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A Private Bank as Lender of Last Resort Under the Classical Gold Standard.

A Private Bank as Lender of Last Resort Under the Classical Gold Standard. When is a central bank a central bank? To the present day, research has failed to fully answer this question. One minority opinion is that central banking should be defined “as being associated with the issuance of central bank money”, while central bank money itself is defined “as financial money [i.e. distinguished from commodity money, D.Z.] of the highest possible credit quality, which is accepted for settlement for any other financial claim in the same way as specie money is accepted […] and which is significantly used in an economy as means of payment.” U. Bindseil, Central Banking before 1800. A Rehabilitation, Oxford 2019, p. 2. The highest possible credit quality is achieved mainly when a state, which in the eyes of its citizens upholds a responsible debt administration, either owns and operates the bank of issue itself, or endows a private bank with certain privileges. The latter are defined by a charter limited to a certain period which as such may be removed again at the end of the term. Such banks might make profits and distribute them among the proprietors, but there is a second condition for the highest possible credit quality. Banks of issue, regardless whether private or public, must manage their balance sheet in an extremely conservative way, i.e. in addition to a precious metal reserve which is regarded as sufficient by contemporary observers to maintain convertibility, investments are only in high-quality liquid and low-risk financial assets such as self-liquidating bills of exchange and short-term loans both to the private and to the public sector. According to this understanding of central banking, the Bank of England can be qualified as a central bank protecting the convertibility of Sterling into gold from 1844 on. L.H. White, Free Banking in Britain, Cambridge 1984, p. ix. Although private banks of issue continued to exist in the English provinces during this period, their right to issue bank notes was legally restricted from this point, so that there was a strong incentive to relinquish the right of issuance and develop further into deposit banks without the right of issuance: Growth potential could only be activated through accepting deposits, F. Capie/G. Rodrik-Bali, Concentration in British Banking, 1870-1920, in: Business History 24/3, 1982, pp. 280-292, here: p. 280; M. Collins, The Business of Banking: English Bank Balance Sheets, 1840-1880, in: Business History 26/1, 1984, pp. 43-58, here: p. 45. and at the same time their investment portfolios no longer had to be put together in such a conservative way as before.For the small community of both economists interested in 19th century economic history and historians specialized in monetary history, the criterion of the issuing of central bank money by a government-owned or chartered bank is not sufficient to define such a bank as a central bank rather than simply as a central bank of issue. From this perspective, a second necessary condition must be met: the role as lender of last resort for the financial market. C. Goodhart, The Evolution of Central Banks, Cambridge/ Mass. 1988, p. 86; F. Capie/C. Goodhart/N. Schnadt, The Future of Central Banking, Cambridge 1994, p. 15. Within this group there is, however, a debate about where the responsibility of a lender of last resort ends. The classical definition formulated by Walter Bagehot in 1873, can be summarized as follows: to avert panic, central banks should lend early and freely, to solvent firms, against good collateral, and at high rates, whereas good collateral is understood by Bagehot as „everything which in common times is good ‘banking security’”. W. Bagehot, Lombard Street. The Description of the Money Market, London 1873, p. 205. Lending early and freely meant, that “the rate should be raised early in the panic so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; [and that] advances should be made […] as largely as the public ask for them”. Ibid., p. 197. Taking this definition as the basis, evidence suggests that the Bank of England became a central bank during the 1870s – 1878 at the latest M. Collins, The Banking Crisis of 1878, in: Economic History Review XLII, 1989, pp. 504-527. –, although the Bank had not yet explicitly accepted its responsibility as lender of last resort. In a private letter to the economist Bonamy Price the Bank’s Governor (and merchant banker) Henry H. Gibbs explicitly rejected Bagehot’s notion of a minimum reserve. B. Price, Chapter on Practical Political Economy, London 1878, p. 519. See also L.S. Pressnell, Gold Reserves, Banking Reserves, and the Baring Crisis of 1890, in: C.R. Whittlesey et al. (Eds.), Essays in Money and Banking in Honour of R.S. Sayers, Oxford 1968, p. 182. An even more restrictive definition is taken by Nevin und Davis, who postponed the date to 1890 when the Bank of England organized a City rescue operation of the London merchant bank Baring Bros. Barings were from the point of view of both the Government and the majority of City houses too important to fail, as their collapse would probably have threatened the City’s position as the world’s financial centre and England’s position as the guardian of the international gold standard: It was „the turning point in the development of the cooperation between the Bank and the joint stock banks – traces of mutual jealousy and suspicion were now few. Such co-operation was crucial to the effective application of Bank control” E. Nevin/E.W. Davis, The London Clearing Banks, London 1970, p. 108. See also R.S. Sayers writings on the Bank, namely Bank of England Operations, 1890-1914, London 1936, pp. 116-127; and The Bank of England, Vol. 1, Cambridge 1975, pp. 28-65; Pressnell, Gold Reserves, pp. 219-224; E.V. Morgan, Theory and Practice of Central Banking, 1797-1913, Cambridge 1943, pp. 224-227; M. Collins, Money and Banking in the United Kingdom. A History, London 1988, pp. 167-171, 189-191; K. Dowd, The Evolution of Central Banking in England, 1821-1890, in: F. Capie/G.E. Wood (Eds.), Unregulated Banking. Chaos or Order?, London 1991, p. 159. or, to use Charles Goodhart’s terminology, the Bank had become a non-competitive actor on the London financial market. Goodhart, Evolution, p. 9.Admittedly it is questionable how far such a bailing out actually belongs to the role of a lender of last resort. Capie/Goodhart/Schnadt, Future, p. 65. That said, the opinion formulated by Thomson Hankey, Director of the Bank of England, in 1867 would probably find very little support today: “I should be sorry to see any interference to prevent persons overtrading or speculating. Let every one invest his own money as he pleases; let every one trade on what capital he pleases, borrow money at what rate and on what security he pleases; but the trading community must be taught […] that no such establishment as the Bank of England can provide ready money beyond a certain clearly-established limit, and that limit is the money left in their hands by their depositors”. T. Hankey, The Principles of Banking, Its Utility and Economy, London 1867, p. 25. Hankey’s statement was a response to the contemporary critique, formulated first and foremost by the Economist, of the mishandling of the crash of the London discount house Overend, Gurney & Co. by the Bank of England in 1866; and it was not simply the private opinion of a City merchant, but contemporaries considered Hankey’s statement rightly as a semi-official statement of the Bank’s Court of Directors. This fact, in turn, induced the editor of the Economist Walter Bagehot to write his Lombard Street.So let us remain with Bagehot’s definition of a central bank under the classical gold standard which is in essence widely upheld today, that „it is the proper function of the Bank of England to keep money available at all times to supply the demand of banks which have rendered their assets unavailable.