Banking and Finance

Case studies in the development of the UK financial sector

John F Wilson, Nicholas Wong, Steven Toms

• Publisher: Routledge
• Year: 2020
• ISBN:
  9780429602573
• Edition: 1
• Topic: Business
• Subtopic: Business History
• Index: Business

This shortform book presents key peer-reviewed research selected by expert series editors and contextualised by new analysis from each author on how the specific field addressed has evolved.

The book features contributions on the development of banking regulation in Scotland, the role of commercial banking on the functioning of the British corporate economy, the impact of British monetary policy on small firm growth, and the politics of corporate governance.

Of interest to business and economic historians, this shortform book also provides analysis that will be valuable reading across the social sciences

Chapter 1
The move to limited liability banking in Scotland and the introduction of bank regulation^*

John D. Turner

I

Over the last two decades there has been a huge interest in the Scottish banking system of the nineteenth century.¹ This interest has been sparked by the modern free banking school of economists who argue that banks do not need to be regulated by government, and that the ‘fragility and instability of real-world banking systems is not a free-market phenomenon, but a consequence of legal restrictions’.² The modern free bankers argue that the Scottish banking system up until 1845 was relatively free from government regulation, this explaining the stability of the system. It is argued here that the Scottish banking system was stable up until 1882 because the private banks were required to have unlimited liability. The unlimited liability of equity holders gave the noteholders and depositors of Scottish banks a credible commitment of ex post contractual performance. Essentially, the period before 1882 can be viewed as one free from government regulation of banks. In 1882, the private banks moved to a limited liability status, and from then, the stability of the Scottish banking system was underwritten by the Bank of England.

Section two examines the reasons why unlimited liability prevented banks engaging in opportunism, and it also discusses the stability of the Scottish banking system under unlimited liability. In section three, the move to limited liability is discussed, and it is argued that the introduction of the lender of last resort was the institutional change which enabled the Scottish banks to move to a limited liability status. Section four investigates the stability of the Scottish banking system before and after the move to limited liability. Section five examines the subsequent development of regulation and supervision by the Bank of England and the final section is a brief conclusion which discusses some policy implications.

II

To what extent can the equity holders of a limited liability bank engage in ex post opportunistic behaviour at a noteholder’s or depositor’s expense? This, in accordance with the analyses of Williamson³ and Alchian and Woodward,⁴ will depend on the plasticity of a bank’s assets. The main asset of any bank is its loan portfolio which is difficult to value at any point in time due to the absence of a market price; and the information necessary to value the portfolio of loans will not be available because borrowers place a high value on a bank’s loan discreteness. This implies that depositors cannot monitor the loan portfolio of the bank. Hence, banks’ loan portfolios are highly plastic due to the information asymmetry which exists because of a bank’s discreteness about its loans. Therefore, sufficiently motivated boards of directors acting on behalf of equity holders can engage in a large degree of ex post opportunistic behaviour.

Banks are typically very highly leveraged firms compared to most non-bank firms. This implies that equity holders have the ability to engage in ex post opportunistic behaviour to an even greater extent. The banking firm differs from other types of firms in another important way. The value of a debt claim held by depositors/noteholders depends not on its intrinsic value, but rather on the value of the assets of the bank, particularly the loan portfolio. Due to the plasticity of these assets, the cost of information to determine their value is prohibitive. For a bank, the marginal cost of printing or issuing a debt claim against itself is essentially zero, while the value of the debt claim, if redeemed, is its money value. A bank therefore has an incentive to lower its asset value in each time period (by taking on riskier projects and issuing as money as many claims as possible). This implies that a bank enjoys a quasi-rent each period, the value of which is dependent upon the ability of the bank to lower its asset value.

In the absence of a credible commitment of ex post contractual performance, a non-existence problem may occur in that risk-averse depositors/noteholders will refuse to hold the bank’s claims at any risk premium. As Bagehot eloquently put it: ‘till it [a bank] is trusted it is nothing, and when it ceases to be trusted it returns to nothing’.⁵ Therefore, it is in the interests of bank equity holders and depositors that some credible commitment to ex post contractual performance exists.⁶

The equity holders of the unlimited liability Scottish banks assured noteholders and depositors of ex post contractual performance because if they engaged in opportunism and defaulted, they had to cover any shortfall between public liabilities and assets plus capital out of their own personal wealth. The unlimited liability of the Scottish banks gave noteholders and depositors a credible commitment that the banks would not engage in opportunism.

However, the three public banks had a limited liability status. Why then did noteholders and depositors trust the public banks? The public banks were set up by Parliament, and they dealt with public business such as remittance of revenue from customs and excise, and payment of armed forces.⁷ A. W. Kerr viewed the public banks as semi-government functionaries.⁸ In a similar vein, Checkland argues that the State had not only created the public banks but had ‘continued to confirm their preferred position, through their limited liability and through their public identity and perpetual succession’.⁹ Checkland further adds weight to the concept that the public banks were essentially State banks by stating that: ‘the selection and manipulation of the boards of directors of the public banks was part of the general political control of Scotland, just as was the manning of Edinburgh town council’.¹⁰ This suggests that these banks, as public banks, had the full backing of the State and were run in the interests of the country. This in turn would have demonstrated a credible commitment to the banking public that the public banks would not engage in opportunism.

Furthermore, the charters of the public banks controlled the amount of capital these banks could issue; it forbade them from engaging in any other business apart from banking; and in some charters, it limited the amount of liabilities that a public bank could issue.¹¹ These requirements would have prevented the public banks engaging in opportunism, and would suggest a reason why Campbell¹² found that the limited liability public banks were more risk-averse than the private unlimited liability banks. Table I suggests that the public banks were required to keep a high percentage of their notes and deposits covered by shareholder capital, and this again demonstrates the prudent behaviour of the public banks. The most likely reason the public banks acted in a prudent manner was because their behaviour was constrained by the State. Furthermore, the public banks could be viewed as unlimited liability banks because they had the implicit back-up of taxpayers’ money, and their behaviour was constrained by the State so that they conducted their business as if they had unlimited liability.

The unlimited liability of the private banks meant that noteholders and depositors were interested in the appropriable wealth of each individual equity holder. To ensure that equity holders had adequate wealth to cover any call made upon them in the event of bankruptcy, depositors could have monitored the observable assets of the main shareholders of the bank. In Scotland a Register of Sasines existed in which all land transactions were recorded.¹³

Table 1.1 The public banks versus other banks

	Public Banks (£1000’s)				Non-public Scottish Banks (£1000’s)
	Capital (c)	Notes (n)	Deposits (d)	cl(n+d)	Capital (c)	Notes (n)	Deposits (d)	cl(n+d)
1744	125	55	74	0.97	25	0	50	0.50
1772	184	139	331	0.39	212	505	518	0.21
1802	2520	1658	2406	0.62	765	1290	3386	0.16
1825	3864	1075	5809	0.56	2196	2187	8758	0.20

Source: Checkland, Scottish Banking A History , pp. 84, 237, 240, 424 and 426.

Notes: The figures for 1772 exclude the infamousAyr Bank.

This register was open to public inspection, so it was very easy for the public to view how muc...

Table of contents

• Cover
• Half Title
• Series Page
• Title Page
• Copyright Page
• Contents
• List of contributors
• Introduction
• 1 The move to limited liability banking in Scotland and the introduction of bank regulation
• 2 The commercial banking industry and its part in the emergence and consolidation of the corporate economy in Britain before 1940
• 3 Did they have it so good? Small firms and British monetary policy in the 1950s
• 4 Corporate governance in a political climate: the ‘City’, the government and British Leyland Motor Corporation
• Index