The history of banking is full of triumphs and tragedies alike. Individual firms and entire business models have risen to dizzying heights before crashing down in disrepute. In each disaster is a lesson more lasting than the success or failure of any individual firm or financier. Although perhaps not the most studied financial market, and arguably the most underrated, French banking has its share of these lessons. One of the most famous examples of the hazards faced by banks is the example of Crédit Mobilier. Its failure, and near dissolution, revealed that banks cannot escape failures by pinning their fortunes on even the most certain trends.
Banking in France
Though France today is known for its large ‘universal banks’ engaged in everything from investment banking to regular consumer banking and even insurance, banking didn’t come naturally for the French. Indeed, early French banks were usually founded and led by foreigners. One of the earliest financiers who journeyed to France to find riches in finance was a Scot named John Law, founder of the infamous Banque Générale. Law was an early 18th century Scottish economist who fled Britain after killing another man in a duel. He was also a successful gambler though his luck did not extend so well to banking.
Nonetheless, John Law rose to esteem unimaginable for a commoner and virtual unknown in France. He must have been quite a charismatic figure, so much so that he managed to influence French fiscal and monetary policy through his ramblings on economics during the high-stakes gambling parties he attended alongside the wealthiest Parisians. In France, Law was credited with envisioning the establishment of a central bank and the liberal issuance of paper money to increase the availability of credit.
To carry out his vision of flooding the French economy with credit, Law established the Banque Générale. The Banque issued banknotes in exchange for deposits of metal coins and kept roughly a fourth of the specie deposited in reserves. However, this proved insufficient after a continent-wide stock market crash in 1720 caused a run on the bank as people sought to convert their cash back into precious metals. This was the very stock market crash that saw the bursting of the South Sea Bubble in London. Law’s Banque Générale was unable to make good on the redemptions and failed. It was an inauspicious beginning for French banking and revealed the dangers of banks exposed, even indirectly, to volatile assets like common stock.
Despite the collapse of Law’s firm, banking in France recovered later in the 18th century. Several new banking firms were organized in the 1700s and early 1800s. Again, many of these were founded by foreigners, like the Rothschilds of Frankfurt and Protestant bankers from Switzerland. In this era, banking in France was divided by scale. First, there were the ‘haute banque’ of Paris which financed trade and specialized in commercial and investment banking functions. Alongside these large firms were smaller local banks which sprouted up in the mid-19th century and mostly focused on offering mortgages to landholders.
Pereire brothers
One of France’s most famous banks of the 19th century was founded by two orphaned brothers, Emile and Isaac Pereire. In addition to being French-born themselves, they also came from quite modest means. Emile was a courier at the Paris Bourse and Isaac a bookkeeper. After arriving in Paris from Bordeaux, they had worked as journalists and political commentators before committing themselves to finance.
Significant to generating the brothers’ interest in banking was the political and economic thinking of Claude-Henri de Rouvroy, the Comte de Saint-Simon. The ideology bearing his name, Saint-Simonianism, was a social outlook gaining significant following in France during this period. It emphasized the rise of science and industry and its potential to improve society. Accordingly, he inspired many gifted young people to pursue careers in industry and business rather than the more ‘ancient’ vocations offered by the Church or the army.
The Pereire brothers were disciples of the theory that extending credit would help make France more productive and ease class conflicts, for the benefit of social harmony, ideas inspired by the Comte de Saint-Simon. Their theories had many high-profile supporters, including the President of France, and future Emperor, Napoleon III, whose appeal rested on class harmony and supporting the industrialization of France.
Crédit Mobilier
It was during this industrialization that the Pereire bothers founded Crédit Mobilier in 1852. The firm was capitalized by the issuance of 120,000 shares of 500 francs apiece. For perspective, an unskilled worker might earn that much in a year, two francs a day being a typical working-class wage at the time. Initial backers of their firm included a couple other financial firms, including a bank run by the family of France’s finance minister under Napoleon III, Achille Fould. Other subscribers numbered around a hundred, purchasing blocks of shares ranging from 10 to as many as 800.
Selling this stock raised 60 million francs in equity capital. The bank was then authorized by its charter to leverage itself up to 10-to-1 with the condition that deposits were payable with 45 days’ notice. That said, most of the leverage employed was legally required to be in the form of long-term debt. The charter limited short-term liabilities, namely deposits and other obligations of under a year in term, to twice the level of equity capital. While the liability side of the balance sheet looked secure enough, as with most financial institutions, the pitfalls awaited on the asset side. This would be no different for Crédit Mobilier, which invested the capital raised in the stock and corporate bond markets.
Even the name ‘Crédit Mobilier’ reveals something about the firm’s intentions. In France, many small banks operated as ‘Sociétés de Crédit Foncier’ where a ‘crédit foncier’ was a kind of mortgage. Most French banks specialized in lending money against property, or other tangible ‘immovable’ assets; these firms may as well have been called ‘Crédit Immobilier’. By contrast, ‘Crédit Mobilier’ would be oriented towards lending money against variable and easily transferable assets, like stocks and bonds.
As such, the bank used much of its capital to acquire stock and advanced loans against shares. The approach got off to a stunning start; the French stock market was booming amidst strong capital investment in railways and other new industries. A popular strategy employed by the bank saw Crédit Mobilier make an equity commitment to a company which could then call on that capital as it wished. Crédit Mobilier would then fund the previously unfunded commitment by issuing banknotes or other liabilities on short-notice. The bank also advanced to other investors the sums needed to honor their capital commitments, using the shares obtained by these investors as collateral. Whether as a direct investor itself, or through its margin loans, Crédit Mobilier was heavily exposed to the daily quotations on the Paris Bourse.