“ Bagehot, Lombard Street, p. 83. The acceptance of this responsibility required, besides a specie reserve sufficient to safeguard convertibility, a substantial banking reserve (consisting of Bank of England notes and coin) to meet the demand of the market in times of panic and, as a second line of defence, a highly-liquid investment portfolio consisting of short-term loans und, even more so, of self-liquidating assets such as commercial bills of exchange.But did the Bank of England keep money available for this purpose? John Clapham and Richard Sayers, the two authoritative historians of the Bank of England under the classical gold standard, would probably have answered in the positive, and most of their successors too. A more sceptical view is held by J.H. Wood, A History of Central Banking in Great Britain and the United States, Cambridge 2005, pp. 109-113. However, the portfolio management of the Bank was unknown, both for contemporaries and for subsequent historians. They looked at the policy of the Bank as pursued during the last decades before the First World War and found no fundamental dissent from what Bagehot would have expected the Bank to do.I will argue in this paper that the gradual commitment to the duties of a modern central bank by the Bank of England during the last decades before the First World War, the acceptance of its role as lender of last resort in particular, is not as obvious as it seems to be: For the resources that would have been available to the Bank as lender of last resort to combat a severe financial crisis were much smaller than contemporaries had assumed. The Bank of England was a privately-owned bank from which shareholders expected dividend payments at a level that was not always easy to generate, and which required measures that were mostly incompatible with its role as lender of last resort.The balance sheet, as published by the Bank on a weekly basis, was the only publicly available source to assess the Bank’s willingness to organize its investment portfolio as conservatively as expected, but it in fact disguised more than it displayed. An extremely conservative balance sheet management by its Court of Directors remains more or less unquestioned and must, as such, be taken for granted – at least so long as it was not possible to see behind the curtain of the published balance sheet.As regards the protection of the gold standard, that is, the redemption of the Bank’s notes into gold, the mechanism worked well after 1866, when the 1844 Bank Act and its limits to the fiduciary issue of Bank of England notes had been suspended for the last time before the First World War. As was stated above, the Bank needed a precious metal reserve that was regarded to be sufficient for that purpose by the informed public. The separation of the Bank of England into an Issue Department and a Banking Department in 1844 had installed an automatism that prevented the overissuing of bank notes by the Issue Department (see appendix). The problem that money was more than simply coins and bank notes, and that the growing amount of book money deposited at the commercial banks was not included in the redemption-protection-mechanism of the Issue Department never became acute during these final decades before the War.The reason for this success was the conduct of the Banking Department which brought the bank notes issued by the Issue Department into circulation. In order to have a certain room to manoeuvre in times of crisis the Banking Department kept a cash reserve, consisting mainly of bank notes convertible into gold at the Issue Department, that was substantially larger than the cash reserve of an ordinary commercial bank. Problems did not arise simply because of stable expectations of market participants, who reacted in a manner so that any stress upon the Banking Department’s reserve was immediately eased. The market or rather the economic journal press defined a minimum amount of that reserve. The closer the actual reserve came to that minimum, £10m in the 1870s, and later £15m and £20m respectively, the more likely became a decision of the Bank’s Court of Directors to raise the Bank Rate of discount. The London money market, in expectation of rising interest rates, acted accordingly. Finally, the higher interest rate level in London resulted in an influx of gold from abroad, so that the Issue Department provided additional Bank notes to the Banking Department and thus strengthened automatically the latter’s cash reserve.As Charles Goodhart has pointed out, this sequence of reaction demanded either a fairly tension-free relationship between the Bank and the financial intermediaries of the London money market, the big London commercial banks in particular, or the control of the market in order to enforce the market to follow its command in case of need. Goodhart, Evolution, p. 54. Both strategies, however, required certain preconditions. In the former case the central bank had to face the market as a noncompetitive, non-profit-maximising bankers’ bank and in the latter case the central bank needed a close contact with and even a strong hand in the market.A strong hand in the market meant that the Bank acted as an important creditor in the money market, at best as a backbone of the other financial intermediaries. However, discount houses and bill brokers were excluded from the Bank’s Discount Office in 1858 and the London based commercial banks did on principle not rediscount at the Bank. As a consequence, the Bank’s Discount Office was open more or less exclusively to non-bank customers, i.e. partly overlapping with the clientele of the commercial banks. Thus, if the Bank’s (re-)discount business was active enough to have a strong hand in the market, the commercial banks, who provided for a large part of the Bank’s interest-free Other Deposits, might no longer be prepared to release a substantial part of their liquidity reserve to a major competitor. Under the given institutional circumstances, the strong hand in the market and the role of a non-competitive bankers’ bank were mutually exclusive.Whether the Bank had the resources at its disposal to act as a major player on the money market or not, can only be assessed if the composition of the Bank’s Other Securities is known. If the Bank did not have a strong hand, because it had to have consideration for the commercial banks, the composition of the Other Securities must also be known, since, as Bagehot had stated, “the best palliative to a panic is a confidence in the adequate amount of the Bank reserve, and in the efficient use of that reserve”. Bagehot, Lombard Street, p. 207. A sine qua non of this confidence in the Bank’s willingness to overcome a panic was the trust also in the second line of defence, Charles Goodhart is very clear on this point, too, by demanding that “financial intermediaries providing payments services should hold only marketable securities”. Goodhart, Evolution, p. 96. a high-quality liquid and low-risk investment portfolio subsumed in the balance sheet item Other Securities. However, the rate of return on such a portfolio is low, so that the Bank must fulfil the second precondition for a central bank, as defined by Charles Goodhart who argued that “it was the metamorphosis from the <central banks’> involvement in commercial banking, as a competitive, profit maximizing bank among many, to a noncompetitive nonprofit-maximizing role that marked the true emergence and development of proper central banking.” Ibid., p. 9; see also Idem, Are Central Banks Necessary?, in: Capie/ Wood (Eds.), Unregulated Banking, p. 11.Whether this step had been undertaken in Britain already before the First World War, however, has only rarely been challenged. John Pippenger has for some time argued that the policy of the Bank of England before the First World War was still determined by “the conflict between its statutory and commercial duties. For example, an upswing in business activity tended to make earning assets more attractive as interest rates rose, but the increased activity also posed a threat to convertibility.” J. Pippenger, Bank of England Operations, 1893-1913, in: M. Bordo/A. Schwartz (Eds.), A Retrospective View on the Classical Gold Standard, 1821-1931, Chicago 1984, p. 209; see also M. deCecco, Money and Empire. The International Gold Standard, 1890-1914, Oxford 1974, p. 99; G. Ingham, Capitalism Divided? The City and Industry in British Social Development, London 1984, p. 164. This means that the Bank was prepared not to act according to its duties as a modern central bank when it felt a threat to its profit-earning capacity. In a very straightforward manner Pippenger criticized that “the conventional wisdom tends to forget that the Bank was private and had to pay dividends.