For as long as money can be borrowed short-term at a rate cheaper than it can be borrowed for longer, banks and borrowers will be incentivized to keep the duration of their liabilities short. While this is economically favorable in the short-run, it carries meaningful risks. Such a maturity mismatch has been the source of frequent tremors for banks and money markets. A borrower may find their ability to refinance their short-term debt, including the unsecured rolling debt called commercial paper today, evaporating just when it is most needed. Such a happening triggered a crisis in Holland’s money markets two-and-a-half centuries ago. The commercial paper crisis of 1763 reveals both the sophistication and risks rampant in 18th century financial innovation.
By the mid-18th century, Amsterdam was an aging, albeit still immensely important, financial center in Northern Europe. It was also the epicenter of the banking panic of 1763. At the time, Amsterdam was home to a distinct banking tradition, one that eschewed accepting deposits in favor of other forms of short-term financing. The banks in Amsterdam regarded financing their operations by accepting deposits that could be withdrawn on demand to be unacceptably risky. Unfortunately, the alternative they chose turned out little better, if at all.
The Amsterdam merchant banks, rather than accept deposits, issued bills of exchange. These bills were short-term orders to pay a fixed sum at a future date and they in the meantime provided the banks with short-term debt financing. These bills traded hands in Amsterdam’s money markets. Thankfully, records of these transactions lived on at the Bank of Amsterdam, since the Dutch central bank was where payment of the bills was settled. The issuer of the bill paid the beneficiary at maturity by transferring funds at the Bank of Amsterdam into the beneficiary’s account.
While the system was sophisticated, it had its shortcomings. Perhaps most importantly, it created a maturity mismatch between a bank’s assets, which might consist of longer-term loans, and a bank’s liabilities, the bills. Financing long-term investments meant rolling over short-term bills when they matured. There was another feature that had potential to cause trouble. In Amsterdam, a holder of these bills looking to sell them to another investor was usually required to guarantee the bill. This requirement was intended to prevent a holder of low-quality paper from selling it on to an unknowing investor. However, the practice linked the original holder of the bill to the credit of the issuing bank; if the bank failed, the seller of the bill was liable to make good on it. Despite these shortcomings, Amsterdam’s 18th century financial system ran on these bills.
The practice was also exported elsewhere given the commercial and financial primacy of the Dutch. The Netherlands at this time was a large net exporter of capital as domestic savings exceeded local investment in the country, the wealthiest in Continental Europe. Much of this investment found its way farther east, to Prussia, which was an 18th century emerging market. This speculation abroad was usually conducted through correspondent banks in Hamburg due to Dutch unfamiliarity with local laws and merchants. However, the bills issued by banks and merchants in Germany were sold to investors in Amsterdam. As investors traded these bills, they were tying their fortunes to the instruments by means of the guarantee, concentrating credit risk back in Holland.
Gebroeders De Neufville
On the eve of the Panic of 1763, one of the largest banks in Europe was the that of Gebroeders de Neufville (the ‘De Neufville Brothers’). The firm was led by a Mennonite banker named Leendert Pieter de Neufville and his brothers. They were more than just bankers; the de Neufville firm was also active both in industry and trade. They owned a glass factory and traded in commodities, including grain, metals, and silk. Some of these latter operations made the firm familiar with foreign markets, including Prussia.
These foreign transactions also included supplying the Prussian army during the Seven Years’ War which lasted from 1756 to 1763. De Neufville’s trading during the war made them knowledgeable of the economic situation and business conditions in Berlin and Prussia, the distant and higher-yielding markets sought after in Amsterdam. These years were a boon to speculators like de Neufville; the war had triggered monetary debasement, more credit availability, and inflation. Rising prices encouraged speculators to place bets on the commodities de Neufville traded in. Gebroeders de Neufville was also connected with Berlin-based merchants and industrialists like Johann Ernst Gotzkowsky who owned silk-works and porcelain factories in Prussia. The firm’s apparent knowledge and competency allowed it to connect Amsterdam’s money markets with investment opportunities farther east.
Gebroeders de Neufville was a massive firm in its day, with a balance sheet almost half the size of that of the Dutch central bank. On the opposite side of the accounts, de Neufville’s liabilities amounted to almost ten million guilders, most of it in short-term bills held by at least a hundred creditors and likely many more. However, the bank was highly levered, possessing an equity capital of just over 400,000 guilders, meaning it was levered almost 25-to-1. As a result, a comparatively small write-down of its assets would trigger its insolvency. Nonetheless, the growth of the bank suggested all went swimmingly well during the good years. Thanks to its early success, other merchant-banks in Amsterdam adopted similar practices of employing high leverage in pursuit of profits from higher-yielding foreign assets.
