How the Victorian Black Friday shaped modern central banking
In the latest in his series of stockmarket crashes from history, John Stepek looks at the original “Black Friday” of 1866, and what it tells us about today’s financial system.
Good morning this morning we have our usual weekly story from financial history.
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These days, if you hear the phrase "Black Friday", people are usually talking about the American tradition of shops cutting their prices sharply on the Friday after Thanksgiving.
Amazon's ubiquity and retailers' eagerness to convince us to shop more has resulted in this particularly soulless idea spreading across the Atlantic.
But I'm not here to subject you to a lecture about consumerism.
No, I'm here on this Friday 13th to tell you about a much earlier Black Friday.
It's a terrifying tale of financial panic and incompetence, dating all the way back to 1866.
And on reflection, it's a valuable lesson in how little the fundamental things change...
The backstory to Black Friday
On 11 May, 1866, a hugely important financial institution in the City Overend Gurney went bust. The newspapers from The Times to The Observer described it as "Black Friday" due to the ensuing panic.
Here's a somewhat understated quote from that Sunday's edition of The Observer: "The great centre of banking business, Lombard-street [sic] and its approaches, was occupied during the day by crowds of persons who lingered in the neighbourhood of the principal banking and discount houses, rendering those thoroughfares all but impassable."
The Times rather more sensationally said: "there has probably been nothing like it within living memory".
What happened? This one requires a bit of back story, so bear with me.
Overend Gurney had its roots in East Anglia's biggest bank, which was set up by the Gurney family wealthy wool merchants in 1775. It was Britain's biggest "discount house". Let's explain that.
The key financial instrument of the day was the bill of exchange. Basically, that was an IOU a promise by a borrower to pay a lender a set sum of money. If the lender then wanted their money before it was due, they could sell it to a discount house, so-called because they would buy the note at a discount. So the discount house might buy a £10 bill for £9.50, giving a discount rate of 5% (in effect, the interest earned).
Meanwhile, the Bank of England was still a private company, but it had a monopoly on currency issuance and it held the country's gold reserves. It also served as a discount house to other financial institutions so if a company such as Overend Gurney needed to raise funds at short notice, it could re-discount a bill of exchange with the Bank of England. In some ways, the discount rate was like the Bank rate the one that's currently at 0.25% of its day.
So Overend Gurney served as a bill broker it matched up buyers and sellers of bills of exchange and a discount house. It would take deposits from banks and use these to discount bills of exchange.
In other words, it would borrow short-term money (the deposits) and lend it out over the longer term (discounting bills that would only be paid at a future date). If the banks wanted their deposits back, and a discount house had insufficient reserves, it would merely re-discount the bills with the Bank of England.
That was a nice profitable business.
There was just one problem. As a Bank of England paper on the topic notes: "The first half of the 19th century had been plagued with recurrent panics in the money market following large credit expansions" (boom and bust, even back then).
During these panics, the Bank of England would provide liquidity, but with a delay. The Bank had to keep the number of banknotes in circulation in line with its gold reserves. When it wanted to provide liquidity, this rule (under the 1844 Bank Charter Act) had to be suspended.
After a particularly nasty panic in 1857 (we'll cover that one another day), the Bank got a bit worried. It felt that the City's financial institutions (including and maybe especially Overend Gurney) were being less cautious because they knew they could fall back on the Bank of England for support in an emergency if things went pear-shaped (this is what's known as 'moral hazard').
So in 1858, the Bank decided to make it harder for big institutions to use it as a discount house, in an attempt to force them to rely more on their own reserves. There was scepticism even at the time neither The Banker nor The Economist felt it was a realistic policy if a big institution ran into trouble, the Bank would have to bail it out. But the Bank went ahead even so.
How to run a good business into the ground
By this point, Overend Gurney was already over-reaching itself. The need to hold more of its own reserves reduced the profitability of the discounting business. And partly and a result, it began lending money to riskier projects. In 1859, it hired one Edward Watkin Edwards to expand its lending business.
Edwards was badly incentivised. In effect, he got paid for making loans, not for making sure they'd get paid. So the investments he made and the business he wrote was of appalling quality, with absolutely awful eventual recovery rates (just as happened in the sub-prime crisis, where lenders were getting paid to write and package sub-prime mortgages without caring about their creditworthiness).
Then in 1860, the Bank of England raised its discount rate (i.e. it charged the likes of Overend Gurney a higher rate to borrow money). In retaliation, Overend tried to spark a run on the Bank of England itself. This failed and it perhaps played at least a minor role in what happened next.
By now it was already losing £500,000 a year. And, to cut a long story short, by summer 1865 (when the partners decided to convert it into a limited liability company in an effort to limit their own losses), it was, in reality, already insolvent.
However, that only became apparent to everyone else in May 1866. Amid growing concerns, a court ruling that prevented Overend Gurney from collecting debts owed to it by the Mid-Wales Railway Company, finally triggered a run on its deposits. The group asked the Bank of England for help. Bank representatives came over, looked at the books, and declared that "the firm was so rotten" that it would not assist.
As a result, on the afternoon of 10 May, 1866, a note was stuck on Overend Gurney's door saying: "We regret to announce that a severe run on our deposits and resources has compelled us to suspend payment".
And the next day was Black Friday.
Why Overend Gurney didn't affect the wider economy
So what happened next? The Bank of England did what it had already been doing for a while it bailed everyone else out. Over the weekend, it wrote to the chancellor of the day William Gladstone and warned him that the Bank had drawn heavily on its reserves to prop up the financial system. Gladstone suspended the 1844 Bank Charter Act, which meant the Bank would be able to issue notes unbacked by gold reserves, if needed.
That in itself restored confidence to the market, and unlike Northern Rock the demise of Overend Gurney basically marked the end of this particular panic, rather than the start.
As the Bank of England research note on the topic points out, Overend Gurney had no real systemic impact because "its primary business was bill broking. It did very little screening of its borrowers meaning that it lent to very few productive firms, meaning that the direct loss to the real economy of its failure was small."
Eventually this gave rise to Walter Bagehot, the famous editor of The Economist, outlining the principles of central banking in his book Lombard Street: A Description of the Money Market. In essence, Bagehot said that a central bank should always be ready to step in to sort out a liquidity crisis by lending to quality companies and against quality collateral.
The biggest conflict in central banking quell fear and you encourage greed
There are lots of echoes of the 2008 financial crisis here, but I think what's most interesting is what this all shows us about the gradual evolution of the financial system. Ultimately, in a credit-based economy, there will always be a point at which someone finds themselves over-extended.
If human beings were all rational actors all the time this wouldn't happen. Because credit controls would be perfect and prices would always be right all the time. But we aren't rational actors. We panic. And sometimes it's the panic that does the damage.
That's why we want a lender of last resort. To stop the unnecessary panics. Why incur the costs of all that unnecessary damage, when a business is in fact perfectly solvent it's just that the headless chickens around it have lost their nerve? A lender of last resort a central bank dampens fear when it threatens to overwhelm the system.
Easy, right? Not quite.
Trouble is, this cuts both ways. A lender of last resort might dampen fear, but in doing so, it amplifies greed. That's moral hazard. And try as it might to prevent that (concerns over moral hazard were a big deal to Mervyn King too), the very existence of the central bank proves to market participants that there's a safety net there.
How can you prevent this? There's no easy answer. But I think we could mostly agree that in our current era of 5,000-year low interest rates and virtually limitless money-printing, we've probably erred too far in the direction of encouraging moral hazard.