Policy Papers


Hitting Northern Rock bottom: lessons from nineteenth-century British banking

Edmund Rogers |

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Executive Summary

  • Following an international credit crisis resulting from the American sub-prime mortgage market, the Northern Rock bank in the UK made headlines by seeking emergency finance from the Bank of England before enduring a run on its deposits.
  • Voices from the nineteenth-century British banking community can teach us how to avoid such calamities in future.
  • The 1890s witnessed its own international 'credit crunch' and the collapse of banks in Australia, which British bankers blamed on the imprudent mortgaging practices of their colonial counterparts.
  • With a strong sense of their professional responsibility, British bankers of the period prided themselves on the separation of 'real' banking and the mortgage business.
  • This highly risk-averse, ultra-prudent business model helped ensure that the British banking system was one of the world's most stable.
  • Modern British banking thus has much to learn from the ideas and approaches of its nineteenth-century counterpart.
  • In lieu of a public-minded banking profession with a firm disregard for risky lending policies, regulation must prevent banks from adopting the Northern Rock business model.

Introduction

In the summer of 2007, global investors began to have doubts about the safety of their investment in the American sub-prime mortgage market - mortgages made to people with less than good chances of paying off their loans. The world financial markets were sent into turmoil as investors became wary, and unwilling to provide the credit that helps make the global economy run smoothly and prosperously. In September, the former British building society turned bank, Northern Rock - a major mortgage lender - sought financial assistance from the Bank of England, the British banking system's 'lender of last resort', because the global 'credit crunch' meant that the Rock could not borrow the money it required to sustain its day-to-day operations from the money markets as usual. This news prompted depositors with Northern Rock to panic and rush to withdraw their funds in the fear that they would lose all their money should the bank collapse.

Until the Northern Rock debacle, there had not been a run on a British bank since 1866, when Overend, Gurney, & Co., the country's wealthiest bank after the Bank of England, famously crashed with 11 million of debt. It is thus unsurprising that journalists, commentators, and policy-makers are looking for a way to prevent such a seemingly old-fashioned incident as a bank panic from occurring again. This paper puts forward the good advice of the banking profession and financial writers of late-nineteenth and early-twentieth-century Britain. They observed a disastrous banking crisis in Australia in 1893 which, like the much less disastrous Northern Rock trouble, occurred hot on the heels of a global credit squeeze, and they portrayed the collapse as a validation of their strongly-held views on the moral and financial importance of maintaining a separation between deposit banking and mortgage lending.

The Australian financial crisis of 1893

The Australian financial crisis of 1893 was one of the most catastrophic financial collapses in history. The GDP of the Australian colonies plummeted 17 per cent over 1891-3, and prices dropped 22 per cent over 1890-4, spelling excruciatingly high real interest rates. It took nine years for Australian GDP to return to its 1891 level. The Australian financial sector was left devastated. Forty building societies and mortgage 'banks' in Melbourne and Sydney failed between July 1891 and March 1892. Over 1890-3, seven of the colonies' thirty-one trading banks shut down. During April-May 1893 alone, over half of the banks, holding 61.5 per cent of total bank assets in Australia, suspended payments to depositors. Undoubtedly 1893 was the annus horribilis of Australian banking, with the closure of fifty-four of the sixty-four banks and finance companies that had been open in 1891, thirty-four of them for good.

As was the case with Northern Rock, a global credit crunch triggered the Australian bank crash. The Australian economy was dangerously over-dependent on a small number of staple exports, such as wool, whose world-market price had been falling for some time. Public borrowing and spending by colonial governments propped up the economy. However, the near-fatal crisis which hit the important British merchant bank, Barings, in 1890 led to a rapid fall in British foreign investment. Australian borrowing was sharply curbed as raising finance in London became more difficult. The economy faltered, and farmers and other borrowers became unable to pay off the loans they had taken out, many of which were from the 'land-finance companies' which had sprung up in Australia from the mid-1860s to provide mortgages to settlers, usually financed by borrowing money in London. Many of these land-finance companies failed in 1891-2, and in 1893 it was the banks' turn. Historians generally concur that intense competition saw banks open up new branches too rapidly and lower their prudential standards to the point where the liquidity of their assets and liabilities were hopelessly mismatched, and too many resources were 'locked up' in illiquid, long-term investments, especially mortgages.

