Hubris: How HBOS Wrecked the Best Bank in Britain (4 page)

To make matters worse, Scotland and England were short of coin; there simply was not enough gold and silver to go round. William III
took much of what was available to pay
his armies fighting Continental wars, leaving a less than adequate supply for merchants and entrepreneurs who needed ready money to expand their trades. As an alternative, barter and payment in
kind were often used to settle domestic debts – tenants paying their rents for example – and Scots merchants paying for purchases from England or abroad or receiving payment for goods
sold, used bills of exchange, essentially IOUs. The weakness of the Scottish economy, however, meant that Scottish bills were often discounted in London – by as much as 10–15 per cent
in bad times.
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Clearly there was a need for banks.

It is an irony that has often been remarked that a Scotsman was a prime mover in the establishment of the Bank of England in 1694 and an Englishman was the first Governor of the Bank of Scotland
a year later. But their nationality was not the most important distinction; they had very different backgrounds, very different temperaments and left very different legacies to history.

The Scot was William Paterson, who was born in rural Dumfriesshire in 1658 to parents who were small tenant farmers. Not much is certain about his early life; by some accounts he moved to
England at a young age, but others have him living with his parents until the age of 17, then moving to Bristol and later to the West Indies. One of his most recent biographers places him as a
young man in Port Royal, a British colony in Jamaica rivalling Boston in size and importance as the largest city in the Americas, but also a nest of pirates ruled over by the notorious Captain
Morgan. There Paterson is said to have first dreamed of the riches of Central America.
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However colourful this part of his life may have been,
we do know that by his mid-twenties he was in London making his way in business.

He bought his way into the Merchant Taylors’ Company, one of the 12 medieval guilds of the City of London and in 1689, at the age of 31, was ‘admitted to its livery’, giving
him a position of respectability, contacts and influence. He had already buried a first wife, but by now had married again and had a child. We cannot be sure what he looked like; an etching in the
National Portrait Gallery, London, shows a rather sharp-nosed, haughty face beneath a full periwig. But other contemporary pictures show him in profile with a softer, more thoughtful look. He was
God-fearing, a lifelong teetotaller, of modest habits, although not a Puritan.

Paterson was clearly clever and he was a thinker who published
numerous essays and articles on economic and financial matters. He would later be hailed as a visionary with
ideas well before his time, but he had a more sinister side too. His entry in the
Dictionary of National Biography
describes him as gaining ‘a reputation for double-dealing and
insincerity, as well earned as that for imagination and persuasiveness’.
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One contemporary was blunter, describing him as ‘one who
converses in darkness and loves not to bring his deeds into the light’.
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Others were more kind in their assessment: ‘He trusted
people he should not have trusted and lacked any sense of humour.’
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He was a serious man, who never told a joke or a funny story.

Wartime shortages always provide opportunities for spivs and speculators and Paterson, although there is no evidence that he ever acted illegally, seemed to have some of the characteristics of
both. The main shortage that King William’s foreign wars created was money. The monarch needed cash to pay his troops and supply his armies and Paterson saw an opportunity to supply it and
make a profit.

He realised that there was money to be made by setting up a bank specifically to lend to the king and his government and, by persuading Parliament, to guarantee the interest payments from taxes.
He was also quicker than most to understand that by issuing notes – promises to pay in coin if the note was presented – the bank could expand the money supply beyond the amount of cash
it actually held. Provided the bank could inspire enough confidence to prevent all holders of its notes from demanding payment at the same time, it could go on creating credit indefinitely. This
was not an original thought, it is one of the basic principles of banking and a number of English pamphleteers had been proposing schemes for banks for years. But previous theorists had
concentrated on the effect bank credit would have on commerce and general economic growth. Paterson was much more interested in the profit it could bring to the bank and its owners. By lending the
credit it created it could earn interest. He wrote: ‘The bank hath benefit of interest on all moneys which it creates out of nothing.’

Other schemes had been tried and failed. Paterson’s masterstroke was seeing how it could be applied in the conditions of the time and making it work.

