John F. Wilson (editor) - Banking and Finance: Case Studies in the Development of UK Financial Sector

John D. Turner

Over the last two decades there has been a huge interest in the Scottish banking system of the nineteenth century.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.

To what extent can the equity holders of a limited liability bank engage in ex post opportunistic behaviour at a noteholders or depositors expense? This, in accordance with the analyses of Williamsonassets. 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 banks 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 banks 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 banks 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.

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. 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.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 thebank. In Scotland a Register of Sasines existed in which all land transactions were recorded.

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 much property a bank equity holder possessed. However, this would only have indicated to depositors how much landed wealth an equity holder possessed. The commercial assets of some equity holders could also be costlessly ascertained by depositors. Depositors would not need to monitor every equity holder, only the most prominent ones who could be monitored at least cost. Depositors could then reasonably assume that it would be in the prominent equity holders interest to ensure that all other equity holders had adequate wealth. For example, the directors of the These requirements would have meant that depositors/noteholders could have easily observed the appropriable wealth of the directors.

However, in the last period, equity holders, realising that their bank was about to become bankrupt, could sell their shares to someone with inadequate wealth to pay the extended liability. If

Prior to 1825, there was only one joint-stock bank established in Scotland, namely the Commercial Bank in 1810. The provincial banking companies were essentially large co-partneries and: