Forgotten History - Crisis of 1763
The financial crisis of 2007-2008 has been widely talked of as a crisis of liquidity, complexity and systemic risk. All three, however, are not new albeit they have now gained sexy status. Perhaps we should have heeded the lessons of the crisis of 1763.
In those days, it was uncommon for banks to take deposits and make investments to the private sector. Its primary function was to facilitate payments between exporters and importers using bills of exchange. Bills of exchange are rather like modern day cheques; the drawer of the bill requires the drawee to pay a specified amount to the holder of the bill at a date in the future. For example, if I imported some rice from Thailand, I (the drawer) would order my bank (the drawee) to pay Thailand (the holder). Bills of exchange could be traded subject to some rules.
Financial centres were Amsterdam, London and Hamburg. Prussia was developing fast and capital hungry. The main problem then was how to get money from Amsterdam to Berlin (capital of Prussia). Berlin merchants could not borrow directly from Amsterdam banks and the use of collateral was limited given the geographical distance.
The innovation was the acceptance loan. It works as follows, a Berlin merchant goes to a Hamburg bank and says: please can you arrange a bill with the great Amsterdam bank, I will pay you before you pay the Amsterdam bank and I will also pay you commission for your troubles. Hamburg bank says OK and pays the Amsterdam bank a commission in return for accepting a bill. The Berlin merchant can then obtain a bill drawn on the Amsterdam bank, which can then be sold to the Amsterdam investor. At the maturity date, the Berlin merchant pays the Hamburg bank who then pays the Amsterdam bank who finally pays the Amsterdam investor. Sounds complicated? Well, in reality the chain was even longer as bills were bought and sold on capital markets.
These acceptance loans have two features worth mentioning. First, if Amsterdam bank fails to pay the Amsterdam investor, then the Amsterdam investor can demand repayment from both the Hamburg bank and the Berlin merchant. Second, if Hamburg bank pays the Amsterdam bank, but the Amsterdam bank goes bankrupt before they can pay the investor, then the investor can demand repayment from the Hamburg bank, so the Hamburg bank then effectively pays “twice”. These two rules prevent people selling bad bills.
The Seven Years War brought an economic boom that lead to an expansion of credit through the acceptance loans, nearly all Northern Europe joined in the fun, leading to increasing interlocking claims between different banks in different countries. The most famous bank in Amsterdam was the de Neufville brothers’.
At the end of the Sevens Years War, recovery took longer than expected and the prices of commodities fell. Falling prices reduced the value of collateral and it become harder to secure credit. Spreads increased and banks had to sell their commodities assets to obtain the liquidity to repay their maturing bills. Given all the banks were selling, prices fell further and a vicious loop develops. De Neufville was the first to go bankrupt, and this lead to a wave of bank bankruptcies as far afield as Sweden, Britain as well as Prussia and Hamburg.
We see many parallels with the crisis of 2007-2008. Then as now, financial innovation lead to a credit bubble, and in a highly interconnected and leveraged financial system, a relatively small liquidity shock can trigger failures. Furthermore, hedging had been proved to have its limits, even though each party in the acceptance loan chain believed they were perfectly hedged, they weren’t. There was still systemic risk. To illustrate, the Amsterdam investor has effectively transferred credit risk of the Berlin merchant to the Hamburg and Amsterdam banks (counterparty risk). But given all three held similar assets (commodities), one’s failure becomes highly correlated with failures of others. The Amsterdam investor is not insured at all when the going got tough.
We should have learnt the lessons from 250 years ago.
In those days, it was uncommon for banks to take deposits and make investments to the private sector. Its primary function was to facilitate payments between exporters and importers using bills of exchange. Bills of exchange are rather like modern day cheques; the drawer of the bill requires the drawee to pay a specified amount to the holder of the bill at a date in the future. For example, if I imported some rice from Thailand, I (the drawer) would order my bank (the drawee) to pay Thailand (the holder). Bills of exchange could be traded subject to some rules.
Financial centres were Amsterdam, London and Hamburg. Prussia was developing fast and capital hungry. The main problem then was how to get money from Amsterdam to Berlin (capital of Prussia). Berlin merchants could not borrow directly from Amsterdam banks and the use of collateral was limited given the geographical distance.
The innovation was the acceptance loan. It works as follows, a Berlin merchant goes to a Hamburg bank and says: please can you arrange a bill with the great Amsterdam bank, I will pay you before you pay the Amsterdam bank and I will also pay you commission for your troubles. Hamburg bank says OK and pays the Amsterdam bank a commission in return for accepting a bill. The Berlin merchant can then obtain a bill drawn on the Amsterdam bank, which can then be sold to the Amsterdam investor. At the maturity date, the Berlin merchant pays the Hamburg bank who then pays the Amsterdam bank who finally pays the Amsterdam investor. Sounds complicated? Well, in reality the chain was even longer as bills were bought and sold on capital markets.
These acceptance loans have two features worth mentioning. First, if Amsterdam bank fails to pay the Amsterdam investor, then the Amsterdam investor can demand repayment from both the Hamburg bank and the Berlin merchant. Second, if Hamburg bank pays the Amsterdam bank, but the Amsterdam bank goes bankrupt before they can pay the investor, then the investor can demand repayment from the Hamburg bank, so the Hamburg bank then effectively pays “twice”. These two rules prevent people selling bad bills.
The Seven Years War brought an economic boom that lead to an expansion of credit through the acceptance loans, nearly all Northern Europe joined in the fun, leading to increasing interlocking claims between different banks in different countries. The most famous bank in Amsterdam was the de Neufville brothers’.
At the end of the Sevens Years War, recovery took longer than expected and the prices of commodities fell. Falling prices reduced the value of collateral and it become harder to secure credit. Spreads increased and banks had to sell their commodities assets to obtain the liquidity to repay their maturing bills. Given all the banks were selling, prices fell further and a vicious loop develops. De Neufville was the first to go bankrupt, and this lead to a wave of bank bankruptcies as far afield as Sweden, Britain as well as Prussia and Hamburg.
We see many parallels with the crisis of 2007-2008. Then as now, financial innovation lead to a credit bubble, and in a highly interconnected and leveraged financial system, a relatively small liquidity shock can trigger failures. Furthermore, hedging had been proved to have its limits, even though each party in the acceptance loan chain believed they were perfectly hedged, they weren’t. There was still systemic risk. To illustrate, the Amsterdam investor has effectively transferred credit risk of the Berlin merchant to the Hamburg and Amsterdam banks (counterparty risk). But given all three held similar assets (commodities), one’s failure becomes highly correlated with failures of others. The Amsterdam investor is not insured at all when the going got tough.
We should have learnt the lessons from 250 years ago.