Response to past crises shames post-Lehman dithering

Parliament in the early 1800s: good at resolving banking crises.

Response to past crises shames post-Lehman dithering

Parliament in the early 1800s: good at resolving banking crises.

The fifth anniversary of Lehman Brothers’ demise is an opportune moment to take stock and contextualise what has happened since. And one good way to do so is to compare this government’s policy response with a predecessor’s response to an earlier, similar, crisis.

To find a British banking crisis of comparable magnitude we must go back as far as 1825. The UK has actually suffered surprisingly little banking instability in the intervening years. Even events which historians have traditionally classified as banking crises pale into insignificance when compared with the devastation of the 1820s.

So what happened? The Bank of England, initially pursuing a deflationary policy in its attempt to return to the exchange rates prevailing before the Napoleonic Wars, started to expand the money supply in a big way from 1822. With more money came more credit, as the government paid off its long-term debts and gave country banks the right to print small-denomination paper money. All this meant there was a lot of money in the system, fuelling a boom in the stock market and foreign investments.

Then, in the autumn of 1825, bank runs in the west of England spilled over to the City and elsewhere. By December, 30 banks had gone bust, with a further 33 entering bankruptcy in the first quarter of 1826. The Bank of England reluctantly assisted these failed institutions.

A subsequent parliamentary enquiry concluded that the entire credit system and economy in December 1825 was within a few days of collapsing. And the crisis had a significant impact on the real economy: GDP fell by more than 5.9% in 1826, a figure not dissimilar to the collapse in UK GDP in the year following the Lehman debacle.

What was the government’s policy response to this crisis in 1825-6? Parliament acted very quickly to remedy the defects in the English banking system by passing a radical piece of legislation to stabilise the system.

Prior to the crisis, banks in England were restricted to partnerships, and note-issuing banks could have no more than six partners. This kept banks small and poorly capitalised, which made them vulnerable to crises. The new legislation was historic in that banks were permitted to form freely as companies, the first time freedom of incorporation was given to any business sector. Within a decade of its passage, more than 100 large and well-capitalised banks had been established, ushering in a long period of banking stability.

England’s banking crisis was a source of amusement for this Scottish comic. University of Glasgow Library

The history of the recent crisis is well known. In some ways it is still ongoing. What is clear is that the financial landscape has been permanently blighted by the ruins of Lehman and others. The economy has yet to fully recover to its pre-crisis levels. While the crisis was more global in nature than 1825-6 and its causes therefore less tractable by any one country, recent history has demonstrated that it remains the responsibility of national governments to design and implement appropriate policy responses to crises.

What steps, then, has the UK government taken to reform the banking system? The government of Lord Liverpool acted quickly, decisively and radically in 1826. But the governments of Gordon Brown and David Cameron have acted slowly, indecisively and conservatively whenever it has come to the reform of the banking system. Despite parliamentary enquiries, the Independent Commission on Banking and the Turner Review, we have not seen a radical reform of the banking system; rather we have witnessed a tinkering with the pre-crisis regulatory regime.

The 1826 legislation resulted in stable banking as bank shareholders were unlimitedly liable for their bank’s debts. This constrained banks from taking excessive risk. After the global financial crisis of 2008, there has been no radical reform of banking and no attempt to make shareholders have more “skin the game” in the form of substantially higher capital, which would act as a check on excessive risk taking. One lesson of the 1826 reforms is that when the political system responds radically and decisively to a banking crisis, it can introduce reforms that promote stability.

Changes in the global economy since the early nineteenth century go some way towards explaining this absence of regulatory radicalism. The UK is no longer a hegemonic economic and political power, and it is far more difficult for its government to act alone out of fear that others will act against it. The European Union could theoretically facilitate a coordinated policy response, but even there an appetite for serious banking reform has remained absent. Popular demonstrations, hung parliaments and electoral cycles have perhaps acted as appetite suppressants.