'Bank of England Crisis Management and the Overend & Gurney Crash of 1866' Sabine Schneider (University of Cambridge)

HISTORY PROJECT REPORT

‘Bank of England Crisis Management and the Overend & Gurney Crash of 1866’

Sabine Schneider (University of Cambridge)

This History Project/Institute for New Economic Thinking (INET) grant generously supported research into the development of central banking in mid-Victorian Britain. The research traced the interests and decisions taken by key stakeholders in the Bank of England during the financial crisis of 1866. The City’s second ‘Black Friday’, on 10th May 1866, was prompted by the collapse of the internationally renowned discount house, Overend, Gurney & Co. Spurred by the financial boom of 1863, Overend’s directorate had ventured into an array of speculative undertakings that fatally overburdened its profitable discounting business. News of the company’s bankruptcy generated a frantic scramble for funds in the London money market and urgent loan applications to the Bank of England. Overend’s collapse and the Governors’ handling of the subsequent financial turmoil form a critical episode in the Bank’s long-term evolution into a mature lender of last resort. As the panic unfolded, liberal provision of liquidity by the Bank of England succeeded in stabilizing the credit system and limited the knock-on effects for the British economy. This research project investigated the Bank’s credit policy at the outbreak of the panic, and in the ensuing months of financial stringency from May to July 1866. It traced the rationale from which decisions to extend liquidity assistance were made, and the significance for the Bank’s gradual transition towards a modern central bank.

Existing scholarship on the Overend & Gurney Panic has maintained that 1866 saw the Bank’s acceptance of its role as lender of last resort in times of financial turmoil. The Bank’s management of the crisis is conventionally regarded as a caesura in the institution’s history, on the grounds that it saw a determined effort by the Bank to come to the rescue of the market through generous emergency lending.1 This view is shared by Marc Flandreau, Stefano Ugolini and Vincent Bignon, whose recent studies have reconstructed the Bank’s crisis lending, by making extensive use of its customers’ and discounters’ ledgers.2 Their joint research contended that 1866 signalled a ‘major turning

N.B.: This article is part of research in progress, and should not be quoted without prior permission of the author (Sabine Schneider, University of Cambridge, [email protected]).

1 Since the classic studies of central banking policy undertaken by Sayers, Hawtrey and Fetter, it has become the broadly accepted view that the Overend & Gurney panic established the Bank’s commitment to last-resort-lending. See R. S. Sayers, Central banking after Bagehot (Oxford, 1957), p. 14, R. G. Hawtrey, The Art of Central Banking (London, 1932), pp. 125-6; F. W. Fetter, Monetary and financial policy (Dublin, 1973), p. 25; P. L. Cottrell, Investment banking in England, 1856-1881 (London, 1985), p. 399; Forrest Capie, ‘The emergence of the Bank of England as a mature central bank’, in Forrest Capie and Geoffrey E. Wood, eds., The lender of last resort: a reader (London, 2007), pp. 307, 314-5; Forrest Capie and Geoffrey E. Wood, ‘Financial crises from 1803 to 2009: the crescendo of moral hazard’, in Christopher J. Green, Eric J. Pentecost and Tom Weyman-Jones, eds., The Financial Crisis and the Regulation of Finance (Cheltenham, 2011), pp. 136-7.

2 Marc Flandreau and Stefano Ugolini, ‘Where it all began: lending of last resort and Bank of England monitoring during the Overend-Gurney Panic of 1866’, in Michael D. Bordo and William Roberds, eds., A return to Jekyll Island: The origins, history, and future of the Federal Reserve (Cambridge, 2013), pp. 113-61; Vincent Bignon, Marc Flandreau and Stefano Ugolini, ‘Bagehot for beginners: the Sabine Schneider (University of Cambridge) History Project Report point’ in the Bank’s approach to crises, and ‘the end of credit rationing that had characterized crisis management until 1857’.3 The sheer size of the Bank’s liquidity assistance has customarily been taken as a measure for identifying the institution’s acceptance of its responsibility as lender of last resort. Such an approach, however, offers only a partial explanation, one that does not take account of the motives and disagreements among key stakeholders. As Charles Goodhart observed at the Bank’s Tercentenary Symposium, the stumbling block for judging the Bank’s conduct is inherent in the difficulty of assessing the ‘intellectual basis, and reasoning, of central bankers for providing such support, rather than the individual act of rescue itself’.4 In re-evaluating the Bank’s response to the Overend & Gurney crisis, this project established that the Governors’ motives for crisis lending were substantially more intricate than could be gathered solely from the Bank’s advances and discounting practice. For much of the 1860s and 1870s, last-resort-lending remained deeply contested among the Bank’s Court of Directors, as evidenced by a long, drawn-out debate in the national press.