Lessons from British bankers of old

Clearly, the Northern Rock saga was nothing compared to the mighty crash of 1893, but the judgment of British bankers on what happened then holds lessons for dealing with problems like that of the Rock and its customers today. 'Unlike most banks, which get their money from customers making deposits into savings accounts,' the BBC News website tells us, 'Northern Rock is built around its mortgage business.' British bankers in the nineteenth and early-twentieth century would have despaired at such an enterprise calling itself a 'bank'. They prided themselves on their avoidance of the mortgage business, for they considered mortgages too long-term and illiquid as assets for the business of what today we would call 'high-street banking'. In their view, if banks mostly dealt in short-term liabilities, like current accounts, they should also mostly invest in short-term assets, like highly liquid commercial bills. Longer-term lending on real estate therefore ought to go hand-in-hand with the business of long-term savings. British bankers felt profoundly uneasy at accepting land, particularly urban real estate, as collateral for loans.They regarded the holding of property as security in the expectation of it rising in value as mere risk-laden speculation. George Rae's celebrated banking textbook, originally published in the 1880s, informed readers that doing business on 'building-land', and holding on 'for better times and a higher price,' was 'virtually to speculate in it.' Its sale was too uncertain, and the demand 'most capricious'. The lesson was clear: 'As a banker, you are a dealer in money, or in securities readily exchangeable for money, and building-land does not come within this category. It is practically inconvertible into money on rational terms, and ought therefore to have no place amongst a banker's assets.'

As the Edwardian banking writer, Henry Warren, explained, advancing on the back of illiquid assets such as property with large proportions of deposit funds may bring in huge profits, but should those assets fall in price, it becomes difficult to sell them and liquidate the debt to the bank. Bankers saw the confidence of the public in the entire banking system as resting on ensuring the safety of their customers' deposits, and not endangering them through reckless lending. British banks thus generally shied away from long-term mortgage lending, although provincial banks and even some London institutions did supply short-term capital to clients using title deeds as security. By the Edwardian period, this bank lending accounted for only around 20 per cent of mortgaging, however, while 'institutional mortgagees' such as building societies, insurance firms, friendly societies and charities could lay claim to only a slightly larger share of the market. The dominant force in mortgage lending in the early-twentieth century was in fact private individuals supplying credit, usually within their locality.

Overend Gurney's problems back in 1866 had resulted from its loans to 'finance companies' which indulged in the 'sub-prime' lending of their day. This left a lasting and powerful impression on British bankers. Similarly, the 1893 Australian crisis was widely seen in Britain as a chastening experience for Australian bankers resulting from their wilful departure from the orthodoxies of 'scientific banking'. It was when, judged the economic writer, Arthur Ellis, 'the revenge of fate was fully wreaked on the Australian "banking" system', having 'transgressed the traditions of banking as understood and practised in England'. The Economist attacked Australian banks for straying 'beyond their province...sinking millions in securities they ought not have touched'. 'An unsound banking system must always have a prejudicial influence upon trade and commerce,' The Times reminded readers, 'but it is perhaps not sufficiently realized how deeply the evil has eaten into the commercial system of the Australian colonies.' The newspaper lambasted Australian bankers for their 'wild speculation in land'.

Bankers and the press in Britain had long warned about the dangers of the blurred line between land-finance companies and retail banks in Australia. The former came under heavy criticism in the British financial press. 'The great majority of the property institutions formed in Melbourne of late years are, in reality,' judged The Economist in 1891, 'cancerous growths upon the sound financial business of the colony. They promote no useful object; their aims are merely speculative'. The land-finance companies' deposit-taking forced the banks into competing with them in the riskier mortgage market, either directly or through companies that were arms of the banks. Such betrayal of 'legitimate' banking practices excited great disdain in Britain for sullying the good name of the profession. The Bankers' Magazine blamed the 1888 legislation in Victoria which permitted bank lending on land for the colony's financial problems, having reduced 'at a stroke banking practice, as we have long known it in England, to a mere system of vulgar pawnbroking.' For British bankers, the word 'bank' ought not to be bandied about without care, for it implied a certain trustworthy business model. Indeed, many of the land-finance companies in Australia adopted the name 'bank' to reassure British investors.

After 1893, talk about Australasian banking died down, due largely to the banks' consequent retrenchment. Colonial finance was now taking on a more 'British' division of labour between commercial banks dealing with short-term credit and deposit services, and intermediary institutions offering longer-term lending on land. The former also shunned intensive competition for co-operation, or rather cartelisation. The lending departments of state savings banks in the colonies offered cheap mortgages. However, six years after the 1893 crisis, it could still be claimed that '[a]ccording to a Londoner's idea' many Australian banks were 'not so much banks at all as big pawnbroking institutions', and that Australians worked off high interest overdrafts 'secured on little or nothing.'

