Unto us a lender of last resort is born: Overend Gurney goes bust in 1866 Link John Lewis.
The 1866 collapse of Overend Gurney sparked widespread panic as investors flocked to banks and other institutions demanding their money back. Failure to provide substantial liquidity threatened to bring down the entire financial system. The Governors of the Bank of England asked the Chancellor to relax the constraints of the 1844 Bank Charter Act, by granting an indemnity to allow the issue of unbacked currency. The Chancellor’s reply, and the policy response it initiated, would save the day, and go down in central banking history as pivotal in the foundation of the “lender of last resort”, a function which has been fundamental to central banking practice ever since.
The demise of Overend Gurney Overend Gurney started life as a broker of bills of exchange, but gradually evolved into something like a money market fund – borrowing at short maturities from investors, and then investing in bills held for its own account. Worried about the excesses of imprudent bankers in the 1857 crisis, the Bank of England decided to restrict bill brokers’ access to the discount window in 1858. The goal was to encourage them to hold larger reserve balances rather than relying on the Bank to provide liquidity. This prompted an angry response, with Overend Gurney joining forces with others in a co-ordinated withdrawal of funds designed to squeeze the Bank’s balance sheet, in order to demonstrate the importance of bill brokers and force a change of heart. But this failed, and so bill brokers had to hold greater reserves at the Bank. This reduced the profitability of Overend Gurney and may have played a role in them expanding into risky customer lending to boost profits. (For more on this episode, see this recent article by Sowerbutts et al).
By 1866 a string of poor investments led to large losses on the asset side of Overend Gurney’s balance sheet. As nervous depositors began to demand their money back, it needed liquidity. Normally, a troubled institution’s first port of call would have been the Bank of England’s discount window, but as Flandreau and Ugolini note, Overend Gurney never showed up there, probably because it lacked the eligible high-quality securities to obtain liquidity. Instead, it made a direct appeal for extraordinary assistance.
The Bank faced a decision which would be faced by policymakers many times subsequently: was Overend Gurney fundamentally solvent but with a liquidity problem, or was it just insolvent? After reviewing the books, the head of the Bank’s deputation concluded that Overend Gurney was “rotten”. So despite its large size – deposits were equivalent to the combined deposits of its three largest competitors – Overend Gurney was allowed to fail, ceasing business on 10 May 1866.
Panic on the streets of London The collapse of Overend Gurney sparked a widespread panic, with depositors flocking to banks demanding their money back. The Banker Magazine described the scenes of “terror and anxiety” that followed:
Source: The Banker Magazine, August 1866
The Times wrote: Source: The Times, 12 May 1866 This panic was similar to the situation analysed in Diamond and Dybvig’s classic paper more than a century later. Banks can normally accomplish maturity transformation and liquidity transformation by pooling idiosyncratic liquidity shocks between their depositors. Only a small fraction of them would wish to withdraw their funds at any one time, and so the bank needs only a small amount of liquid assets on hand. But if an investor fears that others will withdraw, the rational response for that investor is to withdraw their funds too, creating a self-fulfilling prophecy. Those on the receiving end of the run then have to rustle up funds quickly to avoid default. One way is to liquidate assets quickly, but with the likely the consequence that these firesales of assets will depress prices and exacerbate the panic elsewhere.
A liquidity problem…
Faced with a generalised shortage of liquidity, banks looked to the Bank of England. The discount window was subject to huge demand. As usual, institutions presented high quality collateral (“approved securities” in the parlance of the day) and borrowed from the Bank against those. But the problem was that whilst the 19th century Bank of England had the deep-ish pockets, it was still limited as to how much liquidity it could offer by the 1844 Act.
Initially the Bank financed the loans out of its existing cash reserves, but these had almost halved from more than £5.75m to £3m in a single day. Fearing that these would be insufficient to stay the panic, the governors wrote to the Chancellor the day, William Gladstone, to ask for suspension of the Act, in the form of an indemnity permitting the issue of unbacked currency. As in 1847 and 1857, the request was approved.
Letter from the Chancellor to the Governor, 11 May 1866. Source: Bank of England Archive G6/432. Alongside the need to help solvent but illiquid institutions there were broader concerns at play as well. With the money market drying up and because discount houses played a central role in that market, policymakers were worried about a contraction in lending and the broader effects on the real economy of any subsequent credit crunch. Letter from the Chancellor to the Governor, 11 May 1866. Source: Bank of England Archive G6/432. The letter also required that any loans were made a higher rate of interest, not less than 10 percent, with the possibility of the government imposing an even higher rate. Letter from the Chancellor to the Governor, 11 May 1866. Source: Bank of England Archive G6/432.