The classical doctrine of the Bank as lender of last resort was decisively refined in the shadow of the 1866 crisis by the polymath, country banker and political economist, Walter Bagehot. It was during his time as financial journalist and editor of The Economist (1861-1877) that Bagehot formulated his theory of last-resort-lending, later to be crystallized in Lombard Street: A Description of the Money Market (1873). Bagehot’s contemporary verdict on the Bank’s management of the Overend & Gurney panic, published shortly after the crash in his columns in The Economist, has established a potent historical narrative of the crisis. Stemming from his observations of the financial crises of 1857 and 1866, Bagehot’s editorials called on the Bank to disregard its profit motive during emergencies in order to act as a guarantor of liquidity to the national economy. His doctrine of the lender of last resort attributed to the Bank extensive regulatory and supervisory obligations to manage the credit system. When facing a panic- induced drain of its specie reserve, the Bank’s only safe course of action, Bagehot asserted, is to lend ‘quickly, freely, and readily’ in order to prevent collective runs on the country’s credit institutions.5 Bagehot insisted that an effective lender of last resort must adhere to three distinct axioms: it should extend liquidity to solvent but temporarily illiquid institutions, subject to higher interests rates than prevailed in the market and on condition of securing its loans on what, in ‘ordinary times’, would rank as safe collateral. 6 Integral to Bagehot’s formula for financial stability is a credible pre- commitment to crisis lending, from which to cultivate public confidence in the credit

making of lender-of-last-resort operations in the mid-nineteenth century’, Economic History Review, 65 (2012), pp. 580-608; Marc Flandreau and Stefano Ugolini, ‘The crisis of 1866’, in Nicholas Dimsdale and Anthony Hotson, eds., British financial crises since 1825 (Oxford, 2014), pp. 76-93.

3 Flandreau and Ugolini, ‘The crisis of 1866’, pp. 76, 92.

4 Charles A. Goodhart, Forrest Capie, and Norbert Schnadt, ‘The development of central banking’, in Forrest Capie, Charles A. Goodhart, Norbert Schnadt, and Stanley Fisher, eds., The future of central banking: the tercentenary symposium of the Bank of England (Cambridge, 1994), p. 65.

5 Walter Bagehot, Lombard Street: a description of the money market (London, 1873), p. 173.

6 Bagehot, Lombard Street, pp. 197-8. 2 Sabine Schneider (University of Cambridge) History Project Report system.7 It is the quest for signs of official ‘commitment’ that has become the historian’s test for determining when the Bank of England assumed its lender-of-last-resort role.

The project found that the Bank’s response to the crisis was shaped by its distinctive policy trade-offs between its private, profit-maximizing motives and its public function as guarantor of financial stability. Throughout the Victorian period, the Bank’s profit-orientated objectives fundamentally shaped the institution’s long-term approach to crisis lending and moral hazard. The research therefore questions recent studies on British banking crises, which have mistakenly tended to assume historical continuity between the policy objectives of modern central bankers and their nineteenth-century predecessors.8 Until the twentieth century, however, the Bank’s peculiar legal privileges profoundly restricted its policy choices. From 1694 until its nationalisation in 1946, the Bank operated not as a state-owned central bank but as a private banking establishment, guided by the necessity to generate profits for its shareholders. 9 While the Bank did not act as a fully-fledged lender of last resort in 1866, its Governors established a new policy towards the market, which accommodated the liquidity needs of the City without compromising either the Bank’s profits or its autonomy. The Bank’s response to the crisis thus successfully avoided paralysis of the inter-bank market, while generating prodigious profits for its shareholders. Beyond these primary findings, the project identified three central pillars of the Bank’s crisis policy in 1866: a commitment to protect its discretionary power to offer liquidity under certain conditions; a commonly understated concern for its own profitability; and a notorious rivalry with Overend in the London discount market.

Employing insights from political, financial and intellectual history, the project also shed new light on the politics of financial assistance and the history of the ‘too-big- to-fail’ paradigm. Whereas the existing literature assumes a limited set of policy choices, confined either to credit rationing or last-resort-lending, the Bank of England’s intervention in the financial crisis of 1866 demonstrates that multiple facets of crisis lending coexisted beyond these polar opposites. Under close public scrutiny, Bank of England policy gradually evolved into its twentieth-century mould, and as such the trade- offs faced by the Governors between profits and competition on the one side, and financial stability and co-operation on the other, were, in fact, fluid and often mutually- compatible in this period. Between 1866 and 1890, the Bank strategically refined its control mechanisms, so as to safeguard capital market stability without sacrificing either its privileged legal status or its private business concern.

7 Bagehot, Lombard Street, p. 173; Thomas M. Humphrey, ‘The lender of last resort: the concept in history’, Federal Reserve Economic Review (Mar/Apr 1989), pp. 12-13.

8 Lauren Le Maux and Laurence Scialom, ‘Central banks and financial stability: rediscovering the lender-of-last-resort in a finance economy’, Cambridge Journal of Economics, 37 (2013), pp. 1-16; Kenneth K. Kuttner, ‘Victorian financial crises and their implications for the future’, Business Economics, 45 (2010), pp. 102-8.

9 Vera C. Smith, The rationale of central banking and the free banking alternative (Indianapolis, 1990), p. 142. 3 Sabine Schneider (University of Cambridge) History Project Report

The History Project/Institute for New Economic Thinking (INET) grant has enabled targeted archival research into the policy implications of 1866 for the Bank of England’s long-term evolution into a central bank. Collections at the Bank of England Archive, the British Library, the London Metropolitan Archive and the Barclays Group Archives offered valuable insights into the response of Cabinet ministers, Bank officials and City professionals at the heart of the crisis. An article based on this research is currently in preparation, and a link will be provided to the published version.