After 1866, the British banking sector was remarkably stable (although the disastrous failure of the City of Glasgow Bank in 1878, which had actually embroiled itself in risky speculative land investments in Australasia, reminds us it was not perfect). Britain was the only major economy to avoid a catastrophic meltdown of its banking sector in the interwar period. This was largely due to the conservative investment approach of the banking profession. British banks have often been criticised by both contemporaries and historians for 'failing' to spearhead a dynamic domestic investment drive in industry, as they saw in countries such as the United States and Germany, that they believed could have saved the country from relative economic decline. Today's banking community might also see the Victorian and Edwardian suspicion of mortgage-lending as a quaint notion from history, totally inapplicable to the complex financial sector of the twenty-first century. But rather than chastising British banks for avoiding risky yet potentially more profitable investment, they should be credited for providing the country with a solid and stable financial backbone.

Conclusions

On 17 September, the Chancellor of the Exchequer, Alistair Darling, pledged that the government would guarantee all deposits held by Northern Rock. The government and financial authorities then went on to suggest an extension of the banks' Financial Services Compensation Scheme, established in 2001, which currently fully guarantees only the first 2,000 of savings, and a maximum of 90 per cent for the next 33,000. The talk now is of a 100 per cent guarantee. State guarantees for bank deposits are not only potentially enormously costly, but more importantly also create 'moral hazard', meaning that banks may be tempted to take on greater risks in the knowledge that depositors losing out through the banks' imprudent lending will be reimbursed. It is far better, in the long run, for bankers to follow prudential standards and eschew concentrating too heavily on mortgages.

However, laying down hard and fast rules for banking in statute law would not be a wise move. As nineteenth-century bankers and financial publications realised, this can create as much havoc as it attempts to solve, for effective and responsible deposit banking requires flexibility. Observing the recurrent financial crises in the United States, they noted that the statutory minimum reserve ratio of cash to deposit liabilities that federally-chartered and regulated 'national banks' were required to keep had a perverse effect on the banks' behaviour. The Economist blamed the reserve-ratio law for the American financial panic of 1873, for it had resulted in the 'inevitable absurdity' of the public panicking when banks neared their reserve limit, but the banks being unable to use those reserves to allay the panic. By the early 1900s, the financial and economic magazine, The Statist, was calling the reserve stipulation the 'worst provision' of American banking law, bearing no relation to the liquidity of a bank's liabilities.

British bankers and financial writers thus saw the local knowledge of the bank branch and the moral responsibility of the banking profession, not legislation, as the key to a stable banking system. As The Economist observed in 1911, 'banking legislation nearly always attempts to lay down hard and fast rules for the conduct of the business, while experience has shown that the banker must be guided by his knowledge of credit conditions at any particular time and not by fixed rules.' The eminent financial writer, Hartley Withers, himself to be editor of The Economist after the First World War, explained that 'Good banking is produced, not by good laws, but by good bankers. Just as the most carefully planned constitution will inevitably break down if the men at the helm of government are incompetent or dishonest, so no skilfully devised banking system will make banking good'.

It would be desirable, though sadly quite nave, to suggest that preventing a repeat of the Northern Rock incident requires only a revival of the banking profession's public spirit and its embrace of moral responsibility for the safety of individuals' deposits and the nation's financial stability. The British banking sector is today dominated by large, publicly-owned corporations, and the influence of morally-robust individual bankers is minimal. It would also be economically foolish to return to a time of complete separation of deposit banking and mortgage lending. The liberalisation of financial services in Britain since the 1980s, and the blurring of the lines between banks and mortgage lenders, has helped the British banking sector become phenomenally successful in a favourable environment of low interest rates and buoyant demand. However, it is clear that, in lieu of a banking profession with a dogmatic attachment to risk-averse investment, the Financial Services Authority must take a more active role in evaluating high-street banks' balance sheets and, with a firm hand rather than a light touch, discourage risk-laden business models like that of Northern Rock. That bank was an extreme example, financing its loans almost entirely from its own borrowings in the credit markets. But the fact that such a business model was permitted to exist shows a fundamental flaw in the current regulatory regime.


Further Reading


Attfield, J. B., English and Foreign Banks: A Comparison (London, 1893).

Boehm, E. A., Prosperity and Depression in Australia 1887-1897 (Oxford, 1971).

Collins, M., Banks and Industrial Finance in Britain 1800-1939 (Basingstoke, 1991).

Collins, M. and M. Baker, Commercial Banks and Industrial Finance in England and Wales, 1860-1913 (Oxford, 2004).

Collins, M. and F. Capie, Have the Banks Failed British Industry? (London, 1992).

de Serville, P. '1893 remembered', Victorian Historical Journal 64, 2 (1993), 101-121.

Ellis, A. 'The Australian banking crisis', Economic Journal 3, 10 (1893), 293-297.

Merrett, D. T. 'Australian banking practice and the crisis of 1893', Australian Economic History Review XXIX, 1 (1989), 60-85.

Rae, G., The Country Banker: His Clients, His Cares, and Work (London, 1885).

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