people, even in paper money of a guinea value, is so great (a circumstance to which the peculiar respectability of the Scotch banks has contributed), that the distress for gold was little felt in that part of the island. A great demand on the Bank of England was thus created … on the account of people in the country.’ (pp. 41-42)

“Upon receiving news of the suspension, the managers of the four leading banks in Edinburgh at this time — the Bank of Scotland, the Royal Bank, the British Linen Company, and Forbes, Hunter & Co. — met and decided to follow the Bank of England’s example. Had they made specie available while the Bank of England refused, they feared English demand would rapidly have drained them of their reserves.” (p. 42)

“The one general suspension of specie payments experienced by the system, that of 1797-1821, followed the government-sanctioned suspension of the Bank of England rather than a local over-issue. The Scottish banks continued to redeem teir notes in Bank of England notes, restraining themselves from unlimited issues.” (p. 141)

“It is not immediately clear why the Scottish banks (and likewise the English country banks) did not remain tied to specie and let their currency float against the Bank of England note. One explanation is that, London being Britain’s financial centre, suspensions by the London banks made the Scottish banks unable to get extra gold from their correspondent banks or from sale of securities in the London market. In other words, their secondary reserves were immobilised, making it infeasible to continue gold redeemability (unless the banks were prepared to incur the costs of purchasing and importing additional gold). A second explanation is that Scottish bank customers preferred a note convertible into what had become London’s basic cash due to the importance of trade with London” (p. 42)

“To say that one bank ‘pyramids credit’ on top of another is to say that the first holds fractional reserves in the form of the second’s liabilities. … Checkland says that certain other banks held ‘part’ of their reserves in the form of public bank notes – not ‘much’, as Sechrest would have it.” (p. 55)

“Munn notes that ‘the most liquid of the assets of the banking companies took three forms – namely balances with correspondents in London and Edinburgh, the notes of other banks, and specie’.” (p. 55)

‘The mixed notes which often figure in the balance sheets were the notes of other banks and banking companies which had been taken in the course of business. These were unimportant as a reserve asset because they were exchanged at least once per week after the formation of the note exchange in 1771. The amount which appeared in the balance sheet would largely depend on whether the exchange took place before or after the balance was struck. Nevertheless, in times of pressure the amount of mixed notes taken between exchanges might prove to be a useful temporary relief from a liquidity crisis.’ (p. 55)

‘It had become necessary to provide a secondary reserve, after specie, against a sustained run. The Scottish banks had discovered by the 1760s, if not earlier, that in times of trouble they needed assets that were readily realisable in London. They had tried various devices : seeking credits with the Bank of England, or in Holland. But they learned from the late 1770s that nothing served so well as a hold of good securities, of a kind that could be realised in London without serious loss. These were of three kinds : government obligations (including Exchequer Bills), Bank of England stock and East India Company stock. If these were sold, creating a credit with London correspondent, then a bill could be drawn upon London, which could be tendered to note holders and depositors as very nearly the equivalent of specie.’ (pp. 56-57)

“The Scottish banks held ‘secondary reserves’ in the form of ‘good securities, of a kind that could be realised in London without serious loss’ (Checkland, 1975, p. 194). The ability to sell these assets quickly and at low cost for claims on London banks, which the Scottish banks could in many cases use as a redemption medium, permitted the Scottish banks to meet their liquidity needs with less specie in the vault. As Goodhart (1988, p. 51) notes, it is ‘clear that Scottish banks felt able to economise in some part on individual [specie] reserve holdings by being able to draw on London when necessary’.” (pp. 59-60)

“In the case of the Ayr Bank in 1772, which Sechrest (1988, p. 252) curiously cites as an example of last-resort lending, the Bank of England set such stiff terms that the Ayr Bank declined its ‘support’ (Checkland, 1975, p. 131).” (p. 58)

“Cowen and Kroszner, along with Sechrest, give as an example of last-resort lending a long-term credit the Royal Bank negotiated with the Bank of England in 1830. But Checkland (1975, p. 444) adds that ‘in October 1836… the Bank, as part of a general credit contraction, required the Royal Bank of Scotland to pay off its advance’. This withdrawal of credit in a time of stringency was not only much to the consternation of the Royal Bank’s general manager, but contrary to the behaviour of a lender of last resort.” (p. 58)

“Sechrest (1988, p. 252) cites a third supposed example of last-resort lending: ‘In the crisis of 1793, a total of £404,000 was granted to several Scottish banks’. Cowen and Kroszner (1989, pp. 227-28) cite the same episode. Closer reading of the sources both cite (Checkland, 1975, pp. 219-20; Andreades, 1924, p. 188), however, shows that the loans in question were granted not by the Bank of England, but by the government, and were granted not to the banks, but to Scottish business firms.” (p. 58)

“Because the Bank of England did not assure its willingness to lend, or even act consistently with such an assurance, it was not a lender of last resort (in the standard sense) to the Scottish system before 1844.” (p. 59)


Related articles :

My guess is that the shortage of small denomination coins was the most important factor, and that it was the result of a familiar process: wartime inflation that raises the value of coins as foreign exchange or as a raw material above their nominal (face) value as coins. The Seven Years’ War (1754-1763) produced a net drain of specie from Britain. It was a world war and Britain was forced to send funds abroad to support British military actions, and actions undertaken by its foreign allies (Kerr 1902, 88; Graham 1911, 86; Munro 1928, 121). Scotland, moreover, seems to have suffered a balance of payments crisis with England and the rest of the world in 1762 (Hamilton 1953).

