Free vs Regulated Banking: British Parliament and the Bank of England (Part 2 of 3)

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6 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff continues with a brief history of repeated crises and failures in 19th century England’s regulated banking system—in stark contrast to the resilience and stability of Scotland’s unregulated one.

Parliament repeatedly debates Bank of England reform
during the 19th century

III. 1825-1873: ENGLAND UNEVENLY ADDRESSES ITS BANKING PROBLEMS

After Napoleon’s 1815 defeat at Waterloo Britain and France finally cemented a lasting peace after 127 years of on-again, off-again war. As the century-long era of Pax Britannica began, Parliament’s focus on the Bank of England’s mission shifted from that of longtime war financier to steward of economic development.

After another crushing banking panic and depression in 1825 (which Scotland again avoided), Parliament fiercely debated reforms to impose upon the Bank in exchange for its charter renewal.

Lord Liverpool, conservative Prime Minister and proponent of reform, argued the right of joint-stock banking should be extended to all private banks. 

According to Professor Andreades’ classic 1909 history, Liverpool “criticised severely… …the Act of 1709, which limited the number of partners in a bank of issue to six, so that any small provincial tradesman, a fruiterer, a grocer or a butcher, might open a bank whilst the right of issue was refused to genuine companies, well deserving of confidence.”

In the House of Commons conservative MP and future Prime Minister Sir Robert Peel urged his fellow ministers to learn from the deregulated free Scottish banking system which had suffered not a single crisis since its first private bank—the Bank of Scotland—received its charter in 1695. 

Here Andreades records that Peel “contrasted the monopoly which existed in England with the free Scotch system. He pointed out that in England 100 banks had failed in 1793, 157 between 1810 and 1817, and 76 during the recent crisis… …whilst in Scotland, on the contrary, there was only a single bank failure on record, and even in that case the creditors had ultimately been paid in full.” 

Furthermore Peel lamented that “the Bank of England’s monopoly lay like a dead hand on the organization of credit in this country, and demonstrated the superiority of the Scottish system.”

Parliament relaxed the Six Partner Rule in 1826, ending 118 years of crippling legal restrictions and finally permitting joint-stock banking across all of England except within the critical 65 mile radius around London. By 1833 joint-stock banking was finally permitted everywhere and the central bank’s longstanding monopoly on London banknotes was ended. 

But the Bank of England warned it would not do business with any bank that attempted to issue notes within London. As the small country banks would require several years to grow and eventually compete with the Bank of England head-on, the central bank’s threat alone kept the circulation of its own notes paramount for a while longer, particularly in the capital and financial center.

And in a foreshadowing of eventual abandonment of the liberalization trend, the 1833 charter renewal bestowed Bank of England notes legal tender status for redemption of private/country banknotes. Having long been treated as a de facto reserve asset by private banks, the central bank’s notes were now a de jure monetary reserve and became a form of high-powered money. 

Nevertheless progress slowly began. Freed from 125 years of Six Partner Rule constraints, well-managed small banks undertook expansion, several of them eventually into successful conglomerates. 

Taylors and Lloyds, a small Birmingham bank founded in 1765, eventually grew into Lloyds Bank, a modern household name. 

In 1736 a small non-issuance London bank took on a Quaker businessman named James Barclay as partner and renamed itself “Freame, Gould and Barclay.” Once permitted to add more than six capital partners the bank grew over time to become British multinational Barclays plc.

Unfortunately the 1833 reforms didn’t come in time to prevent another major panic just four years later, brought on by the statutory treatment of Bank of England notes as a reserve and such incompetent central bank negligence that Scottish economist Henry Dunning Macleod lamented “Of all the acts of mismanagement in the whole history of the Bank, this is probably the most astonishing.”

To address the causes of the Crisis of 1837 Parliament should have encouraged and waited for the small country banks to expand into a system of large, nationally branched note issuing institutions whose scale would diminish the Bank of England’s outsized influence. 

Instead the British government took a major step backwards and enacted the ill-advised Peel Act of 1844.

IV. PEEL’S ACT

It was thought that the continued panics were caused by overissuance of notes by both the Bank of England and private country banks. But the applied remedy was to prohibit private banknote issuance altogether and grant a complete monopoly to the Bank of England. Furthermore, the central bank’s note issuances would be limited to the balance of its government debt holdings and no more than 100% of the Bank’s gold reserves.

Prime Minister Robert Peel had himself forgotten the experience of the Scottish system he had championed in 1826. For free and universal note issuance had been allowed in Scotland for 128 years and in all that time never once destabilized the money trade. 

Unlike in England, Scotland was ruled by unfettered market forces, free from government-backed monopolies and Six Partner Rules, and it was market competition that prevented Scottish banks from overissuing. The constant threat of redemption calls, often from competing banks, and an efficient private clearinghouse system kept them all in line.

Moreover Peel and Parliament were persuaded by the Bank of England governor and deputy governor that the tight regulatory straitjacket foisted upon both central and private banknote issuance would solve the problem. The directors favored a statutory reassertion of their bank’s dominance and according to economist Lawrence H. White “had been searching for a simple non-discretionary rule that would govern their circulation in such a way as to insulate the bank from public criticism of its monopoly.”

Hence the general trend of steady liberalization that had prevailed from 1826 to 1844 was reversed with a dose of heavy-handed government control over national finance.

With the Act’s passage Parliament adopted a de facto national credit policy dictated entirely by the Bank of England. Whereas before national credit had been incidentally influenced by the central bank, now it would be completely regulated by it.

With private banks no longer able to issue banknotes and forced to accept Bank of England paper as reserves, the entire banking system began to expand and contract credit in perfect concert with the central bank. As Bank of England note circulation increased so did private bank lending and interest rates fell. When Bank of England note circulation contracted, private credit dried up, interest rates rose, and panic and depression ensued.

This arrangement, a pyramiding where private banks amplify the credit movements of the monopoly central bank, is much like that of today’s relationship between U.S. commercial banks and the Federal Reserve System.

Most perversely of all, whenever depositors became nervous and increased their cash holdings, private banks were forced to crawl begging on knee to the Bank of England for more of its exclusive notes. But the Peel Act forbade the central bank from accommodating since it was prohibited from issuing beyond 100% of its gold reserves. 

Unable to obtain paper money to meet customer demands, and restricted from issuing their own, many perfectly solvent English banks failed needlessly due to short-term illiquidity.

Thus even with the Six Partner Rule repealed, Peel’s Act restrictions and a renewed consolidation of the Bank of England’s note monopoly continued to ferment crises in 1847, 1857, 1866, 1878, and 1890, bringing the number of crises since the Bank’s founding to at least seventeen (post-Peels’ Act plus crises in 1696, 1715, 1721, 1745, 1772, 1783, 1793, 1797, 1810, 1815, 1825, and 1837).

So bad a problem had the Peel Act created that on four occasions Parliament was forced to suspend its own law—the 100% gold reserve note restriction—starting with the Crisis of 1847 and lastly at the onset of World War I. 

With each suspension the Bank of England was briefly permitted to purchase assets or loan cash beyond the value of its gold holdings, and the Bank’s directors slowly adopted the institutional role of lender of last resort—albeit by happenstance—a subject we will cover in the last installment on England.