The high charge for this liquidity was meant to reduce threats to the stability of the financial system, though interpretations differ as to the intended channels by which this would work. The most common modern view is that higher rates act as a fine on imprudent behaviour by those who would otherwise lend imprudently or over-leverage themselves. Higher rates are a sorting device whereby only the good lenders can survive, and hence mitigate moral hazard by banks. But Bignon et al propose two other, possibly complementary, channels drawing on the subsequent writings of Walter Bagehot on the crisis. In his 1873 classic Lombard Street, Bagehot talks of a “heavy fine on unreasonable timidity”. That is, the high rate is there to penalise reluctant lenders― by increasing the market rate in times of stress, this raises the opportunity cost of timid lenders not providing liquidity. Bagehot also mentions the possibility of capital outflows in a crisis, and it may be that the higher rate was designed to combat these. The Aftermath and Legacy
The liquidity provision set out in the letter largely achieved its stated goals. In the end the mere expectation that the Bank could and would intervene proved to be powerful enough to stop the panic in its tracks. Investors no longer feared that others withdrawing their funds would bring down financial institutions, and hence they refrained from taking their money out. A little more liquidity was required, but the Bank could finance this out of its own remaining cash stockpile and so unlike 1857 it didn’t have to issue any unbacked currency.
Whilst some insolvent bill brokers did perish, the system as a whole remained resilient. And as Bignon et al document, there were no fire sale crashes in the prices of consols. Flandreau and Ugolini argue that competent handling of the crisis gave an important boost to the credibility of the London markets, and was a key factor in aiding the rise of London as a financial centre.
But the legacy of this episode was broader still. It laid both the operational and the intellectual foundations for the lender of last resort facility that was to prove so important to central banking ever since. It demonstrated that the ability of a central bank to create bank reserves by fiat gives means it can create liquidity in a way and in quantities that no other institution is able to. And three key elements in the liquidity provision outlined by Bagehot: lending freely, against good collateral, at a higher than usual rate; became part of the canonical “lender of last resort” function of central banks. Lawrence Summers, the US treasury secretary at the time of the 2008 crisis, reflected that “there is lot of the current crisis in Bagehot”. Brad de Long noted that much of Bagehot’s subsequent analysis of the episode “is still state-of the-art” in such an episode. Although Overend Gurney was a failed institution, it achieved a special place in central banking history thanks to the policy response its failure spawned.
Take risks - if you win you will become wealthy, if you lose you will become wise
So many organisations should take a leaf out of the bankers books and rush off to the Central Bank when, due to fraud or incompetence, they find themselves unable to meet their contractual obligations.
"Hi Mr Lowe,
Slight problem here, we agreed to pay our creditors before our debtors paid us and now we are in a pickle. Could you lend us a few dollars until the problem passes. We can give you security over some assets of course - how does a first mortgage over the building sound or some of the plant and equipment?.
Thanks Phil you are a top bloke"
Lender of last resort? Such a quaint expression. Mates helping out mates might be more to the point.
Bankers were always free to just accept deposits at term and then lend consistently with those terms.
That way when some term depositor got a case of the worry beads or vapors the banker could legitimately say
"Nick off I don't owe you anything until XXX"
But then a bit of fraud and deception when accepting deposits is what makes the profits of banking so appealing.
The Glass Pyramid - Transmitting on random frequencies to no fixed schedule............ www.pfh007.com
So many organisations should take a leaf out of the bankers books and rush off to the Central Bank when, due to fraud or incompetence, they find themselves unable to meet their contractual obligations.
The problem is they have already done that........
Lender of last resort? Such a quaint expression. Mates helping out mates might be more to the point.
Bankers were always free to just accept deposits at term and then lend consistently with those terms.
That way when some term depositor got a case of the worry beads or vapors the banker could legitimately say
"Nick off I don't owe you anything until XXX"
But then a bit of fraud and deception when accepting deposits is what makes the profits of banking so appealing.
Except they can only access up to the shareholders equity in normal circumstances, at that point they are insolvent and it becomes a decision for Government whether or not to offer support.
People won't tie up their money for 10 years, 15 years, 25 or 30 years, they have shorter time frames - like on demand or 24 Hr access, hence the over night window.
Take risks - if you win you will become wealthy, if you lose you will become wise
Except they can only access up to the shareholders equity in normal circumstances, at that point they are insolvent and it becomes a decision for Government whether or not to offer support.
