2.1. Size and governance of the Scottish banks

The provincial Scottish banks were partnerships with unlimited liability. There were no restrictions, as in England, as to the numbers of partners. Moreover, as described below, these partnerships were, in effect, joint stock in that the shares could be relatively easily passed on/sold and so there was an effective mechanism to separate ownership from control (Acheson et al., Reference Acheson, Hickson and Turner2011; Turner, Reference Turner2014).

The restriction on banks of issue in England dated from 1708 and the recharter of the Bank of England. Feavearyear (Reference Feavearyear1963, p. 154/5) reproduces the relevant part of the Act:

Whether or not this left room for joint stock banks to exist so long as their liabilities were not ‘on demand’ is dismissed by Feaveryear; he argues the intention of the Act was clear, repeated in various Bank of England (Bank) charters and not seriously doubted at the time. Corroborating Feaveryear, Grossman (Reference Grossman2010) notes that the 1742 chartering act made crystal clear the Bank’s ‘privilege of exclusive banking’. That aside, note the application of this restriction to ‘that part of Great Britain called England’.

Data in chart from Collins (Reference Collins1988) based on underlying sources of Cameron (Reference Cameron1967), Collins’ own research and Nishimura (Reference Nishimura1971). Looking at the underlying data we note that there is some disagreement between Pressnell (Reference Pressnell1956) and Cameron (Reference Cameron1967), p. 33. Pressnell (Reference Pressnell1956) thinks there are more branches and fewer banks compared with Cameron.

In any case, from 1694 until 1826 the Bank of England was the only bank in England, note-issuing or not, with more than six partners.

The data in the charts above for Scotland draw on Cameron (Reference Cameron1967). The contrasting profiles of ‘joint-stock’ banking in Scotland and England and Wales are apparent. The number of banks in Scotland had peaked ahead of joint stock banking being permitted in England and Wales (following the 1825/1826 crisis). The peak in the number of banks in Scotland coincides with the peak in private banking in England (not shown) which declined secularly and had all but disappeared by the end of the eighteenth century. The rise of the branch network was quicker in Scotland. Nishimura (Reference Nishimura1971) argues that the rise of branch networks in England was later than many earlier scholars had suggested.Footnote ⁹ In any case, the branch network hits its inflexion point in the last 1880s on this data (which is from Collins (Reference Collins1988) but based on Cameron (Reference Cameron1967), Checkland (Reference Checkland1975a) and Nishimura (Reference Nishimura1971) and Pressnell (Reference Pressnell1956)). Also indicated in these charts, is an increasing concentration in the banking sectors across all of Great Britain. We return to that below.

That said, as documented by Pressnell (Reference Pressnell1956), it is interesting to note that most issuing banks in England had somewhat fewer partners than the permitted maximum of six. Pressnell (Reference Pressnell1956) reports that note-issuing banks in May 1822 totalled 552, of which 375 had three or fewer partners. He reports that 26 issuing banks had 6 partners. The average number of partners per bank was 3. Acheson et al. (Reference Acheson, Hickson and Turner2011) point outFootnote ¹⁰ the equivalent institution in Scotland had over 43 partners. Indeed, 11 Scottish banks had more than 50 partners and one bank had 424 (see the data reported in Munn, Reference Munn1981, p. 152ff).

Acheson et al. (Reference Acheson, Hickson and Turner2011) and Turner (Reference Turner2014) argue that Scottish partnership law allowed Scottish banks to be, in effect, joint-stock institutions with transferable shares—unlimited liability notwithstanding—an effective separation of ownership from control, and separate legal personality. They argue that this latter facet short-circuited a hold-up problem that bedevilled the English banks; and it was this hold-up problem, these authors suggest, that explains the small number of partners in the typical English bank, smaller typically than the legal permissible. In other words, the binding constraint on bank size in England was not the ‘obnoxious clause’, as Joplin (Reference Joplin1822) labelled it, that gave the Bank of England the monopoly of joint-stock banking and limited every other bank of issue to a maximum of six partners; it was the nature of English partnership law and the consequent inability to separate ownership from control.

Turner (Reference Turner2014) suggests that note-issuing banks, hobbled by hold-up problems and inefficient dissolution costs, and with a small number of partners were prone to a form of risk-shifting. That is, if partners’ wealth was diminished for whatever reason, then the partners faced incentives to undertake more risky projects; with less wealth on the line, attitudes towards risk softened. However, that still may not explain why expanding the number of partners was not also a way of effectively limiting the liability of all partners. There seem to have been some interesting trade-offs here and why they were resolved in favour of fewer partners in many instances is not entirely clear. In any event, if Turner (Reference Turner2014) is correct, then the limit placed on note-issuing banks may have been unnecessary as partnership law was the real binding constraint on the stability of the English banking system. And so one might ask: What effect did the limit of six really have if partnership law was the real binding constraint?Footnote ¹¹

In any event, as well as squashing any effective competition to the Bank of England, this paucity of partners was held by many at the time to account for the widespread fragility of banks in England compared with their Scots counterparts. And others would argue that private banks of issue had a propensity to overissue, or otherwise pursue disordered patterns of issue and retirement.Footnote ¹²

One well-known contemporary commentator who blamed the 1708 Charter for the fragility of English country banks put it thus:

Joplin (Reference Joplin1822) and others of his viewpoint made little headway in their arguments against what he called ‘that obnoxious clause’ cited above by Feavearyear (Reference Feavearyear1963). However, following the crisis of 1825/1826, Scottish banks appeared to do much better and certainly did not experience the widespread failures seen in England (where about 10 per cent of all banks failed). That crisis led to fundamental reform.

The upshot was the 1826 Banking Co-Partnerships Act (‘An Act for the Better Regulation of Co-Partnerships of Certain Bankers in England’). This was a major piece of legislation that lead eventually to growth in both the number and size of banks. As Grossman (Reference Grossman2010) notes, this was the beginning of the end of the Bank of England’s monopoly on joint stock banking, although it would remain dominant in that market for some time afterwards (see King, Reference King1937). There was no need to apply it to Scotland as the Act was consciously trying to emulate a perceived strength of the Scottish system.

