John Lewis.
The 1866 collapse of Overend Gurney sparked widespread panic as investors flocked to banks and other institutions demanding their money back. Failure to provide substantial liquidity threatened to bring down the entire financial system. The Governors of the Bank of England asked the Chancellor to relax the constraints of the 1844 Bank Charter Act, by granting an indemnity to allow the issue of unbacked currency. The Chancellor’s reply, and the policy response it initiated, would save the day, and go down in central banking history as pivotal in the foundation of the “lender of last resort”, a function which has been fundamental to central banking practice ever since.
The demise of Overend Gurney
Overend Gurney started life as a broker of bills of exchange, but gradually evolved into something like a money market fund – borrowing at short maturities from investors, and then investing in bills held for its own account. Worried about the excesses of imprudent bankers in the 1857 crisis, the Bank of England decided to restrict bill brokers’ access to the discount window in 1858. The goal was to encourage them to hold larger reserve balances rather than relying on the Bank to provide liquidity. This prompted an angry response, with Overend Gurney joining forces with others in a co-ordinated withdrawal of funds designed to squeeze the Bank’s balance sheet, in order to demonstrate the importance of bill brokers and force a change of heart. But this failed, and so bill brokers had to hold greater reserves at the Bank. This reduced the profitability of Overend Gurney and may have played a role in them expanding into risky customer lending to boost profits. (For more on this episode, see this recent article by Sowerbutts et al).
By 1866 a string of poor investments led to large losses on the asset side of Overend Gurney’s balance sheet. As nervous depositors began to demand their money back, it needed liquidity. Normally, a troubled institution’s first port of call would have been the Bank of England’s discount window, but as Flandreau and Ugolini note, Overend Gurney never showed up there, probably because it lacked the eligible high-quality securities to obtain liquidity. Instead, it made a direct appeal for extraordinary assistance.
The Bank faced a decision which would be faced by policymakers many times subsequently: was Overend Gurney fundamentally solvent but with a liquidity problem, or was it just insolvent? After reviewing the books, the head of the Bank’s deputation concluded that Overend Gurney was “rotten”. So despite its large size – deposits were equivalent to the combined deposits of its three largest competitors – Overend Gurney was allowed to fail, ceasing business on 10 May 1866.
Panic on the streets of London
The collapse of Overend Gurney sparked a widespread panic, with depositors flocking to banks demanding their money back. The Banker Magazine described the scenes of “terror and anxiety” that followed:
Source: The Banker Magazine, August 1866
The Times wrote:
Source: The Times, 12 May 1866
This panic was similar to the situation analysed in Diamond and Dybvig’s classic paper more than a century later. Banks can normally accomplish maturity transformation and liquidity transformation by pooling idiosyncratic liquidity shocks between their depositors. Only a small fraction of them would wish to withdraw their funds at any one time, and so the bank needs only a small amount of liquid assets on hand. But if an investor fears that others will withdraw, the rational response for that investor is to withdraw their funds too, creating a self-fulfilling prophecy. Those on the receiving end of the run then have to rustle up funds quickly to avoid default. One way is to liquidate assets quickly, but with the likely the consequence that these firesales of assets will depress prices and exacerbate the panic elsewhere.
A liquidity problem…
Faced with a generalised shortage of liquidity, banks looked to the Bank of England. The discount window was subject to huge demand. As usual, institutions presented high quality collateral (“approved securities” in the parlance of the day) and borrowed from the Bank against those. But the problem was that whilst the 19th century Bank of England had the deep-ish pockets, it was still limited as to how much liquidity it could offer by the 1844 Act.
Initially the Bank financed the loans out of its existing cash reserves, but these had almost halved from more than £5.75m to £3m in a single day. Fearing that these would be insufficient to stay the panic, the governors wrote to the Chancellor the day, William Gladstone, to ask for suspension of the Act, in the form of an indemnity permitting the issue of unbacked currency. As in 1847 and 1857, the request was approved.
