In particular, the period (after the passing of the Bank Charter of 1844) was one of remarkable financial innovation. On the one hand, banks that had initially issued circulating notes adapted to the new environment by converting to deposit banks and eventually offering checking accounts. On the other hand, new bank like financial intermediaries were developing. Bagehot calls these financial intermediaries bill brokers, and elsewhere they are called discount houses. In any case, as Bagehot makes clear bill brokers, that in the past were pure brokers matching savers with credit-worthy borrowers, had become intermediaries who guaranteed the bills that they placed in large quantities with banks. This was a tight margin business where the "brokers" borrowed most of their capital from these same banks and thus they were essentially earning money on spreads and the value of their highly specialized knowledge of the quality of commercial bills. Aggressive competition meant that it was not profitable for these brokers to maintain reserves (i.e. capital) to back up their guarantees. Instead the bill brokers relied on the Bank of England's discount policy: Even in the worst of crises the Bank was expected to discount good bills at Bank rate.
In the crisis of 1857, the Bank of England advanced more than £9 million to the bill brokers and only £8 million to bankers. After the crisis, the Bank stated a new policy which restricted the Bank tranactions of the bill brokers to advances which were only offered on a quarterly basis. Should the brokers need discounts at any other time, they would have to ask for an exception to the Bank's policy. The stated goal of the policy was to make the brokers "keep their own reserve."
Needless to say, the bill brokers were unhappy with the new policy. Gurneys, which controlled more than half of the commercial bill market and was in many ways a competitor of the Bank of England, apparently tried to start a run on the Bank in April of 1860 by withdrawing from its deposit account an outrageous sum of money all at once. (While Bagehot claims the sum was £3 million, other sources cite a figure of £1.65 million.) This action was roundly condemned in the press.
In the meanwhile Gurneys was being poorly run by a second generation of the family. As badly underwritten bills went into default, the company advanced money on mortgages and even ended up running a fleet of steamships -- also unsuccessfully. By matching short term obligations with long term assets, Gurneys violated one of the most fundamental principles of 19th century banking. This explains the strong words Bagehot uses to describe the company:
The case of Overend, Gurney and Co., the model instance of all evil in business, is a most alarming example of [the] evil [of a hereditary business of great magnitude]. No cleverer men of business probably ... could well be found than the founders and first managers of that house. But in a very few years the rule in it passed to a generation whose folly surpassed the usual limit of imaginable incapacity. In a short time they substituted ruin for prosperity and changed opulence into insolvency.
In 1865 before all of Gurney's problems were public knowledge, the partners took the firm public, creating Overend, Gurney and Co. While this action required the Gurney family to guarantee the new firm against losses on the business of the old, presumably it was hoped that new capital would save the firm. Unfortunately the losses were so great that the Gurneys had to liquidate their personal property and news of this event caused a run on the Company. Those who had bought shares in 1865 ended up losing £2.9 million. (Because they had only paid 30% of the face value of their shares, they had the misfortune to face a capital call in order to satisfy obligations to creditors -- who were paid in full.) The lawsuit that followed this failure found the Gurneys' actions to be incompetent rather than fraudulent and they were acquitted. (Ackrill and Hannah, 2001, Barclays: The Business of Banking, 1690-1996, p. 46-7)
Because many London banks were exposed to Gurneys, there was a run on the London banks and many solvent banks, such as the Bank of London, failed. Wikipedia claims that in the crisis that followed there were a total of 200 bank and commercial failures. By any standard the crisis was severe. In particular because London held large foreign deposits that were slow to return after the run, the Bank of England was forced to keep the Bank Rate elevated for a full three months -- which undoubtedly aggravated the domestic consequences of the crisis.
It was, however, a watershed because for the first time the Governor of the Bank of England publicly acknowledged "a duty ... of supporting the banking community", that is, he acknowledged that the bank was the lender of last resort to the banking system. (While the Bank had been playing this role for almost a century, it often did so with reluctance and heretofore had never publicly recognized the role as an obligation.)
For this reason, Bagehot repeatedly treats the Bank of England's actions in 1866 as the model for a lender of last resort. A few points are worth mentioning:
(i) In Bagehot's time, it was exceptional for lender of last resort activities to last more than a few weeks. Frequently the simple fact that they were available (e.g. a lifting of government restrictions) was enough to end the panic.
(ii) A lender of last resort is not expected to prevent the failure of a systemically important bank. On the contrary, Overend, Gurney and Co. was systemically important, but it was also so badly managed that the Bank of England could not be expected to discount its paper.
(iii) A successful lender of last resort action will leave the bulk of the financial system standing (i.e. at least say 75% to 90% of the banks). Bank failures -- even large numbers of bank failures -- are part of a typical lender of last resort activity.
(iv) The government should never support a bad bank; such action could only serve to prevent the development of good banks.
So long as the security of the Money Market is not entirely to be relied on, the Goverment of a country had much better leave it to itself and keep its own money. If the banks are bad, they will certainly continue bad and will probably become worse if the Government sustains and encourages them. The cardinal maxim is, that any aid to a present bad Bank is the surest mode of preventing the establishment of a future good Bank.
Update: This post is continued here.
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