The 1826 Act did not amend the requirement of unlimited liability which the Bank of England possessed, and the Bank retained other privileges too as banker to the Government and monopoly supplier of notes in the capital.

The 1826 Act gave English banks in effect the same legal possibilities as Scottish banks; banks could be joint-stock companies with shareholders required to have joint and several unlimited liability. Stock could be more easily transferred—a major difference to the set-up under partnerships. Although not formally part of the Act, Directors of a bank had to approve share transfers. This was to make sure shares were transferred to individuals of sufficient wealth such that the unlimited liability obligation remained evenly spread across the owners.

In sum, as England pondered how to reform its banking sector following the crisis in the years after the Resumption, it looked to certain features of the Scotch system, namely its de facto joint-stock structure, to restore a semblance of stability. However, the systems were still somewhat different. Scotland had developed an effective note-clearing system with notes accepted at par and returned rapidly to the participating banks. Scotland did not have a central bank although it was increasingly linked to the London market as a financing source. Moreover, Scotland would develop, ahead of England, a branch structure whilst English country banks would remain essentially unit banks for some time. As discussed below, Scotland had smaller note denominations and fought to keep these despite objections from some in the British Parliament.

2.2. Issues with the Scottish banking system

Detailed data on the Scottish macroeconomy of the time do not exist. Cameron (Reference Cameron1967, p. 94) suggests that a reasonable estimate is that Scotland’s per capita income in 1750 was ‘no more than half that of England’s, but that by 1845 it very nearly equalled England’s’. Many observers, contemporary and more recent, and indeed Smith himself, have been inclined to put this robust growth in part down to the banking sector.Footnote ¹⁴ Whilst Smith seems to see many strengths in the Scottish banking system at the time of the publication of the Wealth of Nations, there were issues with the system. Some of these issues he recognised explicitly and thought banks themselves should address for their own good; others he saw as weaknesses of the system as a whole, needing Government legislation as a remedy. And there were other issues that he seemed not to identify or to care about.

The first issue that Smith seems not to discuss is the fact that despite urging free entry, banking in Scotland over his lifetime was dominated by two big banks: the Bank of Scotland and The Royal Bank of Scotland. These banks were much larger than any of the other banks until Ayr Bank was established in 1769. Clearly, free entry into banking did not necessarily mean a competitive banking system—even absent the two public banks. Moreover, these large banks’ actions or inactions were of economy-wide importance. And that was despite the fact that neither of the public Edinburgh banks (nor Ayr Bank) were linked to Government as was the Bank of England.Footnote ¹⁵

The second issue pertains to a key feature of free banking. It appears that very few details remain of the how the Edinburgh note exchange system actually worked (Munn, Reference Munn1981). The Edinburgh exchange, as Munn recounts, had been preceded by more local agreements between banks often on a bilateral basis to accept and exchange one another’s notes. Such an agreement had been in place between the two Edinburgh banks since 1751. Nonacceptance of notes of other banks was inconvenient to traders, limited a bank’s circulation, could lead to frictions between banks, and became more costly as the economy grew and trading networks expanded internally.Footnote ¹⁶ Ayr Bank made the first decisive moves in November 1769 to end this source of friction between the non-Edinburgh banks by accepting all ‘reputable’ notes at par and inviting reciprocal acceptance. This move was widely accepted (although not by the public banks). This move was still, it would seem, initially a sequence of bilateral deals. But the agreements were struck that regular (weekly) clearing of notes would take place in Edinburgh and the initial bilateral arrangements became multi-lateral. It was not long before the public banks became parties to the clearing (May, 1771); the Edinburgh banks would accept the provincial bank notes. Their customers apparently put pressure on them for acceptance of other notes, and the banks themselves were aware that the new banks were pushing their circulation more widely. However, as Munn (Reference Munn1981, p. 26) observes there was also a sense that this clearing would also help limit overissue by provincial banks. The Aberdeen Banking Company refused to join this nascent clearing system and indeed urged the other banks to decline its notes. It felt its business would be stymied by the clearing of notes and as it felt its business was largely local nonparticipation should leave its notes in circulation for longer. This bank was not the only bank to resist the attraction of clearing sensing the discipline that the note exchange imparted on banks of issue exceeded the benefits of wider acceptance (Munn, Reference Munn1981, p. 27).

However, there are indications that the rules were never really settled and the judgment that a bank was over-issuing could be contentious (e.g. Checkland, Reference Checkland1975a). Munn, (Reference Munn1981) also notes that it was not long before the public banks tried to strong-arm non-participants into joining. It would seem that the big banks did start to take a view on over-issue of participating banks; or, were urged to discipline banks perceived of overissuing. Some indications to this effect are contained in Checkland (Reference Checkland1975a). In time this oversight, and any lender of last resort role, would need to have been formalised. Gorton and Tallman (Reference Gorton and Tallman2018) discuss in great detail similar issues during the National Banking Era in the United States, and how private banks and the clearing houses to which they belonged managed with little official intervention during crises.

There were several key issues that he did acknowledge. Smith argued that banks, including the Bank of England, did not always act prudently or in their own interests. He indicates that while the Scottish economy had benefitted from its ability to operate with little in the way of hard cash, that efficiency gain was attended by potentially serious risks. And these risks needed to be handled in part by banks behaving prudently and in part by government regulation. First, the issue of too little specie is addressed. Then the small notes mania of the 1760s and the collapse of Ayr Bank in 1772 are considered, these being the two events highlighted above on the timeline.Footnote ¹⁷ From these events emerge Smith’s concerns about banks as do his arguments as to how those risks should be managed.

2.3. Too little specie?

Smith argued strongly that the economising of gold and silver by the substitution of paper money that was nevertheless redeemable for specie at sight was a beneficial development. The core advantage of such backed paper money was that it increased the real output of the economy. The gold and silver replaced by paper could be used to purchase abroad goods for consumption or could otherwise be invested in productive projects yielding future consumption. Smith was careful to emphasise that such ‘liberated’ specie had to be employed abroad since the paper money which was its replacement could not of itself boost domestic output; in more modern terminology, Smith was essentially assuming that domestic output was at its full employment level; adding paper circulation in addition to the gold and silver would simply be inflationary (see the Wealth of Nations, p. 326: The whole paper money of every kind that…).

But the risk was that the system may have been prone to operate with too little specie. Ironically, the efficiency of note clearing may have exacerbated that risk. Munn (Reference Munn1981) notes that as the clearing system became established, the public enjoyed greater confidence in notes and sharp practices, such as note picking, ended. The result was that banks were operating on ‘fractional specie reserves which were often as low as 2 or 3 per cent of demand liabilities’.Footnote ¹⁸ A feature of the system that underpinned business expansion could however be taken too far—possibly to a potentially dangerous level if convertibility was to be a founding principle of issue (Kerr, Reference Kerr1908). And this lack of convertibility may especially hit the least vulnerable. Moreover, banks may not always act in their, or society’s, best interests.

In this vein, Smith noted: ‘…the business of the country is almost entirely caried out by means of the paper of those different banking companies…silver very seldom appears…and gold still seldomer’. The extent of the use of paper issue in place of specie marks Scotland apart. Smith famously explains the efficiency of paper money but adds a caution:

Smith was not naïve and was aware that fractionally backed paper could be dangerous. As Rockoff (Reference Rockoff2011) shows, Smith’s worries grew as he developed his ideas on money and banking ahead of the final version of the Wealth of Nations. In earlier drafts of the above passage, Smith extols the virtues of paper money as a great efficiency, but the latter concern as to its fragility is absent. Rockoff (Reference Rockoff2011) argues, as indicated also by Checkland (Reference Checkland1975a, Reference Checkland, Skinner and Wilson1975b), that the failure of the Ayr Bank had the decisive impact on Smith’s thinking. In the normal course of things, there were powerful correctives to counter over-issue by any single banking institution, of promissory notes or bills or via the Scotch system of ‘cash accounts’ (WN, p. 324). First of all, notes in excess of that required by the locality in which the bank is operating will experience an increase in demand for money (i.e. cash/specie) as its notes are returned more often (or later, sent for clearing in Edinburgh). It is costly to store and replenish the stock of specie and so banks will be aware of this cost. And scholars of the Scottish system have suggested that the Edinburgh note exchange was an effective mechanism to ensure this happened, although this was likely only fully in place after 1774 (Munn, Reference Munn1981) once some of the lessons of Ayr bank had been learned.Footnote ¹⁹

However, Smith argued that experience taught that banks had not always understood this. And he names the Bank of England and the Scotch banks as examples of banks who have overissued. He also discusses at length, although not by name, the misdeeds and missteps of the Ayr Bank (WN, p. 341). And as discussed later, lending limited amounts and for short-term only against ‘real’ bills was part of the correct remedy for this tendency (along with a limit on low denomination notes and an end to the optional clause). And a like caution was to be observed with respect to cash accounts by requiring ‘frequent and regular repayments from all their customers…’ (WN, p. 332). But bill market abuses could and did occur and these could be extensive sometimes (WN, p. 339); indeed, so extensive that banks upon discovering the fraud may try to ‘withdraw gradually’ in order to avoid making bankrupts of the projectors and the bank itself. The idea was to make life difficult for the discounters in the hope that they would discount with other banks. The situation more widely could be made worse as a result of such behaviour.

In short, Smith believed paper money to be a material efficiency gain that was helping Scotland grow strongly and catch up on England. But he was equally clear that there were attendant risks. He understood the risks of fractional reserve banking and was aware that banks of all stripes had from time to time in the past overissued; sometimes that was due to unavoidable error and sometimes not.

5.1. Smith’s internal rules

The main internal rules or guidelines to which banks should adhere are: First, that banks should lend against real bills. Second, banks should only lend short-term. What exactly that might mean may be open to interpretation. But for inland bills, Smith mentions the preponderance of dated bills at 2 and 3 months. He does not appear to discuss anywhere the effective increase in usance necessary to cover international trade, something of much importance to the Scottish economy.Footnote ²⁷ Third, there should be no lending for fixed investment purposes or property loans. Fourth, banks should lend only ‘small’ amounts. Again, what exactly that means is open to debate. But Smith states that banks should never lend more than what the trader ‘might otherwise be obliged to keep by him unemployed’. Finally, cash credits (introduced by The Royal Bank of Scotland in 1728) should be governed by the same rules as discounting bills: there should be no long-term finance (rolling over of balances endlessly); accounts should regularly be settled; and all lending should be against high-quality security/guarantees.

It seems that ‘real bills’ were central to these internal rules and that Smith thought of these as akin to a voluntary code of conduct and as best practice. Importantly, however, Smith does not recommend any direct rules from the legislature to enforce them, much less is there any indication that these rules should be implemented by any kind of regulator. The real bills doctrine is perhaps the most controversial—perhaps most misinterpreted—of Smith’s banking doctrines. For some, it came to be seen as a monetary doctrine rather than a banking doctrine. It is worth looking at what Smith actually wrote.

5.2. Real bills doctrine

Although The Royal Bank of Scotland invented the cash credit (an overdraft backed by two guarantors and perhaps security) and this seemed to be adopted more widely as the eighteenth century wore on, it was note issue and bill discounting that formed the core of many earlier banks’ business. Smith had clear views on both notes and lending.

And Smith is equally clear on what the bank should be lending for. It should not be for what we might term fixed capital, long-term investment, property, and mortgages. These restrictions are the clear corollary of the real bills doctrine and clearly indicate that Smith did not think of real bills as a theory of the aggregate money supply but as bank ‘regulation’).

