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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


The consequences and aftermath of the Ayr failure are interesting. The note exchange system, which will be later discussed in depth, was at its simplest a system that allowed banks to quickly and orderly redeem each other's notes. This short turnover time meant that banks were kept in check and if they were over-issued it would become evident by their inability to meet the influx of notes with specie. Accordingly, it was the note exchange system that exposed the over-issue and also prevented the other issuing banks from failing along with the Ayr. As a result of the exchange, they were not holding large amounts of Ayr notes and due to the Ayr's mounting deficit at the exchange had fair warning of the over-issue. Realizing that such a large failure could have very negative implications for the banking industry as a whole, the Bank of Scotland and the Royal Bank decided to accept the worthless Ayr notes. This action bolstered confidence in the banking sector, attracted additional deposits, and increased their respective circulations.

Another vital part of the Ayr bankruptcy was the legal framework of the firms. Non-chartered banks' shareholders were exposed to unlimited liability until 1862 (well after free banking had ended). This helped to self-regulate the firms, but also limited creditors' risks in the event of a default. In the case of the Ayr Bank, its claims of creditors were paid in full. In fact, there was never a single case of a bank with more than 9 partners not being able to pay its liabilities in full. The estimated total loss to the public up to 1841 from all Scottish bank failures was only 32,000 pounds. The public had lost twice that amount in London in the previous year alone. (White, pg. 41) The formation of the Commercial Bank of Scotland in 1810 and the start of its extensive branching signaled the end of small private bankers in Scotland. Founded as the "bank of the citizens," (Anderson, 1910) the Commercial Bank allowed no private bankers to sit on its board and was founded on the joint stock of over 650 shareholders. This particular part of its constitution was not lost on the general population, and bolstered by their policy of heavy branching, the Bank quickly became a success. By 1819, they had 14 branches and by 1830 it had surpassed all competitors with 30 branches.

However, the Commercial Bank was not the only bank of the time rapidly expanding. During the 1830s, small and large banks added branches at a rapid pace and by the end of the decade the number of branch banking offices had exceeded 300. (White, pg. 33) Most importantly, this expansion increased the availability of banking services in Scotland. In 1845, there were 19 banks of issue and 363 branches open in Scotland. This resulted in 1 bank office for every 6,600 people in Scotland, as compared with 1 office for every 9,405 people and 16,000 people in England and the US, respectively. (Macfarlan, pg. 12)

However, the rapid expansion of branching by the large banks did not succeed in driving the provincial and local banks out of business. Thomas Kinner, director of the Bank of Scotland, noted that they had been unable to compete in some areas and had to close down branch offices. (White, 1984) While economies of scale were clearly at work in allowing the large banks to expand, they were not so great as to allow a natural monopoly to form. As noted by White (1984 p.36), there is no evidence from the Scottish experience that the production of convertible currency tends to result in a natural monopoly.

In short, the Scottish system of free banking had resulted in a successful banking industry that consisted of many competitive banks with well-distributed market share. Most of the banks throughout the experience had been well capitalized, and those that were not were quickly weeded out with little repercussions for the general public and depositors. Bank services were available to most of the public, counterfeiting was insignificant, and many important banking innovations still in use today resulted out of the competitive pressures to attract customers. Despite all these benefits, Peel's Act of 1844 and the Scottish Banking Act of 1845 effectively closed down Scottish free banking by ending free entry into the market and instituting additional regulations.

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