The shadow banking crisis of 1772

‘Banking crisis!’ is back in the headlines, and with it a debate about what role banks should really play in an economy, and what should be left to markets.

With that in mind, the New York Federal Reserve’s economists have trawled through the history books to find evidence of why they say a “narrow banking” model — where banks play a far more limited role in an economy — is no panacea against periodic bouts of financial turbulence.

Specifically, they go back to the failure of Dutch merchant banker Clifford & Sons around Christmas 1772, after it had financed a botched takeover attempt of the English East India Company.

Back in the 18th century, classic deposit-taking banks played a minimal or non-existent role compared to the large and often international reach of merchant-financiers like Hope & Co and Clifford’s.

But the latter’s collapse showed that governments often have to ride to the rescue when non-banks fail as well, as the NY Fed’s Stein Berre and Asani Sarkar note:

The failure of Clifford’s has remarkable parallels to the Lehman bankruptcy in 2008-9 in that the failure of a large, interconnected wholesale player turned what was mostly perceived as low-risk, money-like investments into high-risk assets virtually overnight (that is, became information sensitive). Hitherto unknown interlinkages emerged, and entire firms fell as a result. London investors, for example, lost money lent to the firm of Craven which lost on the Anglo-Dutch firm of Maurice Dreyer, which in turn, had heavily invested in one of the Clifford syndicate partners. As with Lehman, the failure of a large financial institution and the unexpected chains of risk contagion became a catalyst for concerted public sector actions to stabilise the financial system.

Although banks retain a special role in the financial system, which dates back to the 19th century, the crisis of 1772 demonstrates that a sophisticated financial system can thrive and fail without banks. Asset cycles, gambling for resurrection, moral hazard and too-big-to-fail issues persist in a world with or without banks. As happened with the rescue of large banks during prior crises, public authorities deemed rescue operations to be the lesser of two evils when large NBFIs failed. The recent growth of non-bank financial firms may thus be viewed, not as something novel, but as the pendulum swinging back to something very old.

That final (FTAV-bolded) sentence is telling. There are actually very few people arguing for a radical reshaping of the entire banking industry and turning them into ‘narrow banks’. The real debate is what to do about the rising importance of the shadow banking system — or “non-bank financial institutions”, in the preferred argot of policymakers.

Since 2008 we’ve been squeezing a lot of the inherent risks of finance out of banks and into capital markets. That is probably a better place for them (given the broader role that banks play) but the risks don’t disappear. They just become more diffuse.

And as recent events have shown, occasionally they can also rebound back into banks.