The downfall of the Scottish banks

• Dark day as centuries of tradition come to an end • Chiefs Goodwin and Hornby brought down • Government takes big stakes in RBS and HBOS • Shares still slump on news of no dividends

'PRUDENT, cautious, responsible" and "stable, reliable, solid" – the characteristics of three centuries of Scottish bankers and their banks all seemed instantly vaporised the moment it was announced yesterday that Royal Bank of Scotland and Halifax Bank of Scotland had been forced to collapse into government ownership.

The humiliation of this admission of catastrophic failure, the injury inflicted on national morale, the shame of having to go cap-in-hand to politicians, will reverberate around the nation for years, with as yet incalculable consequences for the political economy of Scotland.

Never before has the country seen the spectacle of two big bank chief executives with, at one time, more practical power at their command than any government minister, forced to depart quietly into the night with not a penny of the severance pay to which they were entitled.

The sense of complete failure is underlined by the fact that these banks are commercial companies, which prided themselves on their independence from government but are now creatures of it.

Though modern society tends to think of banks as a necessary evil, they are deeply interwoven with the history, character and economy of Scottish society and have shaped the nation in more profound ways than is often appreciated.

The Scottish reputation for thrift, for example, stems directly from the Trustee Savings Bank movement, which was founded in 1810 in the parish of Ruthwell, Dumfriesshire, by the Rev Henry Duncan – his memory is commemorated in the name of Lloyds TSB's Scottish headquarters in George Street, Edinburgh.

He was a man who was appalled by the poverty of the time and came to realise that a bank in which poor people could deposit money in good times would help sustain them in years of famine and poverty.

But the commercial banks of the time required a deposit of 10 to open an account, a sum well beyond the hopes of ordinary labourers, whose wages were counted in pennies not pounds. His solution was to create a bank where sixpence was enough to begin saving.

His iron rule, based on the three years he had spent working for a bank in Liverpool and a departure from the practices of poor-relief charitable movements of the time, was to insist that the bank would operate as a business and not as a charity.

To persuade the naturally suspicious parishioners that their money was safe, he showed off the chest in which their cash would be kept. It had three locks, with keys entrusted to three different trustworthy people – the trustees in the name of the movement.

The bank was an immediate success. In its first year, it attracted 151 in deposits, which were entrusted to the Linen Bank in Dumfries in order to earn 5 per cent interest.

The Rev Duncan, far right, laid down strict rules: "Every depositor must lodge to the amount of four shillings at least within the year, under the penalty of one shilling. Interest at the rate of five per cent is allowed to every depositor who continues a member of the bank for three years; but such as withdraw the whole of their deposits before that period receive only four per cent."

And failure to attend the annual meeting meant a fine of sixpence.

No mean publicist (the Rev Duncan founded the Dumfries and Galloway Standard newspaper to spread the message of his banking cause), he made sure that news of his innovation spread far and wide. More Trustee Savings Banks followed in Scotland, then England, then Europe and even the United States. Within ten years, the money deposited in British TSBs totalled 3 million.

If the TSB movement went a long way to alleviate poverty, the business of the Bank of Scotland and Royal Bank of Scotland was to create wealth. The Bank of Scotland was created in 1695, the only institution founded under an act of the pre-1707 Scottish Parliament to survive into modern times.

It arrived at a time of economic distress. Famines, called the "seven ill years" in Jacobite propaganda, had begun to afflict all of northern Europe as a result of a climatic downturn. Scottish merchants, anxious to trade with England and further afield, found the credit they needed for such work hard to find.

The Scottish currency, too, was unreliable, and merchants preferred to deal with English sterling, which was difficult and time-consuming with London being several days' ride away.

The arrival of the Bank of Scotland began to fix these problems. One problem it fixed was a lack of coins, particularly gold coins, which were being used by the English government to finance war against France.

The bank began experiments with paper currency, backed by its capital, which could be passed as payment from trader to merchant – they soon became sure in the knowledge that the paper note was always redeemable for hard cash at the bank's offices.

The creation of reliable currency and credit facilities did much to finance Scotland's growth during the industrial revolution. Steel mills, shipyards and engineering foundries all required vast sums of money to be created. Scottish banks provided much of it. Among the beneficiaries was Robert Owen, whose New Lanark cotton mill experiment in enlightened manufacturing was financed by Royal Bank of Scotland.

Paper currency was a major innovation that spread rapidly to the rest of Europe – an invention which founded the Scots' reputation for being clever and inventive with money.

There is a long list of inventions: 1728 – Royal Bank of Scotland invents the overdraft; 1750 – British Linen Bank, now part of HBOS, develops the first retail bank branch network; 1777 – Royal Bank of Scotland creates the world's first coloured bank notes; 1826 – Royal Bank of Scotland prints the first double-sided banknotes in an effort to thwart the counterfeiter; 1875 – the Chartered Institute of Bankers in Scotland, the world's first banking institute, is established; 1946 – National Bank of Scotland, now part of RBS, develops world's first mobile bank; 1959 – Bank of Scotland is the first UK bank to computerise its processing of bank accounts; 1972 – Royal Bank of Scotland is the first UK bank to offer house purchase loans; 1986 – Bank of Scotland launches world's first remote banking service; 1997 – Royal Bank of Scotland is the first British bank to announce a fully fledged internet banking service; 2005 – Clydesdale Bank is the first UK bank to offer ATM speech technology for the visually impaired.

Throughout, the two main banks have been shaped by, and have shaped, the country's politics.