It is clear enough from the language used by Smith why it came to be called the ‘real bills’ doctrine. He argues that lending should be short-term and against security. The amount so lent, should be ‘small’ and should replace specie balances that the borrower would otherwise be required to store—unproductively—had the bank not existed. From these guidelines, Smith may not even be endorsing loans for what we might now call ‘working capital’. He is certainly arguing that banks should not be funding long-term loans or fixed capital or property as the quote above makes abundantly clear. And he applied the same stricture to the cash credit, an innovation he praised (as did his friend David Hume, although Hume worried it could lead to overissue).

Smith follows this discussion with some observations on bill market abuses, no doubt motivated by Ayr bank’s collapse. Such abuses would also play a significant role in the great financial crises of the nineteenth century and would be part of the focus of various Parliamentary inquiries into these ‘derangements of credit’. Smith therefore was clearly not naïve to the risk that bills could be abused and that they could easily become accommodation or finance bills.Footnote ²⁸ But he did not go so far as to suggest any external or legal prohibitions in this area. But the possibility of such abuses, suggests he did believe that banks could be complicit in over issue.

Smith’s real bills doctrine was criticised by a leading protagonist in the ‘bullionist controversy’. Henry Thornton, a preeminent monetary and banking scholar, argued that Smith over-simplified the nature of the relation between bill finance and issue, implying he was much less sanguine than was Smith on the restriction to real bills in constraining credit/issue.Footnote ²⁹ An argument based on real bills was used by the Bank of England to defend itself against the charge that inflation during the Suspension—in effect, the Bank argued that it had not overissued paper currency once it had been freed from the legal requirement to redeem notes in specie. The Bank argued that, on account of lending only against real bills, they could as a matter of logic not overissue. Any inflation, or gold premium observed in the market, must have been due to other factors.Footnote ³⁰ However, the real issue appears to centre on where the real bills doctrine is applied. Was it a theory of the aggregate money supply? Or did it apply to banks individually (but somehow not in the aggregate). It seems clear, as indicated above, that Smith was referring to banks individually. It was essentially a normative statement as to how banks should lend. Historically, however, it became identified with fallacious reasoning about the aggregate money supply, or even inflation. Moreover, Smith’s version of the real bills doctrine applied to small, competitive banks of issue who were legally required to redeem in specie on demand. His discussion clearly did not apply to a limited liability, financial giant which Smith recognised as an arm of the state and whom he had explicitly asserted as having overissued in the past and who was now (during the Suspension) legally exempt from paying out on its notes. Nevertheless, the Bank had employed a real bills defence of its actions, and would not be the only central bank to do so. In defending its conduct of monetary policy during the Great Depression in the 1930s, the US Fed also invoked a real bills defence.Footnote ³¹

However, even as a theory of individual bank behaviour Thornton (Reference Thornton1802) argued that Smith’s discussion of issue against real bills was incomplete and that a multiple of notes might be issued against the same transaction depending on the ‘supply chain’ of sale and repurchase before the goods were indeed finally sold at market. This qualification or refinement of the real bills doctrine may have traction even on Smith’s assumptions.

In short, over issue could occur for three reasons, two of which appear to be clearly acknowledged by Smith. First, banks might not act in their own long-run self-interest; they might act irrationally and imperil their ability to redeem in specie. Second, bill market abuses could and did occur and Smith knew it. Sometimes the banks were unaware of the abuse, sometimes not. But abuses happened and overissue could result. And third, Thornton demonstrated that a number of bills—and a corresponding larger issue of paper money—might be erected on a single real transaction. Smith argued that competition would go a long way to alleviate some of the risks. But he argued for further banking regulations and so was unconvinced that the market could be entirely trusted. The debate on whether competitive banks of issue were conducive to monetary stability and external adjustment became a central issue between the Currency and the Banking Schools.Footnote ³²

5.3. Smith’s external rules

What we label as Smith’s five external rules are: First, banks should be constrained as to the maximum interest rate they can charge on their loans (usury). Second, bank owners/partners should face unlimited liability.Footnote ³³ Third, banking (i.e. banks of issue) should be competitive—there should be with free entry. Fourth, all bank notes should be convertible on demand. Fifth, the law should specify the minimum denomination of notes. The first three ‘rules’ were part of the legal landscape in Scotland, but it is worth emphasising their significance since, as subsequent developments would have it, they were not immutable and they did play a significant role on Smith’s banking ‘model’. The final two rules were introduced by the 1765 Act and it was these ‘two rules’ that Smith emphasised at the conclusion of Book II, Chapter II needed to be applied to an otherwise free banking.

Smith recommended a £5 minimum, although the 1765 Act settled on £1. His assessment of the small notes mania and the collapse of the Ayr Bank—especially the latter—seem to have convinced him that these restrictions were required (even though they obviously did not avert that failure). However, there are a few things worth observing. The rules that Smith endorsed and which were introduced into Scotland in 1765, were not the only external restrictions in place on banks. The first was the Usury Law, limiting at that time the maximum interest rate to 5 per cent. And the second was that, along with free entry, all non-chartered banks, indeed all firms (partnerships), carried unlimited liability. That was probably more significant in minimising the fallout from Ayr Bank, as we suggested above. Smith took unlimited liability for granted but more controversially supported the restrictions on banks’ maximum lending rate.

Smith’s overriding concern was for the stability of the currency. And it was this that drove him to support the usury laws as we now explain.

5.4. Usury restrictions

In England and Scotland, as elsewhere in Europe, there had been long-standing prohibitions on charging any interest on lending. After the Reformation, Calvin permitted interest on commercial loans, according to Munro (Reference Munro2011), but not for loan to the needy. In England, Henry VIII’s Parliament permitted interest of up to 10 per cent (on all loans); any higher rates were then defined as constituting usury. This was revoked in 1552 following a religious backlash but revived under Elizabeth I, in 1571. The maximum rate was reduced in stages to 8 per cent in 1624, 6 per cent in 1651 and 5 per cent in 1714, the effective rate for all of Adam Smith’s life. That remained in place until 1833 when the Bank of England was allowed to charge a higher rate, although with some restrictions initially (see King, Reference King1937). That relaxation was in part driven by the need to control credit expansion, a policy concern that was probably absent in earlier centuries. The abolition of the usury laws was finally completed in 1854.

