A forgotten rescue
Much research on financial crises targets policy failures, nonetheless it is vital that you identify successes aswell – including those beyond the well-studied Anglo-American examples. Inside our study of French central banking (Hautcoeur et al. 2014), we’ve recovered the annals of an incipient crisis in 1889, when the Banque de France formed a ‘lifeboat’ to rescue among the largest French banks from failing and inducing an over-all banking panic. The surroundings where this operation occurred is notable for just two reasons:
1. The French bank operating system was largely unregulated – there have been no required capital or reserve ratios and there have been no constraints on universal banking.
2. The federal government provided no guarantees to the banks – deposit insurance and ‘too big to fail’ were far later on.
The actions of the Banque are striking because they violated Walter Bagehot’s strictures define the contemporary debate on what a central bank should behave. In his classic, Lombard Street (1873), Bagehot ordained a lender of final resort should react to a financial meltdown by lending freely at a higher interest on all good collateral, thereby preventing illiquid however, not insolvent banks from failing (Bignon et al. 2012). The work of the central bank had not been to avoid financial shocks, but to neutralise their effects. The threat of moral hazard was too great if the central bank acted otherwise. Yet in 1889, the Banque – acting at the behest of the Ministry of Finance – reacted to a operate on a major bank by giving liquidity to the complete market as Bagehot recommended, but also pre-emptively launched a ‘lifeboat’ to rescue the lender.
The crisis of 1889
The names of the very best contemporary French banks – Société Générale, BNP Paribas, and Crédit Agricole (until recently, Crédit Lyonnais) – are familiar to many. But there is one name that’s missing but which formed part of the echelon in the 19th century – the Comptoir d’Escompte (the Discount Bank), that engaged in commercial and investment banking, financed international trade, provided credit to the currency markets, and assisted with government bond issues. In the tight financial networks of 19th-century France, where in fact the private investment banks were heavily represented in the management and boards of directors of the leading banking corporations, the Comptoir was aware of most major deals. These interlocking relationships carried to the Banque de France, where usually they served to see the central bank of the strengths and weaknesses of finance institutions. However, the demise of the Comptoir was the consequence of the manipulation of the potential conflicts of interest by a little group for huge gains.
Working through a big industrial metals concern, the Société des Métaux (the Metals Company), this group began an effort to corner the world’s copper market in late 1887. Copper was a target because industrial and agricultural demand for the metal was quickly rising. Had the speculation been confined to the group, which provided the original capital, its failure could have caused sharp losses however, not a banking panic. However, to get and warehouse current copper stocks and control future deliveries with forward contracts was beyond its means, and it needed funding from the big banks. Overly looking forward to profits, the management of the Discount Bank was ensnared. Furthermore to granting loans to get copper, the lender signed guarantees for the Metals Company’s forward contracts – liabilities which were from its balance sheet. This assistance was critical, and enabled the syndicate to double the world price of copper.
Soon, deliveries of copper begun to exceed demand, resulting in the growth of a vast stockpile. Covering nearly 2 yrs of the world’s copper supply, the guaranteed forward contracts left the Discount Bank in an extremely leveraged position. After discounting some copper warrants, the senior management of the Banque de France became concerned, and summoned the top of the Discount Bank to provide detailed records. Revealing it to be deeply insolvent, the CEO committed suicide on 5 March 1889 – a meeting that turned a slow drain of deposits right into a run.
The look of the ‘lifeboat’
The Banque initially hoped other banks would privately come to aid from the Discount Bank. Then on 7 March, the Minister of Finance called a midnight ending up in the leading banks and formed a rescue intend to be managed by the Banque. Offered this plan another morning – with only one hour prior to the banks opened – the governing body of the Banque, the Council of Regents, debated whether to acquiesce. A supermajority – necessary to suspend the Banque’s rules – voted to proceed, however the debate was intense, highlighting the concerns about rescuing an insolvent bank.
The Banque decided to offer an emergency loan of 100 million francs against collateral out of all the bank’s assets, no matter quality. However, it required a warranty syndicate of banks that could absorb the first 20 million francs of losses. Although capability to pay – measured by bank capital – partly determined which banks would contribute, responsibility for the Discount Bank’s collapse was an integral element in assigning shares in the syndicate. Conflicts of interest measured using network analysis of the interlocking directorships or subscription lists to the Metals Company’s 1888 capital increase econometrically identify this element in our study. The Banque provided additional liquidity as Bagehot recommended, nonetheless it was secondary and didn’t concern the Regents’ debate – even while another loan of 40 million francs with a warranty syndicate of 20 million was designed to finally squelch the panic. Ultimately, these guarantees weren’t asked, but that was because losses were recouped by large fines – especially on the Discount Bank’s board of directors, who were left ruined or bankrupt. The void left by the Discount Bank was then filled by a fresh Comptoir National d’Escompte, recapitalised with private funds. 1
The story of the Crisis of 1889 leaves two questions. The foremost is why didn’t Bagehot discuss the potential issue of failing SIFIs? The answer could be that in 1873, when he published Lombard Street, the merger waves that swamped British banking within the last quarter of the 19th century had yet to make a SIFI, and insolvent banks weren’t viewed as so interconnected concerning threaten the solvency of the numerous more finance institutions. By enough time that Barings failed in 1890, the lender of England believed it essential to intervene with a lifeboat à la française. Certainly, the Rothschilds believed this to be the case, and saw Barings as a far worse threat to the economic climate compared to the failure of Overend, Gurney and Co. in the last crisis of 1866. The strict usage of Bagehot’s rule may thus require some caution.
The next question is whether lessons from the 19th century can be applied in the 21st. The 1889 crisis – like so numerous others before 1914 – had its origins in the exploitation of conflicts of interest by an individual institution or a little band of institutions. The widespread insolvencies of the united states Savings and Loan Crisis of the 1980s or the financial meltdown of 2008 will vary, and pose a more substantial problem due to systemic risk-taking incentives created by deposit insurance or ‘too big to fail’. Nevertheless, the response of the French authorities is instructive because they didn’t hesitate to impose harsh penalties on those responsible, which might have helped to contain moral hazard – for another 25 years, there have been forget about banking crises in France.
Bagehot, W (1873), Lombard Street: A Description of the amount of money Market, London: H S King.
Bignon, V, M Flandreau, and S Ugolini (2012), “Bagehot for Beginners: the Making of Lender-of-Last Resort Operations in the Mid-Nineteenth Century”, Economic History Review, 65(2): 580-608.
Hautcoeur, P-C, A Riva, and E N White (2014), “Floating a Lifeboat: the Banque de France and the Crisis of 1889”, Journal of Monetary Economics, forthcoming.
Vives, Xavier (2008), “Bagehot, central banking, and the financial meltdown”, VoxEU.org, 31 March.
1 The Comptoir National d’Escompte survived until 1966, when it merged with the Banque Nationale pour le Commerce et l’Industrie to be the Banque Nationale de Paris. In 2000, The Banque de Paris et des Pays-Bas was absorbed by the Banque Nationale de Paris and became BNP Paribas.