Are Scottish notes in banks' or customers' interest?

SEIGNIORAGE. What an excellent word. Not one we see every day, though that is changing. Indeed, it is right at the heart of the outrage which has sprung up over the alleged threat to the much-loved Scottish banknote. I say alleged because, despite Alex Salmond's demands yesterday at First Minister's questions that everyone should rush to the barricades in defence of the Scottish note, it is not clear to me that it really is under threat.

In fact, this seems to be to be a classic producer versus consumer interest clash in which, in true Scottish tradition, the interests of consumers are being ignored in favour of those of producers which, in this case, are the big banks.

First the consumer interest, beginning with a little bit of history. The rights of Scottish (and Northern Irish) banks to issue their own notes was created in an 1845 act. This law was drawn up in response to a series of English banking collapses in which the holders of the collapsed bank's notes found they were worthless. To stop that, Westminster legislated to make all banks use Bank of England notes, which would keep their value regardless of commercial banks going bust.

Scottish banks protested they should be exempt as they were robustly healthy. After a famous campaign by Sir Walter Scott (why he still features on Bank of Scotland notes), they and Irish banks were exempted. Scotland, Ulster and Hong Kong are the only places where commercial banks print their own, rather than a central bank's, notes.

However, the banks were still required to deposit assets at the Bank of England (BoE) to back the issue, the idea being that if, say, the Bank of Scotland did go belly-up, holders of its notes would get their money back from these BoE deposits. The intention of the law, a senior BoE person tells me, was clearly that these deposits should be there seven days a week.

However, Scottish bankers being clever types, they spotted that the value of their note issue was calculated on its value at the close of business on a Saturday. So they figured if they put the necessary deposits into the BoE on a Friday and took them out on Monday, the letter, if not the spirit of the law, would be complied with. Why do this? Because when their money is in the BoE, no interest can be earned on it, but for the other four days it can be deposited in an interest-bearing account, thus earning money for the note-issuing bank.

Good for them. But it also means for us that if any of the three note-issuing banks – the Royal Bank of Scotland, the Bank of Scotland and the Clydesdale Bank – goes bust between Monday and Thursday, their notes will become instantly worthless, so much confetti.

My wallet has about 40 of Scottish notes in it so that would be hurtful but not disastrous to me, but it would hit any cash-rich business, such as a shopkeeper or a taxi firm.

Plugging this hole is what the latest Treasury proposal is all about. It has nothing to do with being horrid to Scotland, but is simply about extending the same protection to holders of Scottish banknotes that is enjoyed by BoE note-holders. And while we all like to think that Scottish banks are as solid as the rock of ages, after Northern Rock, we know that is not necessarily the case.

OK, that's the consumer interest; what about the producer interest? This, I'm afraid, has nothing to do with Scottish heritage, history, or identity. It is all to do with bottom lines.

The fact is that the Scottish banks make money out of issuing notes. When the BoE takes a deposit to cover a note issue, this deposit earns no interest. But the BoE can take the money out of that deposit and put it into an interest-bearing account elsewhere, so making a profit. This is called seigniorage. And when the Scottish banks take their money out of the BoE account and put it into an interest-bearing account Monday to Thursday, they get seigniorage too.

According to Treasury calculations, the Scottish seigniorage amounts to about 65m. This is spread wider than the three note-issuing banks because they also sell their notes to other banks – Clydesdale notes are used by Lloyds TSB and Alliance & Leicester. Though the banks keep the figures confidential, I estimate that Scottish notes are about 2 per cent cheaper to use than BoE notes.

Allowing for this other use, it is possible to estimate how much seigniorage the three banks make, shown in the table below. One fact leaps out from this. While seigniorage is a minuscule proportion of RBS and BoS profits, it is a very significant part of Clydesdale profits, which perhaps explains why it has been shouting loudest about this. The figures for the table are for 2005, so with a near-quadrupled Clydesdale profit by 2007, the seigniorage element of profits will have dropped to about 3 per cent, still quite significant.

This says to me that Clydesdale does mean it when it says that if the proposed change comes to pass, it may well stop issuing its own notes. But I doubt that applies to RBS or BoS, to whom the value of having their own notes probably lies much more in the heritage and brand-identity kudos generated.

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