One of the most continuous and remarkable features of Scottish banking over the years has been the issue of bank notes by almost all banking institutions. There are now just three note issuers. The issue of notes has also been one of the most successful aspects of the system. Yet the experience of most other countries has been neither so successful nor so continuous. Most countries today have notes issued only by a central bank, but Scotland remains one of the few countries where each bank has its own note issue. This poses the questions as to why the Scots have been permitted to continue.

The first notes were issued by the Bank of Scotland when it commenced business in 1695. These were £5 notes but £1 notes followed in 1704, and as the system developed through the period of the Industrial Revolution, banks issued notes of these and other denominations, although £5 and £1 notes, particularly the latter, remained the most popular. The successful issue of notes was absolutely vital to the success of banks, for profitability depended almost entirely on the ability of banks to put their notes into circulation and keep them there. The truth of this can be illustrated from an abstract of the first balance sheet of the Perth United Banking Company.

In the age before deposit banking was common, banks advanced money to customers by issuing notes to them. The customer then used the notes to finance his business and eventually the notes would find their way back to the banker who issued them. The banker could then either retire each note by paying cash (coin) for it or he could reissue it by making a further advance to a customer. Naturally he preferred the latter course of action, for advances earned the banker the interest on which his profitability depended. If on the other hand he retired the note this would have the effect of reducing his reserve assets and, if the banker was trying to maintain a fixed ratio between reserve assets and liabilities, he would then have to take steps to reduce advances (earning assets) and increase cash (non-earning assets). This would have adverse consequences on profits.

Bankers then sought to make their business profits by advancing money to customers by means of their note issue. The note issue was then kept at a high level by increasing advances when notes were returned for payment or when old advances were paid off. If the bankers had not had the ability to issue notes then the economy would have been denied much of the credit which helped to finance the Industrial Revolution and the bankers would have been denied much of their profit. Until the 1830s when the Usury Laws were modified before being finally abolished, the maximum rate of interest which could be charged on an advance was 5 per cent per annum. The cost of printing and issuing notes at that time was minimal so that the profit margin on the note issue was in the order of 4½ per cent. The more notes a bank could issue, then, all other things being equal, the greater the profits would be.

Not unnaturally this facility led to some abuse in the earlier years. The first abuse was that some banks, mostly the smaller ones, tried to force more notes into circulation than the public really wanted to hold. They did this by paying a commission to "note pushers" who went round shopkeepers and merchants offering to exchange any bank notes in their possession for those of their employers. The expense and folly involved in this, however, ensured that the practice did not continue for long. More serious was the problem of small denomination notes. There was no legal restriction on the issue of notes in Scotland, and notes could be issued by anyone and in any denomination. This resulted in the proliferation of small note-issues throughout the country and which culminated in a major abuse; the "small notes mania".

Britain entered the Seven Years' War with France in 1756 and partly as a consequence of wartime finance and troop movements, Scotland's balance of payments with Europe and London became adverse causing a drain on coin of all descriptions. The coinage was already inadequate due to the deficiencies of the Royal Mint and this drain had the effect of exacerbating the problem. Many trades faced with the difficulty of finding coins to use in business, resorted to producing their own. These were known as trade tokens but other traders found that it was even cheaper to produce and issue notes. The result was a rash of note issues up and down the country in denominations often as small as one shilling (5p). The people issuing these notes sometimes described themselves as bankers but more often they were simply shopkeepers. Part of the result of this increase in the circulating medium was inflation as the supply of money increased without any commensurate increase in the supply of goods.

The problem, however, was compounded by what was known as the option clause. Several banks having experienced difficulty in obtaining supplies of coin, had included in their notes, a clause which gave them the option of paying coin for their notes to anyone who wanted it either on demand or, at the option of the bank, at the end of six months from the date when payment was demanded. (See below for illustration.)