Boom
During the first few years of its operations, the bank was unusually profitable for a financial intermediary. Its dividend in 1853 was over 13% of paid-in-capital and grew upwards from there. Shares peaked at 1,900 francs in 1855, just three years after the bank was founded when shares were issued at 500 francs apiece. At that moment, the bank had a market capitalization of almost 230 million francs compared to a book value of 88 million francs. Such a valuation of three times book value is quite rich for a bank; yet, it was seemingly justified by the firm’s amazing profits. At the end of that year, the bank had 192 million francs of assets on paid-in-equity capital of 60 million francs. The profit of 26 million francs Crédit Mobilier generated on its assets in 1855 constituted a return on equity of 43% and an earnings yield of over 11% of its market capitalization.
The profits greatly enriched the firm’s directors as well as its shareholders. The management of the firm and compensation of its leaders was outright unusual by today’s standards. Controls and supervision were lax and directors received 5% of the bank’s gross profits. This generous renumeration was on top of the returns they earned on any shares they already owned. The benefits of being a director of Crédit Mobilier may not have even ended there. Then-journalist Karl Marx asserted that the company’s directors routinely used the inside information gleamed from their banking jobs to profit personally.
All this may have gotten into management’s egos. Whatever the firm’s profitability, it was the bank’s rate of expansion that was most startling. For example, the bank attempted to issue 240 million francs of notes to finance a mammoth subscription of government debt in 1855. At the time, the state was borrowing large sums of money to finance the Crimean War which was then entering its third year. If successful, the move would have expanded the bank’s balance sheet by an amount equating to perhaps 2% of French GDP at the time, all in one swoop. These notes would be redeemable on a fixed schedule and so were not banknotes in the traditional sense and thus did not violate the limits on the issuance of banknotes.
Bust
However, alarmed by this pace of expansion, the French state blocked the issuance of notes by Crédit Mobilier to finance the bank’s purchases of sovereign debt. Limiting the enlargement of its balance sheet curbed the bank’s growth. This was perhaps a predictable intervention though since the Banque de France, the nation’s central bank, had been keeping a tight watch on credit as the Crimean War drew to an end and was weary of the issuance of more obligations by banks, be they in banknotes or bonds. In essence, the bulging balance sheet of Crédit Mobilier was becoming a thorn in the sides of the Banque de France.
Indeed, while the credit the bank was extending was helping French industry fund investment despite the heavily borrowing by the state, this was nonetheless getting in the way of the central bank’s monetary planning.
The following year, 1856, saw the end of the Crimean War but European markets nonetheless cooled as the Banque de France and other central banks raised interest rates. Credit conditions tightened as money dried up; investors everywhere were skittish. Even the venerable Crédit Mobilier was duly affected. The firm was actually having to expend cash to make whole on the capital commitments it had made; in the past, it had simply issued more banknotes. Given the challenging environment, profits at the firm fell to a much lower though still impressive 23% of equity capital, as compared to over 40% the prior year.
However, Crédit Mobilier was also being saddled by loans made to a real estate subsidiary, the Compagnie Immobilière. This company, which was contracted to conduct much of the renovation of Paris led by Baron Haussmann, was performing poorly. The investment may have been made for more political reasons than economic ones. Regardless, by 1857, the bank had 80 million francs in credit extended to the firm. By now, the glory days of Crédit Mobilier were a thing of the past and the bank’s stock price had fallen to 1,000 francs a share.
Profits continued their slide through to the mid-1860s before the boom firmly turned to bust. Much of the bank’s profitability, indeed its very solvency, depended on the health of the stock market. The bank was financing speculative investments in stocks and bonds with fixed borrowings, either through issuing banknotes or bonds. The fateful year came in 1866 when a banking crisis struck London and spilled over, across the Channel, into Paris. Stock prices were falling and poor management didn’t help matters; the bank had invested in companies whose operations they did little to monitor.
Thus, 1866 brought a net loss of 8 million francs and a capital raise that saw another 60 million francs in equity injected into the company. The situation continued to deteriorate though. In September the following year, the founding Pereire brothers were forced out. Their career in banking, seemingly illustrious a few years earlier, was over. Just two months after their departure, their successors announced that losses had ballooned to over 47 million francs, a massive slice of the firm’s equity was lost. As it happened, the bank survived, but only in a restructured, and smaller, form.
Lesson
The history of Crédit Mobilier offers mixed lessons. It’s true that the firm and its international subsidiaries helped finance the growth of European industry in volatile times. Yet the bank nonetheless failed and this despite the fact that most of the firms it invested in survived and many prospered to extraordinary degrees. However, the history of Crédit Mobilier reveals a vital truth in banking. Its failure is evidence that banking is perhaps less about predicting outcomes and more about managing the risk of unintended outcomes.
More from the Tontine Coffee-House
The banking crisis that triggered the near collapse of Crédit Mobilier also caused the failure of another illustrious firm across the channel.
Further Reading
1. Cameron, Rondo E. “The Crédit Mobilier and the Economic Development of Europe.” Journal of Political Economy, vol. 61, no. 6, 1953, pp. 461–488.
2. “Credit Mobilier.” The New International Encyclopaedia, vol. 5, Dodd, Mead and Co., 1902, pp. 417–417.
3. Liesse, Andre. “Evolution of Credit and Banks in France: Chapter 2.” National Monetary Commission, 1909, pp. 96–108.
4. Marx, Karl. Marx and Engels Collected Works. Vol. 15, Lawrence and Wishart Ltd, 2000.
5. Plessis, Alain. “The History of Banks in France.” Handbook on The History of European Banks.
Paul Ochman