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

from Michael Crook

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

Self- Regulation- How and why it worked

The working of the major self-regulatory aspect of free banking (i.e. the note exchange system) has already been discussed. However, there were other aspects of the system that were developed by the banks and had the result of regulating the industry.

One major criticism of unregulated banking is that individuals, or more specifically depositors, will not have adequate disclosure and an asymmetric information problem will be present. This would lead to an inability to assess quality (good banks/bad banks) and proper risk/return. The result is an adverse selection problem that could lead to a lemons problem and drive out the market. Additionally, the depositors have to deal with moral hazard on the part of the banks.

Scottish free banking seemed to resolve, or at least minimize, all of these problems. The note exchange system ensured that reserve ratios were kept at a level to maintain liquidity. Virtually all banks, along with the depositors had some stake in monitoring the other banks. While some firms went bankrupt, there was only a very small loss to the public over the life of the industry. The unlimited liability legal formation of the banks took the moral hazard problem out of the picture. Bank shareholders had a very strong incentive to ensure a bank's solvency and long-term profitability. An example of this is when the Royal Bank decided in 1823 to stop its newly accepted policy of using life insurance as collateral on loans. They felt that while the issuing companies were respectable, the exclusionary terms on life insurance contracts at the time were too broad and therefore made the loans potentially too risky.

In the early 1800s, quite a few small banking companies were founded with very small reserves but large note issues. The established banks refused to accept the notes of these banks after determining that they carried too high of a risk. While accepting the notes of these banks could have been profitable, the respective banks' directors believed them to be too risky to even hold for a short period. Because the banks had been unable to gain the trust of the other note exchange banks and the public, they were quickly driven out of business. Once again, the industry had policed itself and removed its weak members before any significant public harm could be done.

When a bank happened to fail, the shareholders would receive a call "for some percentage of the nominal value of their shares." (White, pg. 41) For instance, when the Fife Bank failed in 1829, each £50 share was assessed at 1100%, or £5500. This is apparently the most extreme case from Scottish free banking, and according to White (1984), all liabilities were paid in full.

Illegal behavior was not nonexistent, but it too was handled with a minimum of loss to the public. The shape of the industry provided that there were many checks on the operation of individual banks as well as the industry on a whole. Consumers also saw protection on a variety of levels. In 1822, the manager of the East Lothian Bank, William Borthwick, stole about £30,000 of the Bank's notes. When he suspected that he might be caught, he actually managed to lock the Bank's directors in "well-ventilated empty wine-puncheons" (Munro, 165) and ship the directors from Dundee to Dantzig. While the Royal Bank's history does not specify whether or not the manager was caught, it does note that all of the creditors of the East Lothian Bank were paid in full.

Even though sometimes popular, it is incorrect to say that without regulation banks would not publish significant financial reports and information to the public. The Scottish banks took it upon themselves to provide the public and their depositors with adequate information regarding bank assets, holdings, and note issue. If the public demands them, a bank facing competition will be innovative and provide statements in order to attract customers. Others will follow, and the market will decide the exact amount of information demanded. Under free banking, customers are not forced to deposit into any one bank. If they do not like the level of disclosure that, for instance, Bank A offers, they can always use Bank B or keep their holdings in specie. Therefore, having a competitive marketplace will insure that the banks are innovative in meeting customers' requirements.

During its suspensions, the Bank of Scotland routinely published reports of its solvency status. Even though it was temporarily illiquid, the bank was still solvent and wanted to maintain public trust in its notes. This policy, along with paying interest for the period that the notes were irredeemable, prevented additional runs and allowed the Bank to continue operating.

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