Smith notes:

We can analyse the effects of Smith’s support for the usury law using a simple ‘Market for Lemons’ model. Consider a bank who is looking to lend to a borrower and cannot immediately differentiate between high-quality borrowers (sobers) and low-quality borrowers (prodigals). Prodigals are willing to borrow at high-interest rates (up to R(QL)) but sobers are only willing to borrow at interest rates up to R(QH) < R(QL). The lender’s required interest rate depends on the probability that a borrower is a prodigal, demanding a higher interest rate if all the borrowers are prodigals. The lender is more willing to lend at a lower interest rate if the probability of the borrower being a prodigal is low.

As we have drawn the diagram, the bargaining set, where borrowers are willing to borrow, and lenders are willing to lend, has two spaces (in green). In the low-interest space, there is a mix of sober and prodigal borrowers. In the high-interest space, there are only prodigals. There is an unobtainable, but ideal space where lenders only lend to sober borrowers (in red). Unfortunately, lenders have no way of excluding prodigals from asking for loans. The famous Akerlof market breakdown result can be found by shifting the willingness to lend schedule upwards, until it still crosses the red space, but no longer crosses the green spaces.

A usury law interest rate between R(QP) and R(QH), as Smith supported, removes the high-interest space from the bargaining set, leaving only the low-interest space, where loans are extended to a mix of sober and prodigal borrowers.

Smith’s final line in the quote above states ‘sober people are universally preferred as borrowers, to prodigals and projectors’ but the usury law does not (on its own) eliminate prodigals as borrowers, rather it generates a pooling equilibrium where prodigals and sober borrowers alike are extended credit. If sober borrowers are sufficient in number, then this will be a good outcome.

The best (or constrained efficient) outcome would be a separating contract, that somehow allows the lender to distinguish between sober and prodigal borrowers, charging low-interest rates to sober borrowers and high-interest rates to prodigals. Smith’s usury law on its own does not generate that outcome, but Smith’s other proposals may do so. Specifically, Smith argued that credit should be short-term, and any overdrafts frequently cleared, as explained above. There is theoretical support for Smith’s frequent clearing proposal in helping to identify borrower types; borrowers expecting brighter future prospects are more likely to select into short-term borrowing, subjecting themselves to the risk of future refinancing, than borrowers expecting future challenges (see Diamond, Reference Diamond1991; Flannery, Reference Flannery1986). In our view, the two proposals should be treated as a single proposal with two complementary branches, with the frequent clearing helping to support the revelation of borrower types, ultimately supporting an outcome that is close to the separating equilibrium—the area marked unobtainable in the diagram.

In sum, Smith’s support for usury is a sophisticated analysis of the problem of adverse selection in credit markets. It also bears some similarity with modern US policymaking, particularly in health insurance and in peril crop insurance markets, albeit these are markets where policymakers explicitly want to achieve a pooling equilibrium, which is not the intended outcome for Smith.

For Smith, the usury law was primarily a way to stop banks becoming excessively risky, although he also appeared to see some merit in the traditional case for usury limits in supressing extortive practices. As the model sketched suggests, there are circumstances in which Smith’s intuition along this dimension is valid even though it is a blunt tool and is Pareto-dominated may by other policies (or combinations of policies).

As time wore on, there was increasing scepticism around the role of usury laws. However, this scepticism revolved not around ‘prodigals and projectors’ but around the control of money and credit at the aggregate level, and in particular in response to external drains. Hayek (1939) notes comments by TookeFootnote ³⁴ describing the difficulty the Bank had in 1795 retaining gold in Britain faced with Government demands for war finance, a French return to the gold standard and continued demand at home for loans. The laws on usury resulted in the bank rationing credit, with deleterious effects on the London money market.Footnote ³⁵ The dismantling of the usury laws begin systematically in 1833 as the Bank struggles with emerging policy pressures; see King (Reference King1937).

5.5. Optional clause

In the early period of Scottish banking, the optional clause was to limit malicious competition between banks where banks might accumulate each other’s notes and present all at once for redemption. Checkland (Reference Checkland, Skinner and Wilson1975b) also reports that banks could threaten to employ the clause if their own borrowers were overly keen on getting their hands on gold. Smith, however, had supported the outlawing of these clauses not, it would seem, to protect banks but to protect customers of banks, to restore the equilibrium exchange rate between Scotland and England, and to retain specie in circulation. Smith also referenced critically in Book II, Chapter II, practices by governmental authorities in the American colonies who issued their own currency, declared it legal tender but made the notes redeemable only several years after issue. Smith does not discuss at length his support for the prohibition of the optional clause, but overissue/lack of specie seem to be behind much of his concern; the issue of paper money could go too far and threaten convertibility. Although banks had every incentive not to overissue, nevertheless it could happen, Smith believed, and did happen:

5.6. Small notes restriction

Along with the optional clause, Smith wanted a prohibition on small notes—those under £5. In the event, as observed earlier, the £1 note became the lower limit. Smith saw that a minimum note size would leave paper money in the hands of those capable of monitoring the banks. And it would leave the smaller trader and merchant and labourer in possession of hard cash. In this way, the latter would be more protected from any banking bumps on the road. Were smaller notes made available, as occurred for example during the mania of the early 1760s, there was a real risk of the banking system de-monetising to a dangerous degree. Indeed, in extremis, with too many small notes in circulation, a collapse in confidence could imperil convertibility.

Smith thus concluded:

The party wall analogy and its clear allusion to ‘contagion’ is reminiscent of the Friedman and Schwartz (Reference Friedman and Schwartz1963) narrative of the waves of bank failures during the Great Contraction in the US between 1929 and 1933. And Smith’s nervousness around this fragility is reinforced by another of his famous metaphors cited above concerning the Daedalian wings.

