Policymakers, economists and bankers typically ignore 1914 when they talk about finance and financial crisis (honourable exceptions have been Mervyn King and Andy Haldane). But it has some of the best parallels going with 2007-08, as a masterly new history from Professor Richard Roberts of Kings College London details.
Interconnected financial system? Short term repo market leverage? Opaque bank balance sheets? Mark-to-market spirals? The crisis spread from market to market as old certainties about what assets were liquid, and what institutions were creditworthy evaporated. Globalised markets vanished – financial institutions retreated to domestic banking.
After the crisis, many of the arguments were also the same. Had the government been too generous to the banks? Why weren’t they lending to industry? Had the currency been debased to save finance?
Well before Britain declared war on Germany, the City had already frozen (and was passionately lobbying for Britain to stay out of the brewing conflict).
Frozen fears
Fears over the consequences of war, and the chance that markets could freeze, led securities firms and investors to liquidate their foreign portfolios. As with all markets once all the business is in one direction, liquidity dried up, and stock exchanges (which also traded bonds at the time) closed across Europe and America. As each exchange closed, this put further pressure on the remaining exchanges, as investors rushing for the exits tried to get out ahead of the end of trading.
London, which was financial capital of the world in 1914, was the last market standing. London exported more capital than anywhere else, had a higher nominal value of securities than New York and Paris combined, and saw more active trading. But this meant it was more vulnerable. As stock exchanges shut around the world and securities could not be sold, international banks started to liquidate their London holdings.
At this point, the story starts to seem spookily familiar. London stock and bond trading inventories were funded by margin loans, marked to market of course, and so dealer financing dried up. The firms involved were honourable partnerships featuring the bluest of blue-bloods, but this made no difference – once their funding dried up, they could not meet their obligations. Across the market, there was a “flight to quality”, with only UK government “Consols” remaining tradeable.
Trade finance, in the form of “bills of exchange” guaranteed by the accepting houses (the organisational forerunners of the investment banks), was next to fall. These bills, in a gold-backed fixed exchange rate system, formed a de facto international currency. Obligations in sterling, the world trade currency, could be met with “accepted” bills of exchange which had been guaranteed (accepted) by one of the leading London houses.
In other words, trade was financed by an asset which was seen as risk-free, but which was underpinned by financial sector guarantees, all of which were highly correlated.
When payments ceased to be made (because securities could not be sold), the accepting houses had their guarantees called at once, an obligation which they could not possibly meet.
The crisis had a further, nastier edge, caused by the existence of the gold standard. In a world of fiat money, everyone wants cash when the market panics. But under the gold standard, cash was not good enough - gold was the currency of choice.
Before the UK government had decided to go to war, citizens were queueing outside the Bank of England to turn their notes into gold, following the decision of the main commercial banks to hoard gold and pay withdrawals, as far as possible, only in notes. But the Bank of England, in turn, had only limited gold, and a hard limit on the ratio of paper money to gold reserves it was allowed.
Lessons for today
Professor Roberts has a light touch in this complex landscape, peopled by City grandees and extraordinary characters such as Hartley Withers, merchant banker and subsequently editor of The Economist.
Roberts also explores what the crisis of 1914 has to teach us. While the circumstances – fear of a European war – are unlikely to be repeated, the sudden loss of liquidity in instruments previously seen as near-cash, and the instant freezing of repo networks seem totally modern, and the sense of crisis in the primary sources Roberts quotes are extraordinarily familiar.
The proliferation of the crisis also raises questions about the dearly held beliefs of financial reformers. The accepting houses, which were the forerunners of today’s investment banks, were partnerships with extraordinarily high capital levels – a ratio of “acceptances” to capital of between two and six times.
But neither factor protected them, nor did it allow the authorities to wind them up in an orderly fashion. All the business they did lay in the same direction – allowing one accepting house to fail meant they all did.
An absence of CDS or a swaps market was similarly irrelevant. Banks proved quite capable of forging complex chains of connections without any of the “financial innovation” of the last 20 years. Margin trading and repo did the job admirably, providing, then as now, embedded pro-cyclical leverage for securities firms.
Bond trading, too, was very different. It was on exchange, and sales and trading (“jobbing”) were strictly separated. But this just focused attention on the issue of whether the exchange was open or closed, rather than whether there were actually any prices to be had in the depth of crisis.
Negotiated trades at eye-gouging levels, phantom prices, and offer-only markets were just as familiar in the old Stock Exchange on Throgmorton Street as they were on Bloomberg Messenger in 2008. Illiquidity is just as real, on or off exchange.
Solving the problem
The remedies taken by the London authorities may also seem familiar. Britain effectively dropped the gold standard, and central bank liquidity rode to the rescue, accompanied by anxiety and hand-wringing over the debasement of the currency.
The Chancellor, David Lloyd George, stepped in with state guarantees for the financial system. The Bank of England would give cash against bills of exchange, even the most doubtful, and the Treasury would indemnify the Bank against loss. In effect, the banks could swap their dodgy collateral for cash at a government-subsidised risk rate. Around a third of total outstandings in the market ended up in “cold storage” at the Bank.
This preserved for posterity some of the leading bill acceptance houses of the time, including a few familiar names – Schroders, Kleinwort, Hambros, and Barings, for example. This scheme, noted Andy Haldane of the Bank of England, bore more than a passing resemblance to the Special Liquidity Scheme, and then, as now, proved controversial for being too favourable to the banks.
Cutting out the rot with state backing, combined with other measures, including a payments moratorium, eventually brought the financial system back on its feet, while the massive wartime demand stimulus ensured there was no associated economic slump.
The financial crisis of 1914 is, rightly, overshadowed by the appalling death and destruction that followed. But though its cost in human life was small (Professor Roberts counts six suicides), it shattered the global financial system just as the war shattered politics. Not until the 1990s did markets recover the level of globalisation and financial openness they had before WWI. “Forgotten Crisis” delves into a fascinating episode with plenty of parallels with today.
(Owen Sanderson studied under Professor Roberts)
