242 Sovereign Rescues

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A special report from Lombard Street Research

Sovereign RescuesHow the forgotten financial crisis of 1914 compares with 20082009

Professor Richard Roberts Brian Reading Leigh Skene

A special report from Lombard Street Research

Sovereign RescuesHow the forgotten financial crisis of 1914 compares with 20082009

Professor Richard Roberts Brian Reading Leigh SkeneThis special report is in two parts: Then In 1914 a storm broke over globalised financial markets. Financial historian Richard Roberts has dug into the National Archives at Kew, the Bank of England Archives, the British Library and sundry other sources such as The Economist to analyse the crisis and has unearthed an incredible story. Now In the second part, Brian Reading and Leigh Skene draw parallels with todays crisis.

Lombard Street Research



by Professor Richard Roberts Professor Richard Roberts is Director of the Centre for Contemporary British History, a research centre at the Institute of Historical Research, University of London.


Special Report : Sovereign Rescues

SUMMARYThe summer of 1914 witnessed the most perilous crisis in the history of the City. Over the course of little more than a week, Londons financial markets ceased to function. The breakdown threatened wholesale bankruptcy among specialist financial firms, as well as the collapse of the domestic banking system. The onset of the systemic crisis was due to an abrupt adjustment to a new risk a European war destabilising domestic and foreign participants in the worlds leading international financial centre and overseas counter-parties. Of course the threat of a major war is a different context to todays crisis, yet the breakdown of liquidity and confidence are common features of the onset of both crises in 1914 before a shot had been fired. In fact, the episodes have many resonances, both as regards problems global market contagion, the freezing of the money market, a credit crunch, toxic assets, the impact of mark-to-market, recalcitrant bankers and responses. The scale and scope of the 1914 crisis led to unprecedented state intervention in the financial system. The authorities conducted a series of novel initiatives to save the banks and revive the markets, including contemporary forms of quantitative easing, the removal of toxic assets from the market, and a partial bail out of the banking system. The measures proved successful - by late 1914 the Citys markets were operating once more and failures among financial firms were minimal. By then Britain was at war and the financial system had been put to work serving its saviour by funding the war effort. Over the longer term, the emergency measures to save the system laid the foundations of rapid wartime inflation. They also involved substantial risk of loss by taxpayers. But, remarkably, when the final account was done, the Treasury had made a profit.2008


86.5xPRICES 1914 : 1.00 2008 : 86.502008


SECURITIES 1914 : 11.3 billion 2008 : 3.5 trillion


NOMINAL UK GDP 1914 : 2.54 billion. 2008 : 1,443 billion.



UK BANK DEPOSITS 1914 : 1.2 billion 2008 : 1 trillion (sight deposits)


Lombard Street Research


THE FORGOTTEN CRISISThe current crisis in the financial markets has greatly stimulated interest in financial history, insights being avidly sought from past precedents. An episode that has been overlooked was the Citys financial crisis of summer 1914. Obviously the circumstances then and now are significantly different they always are but this forgotten chapter features some uncanny parallels in the development of the crisis and its resolution. Perhaps its outcomes hold some lessons for today?

BreakdownThe murder of Archduke Franz Ferdinand, Austrias heir-apparent, in Sarajevo on 28 June 1914 had scant immediate impact on Londons financial markets. After all, there had been sabre-rattling between Continental powers the previous three summers. Risk perceptions were abruptly transformed a month later by an Austrian ultimatum to Serbia that became known to the markets on Friday 24 July suddenly the prospect of a European war was more than just a nightmare. Rattled investors dashed for cash with heavy securities sales on Continental bourses.