In short, then, Smith’s external rules may have been necessary to underpin ‘free banking’ in Scotland. Friedman and Schwartz (Reference Friedman and Schwartz1983) summarise various free banking episodes in the US between 1791 and 1836 and conclude that: ‘Various degrees of laissez-faire prevailed in the several states, but nowhere did it lead to unlimited liability, freely interconvertible bank notes, security of both note holders and depositors from loss, and the other favorable characteristics of the Scottish banking system’ (p. 50).

5.7. What was the point of the internal and external rules?

Adam Smith thus recommended a banking sector that followed certain internal rules and was subject to some external rules. The five internal rules were guidelines on how banks should manage their business. To recall, they were: First, banks should lend against real bills. Second, banks should lend short-term. Third, banks should not finance fixed investment or property lending. Fourth, banks should lend ‘small’ amounts. Fifth, cash credits should be governed by the same rules as discounting bills: There should be no long-term finance, accounts should regularly be repaid, and all lending should be against good security/guarantees. The five external rules were: First, banks should be limited as to the maximum interest rate they could charge (usury). Second, banks should have unlimited liability. Third, banking (i.e. banks of issue) should be competitive with free entry. Fourth, all notes should be convertible on demand. Fifth, there should be a limit of notes of low denomination. These final two rules were introduced by the 1765 Act, and it was these ‘two rules’ that Smith concluded needed to be applied to an otherwise free banking system (although as we note, there are other ‘external rules’ that he took for granted, especially the first and second just mentioned).

For Smith, following these internal and external rules would deliver monetary integrity with what he regarded as the minimum of intervention. In particular, Smith’s rules would appear to result in no need for a central bank of issue or central reserve of specie, something on which Bagehot (Reference Bagehot1973) would later opine. Smith argued that the free entry of banks and their proliferation would be a desirable development. Whilst individual banks might fail in the normal course of things, none individually would be dominant and so could easily be let go without affecting the wider economy. This would result in widespread confidence in banking firms and their issues, and there would no need regulate banks (save for the two restrictions above on small notes and redeemability). Finally, banks could safely be allowed joint stock status, although still with unlimited liability. We explain this last point presently. And as a result of all these rules, note issue could never be excessive for long. That insight is what would later be labelled by Viner (Reference Viner1937) as The Banking Principle.

5.8. Smith and joint stock banking

As described earlier, the Scotch banking system had many features of joint stock firms (excluding limited liability). Smith was typically sceptical of the joint stock firm as he regarded it as often less efficient than a partnership and able to survive only due to state-sanctioned privileges such as monopoly rights and limited liability. Smith argued that joint stock companies, even when not protected by the State, typically performed poorly when faced with competition. That is to say, they had a poor survival rate (see the discussion in Anderson and Tollison, Reference Anderson and Tollison1982).

Smith says:

Anderson and Tollison (Reference Anderson and Tollison1982) are intrigued by Smith’s endorsement of joint stock banking:

The puzzle seems to be that Smith is recommending a role for joint stock banks on the basis that they are simple enterprises with, in modern parlance, little by way of serious principal-agent problems. However, it is important to note that Smith’s observations come in Book V of the Wealth of Nations after Smith has set out in Book II his ‘model’ of banking and the various internal and external guidelines that he envisages being in place. Perhaps the puzzle is not so much that Smith endorsed joint stock banking but that he may have thought the law of partnership as it applied in Scotland was deficient as regards banking? Perhaps by not including any discussion of this in Book II implies that he did not think this much of an issue at all. In any case, the prevailing view is that Scotland was able weather the 1825/1826 crisis because Scottish partnership law provided Scots banks with a ‘flexibility’ deprived the English and Irish banks. Turner (Reference Turner2014) notes.Footnote ³⁷

5.9. Did Smith’s vision for banking prevail?

By the end of the nineteenth century, almost nothing of real substance that Smith recommended for banking and monetary control would prevail. Smith’s ideas on monetary and banking control would be criticised, by the likes of Henry Thornton (Reference Thornton1802). However, as White (Reference White1984) suggests, and before him Joplin (Reference Joplin1822), many of the criticisms of competitive banks of issue, and hence indirectly of Smith, overlooked the fragility of small banks that was as likely the result of the monopoly privileges accorded the Bank of England as they were of country banks of issue as such. Nevertheless, whilst banks would be almost completely joint-stock enterprises and convertibility would be retained, Britain had passed through a number of substantial banking crises. These often revolved around banks in lending practices and bill market abuses that Smith cautioned against. This led to intense debates around money and banking policy. The upshot was that the usury laws were dismantled, beginning in 1833, and by 1844 the Bank of England was the monopoly supplier of legal tender notes and the nation’s guardian of specie. This one gold reserve legally backing the issue was meant to impart monetary stability; be that as it may, it did not guarantee banking stability. And three times in the ensuing decades the Act had to be suspended to allow the Bank of England to play the role of lender of last resort (and potentially supply notes in excess of the legal maximum).

However, the Bank of England’s role as lender of last resort imparted huge moral hazard into the financial system. Lord Overstone (a key influencer and defender of the Peel Acts and the preeminent leader of the Currency School and himself a former banker) observed in a letter to the Chancellor of the Exchequer after the 1844 Act had been suspended for the second time:

Moreover, the banking sector itself after about 1850/1860 or so started to become very concentrated and its gearing rose, as the first chart below suggests. In 1878 the City of Glasgow Bank failed, collapsing due to a, by then, familiar mix of malfeasance and poor lending. That failure led to widespread adoption of limited liability by banks which, although it had been available for some years, had been largely resisted by banks. The concentration of the sector intensified so much so that by 1918 an official inquiry, known as The Colwyn Committee (more formally, the Treasury Committee on Banking Amalgamations), was set up to investigate the sector (Billings et al., Reference Billings, Mollan and Garnett2021). And the advantage of joint stock banking did not appear to have led to a highly capitalised sector.Footnote ³⁸

