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Banking in Scotland
Chapter VI - Lending

Dictionary definitions of banking are usually hopelessly inadequate as a source for conveying an impression of what banks actually do. Most dictionaries refer to the deposit functions of banks and do nothing else when in fact it has, in the past, been quite possible to operate a bank without deposits. Lending and note issuing have a far longer pedigree than deposit taking at least in the history of Scottish banking.

Most Scottish banks in the 17th and 18th centuries began life with a modest amount of capital. Their primary function was then to lend money (by issuing bank notes) to their customers. They did this at first by discounting bills. These were of three kinds: local bills were payable in the town where the bank was established; inland bills were payable in some other Scottish town; and bills of exchange were payable usually in London but could literally be payable anywhere in the world. Rather confusingly the generic term bills of exchange was often used to refer to all three types of bills. Bankers made their profits by charging a discount on the bill, i.e., if the bill was not due to be paid by the drawee or acceptor for three months and the drawer wanted cash now he would take it to his banker who would give him cash for the face value less 5 per cent per annum interest (i. e., 1.25 per cent for three months) and a small charge to cover any postal expenses which might be incurred in negotiating the bill. Usury laws prevented the banks from charging any more than 5 per cent until the 1830s.

When bills fell due for payment they were sent to the acceptor for payment, if local, or an agent of the bank if the bill was due in London. This agent would then collect payment and either hold the funds on behalf of the bank or remit them back to the bank in Scotland. For this reason a bank based, say, in Perth, would have agents for bill collection in Edinburgh, London and Glasgow. Banks in Glasgow had agents in Edinburgh, London and perhaps Liverpool. As the economy grew in the 19th century banks found it necessary to have agents in a wide range of places and so bills could be discounted which were drawn on a much wider range of towns. For this purpose correspondence arrangements were usually entered into with banks from all corners of the country (arrangements usually extended to branches) so that a bank like the Union Bank of Scotland would have arrangements, on a reciprocal basis, with banks in Ireland, Wales and England (usually several to take account of the various regions). The Union Bank also had arrangements with banks on the Continent and in the United States. From small beginnings in the early 18th century the system had spread from its very specific origins into a system with almost worldwide contacts by the mid-19th century and by the end of the 19th century the system was indeed worldwide. World trade could now be financed by the banking system.

Various refinements of the system of discounting of bills of exchange were developed to take account of the rapidly expanding field of trade and these included documentary credits and acceptance finance.

Bills of exchange, however, were not the only credit instruments developed to meet the rapidly increasing needs of industry and trade although they were usually always the largest means of lending measured by volume. Bills were not a Scottish invention, but cash credits, the second major lending instrument certainly were. These were first introduced by the Royal Bank of Scotland shortly after its formation in 1727 and were soon adopted by the Bank of Scotland and the provincial banks as they came to be established.

The cash credit has been likened to the modern overdraft but there are some major differences. Cash credits were authorised by bankers who established the customers credit limit. 1,000 was quite common in the days of the Industrial Revolution. The customer could then draw on the credit at will and repay when it suited him although rapid turnover was expected on the account as this helped keep the notes in circulation. Interest was charged, at 5 per cent per annum, on the daily balance outstanding. Customers who for some weeks or months in the year had no need of credit but were in funds were allowed to accumulate deposit balances on their account for which they were allowed interest at the going deposit rate, usually 4 per cent per annum. The cash credit was therefore both a credit and deposit instrument and its flexibility in this respect made it very popular with customers.

Customers requiring a cash credit were required to sign a bond which set out the terms of the credit and to have two or more cautioners (guarantors) sign the bond. If the primary obligant (the customer) failed to pay up when called upon to do so then the bank could call upon either or both of the cautioners to pay in his stead. The security for these accounts was therefore a personal one and did not involve any heritable or moveable property being transferred to the bank to cover the advance. Cash credits were granted without limit of time but could be recalled at a few days notice. In practice the banks seldom called in these advances. There are many examples in the archives of these advances. There are many examples in the archives of these accounts running on for several decades, e.g., the Shotts Iron Company's account with the Bank of Scotland. So long as a banker was convinced of the customer's ability to repay when called upon he was usually content to let the account continue in operation.

Cash credits or cash accounts as they were sometimes called were highly popular with customers because of the flexibility which they offered between borrowing and depositing and because of the relatively generous charge structure. Customers usually had both a cash credit and a bill discount facility. The two must be seen as complementary aspects of a bank's financing of industry during the Industrial Revolution. Generally speaking the cash credit was traditionally used to finance wage payments and small running expenses in industry while bill discounts provided finance for production and sales.

Advances on the security of heritable property were not unknown in Scottish banking in the 18th century but they were not very common as an Act of 1696 had made it impossible to operate cash accounts on heritable security. So advances of this type could only be made as fixed-term loans and as most banks were preoccupied with note circulation and this could only be maintained by rapid turnover of accounts then loans in heritable security were not popular. The bigger banks operated a few of these accounts but there was some confusion over their legality and practical operation which was not cleared up until 1856 when this type of account became much more common.