Stock exchanges all fall downSubsequent days witnessed probably the first major episode of global financial contagion - the closure of the worlds leading stock exchanges one after another as the scramble for liquidity swept across the world. Fridays news launched a week-long tsunami of selling. Overwhelmed, the Brussels, Budapest and Vienna bourses, and Pariss junior market, shut from Monday 27 July. Tuesday saw the closure of the Madrid and Toronto markets. On Wednesday, Austria declared war on Serbia and the stock markets of Amsterdam, Berlin, Montreal and St Petersburg shut up shop. On Thursday, Rome, Milan and Shanghai followed suit. Friday saw the dominoes continuing to fall and Barcelona, Vancouver and Zurich as well as all the South American exchanges capitulated. The cascade of closures resulted in the London and New York stock markets becoming, according to an observer: the worlds dumping ground for the sale of stocks and shares. On Friday 31 July, for the first time since its formation in 1773, the London Stock Exchange closed. The New York Stock Exchange followed hours later. The Johannesburg, Adelaide, Melbourne and Sydney exchanges shut in following days. In little more than a week, the worlds bonds and shares had become illiquid.

Mark-to-market shuts the London Stock ExchangeOn the eve of the First World War the London Stock Exchange was the worlds largest and most liquid securities market. The rules of the exchange imposed a strict division of activity between two types of member, brokers and jobbers. Brokers acted as agents on behalf of buyers and sellers. Jobbers made a market in particular securities, quoting buy and sell prices to brokers. Brokers had modest capital requirements, but jobbing involved holding a stock of securities which required substantial working capital. The funds, totalling 80 million, were borrowed as short-term call loans from banks, both the major domestic banks and foreign banks with branches in London. The banks loans to jobbers were collateralised by the securities they funded, plus an element of margin. The collateral securities were regularly marked-to-market and if the price went down, firms had to provide increased margin or sell the security and repay the loan. The system operated satisfactorily in normal markets, but, as a banker put it: the delicate financial mechanism of modern London had never been put to the test of a European war. The deluge of selling orders sent securities prices plummeting. Confronted by a relentless one-way market, jobbers stopped dealing, as in the stock market crashes of 1929 and 1987. Many jobbers soon declined to make prices at all, or at any rate insisted on learning which way a broker wished to deal before quoting a price, recorded The Times. Others made very wide quotations, so wide in fact as to


Special Report : Sovereign Rescues

check the desire to enter into a bargain in all but the most determined sellers. The price falls triggered margin calls from the banks. Moreover, the banks, especially foreign banks, were calling in their call loans to boost their liquidity. Either way, jobbers disastrously found themselves being forced sellers in a market without buyers. Seven firms failed on Wednesday 29 July and the following day saw the closure of several more. To forestall further failures, the management closed the exchange. This halted the ruinous write-downs since there were no longer quoted prices to serve as mark-tomarket benchmarks. While closure undoubtedly saved many stock exchange firms from failure, it created significant liquidity problems for investors as well as compounding the array of problems facing the banks.

The London money market key to Londons greatnessThe Stock Exchange drama was paralleled by less publicly visible breakdowns in Londons money and foreign exchange markets. The key to Londons greatness, the word used by a contemporary, as a financial centre in 1914 was the unrivalled scale and liquidity of its money market. This was a wholesale, over-the-counter market among banks that they used for funding and treasury management purposes. Participation in the London money market was the foremost reason why foreign banks maintained branches in London. The key instrument traded in the money market was the sterling bill of exchange arising out of international trade transactions (typically of three-month maturity). It was estimated that such sterling commercial bills financed 90% of British trade and 50% of world trade. These bills also served as the major means for the settlement of international obligations (shipment of gold was an inconvenient alternative) leading to substantial overlap between the bill market and the foreign exchange market. On the buy-side the foremost purchasers of bills were domestic and foreign banks. Bills formed an important part of banks liquid reserves. The money market was served by a set of intermediary firms - the discount houses that acted as brokers and jobbers (combining the roles). They enjoyed privileged access to discounting (purchase) facilities for their holdings of bills at the Bank of England. The discount houses funded their bill portfolios by call loans from domestic and foreign banks collateralised by the bills.

The Accepting HousesThe negotiability of a commercial bill was enhanced by its endorsement by an acceptor a firm or bank which guaranteed payment to the holder upon maturity in case of default by the debtor. Acceptance business was t