The decrease in the capital resources of the banks looks to have been broadly similar in Scotland and the UK. The first chart above for Scottish banks combines the data up to 1800 from Cameron (Reference Cameron1967) with data from Checkland (Reference Checkland1975a) from 1836 on.Footnote ³⁹ The second chart above compares the Scottish experience with Britain as a whole over the shorter sample for which Sheppard (Reference Sheppard1971) provides data. The secular decline in capital ratios, or rise in gearing, is apparent in both charts and particularly steep ahead of the inquiry into bank amalgamations. The Colwyn Committee did not recommend radical reform such as breaking up banks, nor did it recommend legal prohibitions on bank mergers. However, it did in effect put an informal halt to further immediate concentration in the sector. Mergers amongst the big five were in effect prohibited and further amalgamations involving the largest banks with smaller banks required Treasury and the Bank approval. Gorton and Tallman (Reference Gorton and Tallman2018, p. 72) suggest that a US congressman coined the phrase ‘too-big-to-fail’ following the rescue of Continental Illinois Bank in 1984. However, the too-big-to-fail problem had been clearly identified almost 70 years earlier. The only academic economist on the Colwyn Committee was Herbert Foxwell. He is quoted in Billings et al. (Reference Billings, Mollan and Garnett2021) observing

The plots above show banks had indeed been increasing their gearing for some time. Turner (Reference Turner2014, pp. 159–160) suggests that by the time of the Colwyn Committee, or shortly thereafter, it was widely (by the Bank and senior politicians) accepted that the big banks could not be allowed to fail. Various factors, including two world wars, government financial repression and a Great Depression would ensure that the ‘too large to let go’ problem would lie dormant for some decades but by the 1970s it would return with a vengeance.

5.10. Why did Smith’s views not prevail?

The proximate reason why Smith’s views did not prevail is largely as a result of the victory of the Currency School over the Banking School and the Acts of 1844/1845 (Peel Acts). One of the arguments of the Currency School was that the English and Welsh country (provincial) banks had a tendency to overissue their paper. Derided tendentiously as ‘paper mints’,Footnote ⁴⁰ and often having their competence questioned, Peel became convinced that the country banks could operate independently of the Bank of England and that this was potentially dangerous to the country. For example, he worried that an attempt to address an external drain might be made more difficult or worse by the provincial banks.Footnote ⁴¹

That the country banks were a danger to monetary and credit control was perhaps the majority opinion, both then and now (see Feavearyear, Reference Feavearyear1963, p. 239ff for the case against the country banks). That said, important voices have questioned that view, arguing in effect that the Bank of England did ultimately control (see e.g. Viner, p. 154ff). This debate had rumbled on since the Bullionist controversies but was given even more vigour following the English country bank failures of 1825/1826.

Related to, though distinct from, this argument around the country banks, the Currency School argued that in a mixed currency system (that is one where paper and specie circulated) to ensure convertibility and stable adjustment as in Hume’s prices-specie-flow the paper component of the circulation had to be made to behave like gold. That is to say, the circulation had to be controlled. This, Viner (Reference Viner1937) would label The Currency Principle. Into this picture, the notion of many competitive banks of issue seemed to fit less than easily.

White (Reference White1984) argues that free banking has been airbrushed out of the great monetary debates of the early nineteenth century. He argues that Henry Thornton was in some ways very influential in setting the terms of the debate; namely, that free banking would be a dangerous route for England to take. He observes that Thornton (Reference Thornton1802) was critical of the country banks and their susceptibility to runs. He also notes that Thornton believed that the Bank of England, at least in principle, was a stabilising force not just in the capital but in the wider country. He believed that any competitor in note issuing in the metropolis would be highly destabilising and would rob the Bank of the ability to control the general level of credit in the country both in stable and, more importantly, in unstable times. However, White is very critical of Thornton’s failure to recognise that the country banks fragility, as he sees it, was due to a prior restriction. In other words, it was due to the Bank of England’s legal monopoly on joint stock banking which, he argues, had been secured at the expense of wider banking stability. That was despite the fact that Thornton himself notes in passing that the Scottish banks had been free of bank runs in 1797. For White (Reference White1984) and the free banking school, the combination of competitive issue, no limitations on the number of partners, note clearing, and no central bank reserve, meant the free banking system in Scotland was bound to be substantially more stable than the English system.

In short, the free banking school argues that Scotland’s apparently more robust banking structure was the result of two features. First, a greater number of partners enabled banks to be larger, more diversified, and much better capitalised. Second, it was composed largely of banks of issue (at least in the latter part of eighteenth century and early part of the nineteenth, see Cameron’s, Reference Cameron1967 data reported earlier) and not dependent on a central bank of issue. The competitive nature of these banks and the rapid clearing of notes meant that no bank dominated the others and problems were quickly uncovered. And as noted earlier, some contemporary writers such as Joplin (Reference Joplin1822) essentially made that same case.

The ultimate reason why Smith’s vision for money and banking was unrealised was perhaps that as the British economy developed, became more integrated and moved increasingly centre stage in the world economy, two very different banking systems might find it hard to coexist. As Smith recognised, the Bank of England was already at the time of the Wealth of Nations ‘a great engine of state’ (Kosmetatos, Reference Kosmetatos2018),Footnote ⁴² and its role was only set to increase. While he typically opposed joint stock companies with privileges granted by government, he was restrained in overtly criticising the Bank of EnglandFootnote ⁴³; he even seemed to acknowledge what we might now call lender of last resort interventions and (perhaps?) with a degree of approval. Moreover, the Scottish banks were also reliant on the London markets, and hence indirectly on the Bank of England, for liquidity, something the free bank analysis can overlook.