In 1691 he got together a group of prominent merchants, proposing to found a bank on the Dutch model specifically to lend money to the
king and government to finance the
war with France. He also took the lead in persuading the Treasury to let it happen and recruiting the investors.
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Initially rejected by
Parliament, a refined plan, largely written by Paterson and pushed by him with dogged persistence, won approval three years later and the Bank of England was born. It had a Royal Charter and its
sponsors, including Paterson, who was also a director, undertook to raise £1,200,000 and lend it to the Government in perpetuity at an annual interest rate of 8 per cent. In fact most of this
money was not raised in coin, or gold or silver, but in bills of exchange – promises to pay – which were passed to the Government which then used them to pay its bills.
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Interest was thus being earned on money which physically did not exist. The alchemy had begun.

Paterson may have been the genius behind the Bank, but it did not bring him either the recognition or the wealth that he had hoped. His claim to be paid for all the work he had done in devising
and promoting the Bank was rejected by his fellow directors. His less attractive characteristics were not long in asserting themselves and the following year he fell out with the board over a rival
scheme he was also promoting. He sold his stock and left London.

If this was a setback, it did not last long. Paterson had another scheme and he set about pursuing it with vigour. Scotland had long envied the success of the East India Company, which had
acquired from the English Parliament lucrative monopolies on trade with England’s colonies. Paterson proposed a similar concern north of the border, a ‘Company of Scotland’ and in
June 1695 used his considerable powers of persuasion to convince the Scottish Parliament to pass the legislation allowing him to set one up. Since Scotland, unlike England, did not possess
colonies, Paterson proposed to found one at Darien on the isthmus of Panama where, by means of an overland route, it would be able to link the trades of the Atlantic and Pacific.

Meanwhile Paterson’s success with the Bank of England had not gone unremarked among Scots merchants in London and Scotland. A group of them got together to propose a Bank of Scotland and
the man to whom they turned to make it happen was an Englishman, John Holland.

Holland was very different from Paterson in both upbringing and temperament. Where Paterson was a visionary, impulsive and
devious, Holland appears to have been the
opposite, diligent, meticulous and straightforward. He had been born in London, the son of a sea captain who had served in both the English and the Dutch navies and was a sometime friend of Samuel
Pepys. As a young man, John had spent time in the Netherlands learning bookkeeping and accounting, before returning to London as assistant to the Dutchman Francis Beyer, auditor general of the East
India Company. He also made his fortune by investing in some of the company’s voyages.
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Beyer supported the plan for a Bank of
Scotland and was one of the original subscribers. It is likely that he recommended John Holland, who drew up the plan for the new bank, taking the Royal Charter of the Bank of England as his
model.

Paterson was furious. Although his public plan for the Darien Company (as his new venture became known) was to establish a colony and engage in trade, he also secretly intended it to be a bank
and he urged his supporters in Scotland to lobby against the potential new rival. They failed and on 17 July – less than three weeks after Paterson got his Act establishing the Company of
Scotland – the Scottish Parliament passed an ‘Act for Erecting a Public Bank’. Paterson cursed that the Act had been ‘surreptitiously gained and which may be of great
prejudice, but is never like to be of any matter of good neither to us, nor those that have it’.
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Nevertheless, Bank of Scotland was
born, with John Holland as its first Governor.

Although the new institution had been inspired by the Bank of England, it was to be a very different business. Whereas the London bank lent only to the government, the Edinburgh bank was to lend
only to the private sector – landowners, merchants, traders and manufacturers – in fact its charter prevented it from lending to the state. It was thus Britain’s first commercial
bank. The Scottish Parliament had granted it some very special and valuable privileges. It was to be incorporated with limited liability, meaning that its shareholders could not be held responsible
for its debts, and for its first 21 years its dividends were to be tax-free and it was to enjoy a monopoly over banking in Scotland.

