Friday, May 15, 2015

Quick Course: 140 Years of Panic and Policy

I originally wrote the following three years ago, for the financial blog AllAboutAlpha. The 140 years reference then worked well enough if one was dating from the publication of Bagehot's work. Next year, on May 2016, the financial world will mark an even 150 years since the Overend Gurney crisis itself.

In London, in May 1866, a banking panic began at 65 Lombard Street, the address of a discount bank, Overend Gurney. Overend (an ominous-sounding name for a financial institution to begin with!) had only just transformed itself from a partnership to a joint-stock company, making its books public in the process.

At the time of the panic, Overend had been pursuing litigation for the recovery of a £60,000 debt. On May 9, a court held against it. The public discovered that the firm would have to write off that debt, and this datum proved the catalyst for a run.  On the afternoon of May 10, Overend suspended payments.

This panic spread on May 11 to other banks and to the stock market. Further, it was not limited to London: spreading to Bristol, Derby, and the other great cities of Britain. But this particular panic, not especially unique out of all of history’s bank panics, is remembered not only for its city of origin but for its street address, and is remembered because it was the Overend Gurney crisis that stimulated Walter Bagehot to write a classic on finance, a book called simply Lombard Street: A Description of the Money Market (1873).

Stiff Upper Lip

In the Appendices to this book you may find the minutes of a meeting of the proprietors of the Bank of England that September, by which time matters had settled down a bit. At this meeting, the bank’s Governor, Launcelot Holland, addressed the proprietors thus: “[That] the banking establishments generally of London met the demands made upon them during the greater portion of the past half-year affords a most satisfactory proof of the soundness of the principles on which their business is conducted. This house exerted itself to the utmost – and exerted itself most successfully – to meet the crisis. We did not flinch from our post.”

You have to love that attitude. That’s why the Victorians ran the world.  They never ‘flinched.’
In the text proper, one of Bagehot’s key points is that the banking world in his day was reaching a threshold, beyond which it would become impossible for families to manage banks. They would become “very rotten” as control passed from one generation to the next, because of the enormous amount of detail work modern banking requires, the need for professional management.

“We have had as yet in London, happily, no example of this [a great private bank becoming ‘very rotten’]; indeed, we have hardly as yet had the opportunity. Till now private banks have been small; small as we now reckon banks.” Small enough to fail, one might fairly add.

But that dynamic, the superiority of professional over amateurs as managers, is what led to the Overend crisis by pressing the firm to change its own status. “The richest partners had least concern in the management; and when they found that incredible losses were ruining them, they stopped the concern and turned it into a company.”

A Continuing Conversation

That is a profound historical point, made no less so by the fact that it wasn’t yet ‘history;’ when Bagehot made it. Indeed, it provokes thoughts of the work of Alfred Chandler, and other institutional economists, to whom the development of professional managements, and the ‘scale and scope’ professionals can deploy, is still a crucial consideration in understanding contemporary capitalism.
Even more provocative, though, are Bagehot’s policy ideas. How should a central bank, a lender of last resort, respond to a banking crisis? Should it lower interest rates to near zero in the hope that liquidity will drown systemic sorrows?

Bagehot argues for a contrary approach. The interest rates for loans made to desperate borrowers should be high. “This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who do not require it. The rate should be raised early in the panic, so that the fine may be paid early….”

Nonetheless, though the interest rate should include a punishment as a check on what in our day is called ‘moral hazard,’ still such crisis loans should be made, if solid collateral exists for them, “wherever the security is good” as Bagehot says.

In terms of the crisis of 2008, one can make a case that Bagehot would have supported TARP in its original significance (where it was supposed to involve purchase of the assets of the troubled entities). He would likely see this as lending where the “security is good.” But I doubt one can make the case on Bagehotian terms for the actual implementation of TARP as a TERP, that is, through the purchase of equities.

At any rate, as we look forward in contemplation of crises yet unborn, Bagehot continues to have a voice in contemporary discussions. As well he should.