Free vs Regulated Banking: Scotland’s Free Banking Era (Part 3 of 4)

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6 MIN READ - After being temporarily preoccupied with the Biden $1.9 trillion Covid stimulus package and $270,000-a-year government janitors in soon-to-be-bailed-out California, the Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff returns to the history of free market banking in Scotland with the series’ third and penultimate column.

Demonstrators protest the U.K. Treasury
2008 bailout of the Royal Bank of Scotland

Up until now we’ve discussed the origins of the Scottish free banking system, its propensity for financial innovation, contribution to economic development, and most of all its remarkable stability especially compared to England. 

Given Scottish free banking’s remarkable performance, readers might pose two logical questions:

1. Were there literally zero bank regulations all that time?

2. Did Scottish free banking end? If so how, and what became of the industry?

We’ll cover these questions in this week’s column.

V. WHAT SCOTTISH BANKING WAS AND WASN’T 

It’s important to note that no serious student of the free banking era claims it was 100% free of all and any government control, although it was the closest to a laissez-faire banking system the post-Renaissance world has witnessed. 

The Economics Correspondent has only found three interventions (excluding the 1797 Suspension—to be covered last) in the entire 129 year period.

First, as noted in a previous column, British Parliament in 1765 outlawed use of the “option clause” that banks wrote onto their notes to delay specie redemption for up to six months paying interest to noteholders for their inconvenience.

Second, as part of the same 1765 act, the private issuance of banknote denominations under one pound was outlawed throughout all of Great Britain, a regulation intended to protect the poor and prevent the tiniest ventures from entering the bank of issue market. It was also likely a rare act of cronyism for the benefit of established banks across all of England, Wales, Ireland, and Scotland.

Third and lastly, of the 50+ banks operating in Scotland by the end of its free banking era, three were granted limited liability protection via state charter. The remainder operated under full liability until British Parliament made incorporated limited liability the law of the land in 1855. 

However, by 1855 Scotland’s free banking era had already been overturned de jure for a decade so universal limited liability never existed during the unregulated era. 

None of these three, relatively small regulations can be viewed as indispensable safeguards that shielded the industry from some otherwise certain crisis. Nevertheless their existence inclines Scottish banking expert Professor Lawrence H. White to describe the system as “very lightly regulated” while the Correspondent considers even White’s characterization an understatement.

Also no reader of Scottish free banking would venture to argue that it was a panacea or completely free of failures.

Banks did fail in Scotland from time to time, virtually always badly managed ones.

But substandard bank failures are a salutary event. Present day critics of bank bailouts rightly object that bad banks should be allowed to fail and well managed banks to replace them. Champions of statist control in banking counter that large failures can’t be permitted else a major crisis will ensue.

Well imprudent banks were allowed to fail in Scotland, and the result was no systemic crisis ever took place while the system was made better off for shedding poorly managed institutions.

In fact there was one large Scottish joint-stock bank that failed spectacularly in 1772: the Douglas Heron & Company, better known as the Ayr Bank (pronounced “air” bank). 

The Ayr Bank was reckless and overextended with bad loans, yet it limped along surviving for a few years on just-in-time revolving credit from the Neal, James, Fordyce and Down Bank in London.

But when the Crisis of 1772 struck England the Neal, James, Fordyce and Down Bank failed. With its London lifeline cut off the Ayr Bank quickly collapsed, which is precisely what should have happened. Savings and capital were shifted away from a wasteful institution that was channeling funds to value-destroying enterprises and redirected to more productive investments. 

After all, the replacement of failing firms with efficient ones is a fundamental tenet of progress under capitalism, and it’s precisely how the market disposed of the Ayr Bank.

Today the Ayr Bank would be deemed “too big to fail” and rescued by government regulators. Yet even with its spectacular collapse, the Ayr Bank produced little fallout and no systemic crisis ensued.

