This is the first of two books I am reading about financial crises. Originally written in 1873, this volume alludes to the Overends financial crisis of 1866, and sets out the prudent principles that ought to govern the operation of a central bank in the face of a crisis. In our current financial environment, it has much to recommend it.
The Overends crisis of 1866 bears an uncanny resemblance to the collapse of RBS 140 years later. Overends was a bank engaged in the boring, but essential, work of bill discounting in the 1840s and 1850s - the branch banking of its day. The profits weren't spectacular, but they did provide a steady return on capital. Then new management came along, and they wanted to shake things up. To make their mark. The company moved away from the steady work of bill discounting and started to take on the more heady work of railway speculation. Needless to say, the bubble of railway stocks burst, and Overends tumbled with them. However, because of their central role in the discounting of bills, credit froze in London and the house of cards collapsed.
The similarity to RBS is striking. In that case we have established banking brands (Royal Bank of Scotland and NatWest), earning steady returns from boring branch banking. New management looks to spice up the bottom line by engaging in casino banking. Everything works well until the bubble - a property bubble, in this case - pops. Credit freezes and the bank collapses. One key difference between 1866 and 2008 is that the Overends directors had the good sense to ringfence the casino operations to isolate the contagion from the bill discounting business. The geniuses at RBS didn't.
How should a central bank respond to such a crisis? That is the subject of this book. In 1866, the Bank of England made credit freely available, but at a price. Bagehot considers this to be the best possible response, and his views still dominate today. In a policy of what we would now consider as QE, the Bank of England lent freely into the banking sector, but avoided the moral hazard of cheap money by making it relatively expensive. This was to separate those institutions suffering from a liquidity crisis (owing to a mis-match of maturities) from those suffering from a solvency crisis (they were busted flushes).
The book doesn't touch upon how effective this was in 1866, but we now know that the difference between the two can be very fine at times, and that politics helps to determine which is which. Unanswered questions that remain in my mind from our own crisis include, was HBoS solvent when it was absorbed into Lloyds? Did Northern Rock have to be sacrificed? Was Lehman Bros a going concern when Barclays bought the casino banking business? I have no answers to these questions, just ill formed suspicions. What we do know from 1873 is that the resolution of the fall out took decades. Any hope for a resolution in our times, for our crisis, seems like pie in the sky to me.
One final point of interest from the book is the way in which it charts the rise of London as a financial centre. According to Bagehot, the centripetal force in the English monetary system allowed large sums of capital to be accumulated in the London banks, which were then lent to promising ventures, first in England, and then around the world. The routing of capital to find a home at the highest return, combined with the impact of leverage upon the balance sheets of the early capitalists, provided the impetus to allow London to rise as the pre-eminent financial centre in 1873. London still retains it's pre-eminence today, but one wonders if it might not be compromised by Brexit? That is a question for another day, but the start of an answer is locked away in this book.
The aim of the book was to outline the principles by which the Bank of England should assume responsibility for the English monetary system. It was quite influential in its day, and laid down the basis by which future crises were met - lend freely, but lend dearly. Of course, such principles can only be appraised when they are tested, and that is the subject of the second volume in my reading - the great financial crash of 1914.
The Overends crisis of 1866 bears an uncanny resemblance to the collapse of RBS 140 years later. Overends was a bank engaged in the boring, but essential, work of bill discounting in the 1840s and 1850s - the branch banking of its day. The profits weren't spectacular, but they did provide a steady return on capital. Then new management came along, and they wanted to shake things up. To make their mark. The company moved away from the steady work of bill discounting and started to take on the more heady work of railway speculation. Needless to say, the bubble of railway stocks burst, and Overends tumbled with them. However, because of their central role in the discounting of bills, credit froze in London and the house of cards collapsed.
The similarity to RBS is striking. In that case we have established banking brands (Royal Bank of Scotland and NatWest), earning steady returns from boring branch banking. New management looks to spice up the bottom line by engaging in casino banking. Everything works well until the bubble - a property bubble, in this case - pops. Credit freezes and the bank collapses. One key difference between 1866 and 2008 is that the Overends directors had the good sense to ringfence the casino operations to isolate the contagion from the bill discounting business. The geniuses at RBS didn't.
How should a central bank respond to such a crisis? That is the subject of this book. In 1866, the Bank of England made credit freely available, but at a price. Bagehot considers this to be the best possible response, and his views still dominate today. In a policy of what we would now consider as QE, the Bank of England lent freely into the banking sector, but avoided the moral hazard of cheap money by making it relatively expensive. This was to separate those institutions suffering from a liquidity crisis (owing to a mis-match of maturities) from those suffering from a solvency crisis (they were busted flushes).
The book doesn't touch upon how effective this was in 1866, but we now know that the difference between the two can be very fine at times, and that politics helps to determine which is which. Unanswered questions that remain in my mind from our own crisis include, was HBoS solvent when it was absorbed into Lloyds? Did Northern Rock have to be sacrificed? Was Lehman Bros a going concern when Barclays bought the casino banking business? I have no answers to these questions, just ill formed suspicions. What we do know from 1873 is that the resolution of the fall out took decades. Any hope for a resolution in our times, for our crisis, seems like pie in the sky to me.
One final point of interest from the book is the way in which it charts the rise of London as a financial centre. According to Bagehot, the centripetal force in the English monetary system allowed large sums of capital to be accumulated in the London banks, which were then lent to promising ventures, first in England, and then around the world. The routing of capital to find a home at the highest return, combined with the impact of leverage upon the balance sheets of the early capitalists, provided the impetus to allow London to rise as the pre-eminent financial centre in 1873. London still retains it's pre-eminence today, but one wonders if it might not be compromised by Brexit? That is a question for another day, but the start of an answer is locked away in this book.
The aim of the book was to outline the principles by which the Bank of England should assume responsibility for the English monetary system. It was quite influential in its day, and laid down the basis by which future crises were met - lend freely, but lend dearly. Of course, such principles can only be appraised when they are tested, and that is the subject of the second volume in my reading - the great financial crash of 1914.
Stephen Aguilar-Millan
© The European Futures Observatory 2018
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