“ Pippenger, Bank, p. 217. In a direct reply, Charles Goodhart rather defended the “conventional wisdom” by claiming that in the case of the Bank’s attempt to increase its market share in the discount business the profit argument only holds if the Bank sought to maximize profits, but as Pippenger admitted, the Bank was only concerned to maintain its profits. C. Goodhart, Comment, in: M. Bordo/A. Schwartz (Eds.), A Retrospective View on the Classical Gold Standard, 1821-1931, Chicago 1984, p. 224.The conditions for the production of profits, however, are not stable. They vary with the ebbs and flows of the business cycle, in the case of banks of issue especially with the variations of interest rates in the money market; and it is even possible that yields on certain classes of assets display a declining trend lasting longer than a normal cyclical movement of interest rates. A policy aiming to maintain the rate of profit may thus require measures for certain periods very similar to a policy aiming at the maximization of profits. Unfortunately, up to now nothing has been established about the conditions under which the Bank consistently generated a net profit of between £0.65m and £0.7m per half year. Only the intimate knowledge of the Bank’s reactions to changing market conditions enables observers to assess whether the Bank of England had already undergone the metamorphosis from a competitive bank among many into a non-profit-maximizing central bank before the First World War.This paper will examine the question of continuity and discontinuity in the Bank of England’s understanding of its role in the money market before and after the publication of Bagehot's Lombard Street, as well as the significance of its crisis management during the Baring crisis for the final acceptance of its role as lender of last resort until the First World War, as shown by the Bank’s management of its asset portfolio in the unpublished internal balance sheets.1Portfolio Management Before BagehotAlmost every downswing in business activity resulted in a steep decline in the Bank’s customers’ demand for short-term loans and discounts. Each time the Bank responded by reallocating its asset portfolio, i.e., mostly by diversifying the composition of its investments. Apart from an abortive attempt to invest in mortgages in the early 1820s, the Bank invested only in Government stock up to the 1830s. Correspondingly, the return on its investment portfolio was relatively low. Since the income derived from the discount of bills of exchange was relatively stable throughout the 1820s and 1830s (only shifting from Threadneedle Street to the provincial branches), D. Ziegler, Central Bank, Peripheral Industry. The Bank of England in the Provinces 1826-1913, Leicester 1990, tab. 2.4, p. 18. the aggregate net profits were also stable, and the Bank was able to pay a regular dividend of 8 percent per year between 1823 and 1838. In 1839, however, the decrease in Head Office’s discount business forced the Bank to reduce its dividend to 7 percent. Additionally, in the early 1840s the profits derived from the provincial branches also decreased so that even the 7 percent dividend was threatened, and the Bank was in danger of having to pay the lowest dividend since 1787.Under these circumstances the Bank entered into a new market: it began to lend long-term, first to the leading English railway companies, and secondly to provincial municipalities (corporation bonds), where Bank of England branches were located. The advantage of such loans was twofold: they partly absorbed the ”surplus funds” set free by the decreasing demand for discounts and they yielded a higher return than the alternative of investing in Exchequer Bills and Government Stock. British Parliamentary Papers 1847/48, vol. 8, Secret Committee on Commercial Distress, part 3, evidence Morris and Prescott, q. 406. The price which the Bank had to pay was the lock-up of an increasing portion of its assets, because the credit period of the railway loans was between three and seven years, while the corporation bonds were granted as instalment loans, which were to be repaid by annual instalments over up to thirty years. In both cases there was almost no possibility of unloading this burden at the Stock Exchange.Shortly afterwards, the Bank Charter Act of 1844 officially freed the newly formed Banking Department of the Bank of England from any obligation towards the public and enabled the Bank even in its discount business to pursue a more profit-orientated policy. Consequently, the Bank strengthened its competitiveness by introducing a relatively flexible instead of a fixed rate of discount, which was adjusted to the conditions on the money market. This new competitive attitude allowed it to increase the turnover of bills of exchange in London by 1,000 percent in three months. Despite the significantly lower average rate of discount, the Bank already achieved in 1845 a higher income from this source than in 1843. When interest rates rose in 1846 and 1847, the interest received from discounts in London increased to £191,000 and £325,000 respectively (compared to £7,700 in 1843) so that in 1847 and 1848 the Bank was able to pay a dividend of 8 percent per year and in 1849 one of 9 percent per year.A higher portion of bills of exchange in the Bank’s portfolio naturally meant that the Bank’s profits became extremely dependent on general business activity, because both the turnover of bills and the rate of discount tended to move in the same direction. Consequently, in the early 1850s problems arose when demand fell off again and the interest received went down to £76,000 in 1852 (Head Office and branches). The absorption of the surplus funds by investing in loans for railway companies was obviously no solution, since the collapse of the credit demand from an average of £11.4m in 1847 to £3.6m in 1852 was too large to be offset by this channel. The Bank had already invested more than £3m in railway loans (or 12 percent of its interest-bearing assets) All data concerning the half-yearly balance sheets and profit and loss accounts are taken from Bank of England Archive (BofE), Stock Estimates (ADM 19). and the figure rose to more than £4m or 15 percent of the interest-bearing assets in February 1854 (see Table 1). By this time the Bank of England was probably the most important single creditor of a couple of railway companies. D. Ziegler, Das Korsett der Alten Dame. Die Geschäftspolitik der Bank of England 1844-1913, Frankfurt/Main 1990, p. 41 (n. 19).Tab.1Long-term Loans to British Railway Companies Held by the Bank 1842‒1854 (£000).DateAmountAugust 1842125February 1843475February 1844716February 18451,451February 18461,853February 18472,267February 18482,072February 18492,467February 18503,023February 18512,622February 18523,103February 18533,749February 18544,045Source: BofE, Stock Estimates.By the middle of the 1850s the Bank had almost doubled its holding of non-government investments compared with the early 1840s. Although most of them were lock-ups, the Bank kept to its strategy. The declining activity of the discount business after the crisis of 1857 was immediately offset by a further increase in investments (see Figure 1). The average holding of non-government investments in 1858 increased by about £2m (or 22 percent) in only one year. By this time, it consisted of aboutFig. 1Sample caption The Bank of England Portfolio 1845-1913 (£000). Source: Dieter Ziegler, Das Korsett der Alten Dame. Die Geschäftspolitik der Bank of England 1844-1913, Frankfurt/Main 1990, p. 31.