Panic Series (Pt. VI) - 1866 — Investor Amnesia

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The Panic of 1866 is a familiar story of historic financial institutions discarding their conservative principles for higher-yielding and riskier ventures. Today’s post is the story of Overend, Gurney & Company and the Panic of 1866.

Justttt before we get into that, though, I went on the Narrative Monopoly podcast this week to discuss financial history and I encourage people to listen / subscribe!

Bills of Exchange & Discount Houses

Before delving further into the Panic of 1866, we must first understand the important role that bills of exchange, bill brokers, and “discount houses” played in 19th century finance.

Bill of Exchange

While not exactly “sexy” or flashy, Bills of Exchange had been a crucial element of stimulating commercial activity in Europe for centuries. In his lecture on the financial cycle of Empires for my latest course, Niall Ferguson argued:

“The Bill of Exchange is one of those late 14th century inventions that absolutely transforms financial history… one of those extraordinarily important innovations in financial history that we don’t know or read nearly enough about.”

So, what was a Bill of Exchange? These instruments were essentially an IOU, where a Farmer, for example, promises to pay a Bill Broker $100 in 90 days. In exchange, this Bill Broker pays the Farmer $97, pocketing the $3 “discount” as a form of interest on the loan. However, the Bill Broker could then sell this Bill of Exchange to a bank for $98, producing a $1 profit without any substantial credit risk (i.e. risk of the Farmer not being able to pay the $100 in 90 days).

Bill Brokers & Discount Houses

One of the main problems with this system, however, was that this small margin for Bill Brokers encouraged leverage.

“In normal times risks were limited, and so were margins, encouraging substantial leverage. According to King, the ratio of total assets to capital hovered around 10 times in the mid 19th century, and this was larger than what a typical bank would do. This is how Britain’s variant of the modern ‘shadow banking system’ was born.” (Flandreau & Ugolini)

Regardless, these already important credit instruments became critical to Britain’s financial system during the Industrial Revolution. Additionally, “Bill Brokers” and associated “Discount Houses” played an increasingly larger role following the Panic of 1825, when many commercial banks were burned by large exposures to bills of exchange.

“The bill market flourished in England during the Industrial Revolution, and specialized intermediaries (the bill brokers) started to emerge at the beginning of the nineteenth century…

the centrality of bill brokers within the system was established following the crisis of 1825. During this crisis, rampant credit rationing by the Bank of England made major London banks—which were heavily invested in bills—experience a serious maturity mismatch, which forced them to suspend payments. Scared by this episode, commercial banks would have vowed never to find themselves in the same situation again. Instead of keeping all of their assets in bills, the banks started to deposit large amounts of money ‘on call’ with bill brokers, to whom the liquidity risk was shifted.

This very episode transformed the English financial system into one which was unlike any other. Bill brokers (or ‘discount houses’, as they came to be known later on) evolved from being brokers to being money market funds, taking deposits from banks and investing them directly (on their own account) in the bill market.” (Flandreau & Ugolini)

In short, following the Panic of 1825 commercial banks were scarred by their large investments in bills of exchange turning sour and decided to deposit funds with Bill Brokers “on call (demand)” instead of buying bills of exchange themselves. Under this system the liquidity risk was “shifted” from commercial banks to the Bill Brokers.

The diagram below exhibits the English financial system as it pertains to the bills of exchange market (Flandreau & Ugolini). As you can see, Bill Brokers became a money market fund that accepted deposits from commercial banks and invested these funds in the bill market. At this stage, Bill Brokers became “discount houses” that specialized in this niche of short-term financing.

The Bank of England

In addition to bill brokers and discount houses, the Bank of England was another key component of this financial system in the run-up to 1866.

The Discount Window

For central banks, the “Discount Window” is a key tool for providing liquidity to the financial system.

“[The Bank of England] also operated an office called the Discount Window, in which it provided ‘Discounts’ (exchanging through repurchase agreements at discount) on merchants’, brokers’ and other banks’ bills of exchange. This was in addition to ‘Advances’ also provided through the Discount Window.

The discount rate the Bank of England charged on those bills is in some sense similar to the Bank Rate the Monetary Policy Committee sets today. In case of crisis, commercial banks would be able to obtain liquidity by going to the Discount Window for Advances or Discounts.” (Bank of England)

As it relates to bill brokers and Discount Houses, this Discount Window was important for helping discount houses service their cash requirements when the commercial banks that deposited funds wanted to withdraw their money.

“In addition, they [commercial banks] would call back their deposits with the discount houses who, in order to meet the cash requirements of the commercial banks, would in turn have to re-discount the bills on their balance sheet with the Bank of England.” (Bank of England)

However, this system presented a 19th century version of moral hazard in which bill brokers operated under the assumption that in such times of crisis the Bank of England would be there to provide liquidity and safety. Concerns evolved into actions after the Panic of 1857, which we covered last week.

“Following the 1857 crisis, the Bank of England’s directors grew increasingly concerned that the unconstrained provision of liquidity to bill brokers had led to moral hazard. This was the idea that the Bank of England gave bill brokers perverse incentives, as the fact they could rely on the Discount Window when necessary led them to become highly leveraged and hold few reserves of their own.