(1) The Bank had advanced loans for long-term capital investments, violating the key principle of the “real bills doctrine,” described below. (2) Instead of raising the full amount of its capital on the open market, the bank had lent money to its shareholders, so it was more leveraged than its books would suggest. (3) The Bank had made unwise acquisitions of other banking firms. (4) The bank had tried to force its notes into circulation, only to find them returning and depleting its reserves. And finally (5) the Bank had tried to replenish its reserves by drawing on London, and then redrawing when its drafts came due, thus piling up a large short-term debt in London. The Bank had expanded at a remarkable pace, but it was headed for a fall.

The failure of the Ayr Bank was the spark that ignited the Crisis of 1772. Alexander Fordyce, a London speculator, was the key figure. Fordyce had financed a large short position in English East India stock with loans from his bank, Neale, James, Fordyce, and Downe, which in turn was heavily indebted to the Ayr Bank. Early in 1772 the Bank of England tried to limit over-trading by selective limiting credit. … However, when the price of East India shares failed to fall as he had expected, Fordyce went bankrupt and fled to France on June 9, 1772. This event set off a financial panic in London; a number of firms would close by the end of the month. On June 12 a horseman reached Edinburgh with news of Fordyce’s bankruptcy and the alarm in London. A run on the Ayr Bank began, and on June 22 it was forced to stop payment on its notes. A genuine banking panic in Edinburgh ensued. Fifteen private bankers in Edinburgh went bankrupt during the Crisis (Saville 1996, 162).

Even after the resumption of payments in 1821 little coin had circulated; and to a large degree there was a tradition, almost with the force of law, that banks should not be required to redeem their notes in coin. Redemption in London drafts was the usual form of paying noteholders.

… the Scottish system was de facto a central bank system in which individual private banks pyramided their note issues upon the reserves of the three chartered banks, which, in turn, pyramided their issues upon the reserves of the ultimate source of liquidity for the entire British Isles: the Bank of England.

Checkland, who clearly thinks no such autonomy existed, asserts that:

“most important of all, it would be necessary for Scottish banking to hold its own gold reserve … conversely, Scottish banking, by placing itself outside the London system, would relieve the Bank of England of the need to hold bullion reserves against Scottish demands for liquidity … [yet] a willing Scottish dependence upon London had been apparent from the founding of the Bank of Scotland in 1695 … The Scots in expelling their gold by the vigour of their note issue, basing their banking system on the latter, had made themselves ultimately dependent upon London liquidity.”

Shortages of specie and coins in the early 1760s led to a “small note mania”; a large number of smaller banks began issuing small-denomination notes with option clauses. Until then, “most, and perhaps all, of the Scottish banks included no option clause on their smallest notes” (Gherity 1995, p. 717).

The court pointed out that the charter of the Bank of Scotland specified summary diligence on its notes but that requirement did not automatically extend to other banks. In Scotland, according to the court, all banks but the Bank of Scotland could legally suspend convertibility without an option clause.

When a large number of banks adopted and used it, the bank’s customers demanded that it be abolished. Surprisingly, the Scottish banks, the alleged beneficiaries of the option clause, joined the public in demanding recision of the clause. Gherity (1995, p.722) states :

By early 1763, the chartered banks had indicated to the government their willingness to give up the option clause in exchange for the exclusive right to issue bank notes in Scotland…

The regulation imposed by the Act was regarded with dissatisfaction for many years afterwards. In 1864 complaints were coming from Scottish quarters that owing to bank extinctions Scottish note issues had diminished and Bank of England notes were not fitted to fill the gaps because they were not issued below the denomination of £5. And for the comfort of the opponents of Peel’s legislation the next thirty years witnessed two of the worst failures the Scottish banking system had ever experienced, comparable only with that of the Ayr Bank a century before. These were the collapse of the Western Bank in 1857 and of the Glasgow Bank in 1878.

The commercial and political crisis of 1793 caused by the French Revolution saw not only the failure of the Arms Bank, but the Glasgow Merchant Bank was also so weakened that it gave up business a few years later. The other Glasgow banks grew at quite a pace and when problems arose, as they did in 1797, the banks were sufficiently mature to provide support to one another and to defend what was fast emerging as a banking system.

The failure of the Ayr-based bank Douglas Heron & Co in 1772 was a major crisis for the Glasgow banks. They managed to weather the storm, but only after swallowing their pride and seeking assistance from the Edinburgh banks. The Royal Bank’s attempts to capture a slice of Glasgow’s banking business were, for the time being, unsuccessful.

“Most Scottish bank failures (including even the Ayr Bank failure) involved zero losses for customers because shareholders had unlimited liability, and the number of shareholders (or partners) was not restricted.” (p. 813)

“… the Scottish notes were still redeemable on demand. The usual redemption medium was drafts on London, rather than specie. … Notes and deposits were still debt claims redeemable for a reserve money, banks still faced adverse clearings, and marginal liquidity costs associated with holding reserves still constrained overissues.” (p. 815)

At the same time Smith (1981, p. 324) denied, and provided direct evidence against, the hypothesis that Scotland had suffered price inflation on account of an overissue of banknotes: “The proportion between the price of provisions in Scotland and that in England, is the same now as before the great multiplication of banking companies in Scotland. (p. 816)

“And the apparent absence of any major discrepancy between the value of the Scottish pound note and gold for most if not all the free banking period would seem to confirm the convertibility of the Scottish currency.” (p. 823)

Effective from 1765, notes bearing the option clause and notes of denomination smaller than one pound were prohibited in Scotland. All notes were to be either explicitly redeemable in gold on demand, or explicitly post-dated. The right of note issue remained universal, despite the chartered banks’ rent-seeking attempt to have the right legally restricted to themselves (Checkland 1975:120–1). The Act of 1765 left Scotland with free banking in most respects, though it raised an entry barrier against very small-scale banks of issue. (p. 164)



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