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A Brief History and Analysis of Scottish Free Banking, 1716-1845

A Brief History and Analysis of Scottish Free Banking, 1716-1845

By

Michael Crook's Entry For The 2004 Moffatt Prize in Economics

Introduction

    …we only have to look to Scotland to see what has been the effect of a long career of perfect freedom and competition upon the character and credit of the banking establishments of that country. - James Wilson, Capital, Currency and Banking, p.30
Between 1716 and 1845 the country of Scotland experienced a period of banking that was unlike any other ever seen. Banks were virtually unregulated, constrained only by the rule of law at the time. Each bank, and the system as a whole, created solutions to the general banking hazards that we still attempt to resolve through regulation today. Banks also engaged in practices that were complementary with stability and efficiency in the market. Furthermore, banks were profitable, not shown to categorically take on excess risk and loss to the public during failures was greatly minimized.

During its time of free banking Scotland's economy grew much quicker than England's, which had a more regulated and failure-prone system. Even though England was in the midst of its first industrial revolution during this period, Scotland's approximate per capita income went from half of England's in 1750 to being virtually equal to it in 1845. Supported by a banking system marked by innovation, reliability, and stability, Scotland transformed from a poor agricultural and household economy to an advanced industrial economy specializing in iron production, shipbuilding, and engineering. (Cameron, 1967)

This paper attempts to offer a condensed history of Scottish free banking followed by an analysis of its framework, innovations, and possible implications for modern banking.

History

In 1695, the Bank of Scotland was chartered for 21 years by an act of the Scottish Parliament. This period was a unique situation for Scotland. The island had been unified under English rule for nearly 100 years, but the respective parliaments were not scheduled to join until 1707. Under the charter, the Bank of Scotland, which was not a government-controlled bank and was actually prohibited from lending to the government, was given a monopoly on note issue and commercial banking.

The charter was not renewed upon its expiration in 1716 under the assumption that there would be no new entrants desiring to get into the market and thereby no reason to legally protect the monopoly status. However, in September 1727, the Royal Bank of Scotland opened its doors in Edinburgh, which was also the location of the Bank of Scotland. After issuing their first notes in December 1727, a battle between the two banks promptly ensued, where each "used each others notes as missiles," according to Munro, the Royal Bank's historian (p.55). By exchanging their new notes for Bank of Scotland notes and then presenting them in large quantities for redemption, the Royal Bank was able to create a run on the Bank of Scotland. Bolstered by the support of merchants that believed the Bank of Scotland had been too stingy in its extension of credit and the support of an English Government that was afraid the Bank had Jakobite leanings, the Royal Bank was in a good position to obtain its rival's notes. The Bank of Scotland responded in kind, but the Royal bank was able to make the Old Bank, as the Bank of Scotland was referred to at this time, close its doors about three months after the start of the note battle, on March 27th. It was illiquid, but remained solvent.

Once the Old Bank had closed its doors, the Royal Bank's directors "resolved to give relief to the possessors of Old Bank Notes under certain conditions." (Munro, 1928) While their competitive instincts had made the Old Bank illiquid, the directors of the Royal Bank knew that they needed to maintain public trust in the newly formed banking system. This action would also allow them to further increase their note issues and gain market share until the Bank of Scotland reopened. Between March 27th and May 20th, 1728, the Bank maintained a policy of accepting large-value Old Banks notes in return for Royal notes or a bank credit and redeeming small-value Old Bank notes for specie. After May 20th, the Royal Bank announced that no more small Old Bank notes would be accepted by the Royal Bank. The net result of their policy is that Old Bank notes continued to circulate throughout Scotland even though the bank's doors were closed. There was no run on the Royal Bank.

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