In the 1830s and 1840s the great spurt forward in the growth of the economy upset the long-established methods of industrial finance. Urban development, railway building, the hot blast furnace and power weaving are only some of the signs of this growth. The resultant pressure on the banking system was to make larger advances than had hitherto been the practice. One of the responses to these demands was the evolution of a range of joint-stock banks which, together with the three old Edinburgh banks, took over the businesses of the small provincial banks. Scotland was then equipped with a range of large scale banks which were able to offer the larger advances which were required by the increased scale of industry and commerce. Some of the provincial banks like the Kilmarnock Banking Company, had learned the hard way that small banks cannot make large loans. It had to be rescued by Hunters of Ayr in 1821 after a loan to cattle drovers, equal to more than its paid-up capital, became a bad debt.

The development of joint-stock banks and the further growth of the three Edinburgh banks in the 1830s and 1840s is to be seen against this backdrop of greater demands for credit. Apart from their growth in scale the banks responded positively to the challenge by providing larger advances on cash account and discount but they very quickly discovered that the old types of personal security were likely to be insufficient to cover these new credits and so began to look around for new ways to take security for their advances.

Banks began in this period to advance money against the security of life assurance policies, goods, ships, iron warrants and almost anything which the customer offered against which the bank could take a security. The problems of good security, however, were not simple. One example will illustrate some of the problems.

In the 1840s the Glasgow branch manager of the National Bank had been lending money to cotton dealers and manufacturers on the traditional personal security but the advances soon became so large that both he and his board of directors in Edinburgh became concerned that the personal nature of the security was inadequate to cover the advances and that something more tangible was required. It seemed obvious that the thing to do was to take raw cotton as security but this raised the problem of how to get an effective charge against the cotton. The directors felt that—

"nothing short of the cotton being placed in a separate warehouse and the key given to the bank could operate such a transference [actual delivery] while in every view of the case it appeared to the directors quite necessary that the cotton should be insured in the name of the bank."

The sums involved amounted to 400,000 which had been lent to three borrowers and were obviously critical to the Bank but the board had not accounted for the strong prejudice in Glasgow against impledgement by delivery of the key of a warehouse. The problem was solved when the Glasgow manager obtained a letter of transfer in favour of the bank from the owner of the warehouse [constructive delivery]. Readers of other handbooks in this series will find this practice familiar and indeed many of the modern techniques of lending and security taking were developed in the middle years of the 19th century. These new methods evolved over a number of years as banks sought, as banks must, to cover their advances. Some new methods were tried only once or twice and rejected as being inconvenient for bank or customer but many were tried, tested and found satisfactory and so entered into standard banking practice. Banks were then able to increase the size and range of their advances and so accommodate their customers more effectively.

The second major development at this time was the simple overdraft. The first known overdraft occurred in the books of the Perth Banking Co. in 1829 when a customer was allowed "to overdraw his account to the extent of 1,000", if necessary, for "temporary accommodation". This was of course a development from the cash credit system with the important difference that no bond was required. Most lending of this type was initially short-term and for small amounts but as the system developed the distinctions between overdrafts, cash credits and secured and unsecured lending became rather blurred, e.g., by the late 19th century the secured overdraft became quite common. Although difficult to quantify, it seems that the overdraft remains the most popular form of advance in the late 20th century.

The growing use of overdraft facilities led in the late 19th century to the virtual disappearance of the bill of exchange although there was a resurgence in the use of these instruments in the 1970s.

Overdrafts have always been repayable on demand but in practice they have often been allowed to "roll-over" so that many borrowers have achieved long-term loans (sometimes very long-term) in this way. The 1950s also saw a start being made with term loans for small- and medium-sized businesses. This facility was greatly extended in the 1970s. These loans are established by formal agreement and are not repayable on demand but only in accordance with an agreed repayment schedule although the borrower is often empowered to repay the whole loan at certain intervals. Many very large term loans have been made to companies engaged in exploration and oil extraction in the North Sea. Some of these have been made in currencies other than sterling and many have been syndicated, i.e., several banks joining together to provide very large advances thus spreading risks.

Perhaps the major development of the 20th century, however, has been the use of personal borrowing for consumption. For much of the history of Scottish banking, lending was almost entirely to business customers for the prosecution of their trade or industry but following developments in the United States, British banks began in the 1950s to offer advances for the purchase of consumer durables. Mostly this was accomplished by personal instalment loans repayable monthly in fixed amounts over a fixed period but there have been many variants of this. Such loans were usually unsecured.

To some extent this service was developed to meet the challenge of hire purchase companies but banks also this challenge by taking over these companies and operating in leasing and factoring so that even if these services are not offered by a bank direct to its customers they can usually be obtained by reference to subsidiary companies. Factoring and leasing are of course only appropriate to corporate customers.

Also since the inception of the Export Credits Guarantee Department just after the First World War the Scottish banks have provided special finance deals for exports covered by E.C.G.D. policies. These have recently been extended to cover medium- to long-term projects. These advances are of course secured by E.C.G.D. policies but much of Scottish bank lending both to personal and corporate customers remains unsecured. It has been said that Scottish banks remain "more prepared to lend on 'character' rather than on security, than have the English" (S. G. Checkland).

The costs of borrowing from Scottish banks vary with other market rates. Until the 1830s the Usury Laws placed a ceiling on interest rates of 5 per cent but even before then there are examples of interest rates following the Bank of England's Bank Rate. The competitive nature of banking ensured that all banks charged the same for any bank charging more than its competitors would soon lose custom, so the agreement on rates and charges into which the Scottish banks entered in the mid-19th century merely confirmed what the free operation of the market had already established. Even when this agreement was relaxed in 1965 and abolished in 1971 the competitive pressures which developed were primarily on the range of services offered rather than on rates and charges. Differences in this last respect remain minimal.

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