Wednesday, August 10, 2011

Book Review (#27 of 2011) Lombard Street

Lombard Street: A Description of the Money Market by Walter Bagehot (1873, reprinted by Project Gutenberg).
This is the original book about bank runs, financial crises, and the role of a central bank. This is on Ben Bernanke's short-list of recommended books, and he quotes Bagehot often. Bagehot influenced those who would later create the Federal Reserve.

Bagehot is examining the British financial system, then the biggest and most well-capitalized in the world. (Known deposits in London in 1873 were 120,000,000 pounds, while New York was next with the equivalent of 40,000,000 pounds).  The capital had done wonders for British industrial development, as a properly functioning financial market is necessary for any advanced country.  But risk is inherent:
"The peculiar essence of our banking system is an unprecedented trust between man and man: and when that trust is much weakened by hidden causes, a small accident may greatly hurt it, and a great accident for a moment may almost destroy it."

England had recently (1866) gone through a panic very similar to our recent financial crisis, the Overend Gurney crisis, where some very large players dealing with risky schemes and assets went bust and triggered a panic, handled controversially by the Bank, which suspended payments as the system collapsed.
Bagehot on Overend, Gurney, and Co.:
"(T)hese losses were made in a manner so reckless and foolish, that one would think a child who had lent money in the City of London would have lent it better."

The Bank hasn't always done a bad job of being the lender of last resort, and Bagehot gives a good bit of interesting history. 

The Bank of England was privately owned and operated by a large board of executives from various types of industry.  It had a rotating presidency and governorship (which Bagehot actually recommends eliminating for a permanent governor and vice-governor) who seemed to run the bank well and rather conservatively.  The Bank of England held deposits from all the other banks on Lombard Street as well as the British Exchequer, and foreign governments. 

In 1844, Parliament gave the Bank of England exclusive authority to issue notes (ie: currency), so long as they were 100% backed by gold (a rule the Bank could suspend during a crisis).  The Act also created a fractional reserve banking system in the U.K., with no required reserve ratio.  The Bank of England was the bedrock of the system, and it typically kept a very large reserve as a result.  Bagehot gives a lot of insight and praise into its conservative governorship, but suggests it be even more conservative. 

Bagehot much prefers the British system to the American, which had just nationalized the currency after the Civil War. He deplores the 2-charter U.S. system with its different regulators required to keep tabs on what banks are doing.  There are some interesting comments seemingly in favor of free banking, which I found interesting. Bagehot

Bagehot's role for a central bank during a panic is to:
1. Before the panic, build up a large reserve.
2. During the panic, lend freely, at high rates of interest, and on good collateral. 

"A a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be advance it most freely for the liabilities of others."

The high rate of interest is to penalize the bad banks who can't afford the loan. Here, he is unaware of the concept of adverse selection--those who will borrow at high interest rates are more likely to be the bad banks, not the sound ones. He makes the point earlier in the book that a bank or creditor in trouble will pay any price for money rather than go broke, but seemingly misses the connection here. 

The collateral is important, it needs to be what Gorton would call "information insensitive," something everyone recognizes is most likely a good asset--bank loans, for example.  If everyone sees the bank lending freely on decent collateral, then they will stop panicking.  These are the days before deposit insurance.

All banks during a bank run need to lend more, not less.  Otherwise, people will think they don't have enough money to meet their obligations and the run will intensify-- wiping out good banks as well as bad.  The best modern day illustration of this from the Great Depression was in Episode 3 of Milton Friedman's Free to Choose series, I show it to Money and Banking every year.

Another aspect that Bagehot deals with is joint stock companies and the principal-agent problem. He totally identifies that managers and owners may have conflicting incentives. His suggestion is that the members of the board of directors with the most "spare time" basically micromanage the manager's decisions to make sure he's not engaging in overly risky behavior.

Bagehot describes the speculation that happens just before a panic, reminiscent of our housing boom/bust:
"The good times too of a high price almost always engender much fraud. All people are most credulous when they are most happy; and when much money has just been made...when most people think they are making it, there is a happy opportunity for ingenious mendacity." 
Another good quote:
"I am by no means an alarmist. I believe that our system, though curious and peculiar, may be worked safely; but if we wish so to work it, we must study it...Money will not manage itself, and Lombard Street has a great deal of money to manage."
I enjoyed this book and consider it a must-read for students of money, banking, and financial crises.  I have one more book on my crisis reading list to finish before the semester starts.

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