Rotten Banks

Andrew Haldane is Executive Director for Financial Stability at the Bank of England. In article in the London Review of Books, he describes banking in the nineteenth century.

In the first half of the 19th century, the business of banking was simple. The UK had around five hundred banks and seven hundred building societies. Most of the former operated as unlimited liability partnerships: the owners-cum-managers backed the banks’ losses with every last penny of their own personal wealth. The building societies operated as mutually owned co-operatives, with ownership, control and liability all pooled. Financial sector assets amounted to less than 50 per cent of annual UK GDP.

Banks’ balance sheets were heavily cushioned. Shareholder funds – so-called equity capital – protected depositors from loss and often accounted for as much as half of the balance sheet. Cash, and liquid securities such as government bonds, enabled banks to meet their payment obligations to depositors. They accounted for about a third of banks’ assets. Banking systems maintained broadly similar arrangements across the US and Europe. This relationship between governance and balance sheet was mutually compatible. Owing to unlimited liability, control was exercised by investors whose personal wealth was on the line – a potent incentive to be prudent with depositors’ money. Bank directors – the major shareholders responsible for day to day management – excluded investors who didn’t have sufficiently deep pockets to bear the risk. Shareholders were firmly on the hook, and had a strong incentive, in turn, to make sure that managers didn’t step out of line. Managers monitored shareholders and shareholders managers. In this way, the 19th-century banking model kept risk-taking in check.

He then explains how the introduction of limited liability laws in 1855 led to a massive increase in leverage and appetite for risk.

As unlimited liability was phased out, leverage among banks rose from about three or four in the middle of the 19th century to about five or six at its close. Leverage continued its upward march when extended liability was removed, and by the end of the 20th century it was higher than twenty. In 2007, at its high-water mark, bank leverage hit thirty or more.

This strategy translated, by the arithmetical magic of leverage, into higher shareholder returns. Having begun the 20th century in modest single figures, equity returns to banks were, on average, close to 20 per cent by its end. At the height of the boom, bank equity returns touched 30 per cent. Higher leverage accounted for almost all of this. Bank managers no longer had to sweat their assets: they simply had to borrow against them.

The downside of this strategy is now only too clear. With leverage of two (UK banks in 1850), 50 per cent of your assets must go bad before your equity is wiped out and you go bust. But with leverage of twenty (UK banks in 2000), you will go bust if you lose only 5 per cent of your assets.

A related problem was the separation of management from shareholder discipline.

By the end of the 1930s, only six British banks still maintained reserve liability. The governance and balance sheets of banks were, by this time, unrecognisable from those a century earlier. Banks were now controlled by arms-length managers, no longer major shareholders, while ownership was held by a widely dispersed set of shareholders, unvetted and anonymous, their upside pay-offs unlimited but their downside risks now capped by limited liability.

This article by Andrew Haldane is worth a read, for those who want to understand the causes of the rottenness in the modern banking system. He is not so strong on solutions.
See Limited Liability for more.