In March 1858 the Bank took the decision to restrict bill brokers’ access to its Discount Window, in an effort to incentivize them to hold more reserves rather than rely on it to provide liquidity.” (Bank of England)

The Rise & Fall of Overend, Gurney & Company

Founded in the early 1800s by Samuel Gurney, Overend & Gurney had earned and maintained a sound reputation of honesty and respectability for much of its existence.

“Samuel Gurney’s old, sound business had called for ‘great care with every bill’, great knowledge of the ‘standing of parties’, and considered use of that knowledge.” (Capie)

Yet, in his 1873 book, famed Economist Editor Walter Bagehot wrote that between 1860 – 1866:

“[The rich Overend & Gurney partners] lost all their own wealth, sold the business to the company, and then lost a large part of the company’s capital. And these losses were made in a manner so reckless and so foolish that one would think a child who had lent money in the City of London would have lent it better.“

So, what changed?

New Management & A New Business Model

There were two key drivers of Overend & Gurney’s demise. The first problem stemmed from new, younger management.

“Samuel Gurney had died a few years earlier and the original partners had all by this time retired, allowing a younger and less experienced generation of directors to come to the fore. Believing that they were invincible and on the advice of an unscrupulous accountant these young men set the bank on a highly perilous course.” (Winton Capital)

The second – and related – driver of Overend & Gurney’s fall came from its new business model, a.k.a. the “highly perilous course”. This new business model was in response to the Bank of England’s decision in 1858 to close the Discount Window to Discount Houses like Overend & Gurney.

“The inability of bill brokers to access the facilities at the Bank of England’s Discount Window meant that they needed to adjust their business model in response. This included holding greater levels of reserves, rendering the core business of bill discounting less profitable.” (Bank of England)

Overend & Gurney’s new management responded to the declining profitability in their core business model by expanding into riskier but higher-yielding activities like long-term financing (lending), where it had little experience. However, this was problematic for two reasons. First, the new long-term lending business model created a duration mismatch since Overend & Gurney’s liabilities were largely short-term debts. If commercial banks began to withdraw large deposits from their funds at Overend & Gurney, the Discount House’s capital would be tied up in long-term financing projects that they could not readily cash in to fund the commercial bank’s withdrawals.

Making matters worse, Overend & Gurney was offering long-term financing to incredibly risky companies in the speculative railway industry. Overend & Gurney provided sizable advances to David Leopold Lewis, a seedy railway promoter that had been bankrupted three times.

The situation steadily worsened, and from 1860 to 1865 “the firm was making average losses of £500,000 a year, despite £200,000 of profit on the bill broking business (BOE)”.

As the company continued to hemorrhage money, management decided to convert the firm into a limited-liability company by going public in 1865. Overend & Gurney’s prospectus contained some financial subterfuge intended to hide how much money the firm was losing. Investors had no concerns and the IPO was a resounding success… temporarily.

“Overend Gurney was, unknown to its new investors, already insolvent at the moment of transition to a limited liability company… [but] fear of war in Central Europe, a general stock market collapse, a fall in cotton prices and a long period of high interest rates contributed to a series of business failures and made it hard to liquidate investments. A few of those, such as Millwall Ironworks, were known clients of Overend Gurney. But unfortunate coincidences, such as the failure of the railway contractor Watson, Overend & Co. (which had no connection with Overend Gurney) helped rumors spread further.

Those rumors intensified as the partners of Overend Gurney started to sell their own estates in order to meet their liabilities. After a court ruled, on 9 May 1866, that Overend Gurney did not have the power to collect debt owed to it by the Mid-Wales Railway Company, a run on its deposits ensued.” (Bank of England)

While the Discount House still could not access the Discount Window due to the 1858 policy change, Overend & Gurney still turned to the Bank of England for help in its time of crisis. However, the Bank of England refused to assist.

“The partners then applied for assistance from the Bank of England. In response, then Bank of England Governor Henry Holland sent a staff committee including Robert Bevan and led by former Governor Kirkman Hodgson to investigate the books of Overend Gurney. Rescue was refused: in the words of Mr Bevan, ‘the firm was so rotten’ it effectively sealed its own fate.

At 15.30 on 10 May 1866, a note was posted on Overend Gurney’s door stating: ‘we regret to announce that a severe run on our deposits and resources has compelled us to suspend payment’. The Banker magazine recorded that ‘the effect on the city was as the shock of an earthquake’ as depositors started queueing to withdraw their funds from all the banking establishments and the money market seized up. Bankers flooded to the Bank of England discount office in search of funds.” (Bank of England)

It was this note posted on Overend & Gurney’s door announcing the suspension of payments that triggered the Panic of 1866. In terms of monetary policy, this Panic was pivotal in the evolution of central banking. When Overend & Gurney collapsed, depositors at other banks rushed to withdraw their funds out of fear that their funds were also in danger. In response, the banks went “to the Bank of England discount office in search of funds.”

For the first time, the Bank of England acted as a Lender of Last Resort by injecting liquidity into the system, lending out £4 Million to commercial banks in just two days. The Bank of England’s actions quelled the panic and reduced its impact on the “real” economy.

And that, my friends, is the Panic of 1866!