In its early days, the Bank of Scotland was suspected, somewhat unfairly, of Jacobite sympathies. Although it kept its deposits away from the Old and Young Pretenders in the 1715 and 1745 rebellions by securing the money in Edinburgh Castle, its treasurer, David Drummond, was also treasurer of a fund raised to pay for the defence of Jacobite prisoners from the '15.

Yet the suspicions of treasonable activity were enough to help persuade monied Edinburgh Whigs of the early 18th century that the bank should have a loyal competitor. Hence the "royal" in the title of Royal Bank of Scotland, founded in 1727.

The seeds for the expansion of Scottish banks internationally were laid by the discovery of North Sea oil. The Bank of Scotland was in the lead, taking a share in providing the 360 million needed to finance the exploitation of the giant BP Forties field. The project's viability was based on the assumption that the oil was worth $4 a barrel.

Many more such ventures, and profits, for the banks followed.

This internationalisation led to the bankers' eyes opening on far horizons which – as Royal Bank of Scotland in particular began acquiring banks in the US after it beat the Bank of Scotland to buy National Westminster in 2000 – turned Scottish banking into a global player.

So why did it go so wrong? In short, it was because the Scottish banks believed the same things as did nearly everybody else; that the world had moved into an era of cheap credit, low inflation and steady growth. They believed that Wall Street, through the invention of such things as collateralised debt obligations – incredibly complex parcels of mortgages and other loans – had found new ways of raising sums that could be used to finance yet more lending.

Enthusiastically embracing derivatives trading, they believed the risks involved in this new finance could be laid off by yet more complicated mechanisms called credit default swaps. They also believed the international monetary markets would provide them with the billions in loans needed to keep this complicated business going.

To be fair, save for a few dissenting voices here and there, no-one saw how it could all unravel.

But unravel it did, as the subprime mortgage defaults in the US more than a year ago turned from a trickle into an avalanche, and the collateralised debt obligations turned into liabilities.

Should Messrs Goodwin and Hornby have foreseen these problems? Perhaps. Should they have been more prudent? Maybe. Were they and their executives so entranced by the bonuses to be won from immediate profit that they ignored questions of long-term financial viability? Possibly.

The reckoning on these questions will come, but for the moment, the urgent need is to rebuild. It could, after all, have been a lot worse. The two banks are still there, albeit with the government sitting in their boardrooms. The people who have built up the relationships of trust on which banking business depends are still there, though the trust needs some repairing.

Among the debris of battered trust lies the dictum that Sir George Mathewson drummed into his executives: that in order to retain the loyalty of RBS's army of shareholders, they had to deliver a steady stream of dividends. Now shareholders have to wait perhaps four to five years until the government's shareholding is redeemed before their dividends resume.

Scotland has been hit by the blast of the hurricane. But unlike Wall Street, where the vast and mighty investment banks have been whipped away, or Iceland, whose 320,000 people and 10 billion of annual GDP are weighed down by the huge burden of 50 billion of debt, Scotland's banks have not been levelled flat.

If the people who take charge of the banks now can show the prudence, innovation and enterprise of their forebears, the industry will rise and be a power again.

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Q&A: Government takes preference over dividend payouts in return for helping sector to stabilise

How will the deal work?

The UK Treasury is injecting 37 billion into three high-street banks – Royal Bank of Scotland, HBOS and Lloyds TSB. The aim is to give the banks the capital they need to get back to normal trading and restore confidence in the industry.

How much is each getting?

For RBS, the government will buy 5 billion of preference shares and another 15 billion of ordinary shares if, as many expect, the bank is unable to find willing private investors.

HBOS will get 11.5 billion from taxpayers, made up of 8.5 billion in ordinary shares and 3 billion in preference shares, while Lloyds TSB is to get 5.5 billion, 4.5 billion in ordinary shares and 1 billion in preference shares.

Barclays has said it is to raise 6.5 billion of new capital from private investors rather than going to the government. Barclays also said it would scrap its final-dividend payout for this year, saving it 2 billion.

What are preference shares and what are ordinary shares?

Preference shares, as the name suggests, rank ahead of ordinary shares. The Treasury will earn 12 per cent a year – a good deal for the taxpayer. Until the preference shares are paid off, ordinary shares will not get a dividend, which could take several years.

How were the amounts of money arrived at?

Under guidance from the Financial Services Authority, the government negotiated with the banks.

Banks were asked how much they would need to make sure their capital assets represented 8 per cent of their loans.

In banking, capital assets represent the combined total of physical assets and shares. The banking standard is to have capital assets that represent 8 per cent of the loan book, but the government wanted them to be over-capitalised so each was given more than enough to hit that target. RBS has been given enough to take its asset capital ratio to 11. 5 per cent, while the new merged HBOS Lloyds TSB bank will have an asset capital ratio of 8.5 per cent.

Where is the government getting the money from?

To get the money for the rescue package, the government will have to borrow from the international money markets in the form of a government gilt auction – just like the US government does for its own $700 billion bail-out plan.

Were there any strings attached to the investment?

Yes, ministers have stipulated certain conditions – no bonus will be awarded to any board member for 2008, and any bonuses earned in 2009 will be paid in shares.

No dividend will be paid on ordinary shares until the government's preference shares have been repaid. Also, RBS and Lloyds TSB/HBOS have promised they will maintain mortgage lending and small-business lending at 2007 levels.

Will this part of the deal actually work?

The Treasury said last night it was confident that it would work, primarily because the government now has representation on the boards of the banks and because, as a major shareholder, it is able to exert influence at that level as well.