Old Lombard Street’s Greatest Panic

In the spring of 1866, London’s money markets were shaken by the collapse of a single large and previously illustrious firm. The Panic of 1866 was one of the most severe in Victorian finance. However, it was also handled in a surprisingly effective manner by the Bank of England, then merely a private bank, albeit one with a special relationship with the state. Nonetheless, during the Panic, the Bank assumed the responsibilities of a lender of last resort, solidifying its role as a central bank. Details of the Panic have survived to the present day in the writings of the commentator and journalist Walter Bagehot, but to comprehend them requires diving into the archaic yet somewhat familiar world of Britain’s mid-19th century money market.

Money Market

The Panic of 1866 had its origins in London’s money market. In this vibrant market, millions of pounds in short-term credit was extended to London’s industrial, mercantile, and financial concerns. At the center of the market for short-term funding were bill brokers. These firms extended credit to businesses by trading in bills of exchange at a discount. Under a bill of exchange, borrowers had a period of a few weeks or months to repay a sum lent today. The difference between the amount to be repaid and the amount lent was called a ‘discount’ and this composed the bill brokers’ interest. In the normal course of business, bill brokers financed their short-term lending either by selling the bills on to a bank or by borrowing money from other creditors.

As an example, a merchant might write a bill of exchange to a bill broker promising to pay the broker £100 in ninety days. For this bill, the broker might pay just £97; the £3 discount here equates to a roughly 13% annualized interest rate. The broker might then sell the bill to a bank for £98 the next day, making £1 off the transaction while taking almost no credit risk. Alternatively, the broker might borrow money from a bank or take in deposits at 6%, for instance, and profit off the spread between this cost of financing and the implicit interest earned on his bills of exchange.

In either case, the bill brokers were merely intermediaries. They relied on their reputation for solid underwriting to obtain the funding needed to carry out their business. Banks benefited from being able to acquire bills in bulk from the brokers who actually specialized in extending credit to individual borrowers. In return, brokers were essentially collecting a fee or earned a spread between their cost of funding and the return on the bills they owned.

Before discussing the bill brokers at the center of the Panic, it is worth tackling the obvious issue with the term ‘bill broker’. Namely, it is hard to call institutions trading with their own account ‘brokers’. Indeed, early in the history of the bill brokering business, the firms in the sector were truly just brokers. They connected lenders with borrowers but did no lending themselves. This changed as the brokers morphed into ‘discount houses’ investing their own money in discounted bills. In the process, these firms looked something like modern money market funds. However, discounting was a low margin business so these firms employed high leverage by the standards of the time, at least occasionally around 10-to-1.

Bank of England

The Bank of England also played a large role in London’s money market. The Bank was, of course, Britain’s central bank. It had a monopoly on issuing banknotes in London, though not in the whole of Britain, and was in charge of managing the country’s gold reserves and providing debt financing for the government. Despite all this, it was still a private bank, answerable to shareholders and the Bank accordingly lent money to maximize its return. Even in its money market operations, the Bank combined profit-seeking investment decisions with policymaking. It purchased discounted bills under repurchase agreements, essentially a form of collateralized lending, both profitable to the Bank and the origin of the central bank’s ‘discount window’.

The Bank of England is certainly relevant to the story of the Panic of 1866. Of particular importance was its decision to restrict bill brokers’ access to the discount window following a smaller panic in 1857. That year, rising interest rates caused bank reserves to diminish to the point of scarcity, triggering the failures of certain financial firms. Following that episode, the Bank took the view that restricting access to emergency funding would encourage banks and bill brokers to hold more reserves; it was a 19th century response to moral hazard. Under the new arrangement, bill brokers would no longer be able to get discount window financing from the Bank, they would only have the option to sell their bills to the Bank outright during periods of low liquidity.

In response, many bill brokers, including Overend Gurney, the firm at the center of the 1866 debacle, registered their disapproval by withdrawing reserves from the Bank of England in protest. This punitive ‘run’ on the Bank of England was unsuccessful. At any rate, the disaffected bill brokers argued that by leaving reserves with the Bank they were essentially financing a competitor and would not get to benefit from the Bank’s emergency lending. This self-imposed restraint on the part of the Bank was not the only factor that threatened to restrict its ability to respond to a crisis though. Its capacity to provide liquidity was also curtailed by the Bank Act of 1844, which limited the issuance of new banknotes not backed by gold.

Overend Gurney

Overend, Gurney, and Company, whose failure triggered the Panic of 1866, was one of Britain’s largest discount houses. The firm was founded in 1800 by both bankers and bill brokers, including the illustrious banker Samuel Gurney. Like other bill brokers, initially the company was in the business of matching creditors and borrowers and charging a brokerage fee, thus avoiding any credit risk altogether. However, this changed as the firm grew and began to lend on its own account. The firm’s scale and sound management in its earlier days allowed it to play a large roll during a financial panic in 1825. That year, the company extended credit to other banking firms, earning it the epithet, ‘the bankers’ banker’. It continued to grow from there; by 1850, the firm had deposits equal to its three largest bill brokering competitors combined.

In the decade before the 1866 panic, Overend Gurney had been keeping larger reserves at the Bank of England in response to the Bank’s efforts to limit access to emergency financing. However, larger reserves limited the bill brokers’ profitability and so encouraged the firm to reach for higher yielding investments to make up for the drag caused by the reserves. Thus, Overend Gurney drifted away from the traditional bill brokering business and began extending longer term credit to businesses that needed to finance lengthier projects, like shipping and railway companies. This caused a widening mismatch between the duration of its assets and its liabilities, with short-term debts far exceeding liquid assets. Loosening underwriting standards didn’t help matters either.