– £3.5m in railway loans,– £2m in loans to local authorities (other than City Bonds),– £2m dock and canal company debentures,– £2m East India securities, of– somewhat less than £1m in City Bonds and of– £0.3m in loans on mortgages.Their aggregate portion of all interest-bearing assets made up more than 35 percent during the late 1850s and early 1860s.This portfolio composition enabled the Bank to keep the dividend at the attained level even during the years of cyclical downswing, especially since interest rates remained relatively high throughout the first half of the 1860s. Although there should have been no inducement for innovation, the Bank diversified its portfolio composition again, namely by Government Securities. This time, however, the choice was dictated not by the strain on the dividend, but most probably by a request from the Treasury which had guaranteed some foreign and colonial loans as well as a loan of the Metropolitan Board of Works and which was strongly interested in the success of these loans. See BofE, Committee of Treasury Minutes No. 40, 07.12.1892. In general, the Bank declined any government interference in its investment decisions, Examples can be found in D. Ziegler, Zwischen Gurney und Baring. Die Geschäftspolitik der Bank of England, 1867-1890, in: Bankhistorisches Archiv 12, 1986, pp. 67-95. but in this case the Bank accepted the request, because the Treasury offered an important inducement. The yield on these loans was substantially higher than the yield on Government stock. An exchange of these loans for a certain portion of British Government stocks in the Bank’s portfolio consequently meant a higher average return on Government Securities.This became an important factor during the next depression. By the late 1860s the guaranteed loans made up more than 50 percent of the Bank’s Government Securities. Additionally, after the crisis of 1866 the railway companies came under heavy pressure and had to offer very high rates of interest for the prolongation of their loans. Both developments resulted in the highest average return on the Bank’s portfolio for the whole period under review (see Table 2). On the other hand, the decrease in the credit demand was felt even more strongly than before, since it followed a long-lasting period of very high demand (see Figure 1). Additionally, its impact on the Bank’s earning capacity was aggravated by an extremely low interest rate level which was only partly offset by the high average return on the Bank’s investment portfolio. Consequently, the dividend came under pressure again. To invest the surplus funds in railway loans was obviously not desirable because of the general uncertainty concerning the financial situation of even the first-class railway companies. P.L. Cottrell, Railway Finance and the Crisis of 1866, in: Journal of Transport History 3, 1975/76, pp. 20-40, here: p. 29. The Bank had to look for an alternative. The debenture bonds of Indian railway companies carrying a state guarantee of interest payments were some sort of natural alternative in this situation: a new step in the Bank’s portfolio diversification was taken. It should be noted that this decision met serious opposition amongst the directorate. As there were some directors who were connected with British railway companies by kinship relations, it is very probable that these persons fought for additional assistance for British companies (see BofE, Court Minutes No. 90, 11.07.1867), while the then Deputy Governor Crawford was chairman of the East India Railway Co., which was the first Indian railway company connected with the Bank in this way.Tab. 2Average Return on Assets Held by the Bank of England, 1865/66-1889/90 (%).PeriodShort-term SecuritiesGovernment InvestmentsOther InvestmentsAssets Total1865/66-1869/704.53.54.24.01870/71-1874/753.63.454.03.71875/76-1879/803.353.53.83.61880/81-1884/853.63.33.63.51885/86-1889/903.43.453.63.5Source: BofE, Stock Estimates.By 1870 the English capital market was not yet perfected. Diversification of the investment portfolio consequently meant a serious lock-up of resources. Of all banks in England, the Bank of England, the central bank of issue, had most probably the highest portion of lock-up assets in its portfolio. By the late 1860s it had invested in between £12m and £13m lock-up securities, that is,– about £6.2m in Metropolitan Board of Works loans; £4m of this amount was guaranteed by the Treasury (instalment loan not traded at the Stock Exchange; duration until mid-1880s). The rest was an ordinary non-Government loan (to be repaid by annuity until the late 1890s). In 1869 the Treasury forced the Bank to convert at least a substantial part of these loans into the new Metropolitan Consolidated Stock. Despite the improved marketability of the Stock (compared to the loan) the Bank was not prepared to meet the Treasury’s wish voluntarily, because the Stock's rate of interest was lower. Finally, however, the Bank agreed “upon public grounds as far as it may be in the directors’ power to do so with proper regard to the interests of the Bank”. See BofE, Secretary’s Letter Books (G 23), 03.11.1869.– about £3.3m in railway debenture bonds;– about £0.9m in dock company debentures;– about £0.7m in canal company debentures;– about £0.7m in corporation bonds (excluding the above-mentioned Metropolitan Board of Works loan and the more marketable City Bonds);– about £0.5m in Indian railway company loans.In sum, the illiquid and not readily available portion of all assets (including cash) made up a total of between 35 percent and 40 percent. The masse de manoeuvre was very small indeed and the Bank had to be most careful as regards its role as lender of last resort. A Bank of England director, having this portfolio composition in mind, might not have argued in a different manner than Director Hankey did in 1867. Even when the Bank increased its contribution to high-powered money held by the private sector, See T. Ogden, An Analysis of Bank of England Discount and Advance Behaviour, 1870-1914, in: J. Foreman-Peck (Ed.), New Perspectives on the Late Victorian Economy, Cambridge 1991, pp. 306-309; M. Collins, The Bank of England as Lender of Last Resort, 1857-1878, in: Economic History Review XLV, 1992, pp. 145-153. the market had every reason to believe the directors that this was no predictable action in the case of liquidity crises. The relief during the mid-nineteenth century crises The Bank’s lending activities must not be regarded as a relief action which was effectively helping the whole market, but applied only to a small segment. Other segments were excluded by certain institutional constraints (as regards the conditions on which the Bank was prepared to lend) and on credit rationing on the part of the privileged segment. See Collins, Banking Crisis of 1878, pp. 504-527; D. Ziegler, The Banking Crisis of 1878. Some Remarks, in: Economic History Review XLV, 1992, pp. 137-144. depended, in fact, on the commercial banks’ willingness to increase their own reserves at the Bank of England. If the banks were forced to resort to their reserves deposited at the Bank of England themselves, the impact on the Bank’s lending activities would have been disastrous.2Did Bagehot Matter? The “Greatest Investment Bank in the World” 1873‒1900During the 1870s and 1880s the English capital market developed very quickly. Railway companies and local authorities in particular converted their debts into marketable debenture stocks. Less risk, however, meant a lower return for the investor. The average nominal yield on railway debenture stocks, for example, fell decisively during the last quarter of the 19th century. It was most probably the fear of a lower return on its investments as well as the risk of a fall in the market price of such stocks that prevented the Bank from unloading its lock-ups as fast as possible. Although such conversion was to be expected from the protector of Sterling convertibility – not to speak of a lender of last resort for the London and provincial money markets –, it was only the success of the debenture stocks in the market that finally induced the Bank to convert its lock-up securities into marketable stocks. The stocks’ success put the railway companies in a very strong position when they negotiated the prolongation of the old loans. The Bank could either accept the conversion of loans into stock or had to agree to a lower rate of interest. Otherwise, the railway companies would have repaid the loan and prepared the issue of additional stock in the market. See S. Broadbridge, Studies in Railway Expansion and the Capital Market in England, 1825-1875, London 1970, pp. 97-98; Ziegler, Gurney, pp. 79-82.As a result, the declining return on the Bank’s aggregate portfolio put the dividend under pressure again (see table 2). Additionally, the structural crisis of the bill of exchange as means of payments and credit, which began in the mid-1870s, S. Nishimura, The Decline of the Inland Bill of Exchange in the London Money Market, 1855-1913 Cambridge 1971, pp. 24-25. led to an immediate collapse of the discount business. Contrary to the commercial banks, this development could not be offset by an increase in short-term loans because of the Bank’s strict regulations concerning the terms of such loans. As early as in 1877 the portion of the short-term securities in the Bank’s portfolio had fallen to 17 percent of all interest-bearing assets – the lowest figure for 25 years. It may be seen as an emergency action that the Bank invested £3.3m net in stocks in 1876 and thus increased its investment portfolio by more than 13 percent in less than two years (see Figure 1). As a supplementary measure the Bank introduced a special rate of discount for sole customers in Threadneedle Street BofE Court Minutes No. 100, 31.01.1878 and 14.02.1878. in order to halt the decline in the number of clients, which had similarly fallen since the early 1870s. Number of discounters in Threadneedle Street in 1871: 438 and in 1876: 276. BofE, Special Discount Committee Reports (C 35 No. 4). In the medium term, however, this measure provided no significant relief for the discount business. Between 1878 and 1883 the special rate was only rarely charged. See BofE, Special Discount Committee Reports (C 35 No. 4 and C 35 No. 5). By the late 1870s the Bank of England had become ”the greatest investment bank in the world”, as the Bankers’ Magazine rightly surmised in 1880. Bankers Magazine Vol. 40, p. 903. It is not known on what data this claim was based. The only conceivable sources are likely to have been either a whistleblower from Court of Directors’ circles or among those Bank clerks who were in charge of the accounts or simply stock market rumours. In any case, officially accessible sources cannot have been the basis for this claim.Investment in railway stocks, however, would have meant that the decline in the average return on the investment portfolio accelerated. A new step in the portfolio diversification was inevitable. Up to the mid-1870s the Bank had always declined requests for lending to colonial governments. Exceptions were only made when the British Government was prepared to guarantee these loans. Under the circumstances of the moment, however, the directors abandoned the Bank’s rule to lend long-term only to debtors on which the Government or at least Parliament had some influence and decided to invest £1m in bonds of seven colonial governments (such as Cape of the Good Hope, Canada and Victoria). BofE, Court Minutes No. 99, 28.09.1876. This margin was quickly exceeded and in 1883 the Colonial Government Securities in the Bank’s portfolio had already reached the level of the Railway Securities with a share of 8 percent of all interest-bearing assets. In 1885 its portion made up 12 percent, by this time the largest single item of all non-(British-)Government investment (see table 3).Tab. 3Colonial Government Loans Held by the Bank of England, 1877‒1885 (£000).DateAmountFebruary 18771,162February 18781,290February 18791,203February 18801,312February 18811,400February 18822,307February 18833,048February 18843,044February 18854,218Sources: BofE, Stock Estimates.The reason for this particular step in the Bank’s portfolio diversification was twofold. First, the return on these bonds was significantly higher than the return on those debenture stocks the Bank had invested in during the first half of the 1870s (including the converted loans). The profit motive behind this decision becomes obvious from the fact that from about the mid-1870s the Bank bought only second rank railway debenture stocks, in which it had never invested before and which, moreover, yielded a higher return compared to the old-established ones. Secondly, the creditor relations with colonial governments opened up a new source of income, because from the late 1870s the colonial (bearer) bonds were converted into (registered) stocks. This meant that the colonial governments needed a London bank for the issue and management of their debts. In their view, the Bank of England with its unique prestige and with its long-lasting experience in the issue and management of the British and Indian Government debts was certainly a well-suited bank for these services. This held especially for the 1880s when the Treasury prohibited the intermediation of the Crown Agents in the issue of colonial loans in order to demonstrate the exclusive responsibility of the dominions for their debts. T. Schilling, London als Anleihemarkt der englischen Kolonien, Stuttgart 1911, p. 38. In this particular situation, dominion governments might have thought that only the Bank of England acting as the issuing house for their loans could make good this enforced (and costly) stipulation.The Bank’s first customer was the New Zealand Government for which it had issued a loan already in 1878. A few years later it managed the conversion of different loans into the newly created New Zealand Government Stock. Until the mid-1880s the Bank acted as the issuing house for the New Zealand, New South Wales and Queensland Governments and even for some larger provincial towns such as Liverpool, Birmingham, Nottingham, Swansea, Hull and Wolverhampton. BofE, Capital Issues (C 16 No. 1). The gross income derived from debt issue and management rose from less than 15 percent of the Banking Department’s gross profit to more than 20 percent in the second half of the 1880s. Additionally to the profit-taking achieved by the selling of the railway debenture stocks in which the Bank had invested in the mid-1870s and which had undergone a slight but steady price appreciation, BofE, Stock Estimates, Profit and Loss Accounts; Ziegler, Gurney, pp. 88-91. these new sources of income more than offset the substantial decrease in the interest received from discounts and short-term loans. Consequently, despite the lowest business activity of the discount offices in London and at the provincial branches the Bank paid the highest average dividend during the 1880s compared to all other decades of the period under review.From the late 1880s, however, the investment bank scheme entered into a crisis, since the return on all asset classes in which the Bank was prepared to invest had decreased significantly. The Bank could, therefore, create additional surplus funds neither by a continuous reduction in the discount business nor by the selling of investments in order to realize an extra profit from price appreciation. Secondly, from the late 1880s and especially since the Baring crisis in 1890, the demand for new colonial (especially Australasian) loans in London fell off. Equally, the gross profit derived from the issue of these loans decreased while the gross profit derived from debt management stagnated. In this situation the Bank had two options: either a new portfolio diversification (such as the purchase of American railway bonds or British railway shares) resulting in a higher average return on the investment portfolio, or the return to a bank of deposit portfolio structure (i.e., an increase in the proportion of bills of exchange and short-term loans).In the late 1880s the Bank was obviously not prepared to take the risk of investing in securities the short-term price fluctuations of which were substantial and in 1888 the special rate of discount was introduced at the provincial branches and both the Chief Cashier at Head Office and the branch agents were granted discretion in the fixing of short-term loan rates. BofE, Court Minutes No. 110, 26.01.1888. Additionally, the Bank began to lend on the Stock Exchange at first on customers’ account only (1890) It is not yet clear, when the Bank began to lend on the Stock Exchange. Sayers found evidence even for 1882 (Bank of England, Vol. 1, p. 20). More important than such early cass, however, was the ‘Hampshire County Council Agreement’ of 1890, because from then on the Bank lent on customers’ account with its own full responsibility for repayment. See Economist 22.02.1890; J. Clapham, The Bank of England, Vol. 2, Cambridge 1944, p. 346. and later (1893) its own (“surplus”) funds, too. Finally, in 1890 bill brokers and discount houses were allowed to re-discount at the Bank, provided the bills did not have more than 15 days to run, at the discretion of the Governor. BofE, Court Minutes No. 113, 24.07.1890.In contrast to the interpretation in this paper, which at this point follows John Clapham's account from 1944, Clapham, Bank, p. 357. Richard Sayers in his three-volume history of the Bank of England from 1976 sees the (re)admission of the bill brokers and discount houses to the rediscount at its Discount Office as a decisive step towards assuming responsibility for the functioning of the London financial market: “The days of isolationism […] were over, and it was now the policy of the Bank to make firms in the market more reliant on facilities at its Discount Office. In doing so, the Bank added something to its earning capacity, but this was an incidental result, not the object of the changes.” Sayers, Bank of England, p. 34.The immediate reason for this reform, however, was not the directors’ attempt to “control the