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ALCHEMISTS OF LOSS

and if they turned sour hope that the central bank would rescue them too from the adverse consequences of their own risk-taking. In the case of the first Barings crisis, the Bank opted for short-term damage limitation, but it was acknowledged even at the time that this had set a dangerous precedent. The rescue of Barings meant that some banks were now (or even might in future be) considered too big or too important to fail, and the problem of how to rein in the moral hazard this created was to be a recurring (and indeed, worsening) headache in the second half of the twentieth century and beyond.

***
Going further back in time, we come to the quintessential bank failure of the Victorian period, the 1866 collapse of the banking house Overend & Gurney.7 Overend & Gurney grew out of a Norwich banking house controlled by the immensely wealthy Gurney family. It was not itself primarily a bank, but a discount house that traded bills of exchange, generally of90 days or shorter maturity, drawn on the numerous London and country banks. It was therefore at the centre of the London money market, which was itself the centre of the London financial system, and was to remain so until the 1980s. It was a private partnership with unlimited liability until just before its demise. Under the steady management of Samuel Gurney, who died in 1856, Overend & Gurney became the most important financial institution in the London market, known affectionately as the "Corner House." It was central to the financing of British trade, which was typically financed by merchants issuing bills that were then "accepted" or guaranteed by local banks. Discount houses tended to get into trouble during the periodic liquidity crises, such as those of 1836, 1847, and 1857. After Samuel Gurney died, the Corner House was run by his nephew, David Barclay Chapman, a man of an altogether different character. Chapman had attempted to cover up a serious loss from taking fraudulent security in
7

The Overend & Gurney story is well told in Geoffrey Elliott's The Mystery ofOverend & Gurney. Its 1857 and 1860 confrontations with the Bank of England are described

in detail in Kynaston, 1995, pp. 192-202.

LESSONS FROM PAST FINANCIAL CRISES

49

1853, as a result of which he was known not-so-affectionately in the City as "Gurney's Liar." In the crisis of 1857 he recklessly attempted to bring the Bank of England down by presenting large quantities of Bank notes for immediate redemption in gold, in the hope that the Bank did not have the gold in its vaults to meet those commitments. But the Bank survived and won the battle, in part by calling on the Chancellor of the Exchequer to suspend temporarily the restrictions on its note issue imposed by the Bank Charter Act of1844, and which had made the Bank more vulnerable to attack. David Barclay Chapman was then forced into retirement, to be succeeded by his son, David Ward Chapman. The younger Chapman was more like his father than his greatuncle. He had a lifestyle altogether flashier than most bankers of his day, with a large new house at Princes Gate, a fashionable wife, and a penchant for lavish entertaining. He was also very ambitious and, in spite of spending only five hours a day in the City, x he pushed the limits of Overend & Gurney's business to increase profitability. His most dangerous diversification was into private equity investment, including a shipping line that attempted to lay the first transatlantic cable, a Greek Mediterranean shipping line of doubtful provenance, and a shipyard that built Isambard Kingdom BruneI's steamship Great Eastern. As usual, some of these investments were fraudulent, some were mildly promising, and some were simply unsuccessful. This move into private equity investment was financed through a highly risky innovation: he financed the entire portfolio by three-month bank bills, rolling them over frantically as necessary. (Modern Financiers: before you mock, don't forget asset-backed commercial paper or Northern Rock.) Thus, as with Northern Rock later, the company was highly exposed to liquidity risk. Ward Chapman's other folly was to follow in his father's footsteps by taking on the Bank of England again, in 1860. After the Bank had refused to buy discount house paper from him, Ward Chapman arranged for a syndicate to withdraw £2 million of £1,000 notes from the Bank within 24 hours. There followed a sinister anonymous message to the Bank: "Overends can pull out every note you have; the writer can inform you that from their own family assistance they can
8

Xenos, 1869, p. 64.

50

ALCHEMISTS OF LOSS

nurse seven millions." But again, the bold coup failed; needless to say the Bank was now thoroughly alienated. As a consequence, when Overend & Gurney began to run into real trouble, the Bank and its supporters (which comprised most of the City of London) sat on their hands and watched. Ward Chapman then attempted to rectifY Overend & Gurney's deteriorating position by a novel tactic. He took advantage of the new Companies Act of 1862 to convert the Overend & Gurney partnership into a limited company - Overend, Gurney & Co. - and float it inJuly 1865 through the dodgiest of the new share promoters, Baron Grant, later the model for Anthony Trollope's scoundrel Melmotte. 9 The issue was remarkably successful, however, selling 100,000 £50 shares and moving to a premium. Had the shares been fully paid up, this huge £5 million of new capital might have rescued the bank's fortunes, but regrettably following the custom of the time the shares had been issued with only 30% paid upfront. After the hefty issue commissions and expenses had been met, this provided nothing like enough new money, and so on May 10, 1866, "Black Friday," Overend, Gurney & Co. was forced to close its doors, prompting another crisis in the London money market. The shareholders' fury at finding their ten-month old paper worthless was only compounded when the liquidators came to them and demanded subscription of the unpaid 70% of the issue amount to which they had unwisely committed themselves. Their money did however ensure that the creditors were eventually paid in full. For his part, the anti-hero of the episode, David Ward Chapman, was bankrupted and fled to the Continent to avoid the bailiffs hot on his heels. The Overend & Gurney failure has a number of parallels with recent events. Its main protagonist led a flashy lifestyle more reminiscent of modem Wall Street than of the conservative bankers of his time (though most modern bankers don't get away with a five-hour day!). It involved misguided high-tech investment and a massive quasi-fraudulent share issue, made on the basis of questionable accounts. It was generated by a novel financing technique that was not properly understood and whose risks were poorly managed, and which led to sudden crisis when liquidity'ran short. Its collapse also had important systemic
9

Trollope, 1873.

LESSONS FROM PAST FINANCIAL CRISES

51

effects, because of the bank's network of connections throughout the discount market.

***
Further back in time, we come to the most misunderstood period in US financial and monetary history: the period of the late 1830s and early 1840s, an earlier Great Depression also caused by misguided policies. This is a period that modem economists have been particularly apt to misunderstand, because most of them take the necessity of a central bank for granted and the US had no central bank after 1836. Standard textbooks dismiss this as a period when unsound "wildcat banking" flourished: crooked banks were said to issue notes redeemable "where the wildcats roamed." Their noteholders, fearful of wildcats, were then reluctant to demand redemption, and the notes would trade at heavy discounts relative to their notional par values. Both these, however the necessity of a central bank and the characterization of the banks of the period as "wildcats" - are myths, albeit the latter an entertaining one. The background to this period is a combination of protracted policy controversy, legal restrictions, and tight money. The controversy centered around the question of whether the federally chartered Bank of the United States should have its charter renewed. This institution is known to historians as the Second Bank of the United States, as its unfortunate predecessor, the First Bank of the United States, had expired after the renewal of its charter had been blocked in 1811. Opponents of both institutions had argued, rightly in our view, that they were unconstitutional, based on a strict interpretation of the Constitution under which the federal government had no authority to charter a bank. The most vociferous, even rabid, opponent of the Bank was the President, Andrew Jackson, who had based his 1832 re-election campaign on a platform opposed to the Bank's re-charter. The Bank War, the prolonged conflict between the President of the United States and the President of the Bank of the United States, Nicholas Biddle, went on for years. The Second Bank was a quasi-central bank. Chartered in 1816, its notes were legal tender for all payments to the government, and it acted as the federal government's bursar and depository. Its history was however somewhat checkered. It had single-handedly triggered

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