Learning from the Crises of 1857 and 1866 Continued

In my last post I never did get to the parallels between 1857/66 and today. First of all note that in 1857 Gurneys was a huge player in the money market and thus in 1857 when the Bank of England lent £9 million to the bill brokers, you can expect that at least £2 million and possibly as much as £4 million went to Gurneys.

In other words the Bank of England probably saw evidence that in a crisis the line of credit it was giving to an individual firm was becoming unreasonably large. Even if all the bills discounted at the Bank by Gurneys were good quality bills at this particular time, the Bank was opening itself to a future problem where reliance on the careful management of Gurneys allowed low quality bills to be discounted at the Bank and thus exposed the Bank to significant credit losses. As the Bank was a private institution, it had an obvious interest in limiting it's exposure to the credit risk of a single firm or to the credit judgment of a single underwriter of commercial bills.

In fact, it was precisely the ultra-conservative management of the Bank of England that created the trust necessary for the Bank to be relied on as a lender of last resort:

The great respectability of the directors, and the steady attention many of them have always given the business of the Bank, have kept it entirely free from anything dishonorable and discreditable. Steady merchants collected in council are an admirable judge of bills and securities. They always know the questionable standing of dangerous persons; they are quick to note the smallest signs of corrupt transactions; and no sophistry will persuade the best of them out of their good instincts. You could not have made the directors of the Bank of England do the sort of business which 'Overends' at last did, except by a moral miracle—except by changing their nature. And the fatal career of the Bank of the United States would, under their management, have been equally impossible. Of the ultimate solvency of the Bank of England, or of the eventual safety of its vast capital, even at the worst periods of its history, there has not been the least doubt.

Thus, in 1858 the Bank put in place a policy that only allowed bill brokers access to emergency credit by exception. The purpose of the policy was to force bill brokers to keep their own reserve, or in other words to be prepared to act as their own lenders of last resort.

Thus, faced with financial innovation and the growth of an extremely large, highly leveraged firm closely intertwined with the banking system, the Bank of England immediately made it clear that it did not support the growth of this firm. It set a policy: if financial innovation was going to allow huge firms to develop, then those firms should be prepared to support themselves through a crisis.

One obvious consequence of this policy is to push the bill brokers to reduce their leverage ratios and thus reduce the likelihood that they will (i) need the services of a lender of last resort and (ii) cause a financial crisis by failing. In short, even though the Bank of England had no regulatory authority whatsoever over the financial system, the fact that it was the lender of last resort meant that its policy decisions affected the stability of the financial system by affecting the leverage in the financial system.

Contrast the behavior of the Bank of England in 1857-8 with the behavior of authorities in the US after the 1987 investment banking crisis. In 1987 the stock market crash could have led to the complete collapse of the investment banking industry were it not for the actions of the New York Federal Reserve President (who basically told the commercial banks to give the investment banks unsecured loans). Notice that at the moment of the 1857 and the 1987 crises both central banks took aggressive action. The difference is in their behavior after the crisis was over. The Bank of England immediately acted in a manner that would push the firms that were endangering the financial system to reduce their leverage ratios and be less reliant on the Bank of England in the future. By contrast, the Federal Reserve stood by without objection when Congress extended it's authority to permit it to lend directly to the investment banks in the 1991 FDICIA law.

In other words the two Banks took diametrically opposed actions: that of the Bank of England would tend over the long run to decrease the leverage of financial institutions and thus decrease the risk of financial instability, whereas that of the Fed tended to increase leverage and increase instability over the long run. Observe, however, that the short run effects of these different policies were precisely the opposite of their long run effects.

The willingness of the Bank of England to let a bill broker fail was tested within a decade. Overend and Gurneys actually made the decision easier by being the subject of rumors (which turned out to be well founded) for over a year before they finally turned to the Bank of England for aid in 1866. (The Economist wrote at the time "the failure of Overend, Gurney and Co. Ltd. has given rise to a panic more suitable to their historical than to their recent reputation." Victor Morgan, 1943) Despite their size, the Bank of England did indeed refuse to discount their bills -- and the result was a financial crisis that matched the worst in living memory.

On the other hand, no further failures threatened to rock the market until 1890, when Barings' exposure to South American loans could have resulted in failure and a major crisis. The potential losses were so great that the Bank of England refused to intervene directly, but it did broker a joint support from the other large banking houses. Overall, however, England's financial system was remarkably stable from 1866 up through 1914 (the year which marked the beginning of the end of the gold standard).

By contrast the Federal Reserve's policy of bringing the investment banks under their wing forced the Fed in 1998 to extend the safety net even further. When the Fed brokered a bailout, it was not a bailout of a systemically important bank, it was the bailout of a hedge fund. In hindsight it's extremely easy to see that the fact that a hedge fund had grown large enough to be systemically important was a clear sign that the financial system was dangerously overleveraged.

If the Fed had been a private bank like the Bank of England in 1857, at this juncture it would have made it clear to all members of the financial system that its balance sheet could not support the liabilities that were growing. It would have told them that they needed to start paying attention to their own reserves by dramatically reducing their leverage ratios.

Instead, the calming effects of an endless sequence of government bailouts of the banking system (Continental Illinois in 1984, Brady Bonds in 1989, low interest rates to ease the burden of bad debts in the early 90s, the late 90s and early noughts) left the Fed with the illusion that financial instability was no longer a problem that needed to be addressed, while at the same time fostering an accumulation of dead wood in the financial system that ensured that the resulting conflagration would be beyond all imagination.

In short, while the Bank of England in 1858 was willing to precipitate a crisis in order to foster stability, the Fed in the 1980s and 90s fostered the illusion of stability, while at the same time creating an environment where crisis was inevitable. Thus, just as the forest manager is better off allowing small fires to flare up regularly, so a central banker is better off precipitating small crises to avoid a disastrous and uncontrolled burn.