1 Robert Jobson, Cashier to George Dempster and Co., Bankers in Dundee, in virtue of powers from them promise to pay to---------------- or the Bearer on demand at the Companys Office here One Pound Sterling, or, in the option of the Directors, One Pound and Sixpence Sterling at the end of six months either in Cash or in Notes of the Royal Bank or Bank of Scotland, and for ascertaining the Demand and Option of the Directors the Accomptant is hereby ordered to mark and thus note on the back hereof.

The situation which had evolved by the early 1760s, just as Scotland's economic development was beginning to gather pace, was potentially very damaging. Not only was the issue of notes completely uncontrolled, but it was pursued in a way which could inflict great damage on the economy. Clearly some control was required.

Political pressure for the imposition of some regulation came from the bankers themselves and they were successful in pushing through legislation in 1765. The Act prohibited the use of the option clause, made £1 notes the smallest which could be issued and allowed summary diligence (a simple legal procedure) on bank notes, so that if any bank refused to pay coin for its own notes when asked, it was then a simple matter for the holder of the notes to proceed at law to try to enforce payment.

The Act was a milestone in the history of Scottish banking. Certainly it permitted freedom of issue so that anyone could set up as a banker and issue notes and this had a potentially destabilising effect on the economy but, most importantly, it ensured that notes were payable in coin on demand, i.e., that they became legally convertible into legal tender. It was the absence of convertibility in many other countries which resulted in the failure of note issues and banks. The existence of convertibility in Scotland ensured the increasing popularity of bank notes and the certainty that people could obtain coin on demand in exchange for their notes, meant that few asked for it. This enabled the banks to keep smaller reserves of gold and silver coin and to expand their businesses accordingly.

Although the initial problems associated with note issues were overcome by the Act of 1765 the banks had still not learned to live in peaceful co-existence with one another and instead often treated their competitors with great suspicion and hostility. It did not take long, however, before part of this problem was resolved.

In 1771 the Bank of Scotland and Royal Bank of Scotland decided to set up a note exchange and persuaded other issuing banks to join it. (They had operated their own exchange from 1751.) The existence of the exchange facility encouraged banks to take the notes of other banks in payments over the counter, and so added greatly to the smoothness of the payments mechanism in Scotland. The fact that banks would take the notes of other banks in payment encouraged traders to do likewise. The result was a general expansion of note issues and a consequent growth of the banking system.

Just as important as the growth which developed from the note exchange, was the increased stability which the exchange gave to the system. Banks could no longer force their note issues and create an unrealistic circulation for themselves. Notes which found their way into the hands of other banks—and there was an increasing tendency for this to happen—soon found their way to the exchange and from thence back to the issuing bank. The note exchange therefore was an important check to the over-issue of notes. It was the first of its kind in the world.

Having overcome the difficulties at an early stage the system was then free to grow unhindered. The Scots had been fortunate in 1765, that the Act of that year had allowed them to issue notes from £1 upwards. The English were not so fortunate. When legislation was passed in 1775 and 1777 it was enacted that the £5 note should be the smallest denomination. This had serious consequences for the development of banking in the two countries. The existence of the £1 note in Scotland had meant that the banking habit percolated down to most levels in society and gained the support of the mass of the people for the banks and the banking system. This never really happened in England where, for many years, the £5 note was the smallest denomination, and £5 was a substantial sum of money in the age of the Industrial Revolution. The banking habit was, therefore, less popular in England than in Scotland at this time, with the result that the banks were less well supported in times of commercial distress.

