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

Another often mentioned concern with free banking is the possibility of extensive counterfeiting because of the multiple note issuers. The Scottish system had virtually no trouble with counterfeiting even though many of the notes were crudely printed and could have been replicated without extreme difficulty. One reason for this was the short holding time that bank notes experienced. Because one bank would not hold another's notes for very long, the issuing bank could detect counterfeit bills quickly. Keep in mind, however, that the banks had to pursue a policy that would limit counterfeiting and at the same time maintain confidence in its notes. The result was a policy in which unsuspecting note holders who redeemed their notes at the issuing bank would have the counterfeit notes paid in full. However, the banks would not pay on notes returned to them through the note exchange. This provided incentive for other banks to keep an eye out for all counterfeit notes. Furthermore, present-day Scotland successfully continues the tradition of Bank issued notes, with notes from the Bank of Scotland, the Royal Bank, and the Clydesdale Bank (est. 1838) making up the present currency.

As is expected, the Bank of Scotland could not be expect to put time and money into checking the notes it received belonging to The British Linen Bank unless it would incur a loss for accepting counterfeit ones. While it added to the cost and risk of each bank for accepting others' notes, it was well worth it because of the reciprocal agreements that had other banks looking out for their notes.

It bears mentioning that only bad counterfeiters are caught, so actual amounts cannot be known except that they were not enough to be noticed by the issuing banks. This is of course true in any paper currency issuing system.

Potential Problems with the Scottish System

While most evidence points toward a successful banking period, there are a few questions about the Scottish system that need to be addressed. As of yet, there has been no serious research addressing these problems so definitive answers cannot be made.

First off, there appears to be evidence of collusion or attempts at collusion between the big firms to keep out smaller firms. The Bank of Scotland and the Royal Bank signed agreements to pull their respective notes out of Glasgow in an attempt to drive their competition there out of business. While they were not successful, it cannot be shown that possibly other attempts like this limited competition in the system. More research need to be done to determine how much market-power the larger firms were able to obtain.

The note exchange system could have taken on the form of an instrument to limit competition. Instead of providing a method to ensure soundness, such a set-up could have been used to prevent entrants into the markets. Whether or not this happened is not known. Multiple note exchange systems operated at the same time, which would point towards the conclusion that it could not be successfully used to limit competition. However, they did eventually merge into one system, so the economies of scale of such clearing houses and the evidence from Scotland need to be looked at more closely.

Next, the fact that the limited liability firms operated as successfully as the unlimited liability firms in intriguing. Additional research needs to be done to determine what made the unlimited liability companies escape the problems or moral hazard and adverse selection that are commonly associated with limited liability. Maybe ownership characteristics had nothing to do with the functioning of the firms in the Scottish system.

Finally, it appears that the system created a sort of "too big to fail" policy that virtually had the effect of insuring deposits. It would be interesting to know if this increased moral hazard on the part of the firms, or if they were sufficiently regulated by other aspects of the system. Be Sure to Continue to Page 9 of "A Brief History and Analysis of Scottish Free Banking, 1716-1845".