Letter from the Chancellor to the Governor, 11 May 1866. Source: Bank of England Archive G6/432.
Alongside the need to help solvent but illiquid institutions there were broader concerns at play as well. With the money market drying up and because discount houses played a central role in that market, policymakers were worried about a contraction in lending and the broader effects on the real economy of any subsequent credit crunch.
Letter from the Chancellor to the Governor, 11 May 1866. Source: Bank of England Archive G6/432.
The letter also required that any loans were made a higher rate of interest, not less than 10 percent, with the possibility of the government imposing an even higher rate.
Letter from the Chancellor to the Governor, 11 May 1866. Source: Bank of England Archive G6/432.
The high charge for this liquidity was meant to reduce threats to the stability of the financial system, though interpretations differ as to the intended channels by which this would work. The most common modern view is that higher rates act as a fine on imprudent behaviour by those who would otherwise lend imprudently or over-leverage themselves. Higher rates are a sorting device whereby only the good lenders can survive, and hence mitigate moral hazard by banks. But Bignon et al propose two other, possibly complementary, channels drawing on the subsequent writings of Walter Bagehot on the crisis. In his 1873 classic Lombard Street, Bagehot talks of a “heavy fine on unreasonable timidity”. That is, the high rate is there to penalise reluctant lenders― by increasing the market rate in times of stress, this raises the opportunity cost of timid lenders not providing liquidity. Bagehot also mentions the possibility of capital outflows in a crisis, and it may be that the higher rate was designed to combat these.
The Aftermath and Legacy
The liquidity provision set out in the letter largely achieved its stated goals. In the end the mere expectation that the Bank could and would intervene proved to be powerful enough to stop the panic in its tracks. Investors no longer feared that others withdrawing their funds would bring down financial institutions, and hence they refrained from taking their money out. A little more liquidity was required, but the Bank could finance this out of its own remaining cash stockpile and so unlike 1857 it didn’t have to issue any unbacked currency.
Whilst some insolvent bill brokers did perish, the system as a whole remained resilient. And as Bignon et al document, there were no fire sale crashes in the prices of consols. Flandreau and Ugolini argue that competent handling of the crisis gave an important boost to the credibility of the London markets, and was a key factor in aiding the rise of London as a financial centre.
But the legacy of this episode was broader still. It laid both the operational and the intellectual foundations for the lender of last resort facility that was to prove so important to central banking ever since. It demonstrated that the ability of a central bank to create bank reserves by fiat gives means it can create liquidity in a way and in quantities that no other institution is able to. And three key elements in the liquidity provision outlined by Bagehot: lending freely, against good collateral, at a higher than usual rate; became part of the canonical “lender of last resort” function of central banks. Lawrence Summers, the US treasury secretary at the time of the 2008 crisis, reflected that “there is lot of the current crisis in Bagehot”. Brad de Long noted that much of Bagehot’s subsequent analysis of the episode “is still state-of the-art” in such an episode. Although Overend Gurney was a failed institution, it achieved a special place in central banking history thanks to the policy response its failure spawned.
John Lewis works in the Bank’s Research Hub.
If you want to get in touch, please email us at bankunderground@bankofengland.co.uk. You are also welcome to leave a comment below. Comments are moderated and will not appear until they have been approved.
Comments will only appear once approved by a moderator, and are only published where a full name is supplied.
Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.
The Chancellor of the Exchequer in May 1866 was not “Russell Gladstone” (Lord John Russell was Prime Minister), but William Ewart Gladstone, future Liberal Prime Minister and the politician who, alongside Disraeli, bestrode the second half of the 19th century. It is apt that a great milestone in banking history should be triggered by one of the great Chancellors, who combined a formidable intellect with rock-hard moral values. He would have seen sound money, and a sound banking system, as part of God’s purpose. (An uncharitable complaint, towards the end of his very long political career, was that he would not merely hold the ace of trumps up his sleeve, but maintain that Almighty God had put it there).