market”, but rather a motion of the most important “commercial banker” amongst the Bank of England directors. In June 1890 Thomson Hankey, who had “never abandoned the circumspect attitude that had been criticized by Bagehot” (John H. Wood), Wood, History, p. 111. proposed to abandon the practice of publishing the Bank rate of discount. According to the practice of its competitors, the Bank should discount at individual (= flexible) rates. Hankey’s objective was not only the reconstruction of the “bank of deposit” portfolio, but, as it had been 25 years ago, that the Bank of England should become an ordinary bank of deposit itself. Although the directors were not prepared to follow their colleague in such a radical manner, they set up a “Special Committee to consider the management of the discount business.” BofE, Court Minutes No. 113, 12.06.1890. This Committee proposed the bill brokers’ reform to the Court of Directors only one month later, as an alternative device of “getting discounts”. BofE, Court Minutes No. 113, 24.07.1890.The sequence of events gives every reason to believe that this decision formed a major part of a set of reforms with the primary objective of increasing the Bank’s competitiveness. As Sayers himself admitted elsewhere, the flexibilization of the discount rate was nothing more than an attempt to “avoid the loss of income”, resulting from its inflexibility. Sayers, Bank of England Operations, p. 2. Similar comments were made about the Bank’s lending to the stock market. Idem, Bank of England, p. 20. Indeed, there is no reason to believe that the bill brokers’ (re)admission, enacted “at the same time”, was, as Sayers put it, “intended to give the Bank rate fresh significance” Idem, Bank of England Operations, p. 3.. If anything, all named measures showed the opposite to a special concern to regain a strong hand in the market and, even worse, they were a major obstacle for a better cooperation with the commercial banks, the funds of which were needed to build up a higher central bank reserve.In the medium term, however, the reforms of 1888-1890 did not work as well as it was expected. After a relatively short period of remarkable success, The success, however, was partly due to the high interest rates during the aftermath of the Baring crisis as well as to a £4m loan for Barings as part of the City rescue operation. See Bankers' Magazine Vol. 57 (April 1894), p. 595 and Vol. 58 (October 1894), p. 530. when the interest received from bills of exchange and short-term loans made up more than 25 percent of the Banking Department’s gross profits in 1890-1893 (compared to between 10 percent and 15 percent during the 1880s), demand fell off again. Since the Bank was forced to sell investments in order to make room for the short-term securities in 1890 and 1891, the reduction in the credit demand in the mid-1890s resulted in the Bank’s most serious profit crisis for the whole period under review. Contrary to the 1880s, the remaining investment portfolio was all too small The income derived from investments was as low as about £660,000 in 1894/95 compared to more than £lm per year in the 1880s. BofE, Stock Estimates, Profit and Loss Accounts of the respective years. to make up for the reduction of income derived from short-term securities. Only the provincial branches were able to avoid a collapse similar to that which occurred during the late 1870s and mid-1880s, Ziegler, Central Bank, tab. 2.16, p. 61. while in London the turnover of bills was as low as during the mid-1880s. Moreover, the interest payments received were even lower, since interest rates were below their former depression levels. It was only the mobilization of hidden reserves that enabled the Bank to keep its dividend at some 4 percent to 4.5 percent per half year. The net subsidy in the two half-year-balances ending August 1894 and February 1895 was £100,200 (or 14% of current gross profits) and £109,900 (or 16% of current gross profits) respectively. (Ziegler, Korsett, tab. 5, p. 64). The most important single source for these subsidies was a profit of £143,900 derived from dealings in Liverpool 3.5% Stock and accumulated since 1881 (BofE, General Ledger Supplements).In 1895, however, these resources had been used up without any prospect of improvement. Even further relaxations of the regulations concerning the terms for the re-discount of bill brokers’ bills (extension of the duration of bills rediscounted to 30 days) BofE, Court Minutes No. 116, 08.02.1894. had almost no impact. Consequently, the Bank reacted as it had reacted for decades in such situations: it invested, and in this particular situation even more heavily than before. The interest-bearing assets in the Bank’s portfolio increased by £11.5m (or 35 percent). Although the Bank continued its attempts to increase its competitiveness (extension of the duration of bills re-discounted to 63 days and the introduction of an official Stock Exchange rate) BofE, Court Minutes No. 118, 23.05.1895, 25.06.1895 and 05.09.1895; Sayers, Bank of England, p. 20. the investment bank portfolio structure was restored. As in former cases this growth was accompanied by a diversification of the Bank’s portfolio. Because of the extremely low interest rate level all fixed-interest-bearing investments fetched uniquely high prices. Investment in these classes of securities consequently meant first an extremely low return on the Bank’s funds and secondly a very high risk of price depreciation when interest rates rose. On the other hand, by the mid-1890s equity stocks such as railway shares paid relatively poor dividends and were thus quoted at relatively low prices. When interest rates rose, the Bank could also expect an increase in business activities so that companies were expected to pay higher dividends with corresponding effects on the share prices. These considerations might have induced the directors to part with the Bank’s (and English banks’ in general) C. Goodhart, The Business of Banking, London 1972, pp. 127-141; see also J.J. Madden, British Investment in the United States, New York 1985, p. 85. tradition not to invest in equity, as they decided to purchase about £0.5m (market value) ordinary stocks of three leading British railway companies. BofE, Court Minutes No. 118, 19.09.1895. Additionally, the Bank invested in more than £3m foreign state loans These investments were only meant as a temporary employment of a special deposit. BofE, Stock Estimates; Morgan, Theory, p. 208. so that the importance of the 1895 portfolio diversification can be regarded as second only to the decision to lend long-term to English railway companies in 1842.3Ostensible Strong Hands and Disguised ProfitsWhen the depression was over in 1897 the reforms of the years 1888 and 1890 proved to be fully as important as the Bank had expected. Demand for discounts and short-term loans rose significantly during the cyclical upswing of the late 1890s and remained high throughout the years after the turn of the century until the First World War (Table 4).Tab. 4Composition of Interest-Bearing Assets of the Bank of England Banking Department (%).186118861911British Government Securities36.542.531.036.542.531.0Other Securities- Railways16.511.25.6- Docks, Canals etc.9.33.84.1- Corporation6.911.87.6- India7.78.12.6- Colonial/Foreign Governments-10.010.2- Loans on Mortgage1.4--41.844.930.1Advances on Securities2.88.920.2Bills Discounted19.03.618.821.812.539.0Source: BofE, Stock Estimates.The interest received from this source increased to more than 35 percent of Banking Department’s gross profits (1906 and 1907: the highest figure since the 1860s), and only once did it fall below the 20 percent-margin (1909: a margin which was only once surpassed during the years of the investment bank). Contrary to its first attempt to reconstruct the bank of deposit portfolio in the early 1890s, the Bank could keep its investment portfolio and consequently increased its interest-bearing assets by an average of £8m (or more than 20 percent).It was a substantial increase in the private sector deposits that enabled the Bank to pursue such policy. One reason for this development was the Bank’s success in attracting higher commercial bank deposits. The Bank argued – and was supported by the Treasury – that it defended convertibility and needed thus both a strong hand in the market and a high central bank reserve. This was to be achieved by additional non-interest-bearing funds deposited by the commercial banks at the Bank of