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How banking came back from the brink

23 September, 2019William A Allen

As part of our Time Machine series, William A Allen looks back at the 1930s economic crisis, which hit merchant banks hard and changed the financial world forever. This is the first of two articles.

Banking-back-from-the-brink-

In the 1920s, the world attempted to rebuild the prewar institutions of orderly finance based on gold, balanced budgets and free trade, but the structure finally collapsed in the early 1930s.

The world went into recession in 1929. Prices fell. Loans went into default. In 1931, the largest bank in Austria, Creditanstalt, got into distress, and soon afterwards there were widespread bank failures in Hungary and Germany. Exchange controls were imposed in much of central Europe.

Consequences

The consequences were serious for London merchant banks that did business in central Europe. The loans they had made did not get repaid and deposits were withdrawn – either because the depositors suddenly needed the money, or because they were worried about the solvency of the bank.

There was a continuous heavy demand for gold from the Bank of England (BoE) – more than £200m was withdrawn from the London market from the middle of July to mid-September, some of which was paid out in gold – and withdrawals of foreign balances “accelerated sharply” in September.

The Treasury announced the suspension of the convertibility of sterling into gold on 20 September, 1931. The financial world changed for ever.

Contained

The London merchant banks’ problems were successfully contained.

The banks were supported by the clearers, by the BoE and by the standstill agreements with Germany – in which Germany agreed to pay interest on outstanding commercial bills provided that they were renewed on maturity, and to accord a certain priority to repaying them in the allocation of foreign exchange.

The BoE and the merchant banks’ auditors pretended that they were safe assets, thereby giving the merchant banks time to find new capital and reduce the scale of their commitments gradually.

Over the decade, the scale of the merchant banks’ business was much reduced and in many cases the partners needed to sell their private assets to meet their losses.

By contrast, the clearing banks were safe and secure. After the amalgamation movement had ended in 1920, there were five dominant London clearing banks and they formed a cartel, known as the Committee of London Clearing Bankers. They made decisions about interest rates collectively, had large reserves of liquid assets and were reasonably profitable.

Combatting the depression

After the end of the gold standard, the Treasury, rather than the BoE, was the dominant influence on monetary policy, and in 1932 a cheap money policy was instituted to lift prices and combat the depression. The expensive 5% War Loan, issued by the government in 1917, was converted to a 3½% interest rate.

The clearing banks had hitherto made advances on average security at one percentage point above the BoE discount rate, but subject to minimum of 5%. Although the BoE cut its rate to 2% in 1932, the clearers’ minimum of 5% was largely maintained throughout the 1930s.

Reginald McKenna, chairman of the Midland Bank and former chancellor of the exchequer, defended the policy in 1934 on the grounds that a reduction of one percentage point in the rate charged on Midland’s advances would have entailed either a one-third cut in salaries or an almost complete suspension of dividend payments.

Imagine the reaction if a banker said that today. The clearing banks’ total advances fell by £341m from the end of 1929 to the end of 1933, and recovered by £241m by the end of 1938.

The banks accumulated surplus deposits but invested them in gilt-edged securities. In this, they were aided by the obsessive ‘funding complex’ from which the government and the BoE were suffering at the time – and which led them to issue large amounts of gilts to finance their large purchases of gold after 1931.

Read more in our Time Machine series

Bill-Allen

 

William A Allen is a visitor at the National Institute for Economic and Social Research, London. He worked for the Bank of England from 1972 to 2004 in a wide range of functions, including monetary policy and financial market operations, and was a specialist adviser to the House of Commons Treasury Committee from 2010 to 2017.

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