The Scottish Banking Act of 1765 established the legal foundations that enabled Scotland to pioneer the evelopment of free banking, a system of banking that flourished in the United States before the Civil War. Under a system of free banking no one bank, usually called a “central bank,” claims a monopoly on the issuance of banknotes, as the Federal Reserve System enjoys in the United States. Instead, each private bank issues its own banknotes, and maintains the convertibility of its notes into gold or silver, or other commodity, depending on the monetary standard. Under free-banking systems, the privilege to start a new bank is removed as far as possible from political processes.
The act of 1765 was entitled “An Act to prevent the inconveniences arising from the present method of issuing notes and bills by banks, banking companies, and bankers, in that part of Great Britain called Scotland.” The act authorized all “banks, banking companies, and bankers” to issue banknotes, and for a century, the issuance of banknotes became the defining characteristic of Scottish banks. In England, the Bank of England had a monopoly on the privilege to issue banknotes in London. In Scotland, the Bank of Scotland and the Royal Bank of Scotland campaigned to give themselves a monopoly on the issuance of banknotes, but the public sided with the small banks wanting to maintain the privilege to issue banknotes.
The act forbade the issuance of banknotes with a face value less than 20 shillings (or 1 pound sterling, £1). The smallest note issued by the Bank of England was £5, but small note issues had circulated widely in Scotland, some as small as 5 shillings, or even 1 shilling. In Scotland, a shortage of small change created a vacuum that low-denomination banknotes filled.
The act of 1765 also forbade the so-called optional clause. In 1730, the Bank of Scotland, to protect itself from bank runs, began printing on its notes the optional clause, stating that the bank could either redeem the banknotes on demand, or defer redemption for up to six months. The clause also stated the interest rate that banknotes would earn if redemption was deferred. The notes only bore interest for the time redemption was suspended. To encourage banks to follow safer banking policies, optional clauses were banned.
Scotland’s free banking system did not exactly find smooth sailing. Several banks failed in 1772, including the Ayr Bank that Adam Smith described in the Wealth of Nations. Notwithstanding a few bank failures, Smith sang the praises of Scotland’s banking system, and noted the expansion of Scottish commerce that had coincided with the development of banking. During the Napoleonic Wars, Parliament came to the rescue of the Bank of England and Bank of Ireland by ordering the suspension of their banknote convertibility. The banks of Scotland, however, maintained the convertibility of their banknotes and never had to throw themselves on the government for protection.
Checkland, S. G. 1975. Scottish Banking: A History, 1695–1973.
Colwell, Stephen. 1859/1965. The Ways and Means of Payment.
Kroszner, Randy. 1995. Free Banking: The Scottish Experience as a Model for Emerging Economies.