When the Seven Years’ War ended with the Treaty of Hubertusburg in the winter of 1763, peace caused prices to decline for some of the commodities de Neufville traded in. With grain prices having fallen 30% in Prussia, Leendert Pieter de Neufville decided to buy grain at reduced prices. He joined forces with three Berlin-based bankers and merchants, including Gotzkowsky, to buy unused grain from a withdrawing Russian army in Poland for one million guilders. The purchase was financed by debt taken on by de Neufville in Amsterdam. Unfortunately for him, and his creditors, this was just before Frederick the Great, the King of Prussia, released grain from the state granaries. As a result, grain prices in the region fell by 75% between May and August. Prices for other commodities in Amsterdam were falling as well.
It was clear by now that the war-time inflation had given way to post-war deflation as prices for commodities – agrarian and industrial, local and imported – mostly fell, some sharply. This put pressure on merchants, reducing the value of their inventories. It also prompted creditors to tighten their purse strings, making refinancing of short-term bills difficult just at the worst time. The fact that these firms were so reliant on commercial paper, a form of short-term unsecured credit, meant that the change in fortunes was swift. Banks quickly began to face losses resulting from borrower defaults and their own bad bets. Gebroeders de Neufville was especially vulnerable since it had little in reserves held at the Bank of Amsterdam.
The de Neufville bank’s leverage, the illiquidity of its assets, and the inadequacy of its reserves meant it was unable to refinance its debt. The firm went bankrupt on August 3rd, 1763. It was perhaps the worst afflicted of the Dutch merchant-banks, its creditors recovered only 11% of their losses following the firm’s liquidation. Whether the most spectacular failure or not, it was the largest in Holland and triggered a further seizing up of the money markets in the Netherlands and Germany. Dozens more Dutch and German banks failed in August 1763, more than 100 in total by the time the crisis ended. The effects were felt beyond the financial sector as industry and trade slumped following the withdrawal of credit. There was a spiraling evaporation of trust and a hoarding of liquidity.
The events triggered some peculiar happenings. Among these was a surge in mint output as the need for immediate liquidity prompted people to bring bullion to the mint to be struck into a record number of coins. Other signs of extreme distress included a preference for physical currency over deposits at the central bank. Every business day, a market was organized outside the Bank of Amsterdam where people could trade bank reserves held at the central bank for physical currency. On August 6th, just two days after the failure of Gebroeders de Neufville, the demand for liquidity was so great that coins began to trade at a premium to money held at the Bank of Amsterdam.
This was a peculiar event because it was usually money at the central bank that commanded a premium given that bank money was better suited for investing in bills and was more convenient than conducting business in coins. However, so great was the demand for cold hard cash by merchants and bankers that it trumped the demand for bank money by those having to make good on maturing bills. Only an intervention by the central bank reversed the situation.
Beyond the immediate monetary distress, other indicators showed financial conditions were still deteriorating. Credit spreads widened and illiquidity premia grew. This was evidenced by the discount rates on bills traded in the city’s money markets. The discounts required by purchasers buying the bills of merchant-banking firms rose from 4% to 6%. Before the trouble began, rates had been closer to 2-3%. These elevated rates also existed alongside reduced trading in bills. Obligations of firms active in Berlin were now being particularly shunned as investors avoided risk. The lack of a market for bills limited new issuance, triggering liquidations as merchants failed to refinance their liabilities. Liquidations only caused further contractions in asset and commodity prices.
The Bank of Amsterdam did take actions to provide relieve to the commercial paper market in Holland. It expanded the collateral that could be lent against by the bank. However, any potential emission of currency was limited by the available reserves of gold and silver. Nonetheless, the central bank’s lending grew 40% in the six months after the panic as the balance sheet grew from 22 million guilders to over 30 million. Liquidity soon became available once again and many banks that had previously failed reopened, fully repaying their creditors. The course of events reveals that the crisis was mostly one of illiquidity rather than insolvency.
Whatever the events in Amsterdam, it was hardly the only affected market. Scarcity of liquidity was also afflicting Hamburg and Berlin. Events in the latter unfolded in the jurisdiction of Frederick the Great. The King of Prussia intervened by orchestrated a bank holiday, effected by the Moratorium Edict of 1763, allowing debtors to suspend payments for fourteen days starting on August 22nd. The King also arranged bail-outs for de Neufville’s associates in Berlin, including his business partner in the Russian grain trade, Johann Ernst Gotzkowsky. In time, the panic came to an end.
The crisis of 1763 was both similar and dissimilar to more archetypical financial crises. For one, while it did not feature an old-fashioned bank run where people demanded the redemption of their deposits, it did feature a different kind of bank run. Money markets are susceptible, today as in 18th century Holland, to so-called shadow runs where creditors refuse to refinance debt to vulnerable borrowers. To make good on the debt, the borrower must produce a large amount of cash on short notice. If that borrower is in turn a creditor to others – if it is a financial institution – then this can ignite a vicious cycle of evaporating credit. Until it was arrested, this is exactly what happened in 1763.
More from the Tontine Coffee-House
Read about another Dutch episode of financial turmoil, one brought about by an excessive speculation in tulip bulbs.
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