People won't tie up their money for 10 years, 15 years, 25 or 30 years, they have shorter time frames - like on demand or 24 Hr access, hence the over night window.
They don't need to tie up for 10, 15 etc years.
All that matters is that overall lending is consistent with term.
Which is what I said
That does not mean every loan is matched to a specific deposit.
Simon_S
28 Dec 2016, 11:06 PM
Do you honestly believe that it will work next time around?
Australian Property Forum is an economics and finance forum dedicated to discussion of Australian and global real estate markets and macroeconomics, including house prices, housing affordability, and the likelihood of a property crash. Is there an Australian housing bubble? Will house prices crash, boom or stagnate? Is the Australian property market a pyramid scheme or Ponzi scheme? Can house prices really rise forever? These are the questions we address on Australian Property Forum, the premier real estate site for property bears, bulls, investors, and speculators. Members may also discuss matters related to finance, modern monetary theory (MMT), debt deflation, cryptocurrencies like Bitcoin Ethereum and Ripple, property investing, landlords, tenants, debt consolidation, reverse home equity loans, the housing shortage, negative gearing, capital gains tax, land tax and macro prudential regulation.
Forum Rules:
The main forum may be used to discuss property, politics, economics and finance, precious metals, crypto currency, debt management, generational divides, climate change, sustainability, alternative energy, environmental topics, human rights or social justice issues, and other topics on a case by case basis. Topics unsuitable for the main forum may be discussed in the lounge. You agree you won't use this forum to post material that is illegal, private, defamatory, pornographic, excessively abusive or profane, threatening, or invasive of another forum member's privacy. Don't post NSFW content. Racist or ethnic slurs and homophobic comments aren't tolerated. Accusing forum members of serious crimes is not permitted. Accusations, attacks, abuse or threats, litigious or otherwise, directed against the forum or forum administrators aren't tolerated and will result in immediate suspension of your account for a number of days depending on the severity of the attack. No spamming or advertising in the main forum. Spamming includes repeating the same message over and over again within a short period of time. Don't post ALL CAPS thread titles. The Advertising and Promotion Subforum may be used to promote your Australian property related business or service. Active members of the forum who contribute regularly to main forum discussions may also include a link to their product or service in their signature block. Members are limited to one actively posting account each. A secondary account may be used solely for the purpose of maintaining a blog as long as that account no longer posts in threads. Any member who believes another member has violated these rules may report the offending post using the report button.
Australian Property Forum complies with ASIC Regulatory Guide 162 regarding Internet Discussion Sites. Australian Property Forum is not a provider of financial advice. Australian Property Forum does not in any way endorse the views and opinions of its members, nor does it vouch for for the accuracy or authenticity of their posts. It is not permitted for any Australian Property Forum member to post in the role of a licensed financial advisor or to post as the representative of a financial advisor. It is not permitted for Australian Property Forum members to ask for or offer specific buy, sell or hold recommendations on particular stocks, as a response to a request of this nature may be considered the provision of financial advice.
Views expressed on this forum are not representative of the forum owners. The forum owners are not liable or responsible for comments posted. Information posted does not constitute financial or legal advice. The forum owners accept no liability for information posted, nor for consequences of actions taken on the basis of that information. By visiting or using this forum, members and guests agree to be bound by the Zetaboards Terms of Use.
This site may contain copyright material (i.e. attributed snippets from online news reports), the use of which has not always been specifically authorized by the copyright owner. Such content is posted to advance understanding of environmental, political, human rights, economic, democratic, scientific, and social justice issues. This constitutes 'fair use' of such copyright material as provided for in section 107 of US Copyright Law. In accordance with Title 17 U.S.C. Section 107, the material on this site is distributed for research and educational purposes only. If you wish to use this material for purposes that go beyond 'fair use', you must obtain permission from the copyright owner. Such material is credited to the true owner or licensee. We will remove from the forum any such material upon the request of the owners of the copyright of said material, as we claim no credit for such material.
Privacy Policy: Australian Property Forum uses third party advertising companies to serve ads when you visit our site. These third party advertising companies may collect and use information about your visits to Australian Property Forum as well as other web sites in order to provide advertisements about goods and services of interest to you. If you would like more information about this practice and to know your choices about not having this information used by these companies, click here: Google Advertising Privacy FAQ
Australian Property Forum is hosted by Zetaboards. Please refer also to the Zetaboards Privacy Policy