The private clearinghouse system had largely prepaid the Ayr Bank’s obligations to the joint-stock banks thus limiting contagion to a handful of smaller nonissuing private houses. And the Ayr Bank’s depositing customers were all paid 240 pennies on the pound with any shortfalls covered by the personal assets of the bank’s owners.

Furthermore the Ayr Bank’s failure served as a warning to other large Scottish banks that mismanagement would not be rewarded by government rescue. Its collapse taught other bankers a valuable lesson in accountability, and it’s no coincidence that no large joint-stock bank failed again for the 83-year remainder of Scotland’s free banking era.

VI. THE END OF THE SCOTTISH EXPERIMENT

Eventually free banking ended in Scotland.

The English Peel Act of 1844 was extended to Scotland in 1845 and Scottish banks were placed under the veritable domination of the Bank of England.

No new banks of issue were allowed to open, private banknote circulation was limited to that of May 1, 1845 (£3 million, an insignificant amount today but raised steadily over time), and the Bank of England obtained a monopoly on all remaining banknote issues outside of the Bank of Scotland, Royal Bank of Scotland, and Clydesdale Bank's limit.

In 1914 all of Great Britain went off the domestic gold standard and the Bank of England stopped gold payment to foreign central banks in 1931. 

Ironically once Scottish banking was placed under the Bank of England’s note monopoly, Scottish banks not only lost their resilience to panics but in a dramatic reversal they themselves became instigators of British crises—notably when the Western Bank of Scotland and City Bank of Glasgow failed, setting off the Crises of 1857 and 1878 respectively. 

Once the Bank of England adopted Bagehot’s Rule British banking under the gold standard generally stabilized, but by the late 20th century the United Kingdom had transitioned to a total fiat standard and its banks were highly regulated. 

Deposit insurance, introduced by the British government in 1979, encouraged moral hazard with both bankers and customers who were no longer as concerned with their banks’ financial soundness. And political interest groups had begun affecting lending policies although not nearly to the same degree as in the United States.

As the Bank of England coordinated a real negative interest rate policy with the world’s central banks in the early 2000’s, they collectively inflated dangerous housing bubbles in at least 32 countries—including the U.K.—which burst in 2006-07. 

When the global financial crisis of 2008 struck, the Bank of Scotland and Royal Bank of Scotland were no longer the solid, financially sound exemplars of the 19th century free banking era. Both were large U.K. market mortgage players. Both had also expanded into overseas mortgage markets—the Bank of Scotland primarily in Ireland, Australia, and continental Europe, the Royal Bank in the U.S. subprime securitization market. 

Loaded to the hilt with bad loans and holding lousy British, Australian, European, and particularly American mortgages the two venerable firms posted huge losses and quickly became insolvent.

These storied institutions, two of the world’s oldest banks with proud heritages of soundness and innovation, were forced to seek massive rescue packages from the British government. In an AIG-like bailout, the British Treasury bought 43% and 80% stakes in the Bank of Scotland and Royal Bank of Scotland. 

Five years later the Treasury sold its Bank of Scotland stake for a tiny £65 million profit. However twelve years after rescuing the Royal Bank of Scotland the British Treasury still sits on losses in the tens of billions of pounds.

Yet there is no shortage of critics on both sides of the Atlantic who continue to blame the Scottish banks’ failures on “deregulation,” “free market dogma,” and “unfettered capitalism.”

The Bank of Scotland and Royal Bank of Scotland names live on, the former as a unit of the Lloyds Banking Group. 

The Royal Bank of Scotland's name is now more hated in the U.K. than AIG, Goldman Sachs, and Lehman Brothers combined in the USA. Thus in 2020 RBS Group holding company rebranded itself as NatWest Banking Group (the Scottish banking unit remains RBS) which, despite an English title, remains an Edinburgh-headquartered enterprise. 

However NatWest is effectively government owned, the lingering aftermath of its Treasury equity investment, and the British government has no plans to divest its share ownership to private hands until at least 2025.