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

Lessons From Scottish Free Banking

During the past 300 years banking has proven itself to be indispensable but at the same time inherently fragile and prone to failure in the United States, Latin America, Europe, and the rest of the world. Even today, banks are at the center of most economic crises.

Economists refer to the two major complications with banking as moral hazard and adverse selection, and they work against both depositors and bankers. Banks have become very adept at handling moral hazard and adverse selection on the part of borrowers, but effective remedies to moral hazard on the part of the bank are still hard to come by. Because the vast majority of deposits are insured, present-day regulation in the United States has created a system where depositors have no incentive to help regulate banks, so government-appointed regulators are the only parties concerned with bank risk-taking. Unfortunately for the supporters of such a system, it appears that the regulators might not be equipped to keep up with the increasing complexity of bank behavior.

An analysis of Scottish free banking offers some solutions to that problem. Banks in Scotland attracted depositors on the basis of trust. Without first gaining the trust of the public, they could not hope to receive any deposits. Trust was gained through reputation and transparency. This element is missing from our current-day system. It is likely that without as much (or any) deposit insurance, consumers would demand more conservative investments and less off-balance-sheet transactions, which would expose their deposits to less risk. Present-day banks could have the same effect by increasing the number of uninsured debt holders to the bank. If banks were motivated to (or forced to) issue an increased amount of subordinated debt, the number of parties with incentive to monitor the bank would increase. This would mirror the large number or monitors each bank in Scotland had interested in its solvency. Furthermore, the cost of raising such capital (the interest rate) would be a good indicator of the bank's perceived risk.

Another method to solving the moral hazard and adverse selection problem is increasing the liability of bank owners. Most Scottish banks operated with unlimited liability. This had a serious muting effect on high-risk bank behaviors by the owners. They had ample reason to monitor the banks, which decreased moral hazard. Because their losses were not capped and bankers had to gain the trust of other banks as well as the general note-accepting public, adverse selection was diminished.

Additionally, competitive banking also offered a high degree of stability, efficiency, and reliability to Scotland's economy. Combined with a strong domestic legal system and sound property rights, competitive banking spurred huge growth in the economy and provided a damper against macroeconomic shocks to the economy. During the crash of 1825-26, which originated in England, seventy-three English banks suspended payment in one month. Even the Bank of England, a legally protected bank with a near monopoly on note-issue, came very close to shutting its doors and had to bail out 700- 800 country banks.

The crash reached Scotland in late 1825 and affected only four banks. One was made illiquid but retired solvent; the Commercial Bank of Scotland purchased another at no loss to its note holders. The third bank affected was insolvent, but all creditors were paid in full and the fourth bank stopped payment temporarily. Other macroeconomic crises can be characterized similarly: a small number of banks affected, with generally no loss to the public.

In sum, competitive banking in Scotland resulted in an effective system that appears to have been innovative, stable, reliable, and efficient. It protected individuals and spurred growth while creating solutions to the moral hazard and adverse selection problems. While there is a considerable amount of work remaining to collect vital data about the period, current research shows that the profit motive created a sound banking system in Scotland.

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