The firm was certainly in decline by 1860, when lending portfolio losses had started mounting. In the next few years, the company was still profitable in its traditional bill brokering business, but overall it was losing an average of £500,000 a year. The firm’s partners incorporated the company in 1865 to obtain limited liability for shareholders, an event that would later be treated with suspicion and viewed as a harbinger of future trouble.

Indeed, limited liability had only been extended to financial companies in Britain in 1862 and the firm was almost certainly insolvent before it incorporated. At the time however, incorporation offered an opportunity to sell new shares and thus raise equity capital. During this reorganization, the company sold 100,000 shares, raising £1.5 million in equity capital with commitments made by investors for another £3.5 million. However, incorporation also meant that a wider shareholder base was now aware of the firm’s troubles and this knowledge helped the firm slide closer into oblivion.

Panic

On the eve of the Panic, trouble arose in the money markets as the Bank of England raised interest rates in 1865 and 1866, from around 4% in the beginning of 1865 to 7% a year later. The constricting financial conditions raised the cost of the firm’s borrowings and caused some of Overend Gurney’s clients to go bankrupt. As short-term interest rates rose, the duration mismatch discussed earlier became a severe problem. The firm found no interest in last minute requests it made for loans from other banks and could not take advantage of the Bank of England’s discount window. Overend Gurney may not have had sufficient quality collateral to begin with.

“We regret to announce that a severe run on our deposits and resources has compelled us to suspend payment” – Message on the door of Overend, Gurney, & Company at 65 Lombard Street, May 10, 1866

The company ceased business on May 10th and liquidated the following month. The firm’s sudden collapse ushered in a banking crisis as other firms faced bank runs. Unlike in past episodes when economic weakness coincided with a financial panic, the Panic of 1866 was mostly just a banking crisis, one which fortunately had limited repercussions on industry. Nonetheless, Overend Gurney was so large that its failure alone warranted a serious response. London’s Pall Mall Gazette reported that just before the firm’s collapse, Overend Gurney had obligations of £3.5 million in demand deposits and £6 million in other liabilities with just £500,000 of liquid securities.

“…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…” -Walter Bagehot in Lombard Street

Resolution

The Panic of 1866 marks one of the occasions when the Bank of England assumed the responsibilities expected of a modern central bank. It requested that the Bank Act of 1844 be suspended. This would have allowed the Bank to print new banknotes without increasing gold reserves in order to extend credit into London’s troubled money markets. The request was approved by the Chancellor of the Exchequer, and future Prime Minister, William Gladstone.

While awaiting a change in policy, the Bank of England extended credit out of its own cash reserves, sidestepping the need to print new notes. Credit was extended liberally but at a high rate. Interest rates, which had risen over the previous year, were increased still further during the panic from 7% to 9%, and then soon after to 10%. However, the bank kept money market rates from rising further; upwards of £4 million was advanced to banks, bill brokers, and others, mostly through outright purchases of bills but also by some lending. This intervention depleted most of the Bank’s reserves, which started May 1866 at just shy of £6 million and ended the month at under £2 million.

However, so effective was the response that, in the end, the crisis dissipated without the issuance of new banknotes. So quick was the response that the economy seemed successfully insulated from the troubles on Lombard Street. The eventual lowering of interest rates certainly must have helped matters. The Bank cut rates to 8% from 10% in the following August and slashed its discount window rate still further, to 5% by early September.

Nonetheless, many criticized the Bank’s slowness in cutting interest rates, including The Economist, then led by Walter Bagehot. In its defense, the Bank of England did not feel the need to cut rates because it appeared able to stem the crisis merely by extending credit out of its existing cash reserves at a premium rate. The Bank was also weary of the moral hazard of rewarding bad behavior with cheaper money. The critics gave credit where it was due however, and for extending credit, Bagehot and others did give the Bank substantial praise. In time, they got their rate cuts anyway, the Bank’s discount rate was a mere 3.5% by year end.

As for Overend Gurney, shareholders were required to deliver their committed capital of £3.5 million to help make good on the bankrupt firm’s debts. This was in addition to the loss of their £1.5 million of paid-in capital. The firm, once illustrious, became London’s most famous example of financial failure, the firm that kicked off one of the City’s largest panics. Indeed, the Panic of 1866 was an expensive reminder to all of the dangers of funding long-term investments with short-term credit.

“The downfall of Overend and Gurney, and of many other houses, must be traced to the policy which they adopted of paying interest on deposits at call, while they were themselves tempted to invest the money so received in speculations in Ireland or in America, or at the bottom of the sea, where it was not available when a moment of pressure arrived.” – Walter Bagehot in Lombard Street

Lesson

The minimal impact of the Panic of 1866 on Britain’s ‘real’ economy deceives how transformative the event was. Not only were the events of the Panic an illustrative case of a banking crisis which is recounted to this day, the Panic also helped create modern British economic institutions. The role of the Bank of England took another step towards becoming that of a modern central bank and the actions expected of it going forward were increased substantially, in part owing to the insistence of men like Walter Bagehot who envisioned a reformed financial market where such panics could be more effectively arrested.

More from the Tontine Coffee-House

Read about the near failure of another firm during the same panic and more about the Bank of England, including how it was formed and how a weather-vane was once used to conduct monetary policy.