The Ayr Bank was a Scottish bank of the latter eighteenth century that caused one of the most famous banking debacles in European history. In part the bank owes its notoriety to Adam Smith, who, in the Wealth of Nations, devoted a good bit of space to describing its story.
The Ayr Bank, more accurately called the firm of Douglas, Heron, and Company, came into being in November 1769. It was founded along the lines of the land bank schemes suggested by John Law, but unlike Law’s schemes, it was a purely private initiative without official backing. As a copartnership, as opposed to an incorporated business, its owners were fully liable for all the debts of the business. Its founders were landowners of the first order, one of whom, the Duke of Buccleuch, had accompanied Adam Smith on a tour of Europe and had the benefit of the famous economist’s advice. Land owned by the founders was the ultimate security for the bank’s notes.
The Ayr Bank burst upon the scene when the Scottish economy was in a contraction and many observers felt that a shortage of circulating money acted as a drag on the Scottish economy. According to Smith, writing in the Wealth of Nations:
This bank was more liberal than any other had ever been, both in granting cash discounts, and in discounting bills of exchange. With regard to the latter, it seems to have made scarce any distinction between real and circulating bills, but to have discounted all equally. It was the avowed principle of this bank to advance, upon any real security, the whole capital which was to be employed in those improvements of which returns are the most slow and distant, such as the improvements to land.
The liberal lending policy of the bank led to a rapid expansion of bank notes, greater than what the bank’s resources could support. The Ayr Bank expansion of credit found its way into speculation in real estate and the London stock market. Bank notes were redeemed with bills of exchange drawn on London banks in amounts that exceeded the bank’s London resources. In 1772 a London-Scottish banking house with close connections with the Ayr Bank failed, and the Ayr Bank’s house of cards collapsed. Scotland’s public banks refused to grant credits to the failing bank. The bank was liquidated, and the income from the land was pledged to the redemption of outstanding bank notes. The founders of the bank lost everything, some of whom were apparently unaware that their liability was unlimited.
The failure of the Ayr Bank was probably due more to mismanagement than to faults in the land bank principle. The bank may have actually spurred the economic development of Scotland, but its failure weakened public confidence in land banking schemes, leaving gold and silver as the most acceptable security for bank notes. The bank’s history shows how easily an expansion of bank notes leads to a speculative bubble that ends in collapse. History has continued to repeat itself, with Tokyo being the last scene of a speculative bubble fed by overly generous credit policy.