Perhaps for this reason alone—the central importance of the Bank of EnglandFootnote ⁴⁴—the Scotch system could not come to dominance in Britain, or even endure. Indeed, both the Currency School and the Banking School supported having a ‘central bank’ even though they disagreed on how that bank should operate (and how dangerous to monetary stability were country banks of issue). The free bankers—who would have done away with a central bank—were a minority view. And so, England being much the larger country and economy and London the dominant financial centre, not merely in Britain but also increasingly the world, the Scottish system’s influence on wider questions was increasingly side-lined.Footnote ⁴⁵

6.1. How would Smith approach banking regulation?

Our argument above is that Smith endorsed rules on banking in so far as they contributed in important ways to monetary stability—the integrity of note issue and the avoidance of contagion. To that end, he wanted banks to observe an internal code of conduct. But that code was underpinned by a law to limit balance sheet risk (usury), measures to ensure sufficient specie was in circulation (the 1765 Act mandated convertibility on demand and a lower limit on note denomination so that some specie would be in circulation), and measures to ensure banks could fail safely (unlimited liability and free entry into banking). These rules applied to all banks and no rules were applied to one bank and not to another (the chartered banks were the exceptions). In other words, rules were, in modern terminology, macroprudential and intended to underpin monetary policy and stability. And it was for much the same reason that Friedman and Schwartz (Reference Friedman and Schwartz1963) ‘endorsed’ the establishment of deposit protection in the US in 1933.

If the above argument is correct, then presumably Smith would devise rules that would support the currency and so the first question would be: Who should supply the medium of exchange? There are two basic options. The first option would be to follow Friedman (Reference Friedman1959) and endorse the State as the monopoly supplier of a fiat currency.Footnote ⁴⁸ A second option might be competing private sector fiat (fiduciary?) currencies as suggested by Hayek.Footnote ⁴⁹ Of course, the first option has come to dominate and there seems little likelihood of option 2 emerging. So, how did Friedman propose to reconcile monetary stability and bank regulation?

Friedman (Reference Friedman1959) argued that the state should be the monopoly supplier of paper notes and that banks should hold 100 per cent reserves against deposits (the so-called Chicago plan). The plan was formulated originally by Frank Knight, Lloyd Mints, Henry Simons, and other well-known Chicago economists.Footnote ⁵⁰

He endorsed government control of the money supply on the basis of four main arguments. First, there is a resource cost of running a pure commodity currency. That led to a tendency, he argued, for unbacked paper currency or fiduciary issue to emerge. Next, as noted earlier, he observed the ‘peculiar difficulty of enforcing contracts which involve promises to pay but that also serve as a transactions medium and the consequent tendency to their fraudulent use’. Third, Friedman argued that the ‘technical monopoly character’ of pure fiat currency meant that it was necessary to set an external limit on its amount. And finally, ‘the pervasive character of money which means that the issuance of money has important effects on parties other than those directly involved and gives special importance to the preceding features’. Friedman (Reference Friedman1959) concludes that ‘[I]t is dubious that the market can by itself provide such a framework’.

Of course, the US in the end did not adopt the Chicago Plan. Instead, the Banking Acts of 1933 (also known as Glass-Steagall) and 1935 formed the core of the financial reforms. Amongst other things, these separated commercial and investment banking, created the FDIC, and strengthened the decision-making at the Fed, providing the Board with more power to regulate banks and set interest rates.

In the intervening years that perspective—regulating banks only in so far as doing so is necessary for monetary stability—has perhaps been lost. Certainly, in the post-WWII the focus has been on microprudential regulation of banks. As the Bretton Woods system broke down, international banks and capital markets began to flourish and central banks around the world were confronted by ‘new’ risks of increasingly large, innovative (not always in a good way) and internationally active banks. For example, in the UK the secondary bank crisis materialised more or less at the same time as Herstatt Bank failed in Germany and Franklin National Bank failed in the US. Bank regulation became an increasingly important task for national authorities; but that regulation was largely microprudential. As it developed, it was focused mostly on individual bank risks, depositor protection and in minimising the cost of bank failure (Goodhart, Reference Goodhart2011). The notion that there were risks common across banks and that the banking sector had the potential seriously to disrupt monetary policy receded somewhat.Footnote ⁵¹

It is difficult to pin down the degree to which microprudential regulation was either a success or a failure for most of the post-WWII. In the UK, regulation developed at the same time as banking and financial services were liberalised. The periodic bank failures and credit booms were for some a price worth paying along a transition path to a more efficient economy; for others, they reflected an enduring Achilles heel in financial markets; for still others they were a predictable outcome of a political game over income and wealth distribution. The global financial crisis in 2008/2009 and its aftermath may have changed the terms of the debate. There has in the UK been a clear pivot towards a macroprudential perspective on financial regulation. As well as global moves towards increased capital and liquidity requirements for banks and other financial intermediaries, in the UK the enactment of the Vickers Commission proposals on bank ringfencing, and the establishment of the Financial Policy Committee (FPC) within the Bank of England have been amongst the most striking institutional developments anywhere. The Bank of England is now responsible for operational monetary policy (via the Monetary Policy Committee, MPC), microprudential regulation (via the Prudential Regulation Authority, PRA) and macroprudential regulation (via the FPC). The Bank is also the resolution authority for UK-regulated financial intermediaries. The FPC’s statutory responsibility is to assist the Bank in ensuring the stability of the UK financial system. The FPC can request or require additional capital and liquidity requirements to be imposed on all regulated intermediaries if it deems financial stability is at risk. It has also been granted additional, far-reaching powers, such as those to limit aggregate bank exposure to the property market.

It could be argued that since the global financial crisis the UK has moved in the direction of Smithian/Friedmanite regulation in embracing a macroprudential perspective on regulation. Monetary policy was neither able to avert the crisis nor on its own to help the economy recover from its aftermath. So, perhaps macroprudential measures will help restore the efficacy of monetary policy.

However, the system of rule setting is very complex here in the UK and elsewhere. Microprudential regulation remains a key focus of policymakers and is becoming ever more complex. Moreover, macroprudential is also very heterogeneous across countries. And even in the UK, where macroprudential policies and institutions are amongst the most well-formulated anywhere, there are serious issues of accountability both as to objectives and accountability. It is not clear what policymakers are ultimately trying to achieve with these myriad policies.Footnote ⁵² On this, Smith had the advantage.