Legal Framework
The legal framework of Scottish banking was very simple. Initially, there were no legal restrictions or regulations relating to banking. By common law, all contracts were upheld, but the banking industry did not have a separate set of rules. Entry into the market was free and there were no reserve ratios, limits on shareholders, capital holding requirements, or a designated "legal tender." Eventually, two banking regulations were put into place by the Act of 1765. First, the issuance of notes for less than 1 pound was ended. This was a restriction that was supported by the larger banks that most likely saw it as a way to limit competition from smaller firms. In a public interest framework, it was billed as a way to keep firms from over-issuing with the smaller notes. Second, the option contract on notes that had been instituted first by the Bank of Scotland and later by the Royal Bank, among others, was made illegal. Notes would have to be payable immediately on demand.
Adam Smith
Adam Smith drew on the Scottish Banking system as an example of free banking in Wealth of Nations, stating, "if bankers are restrained from issuing any circulating bank notes, or notes payable to the bearer, for less than a certain sum; and if they are subjected to the obligation of an immediate and unconditional payment of such bank notes as soon as presented, their trade may, with safety to the public, be rendered in all other respects free." (Smith, pg. 268) In addition to the efficiency of using a paper currency over an actual coined commodity, Smith saw a number of additional benefits to free banking, all which appear in the Scottish system. While he is correct on those accounts, Smith mistakenly puts forth that restrictions were needed without real evidence to support the assertion.First, he argued that competition between currency providers forces them to be "circumspect in their conduct," (Ibid.) which would mean not over-issuing and protecting themselves against runs. This was evident in the actions of the Scottish issuing banks. By the operation of the exchange system, they had to deal with short redemption times on notes. They also were inclined to keep an eye on the solvency and liquidity of the banks that they dealt with in order to protect themselves. If a bank appeared overextended, the others could threaten to refuse its notes until proper reserves were restored.
Second, Smith believed that the result of having the note issue divided up between more than one issuer would dampen the impact of any one firm going under. For instance, when the Ayr Bank became insolvent, the industry was affected but not significantly hampered (as previously mentioned, the system absorbed the shock without passing along the losses to the public.
Third, he makes the claim that competition would force the bankers to "be more liberal in their dealings" (Ibid) with customers, resulting in innovation and better service to the public. The Scottish banks offered services to customers that had never been used in banking before and competitive interest rates on deposits and loans.
Smith does not offer a very compelling argument to support putting restrictions on banks. He seems to have not grasped the benefit of the options clause in further solidifying bank balance sheets (as will be discussed below) and ignores the fact that notes containing the option clause maintained full acceptance with the public, even when they were offered a choice. Regarding the restriction he supported on minimum note value, he also ignores the fact that while theoretically it could pose a problem, there is no evidence there being such a problem in the banking system. Be Sure to Continue to Page 5 of "A Brief History and Analysis of Scottish Free Banking, 1716-1845".
