The Evolution of Banking (I)

Financial historians disagree as to how far the growth of banking after the seventeenth century can be credited with the acceleration of economic growth that began in Britain in the late eighteenth century and then spread to Western Europe and Europe's offshoots of large-scale settlement in North America and Australasia. There is no question, certainly, that the financial revolution preceded the industrial revolution. True, the decisive breakthroughs in textile manufacturing and iron production, which were the spearheads of the industrial revolution, did not rely very heavily on banks for their financing. But banks played a more important role in continental European industrialization than they did in England's. It may in fact be futile to seek a simplistic causal relationship (more sophisticated financial institutions caused growth or growth spurred on financial development). It seems perfectly plausible that the two processes were interdependent and self-reinforcing. Both processes also exhibited a distinctly evolutionary character, with recurrent mutation (technical innovation), speciation (the creation of new kinds of firm) and punctuated equilibrium (crises that would determine which firms would survive and which would die out).


In the words of Adam Smith, 'The judicious operation of banking, by substituting paper in the room of a great part of . . . gold and silver . . . provides . . . a sort of waggon-way through the air.' In the century after he published The Wealth of Nations (1776), there was an explosion of financial innovation which saw a wide
variety of different types of bank proliferate in Europe and North America. The longest-established were bill-discounting banks, which helped finance domestic and international trade by discounting the bills of exchange drawn by one merchant on another. Already in Smith's day London was home to a number of highly successful firms like Barings, who specialized in transatlantic merchant banking (as this line of business came to be known). For regulatory reasons, English banks in this period were nearly all private partnerships, some specializing in the business of the City, that square mile of London which for centuries had been the focus for mercantile finance, while others specialized in the business of the landowning elite. These latter
were the so-called 'country banks', whose rise and fall closely followed the rise and fall of British agriculture.

A decisive difference between natural evolution and financial evolution is the role of what might be called 'intelligent design' - though in this case the regulators are invariably human, rather than divine. Gradually, by a protracted process of trial and error, the Bank of England developed public functions, in return for the reaffirmation of its monopoly on note issue in 1826, establishing branches in the provinces and gradually taking over the country banks' note-issuing business.*

(NB*Technically, the monopoly applied only within a 65-mile radius of London and, as in the eighteenth century, private banks were not prohibited from issuing notes.)

Increasingly, the Bank also came to play a pivotal role in inter-bank transactions. More and more of the clearing of sums owed by one bank to another went through the Bank of England's offices in Threadneedle Street. With the final scrapping in 1833 of tne usury laws that limited its discount rate on commercial bills, the Bank was able fully to exploit its scale advantage as the biggest bank in the City. Increasingly, its discount rate was seen as the minimum shortterm interest rate in the so-called money market (for short-term credit, mostly through the discounting of commercial bills).

The question that remained unresolved for a further forty years was what the relationship ought to be between the Bank's reserves and its banknote circulation. In the 1840s the position of the Governor, J . Horsley Palmer, was that the reserve should essentially be regulated by the volume of discounting business, so long as one third of it consisted of gold coin or bullion. The Prime Minister, Sir Robert Peel, was suspicious of this arrangement, believing that it ran the risk of excessive banknote creation and inflation. Peel's 1844 Bank Charter Act divided the Bank in two: a banking department, which would carry on the Bank's own commercial business, and an issue department, endowed with £14 million of securities and an unspecified amount of coin and bullion which would fluctuate according to the balance of trade between Britain and the rest of the world. The so-called fiduciary note issue was not to exceed the sum of the securities and the gold. Repeated crises (in 1847 , 1857 and 1866) made it clear that this was an excessively rigid straitjacket, however; in each case the Act had to be temporarily suspended to avoid a complete collapse of liquidity. *

 (NB* Illiquidity is when a firm cannot sell sufficient assets to meet its liabilities. It has the right amount of assets, but they are not marketable because there are too few potential buyers. Insolvency is when the value of the liabilities clearly exceeds the value of the assets. The distinction is harder to draw than is sometimes assumed. A firm in a liquidity crisis might be able to sell its assets, but only at prices so low as to imply insolvency.)

It was only after the last of these crises, which saw the spectacular run that wrecked the bank of Overend Gurney, that the editor of The Economist, Walter Bagehot, reformulated the Bank's proper role in a crisis as the 'lender of last resort', to lend freely, albeit at a penalty rate, to combat liquidity crises.

The Victorian monetary problem was not wholly solved by Bagehot, it should be emphasized. He was no more able than the other pre-eminent economic theorists of the nineteenth century to challenge the sacred principle, established in Sir Isaac Newton's time as Master of the Mint, that a pound sterling should be
convertible into a fixed and immutable quantity of gold according to the rate of £3 17s ioHd per ounce of gold. To read contemporary discussion of the gold standard is to appreciate that, in many ways, the Victorians were as much in thrall to precious metal as the conquistadors three centuries before. 'Precious Metals alone are money,' declared one City grandee, Baron Overstone. 'Paper notes are money because they are representations of Metallic Money. Unless so, they are false and spurious pretenders. One depositor can get metal, but all cannot, therefore deposits are not money.' Had that principle been adhered to, and had the money supply of the British economy genuinely hinged on the quantity of gold coin and bullion in the Bank of England's reserve, the growth of the UK economy would have been altogether choked off, even allowing for the expansionary effects of new gold discoveries in the nineteenth century. So restrictive was Bank of England note issuance that its bullion reserve actually exceeded the value of notes in circulation from the mid 1890s until the First World War. It was only the proliferation of new kinds of bank, and particularly those taking deposits, that made monetary expansion possible. After 1858, the restrictions on joint-stock banking were lifted, paving the way for the emergence of a few big commercial banks: the London ÔC Westminster (founded in 1833), the National Provincial (1834), the Birmingham & Midland (1836), Lloyds (1884) and Barclays (1896). Industrial investment banks of the sort that took off in Belgium (Société Générale), France (the Crédit Mobilier) and Germany (the Darmstàdter Bank) fared less well in Britain after the failure of Overend Gurney. The critical need was not in fact for banks to buy large blocks of shares in industrial companies; it was for institutions that would attract savers to hand over their deposits, creating an
ever expanding basis for new bank lending on the other side of the balance sheet.

to be continued...