During the Napoleonic Wars because of the general shortage of coin, English banks were allowed to issue notes of smaller denomination and many did so, but when the war ended plans were made to terminate the issues of these £1 notes which were blamed, by some, for the inflation which had taken place. It soon became known that the Government planned to put an end to small denomination notes not only in England but in Scotland and Ireland. The result was a deluge of petitions from all over Scotland from bankers, industrialists, merchants and town councils in support of the status quo. Perhaps the most dramatic impact on the debate which followed was made by Sir Walter Scott in a series of letters to the Edinburgh Weekly Journal under the ill-disguised pen name of Malachi Malagrowther. As a result of this pressure the Government set up committees of the Lords and Commons which took evidence between March and May 1826. Bankers who gave evidence to the committees claimed that if small notes were abolished, then they would no longer be able to operate the cash credit system nor to pay interest on deposits, with the result that the benefits of these services would be lost to the economy. The overwhelming weight of evidence in favour of the Scottish banking system resulted in the Scots being allowed to keep their small notes, and the only change that was made was that they were banned from circulating their notes in the north of England which had been their practice for many years.

The right to issue small notes had been defended with great energy and justification for, as the Lords Commissioners concluded in their report the Scottish banking system was—

"found compatible with the highest degree of solidity and had the best effects upon the people of Scotland, and particularly upon the middling and poorer classes of society, in producing and encouraging habits of frugality and industry."

The enquiry of 1826 marks the high point of the Scottish note issue, for thereafter it began to decline in importance as a source of profit to the banks although, of course, its popularity did not decline.

In the 1830s and 1840s great strides were made in the development of the Scottish economy. This was the age when a success was made of the iron industry for the first time, when railways were built and when there was substantial urban growth. In short, it was a period of rapid technological and social change. But just as the economy was changing so the banking system transformed itself to meet the challenge of the new scale of industry. The joint-stock banks which developed in this period placed much more stress on deposit banking than on note issuing. Transferring money from bank account to bank account by cheque began to develop and was soon commonplace, particularly in the cities.

The result of this was that when the system was again threatened with legislation in the early 1840s it was defended with much less energy than it had been in 1826, yet the pressure which the Scottish banks did exert, ensured once again that they would be treated differently from their English neighbours. In England legislation passed in 1844 ensured that no new bank of issue could be formed. Even the Bank of England did not escape from the restrictions. Its issues were confined to a fiduciary issue of £14m plus an amount equivalent to its reserves of gold and silver. The long-term effect of this—largely as a result of the merger movement in English banking—was to confine the right of issue entirely within the hands of the Bank of England.

In Scotland, however, an Act of 1845 prohibited the formation of any new banks of issue. Banks already in existence were given an "authorised issue" equivalent to the average of their issues in the year preceding 1st May 1845. The banks were given permission to exceed this limit provided that the excess was covered by reserves of gold and silver (three-quarters gold) held in the banks' own vaults. The amounts authorised were as follows:

If the Scots had not been treated differently from the English by being allowed to keep their note issues when they merged with another bank there would now be no Scottish bank notes.

The success of the Scottish note issue until this time has been achieved without notes having become legal tender except in war-time. That they were not legal tender had been established in a court case in 1756. Nevertheless the public had displayed an increasing preparedness over the years to accept bank notes in payments and to use them in their businesses and in their private lives as a medium of exchange. Their willingness to do so was in large measure attributable to the convertibility guaranteed by the Act of 1765, and also to the great faith which they placed in their bankers, a faith which was justified by experience.

After 1845 the Scottish note issue grew in volume but declined in importance. The figures below indicate the trend.

Notwithstanding this substantial increase in volume, however, the note issue declined in importance as an earning asset after 1845, as all notes issued in excess of the authorised issue had to be covered in the banks' vaults by non-earning assets i.e., cash or bullion although nowadays the banks keep these reserves in the form of Bank of England notes and coin held at two approved offices in Scotland, or certificates in respect of notes deposited at the Bank of England. These are non-earning assets. The effect of this is that the note issue is not so important for the profitability of the banks as it once was. Nevertheless the banks contend that their issues are still profitable and worth maintaining, and the right to issue notes is zealously guarded. This is also a highly useful advertising medium because they present the banks' names to the public every time they make a transaction. The advantage of having their own notes as till money also enables the banks to keep open some rural branches which might otherwise have to be closed.