England. Pressnell, Reserves, pp. 208-219; Sayers, Bank of England, p. 60. The structure of the Bank’s portfolio, however, shows that these funds were only partly used for central bank purposes such as a higher reserve. Instead, they were mainly used to increase the gross profits of the Bank of England.Higher profits, however, did not result in higher dividends as in the 1880s. Instead of distributing between 98 percent and 102 percent of its net profits, Ziegler, Gurney, appendix, p. 95. the Bank transferred each half year up to several hundreds of thousands of pounds to an account Unappropriated Profits, which was kept separate from the Rest of undistributed profits in the published balance sheet and which remained, therefore, invisible for the public, including the Bank’s shareholders. This accounting operation enabled the Bank to re-build the hidden reserves which had been used in the early phase of the depression and, to put it pointedly, the Unappropriated Profits became de facto a dividend equalization account. In absolute terms and following its former practices the Bank had been able to distribute 5.25 percent to its proprietors for the half year ending September 1899 and at the turn of the following five half-years even 5.75 percent each. Yet, there can be no doubt that an increase in the Bank’s dividends would have strengthened the arguments of the commercial banks which claimed that the Bank had become unfairly competitive in the market. From their point of view, being induced to deposit additional funds at the Bank of England meant providing ammunition for a most serious competitor. An impressive account is given in R. Fulford, Glyn's 1753-1953, London 1953, pp. 212-217. See also F. Schuster, The Bank of England and the State, Manchester 1906, p. 28. For the reaction of country bankers, see Goodhart, Business, p. 180 (n. 15).Had the Bank of England really been concerned to act as a non-competitive, non-profit maximizing central bank, it could have liquidated its investment holdings and thus have created sufficient funds to meet its obligations as demanded by the contemporaries, i.e., the protection of both Sterling convertibility (until war conditions would have rendered this task impossible even with a substantially larger reserve) and the liquidity of the money market(s). The Bank’s investment portfolio was built up in times when the Bank was unable (or unwilling) to invest its funds in short-term securities and it could thus be liquidated when this inability (or unwillingness) had gone. During the first decade of the 20th century the Government Securities and the investments amongst the Other Securities made up about £15m each. Such an amount of investment was in no way necessary to fulfil central bank obligations. For its open market operations, an instrument to make the hand in the market even stronger, the Bank used a maximum of a few millions, mostly of Government Securities. Clapham, Bank, pp. 295-296.The Bank’s investments – altogether about two thirds of all interest-bearing assets of the Banking Department – were only used to level the extremely fluctuating yields on the short-term securities’ portfolio and to employ surplus funds; in short, they were used in order to keep the dividend at between 8 percent and 10 percent per year. This was true even before the First World War, since the final step in the Bank’s portfolio diversification was undertaken in 1912. But this time it could not even be argued that it was a depression creating surplus funds which forced the Bank to look for employment. On the contrary, it happened during a cyclical upswing when private sector deposits increased by an unusually high amount of about £5m and when demand for discounts and short-term loans increased by the usual amount of about £2m. Contrary to its pretended policy, the Bank did not use the additional funds to increase the central bank reserve but rather purchased new investments. The reserve only rose by about £0.5m, while the investment portfolio increased by about £1.8m and was diversified by colonial non-government stocks and bonds of Canadian and US railway companies (see Table 5).Tab. 5Colonial and Foreign Investments Held by the Bank of England 1908-1914 (£000).DateColonial GovernmentForeign SecuritiesColonial non- Gov. SecuritiesUS-Railroad BondsFebruary 19082,768262--February 19094,534754--February 19104,379790--February 19114,148678--February 19125,5221,217318-February 19135,0359141,058860February 19147,3859851,0301,223Sources: BofE, Stock Estimates.Contemporaries were not in a position to detect this policy. Since the Bank’s balance sheet summarized such different items as short-term loans, bills of exchange and non-(British-) Government investments, many of them hardly marketable in times of crisis, under one head (Other Securities), contemporaries might have thought that an increase in the Other Securities had resulted from a larger demand for short-term loans and discounts – from the strong hand. If they had known the real reason for the unsatisfactory impact of the additional deposits on the central bank reserve, no doubt, indignation would have been general; especially if they had known the impact on the Bank’s gross profits. In 1912 and 1913 the Bank wrote off altogether £1.35m on its investments. About 70 percent of this enormous figure, which was almost equal to a yearly dividend, were financed out of current profits, and in 1914, in addition to a transfer of £200,000 to the Unappropriated Profits, the Bank paid a dividend of 5 percent or £727,640 for the half year ending February 1914.4ConclusionThis paper attempted to show that the conventional wisdom needs revision. This holds especially for statements such as: “Though nothing can be proved from the statistical evidence, the available figures are at least consistent with what the Bank said it was doing and with what the contemporary commentators said it was doing.” Sayers, Bank of England, p. 43. or: “As the Bank's profits did not significantly increase, one can […] suppose that this represented resignation on the part of the Bank that profits now had to take second place.” Dowd, Evolution, p. 193 (n. 62).Statements like these benevolently overlook that the Bank of England was a privately-owned joint-stock bank that paid an annual dividend to its shareholders that was more than double the interest rate on the British national debt (consols). This meant that Bank of England stock was seen by investors as an attractive alternative to the consols at hardly any higher risk. Bank of England stock was not an object of speculation but was readily acquired by wealthy husbands and fathers as a retirement provision for their wives or unmarried daughters. It is therefore no exaggeration to describe the stability of the dividend as a socio-political task for the upper middle class of British society.Of course, the Bank of England was not an ordinary joint stock bank, but as the government's bank, important privileges had been conferred on it, which, however, could also be withdrawn again thanks to the regular renewal of its charter. Accordingly, it could not pursue an aggressive business policy to maximise profits, but had to meet the government's expectations to a minimum extent. Seen from this perspective, a business policy could be expected that was primarily committed to making a profit, but which had to be so moderate that no serious offence could be taken at it. In this respect the business policy of the Bank of England was highly successful during the whole period under review.Three times since the reform of the Bank Charter Act of 1844, most recently in 1866, the Banking Department's banking reserve (bank notes and coin) had been insufficient to meet the market's demand for credit. A race to the bottom set in in each case. In anticipation of credit restrictions, the demand for credit continued to swell, while banks, discount houses and City merchants simultaneously withdrew deposits. The banking reserve was thus squeezed from two sides, by the demand for credit (Other Securities) on the one hand and the loss of bankers’ balances (Other Deposits) on the other. The government then suspended the Bank Charter Act and with it the limitation of the fiduciary issue, whereupon the situation quickly calmed down, especially since the bank rate of discount had been raised to 10 percent.Once the crisis of 1866 was over Walter Bagehot argued that the Bank should maintain a much higher banking reserve than before, even in quiet times, so that no