The Bank had first to raise its capital, £1,200,000 like the Bank of England, but since Bank of Scotland’s capital was to be in Scots pounds and the exchange rate was £1
sterling to £12 Scots, it would be a much smaller enterprise than its older sister. A subscription book was opened in the Cross Keys Tavern, in a close off Edinburgh’s High
Street, and another in London. The Bank’s shareholders, quaintly called ‘Adventurers’, were only asked to put up an initial tenth of the capital, although in the
ensuing turbulent years they would be asked to put their hands in their pockets again. Of the 172 people – including seven women – who were the Bank’s subscribers, three-quarters
lived in Scotland and comprised the great and the good – landowners, lawyers and judges, merchants, nobles and government ministers and officials. The Act of Parliament also specified that
any non-Scottish subscriber was to be given automatic Scottish citizenship. The Bank opened for business on New Year’s Day 1696.
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Since there were no precedents for a bank of this type, the directors and proprietors of the Bank had to make up the rules as they went along. From the start their Presbyterian rectitude
asserted itself. Although John Holland was Governor and manager, he was not to be allowed to decide loan applications on his own. A committee was set up – and there were to be similar
committees in branches when they were opened – consisting of men of ‘Credit and Substance’ who would decide each application by ballot – the first-ever credit committee. A
cashier would look after the money, but there was also to be an ‘Overseer’ to watch over him, effectively an auditor. The directors intended to keep a very close eye on the day-to-day
running of the company and their sanction was needed to increase salaries or to sack staff, a restriction which remained in force for 200 years.
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Holland invented some very prudent rules. The Bank would make money by lending, but its advances were to be made on a very cautious basis. Loans were for a maximum of one year and could be
recalled by the Bank at 30 days’ notice. They all had to be backed by collateral, in the form of land, a personal security or pledges of ‘non-perishable commodities’. In the case
of personal security, the Bank not only demanded the ability to seize the borrower’s ‘moveables’ in the event of a default, but also insisted on having two
‘cautioners’ to act as guarantors. It would also take deposits and, crucially, would issue its own banknotes – promises to pay the bearer on demand the face value of the note in
coin.

The Bank rented a head office in Edinburgh’s High Street and branches were quickly established in other major Scottish commercial centres. In June Holland returned to London with the
thanks of the directors for getting the Bank up and running. He had been paying his own expenses while living in Edinburgh and drawing no salary, his
remuneration being set
at ten per cent of the Bank’s profit after the Adventurers had taken a 12 per cent dividend. Since the bank was in no position to pay a dividend in 1696, he must have received nothing.

No sooner had he gone than Paterson struck. Using his considerable powers of persuasion and unrivalled contacts, he had been phenomenally successful in raising capital for his Darien Company,
amassing pledges of £400,000 sterling, a sum which dwarfed the nominal capital of the Bank, which at that time stood at a quarter of that figure, and of which only a puny £10,000
sterling had been subscribed in cash.
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Organising and equipping an expedition to Panama would take time, but in the meantime Paterson
intended to put his funds to profitable use.

From offices on the opposite side of Edinburgh’s High Street from the Bank, he began making loans and issuing notes, ignoring the monopoly given by Parliament to Bank of Scotland. There
was concern as the Darien Company began lending to many of the people the Bank had regarded as its natural customers. Rumours began to circulate about the Bank’s stability and its notes were
being presented for payment in cash in large quantities, straining the Bank’s reserves. The directors were in no doubt who was behind these moves and wrote in alarm to Holland: ‘We
understand that there are formed designs to break us.’
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Holland tried to broker a peace and met Paterson, who rejected any
compromise.

For a while it looked as though the Bank might go under before it had really got started. The Darien Company itself had acquired large amounts of Bank of Scotland notes and might at any time
present them for payment, precipitating a collapse. Holland initiated emergency action. Branches were ordered to return as much cash as possible to Edinburgh, the Bank began to call in its loans
and demanded that its subscribers stump up a further 20 per cent of the authorised capital, precipitating a dispute between the Scots shareholders, who paid up promptly, and the Londoners, who were
more reluctant. Even so the Bank came perilously close to running out of cash and was itself forced to borrow.
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