doubts would arise about the Bank's ability to provide the market with sufficient liquidity. In 1866, the banking reserve had fallen from about £8.8m in March to £0.9m at the end of May. But a higher banking reserve was only possible at the expense of interest-bearing Other Securities, which in turn had to be kept as liquid as possible to be able to replenish the banking reserve if disaster threatened. In addition to the lower share in the bank's assets, this meant a low average interest rate for the Other Securities. But that was precisely the problem from the Bank’s point of view, which Bagehot did not know, or at best could have guessed.At the beginning of the 1840s, Other Securities, apart from quantitatively insignificant mortgages, consisted exclusively of good commercial bills of exchange and short-term loans, which were mostly granted against bills of exchange and British government securities. The portfolio was therefore highly liquid, as it consisted mainly of self-liquidating assets and short-term loans covered by self-liquidating assets. The short-term loans against government securities were probably to be regarded as a service provided by the government bank, as it would have been a strange signal if the bank of the Government had not accepted Government bonds as collateral. The problem was, however, that by the beginning of the 1840s this portfolio no longer ensured a sufficient return to secure the targeted annual dividend. The Bank therefore began to grant longterm loans to English railway companies, which on the one hand earned a much higher interest rate than short-term loans and discounts and on the other hand could fill the gap left by the money market’s low demand for credit. For in view of low interest rates and a Bank rate of discount that was not in line with the market, the Discount Office had very little to do.The Bank Charter Act of 1844 changed the situation insofar as the Bank rate of discount could now be set more in line with the market and the Discount Office was again fully stretched, so that the profit situation initially improved again. By the spring of 1846, discounts and advances had roughly tripled, while the banking reserve was below the initial value of September 1844. The share of the banking reserve in the bank's assets had fallen from 28 percent to 20 percent during this period. At the beginning of 1866, the share of the banking reserve was still at about the same level. In Bagehot's opinion, this should change urgently.After the publication of Lombard Street in 1873 the Bank seemed to have followed Bagehot’s advice, but the increase in the banking reserve observable by contemporaries was bought by a significant deterioration in the liquidity of the Other Securities, which was not displayed to contemporary observers. In each cyclical downturn with low interest rates and low demand, the Bank responded with ever new investments under the Other Securities. By the 1880s, the proportion of lock-ups among the Bank’s assets had risen to such an extent that Bankers' Magazine made the assertion that the Bank of England might now have become the largest investment bank in the world. While the banking reserve oscillated around a share of 20 to 25 percent of total assets in the second half of the decade, that is, only slightly higher than in Bagehot's time, the share of discounts and advances was no longer even one third of the Other Securities. At this point, the Bank of England was at least as far removed from its commitment to keep money available at all times to supply the demand of the money market as it had been in 1866.At the beginning of the 1890s, however, the Bank of England changed its policy. The banking reserve increased, both in absolute and relative terms, as did the share of discounts and advances in Other Securities. The conventional interpretation is that this was an attempt to increase the strength of Bank rate in order to control the market, to have a strong hand in the money market. In fact, looking at the Bank’s decision-making process and considering the medium-term developments, it was rather the attempt to increase the competitiveness of the Discount Office, as the investment bank portfolio had proved to be a dead end.The Bank was indeed successful in its reactivating the Discount Office, but at the same time it annoyed the London based commercial banks, on whose deposits it was dependent. The more active the Bank of England became in the money market, the less willing the commercial banks were to cede the Bank of England their cash reserves free of interest. In the end the dance on the razor's edge was only partly successful, as the commercial banks left only a decreasing part of their cash reserves to the central bank. Instead, 46 English commercial banks, led by the London & Midland Bank and the Union Bank of London & Smiths Bank, jointly built up a decentralised gold reserve, which was managed independently of the Bank of England. Its size was estimated at around £35 million in 1913, T. Seabourne, The Summer of 1914, in: F. Capie/G.E. Wood (Eds.), Financial Crises and the World Banking System, London 1986, pp. 77-119, here: pp. 80-82. whereas the bankers’ balances deposited at the Bank of England at the time averaged just over £25m.As long as the London based commercial banks did on principle not rediscount at the Bank of England so that the Bank’s Discount Office was open more or less exclusively to non-bank customers, the central bank and the commercial banks were competitors. Consequently, the strong hand in the market and the role of a non-competitive bankers’ bank lending in the last resort were mutually exclusive. The commercial banks’ decentralised cash reserve proves this more than clearly. This shows, however, that the conventional wisdom argues one-sidedly by being too much oriented towards the contemporary interpretation predicating on an insufficient data base. Rather, the long-term analysis of the Bank of England's business policy since the 1844 reform shows that even during the last 25 years before the War, the profit motive remained the guiding principle for the directors of the Bank of England; or, to put it more bluntly, it was the directors’ concern for a stable dividend that appears to have prevented the metamorphosis of the Old Lady into a non-competitive, non-profit-maximizing central bank before the First World War. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Jahrbuch für Wirtschaftsgeschichte / Economic History Yearbook de Gruyter

A Private Bank as Lender of Last Resort Under the Classical Gold Standard.

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Abstract

When is a central bank a central bank? To the present day, research has failed to fully answer this question. One minority opinion is that central banking should be defined “as being associated with the issuance of central bank money”, while central bank money itself is defined “as financial money [i.e. distinguished from commodity money, D.Z.] of the highest possible credit quality, which is accepted for settlement for any other financial claim in the same way as specie money is accepted […] and which is significantly used in an economy as means of payment.” U. Bindseil, Central Banking before 1800. A Rehabilitation, Oxford 2019, p. 2. The highest possible credit quality is achieved mainly when a state, which in the eyes of its citizens upholds a responsible debt administration, either owns and operates the bank of issue itself, or endows a private bank with certain privileges. The latter are defined by a charter limited to a certain period which as such may be removed again at the end of the term. Such banks might make profits and distribute them among the proprietors, but there is a second condition for the highest possible credit quality. Banks of issue, regardless whether private or public, must manage their balance sheet in an extremely conservative way, i.e. in addition to a precious metal reserve which is regarded as sufficient by contemporary observers to maintain convertibility, investments are only in high-quality liquid and low-risk financial assets such as self-liquidating bills of exchange and short-term loans both to the private and to the public sector. According to this understanding of central banking, the Bank of England can be qualified as a central bank protecting the convertibility of Sterling into gold from 1844 on. L.H. White, Free Banking in Britain, Cambridge 1984, p. ix. Although private banks of issue continued to exist in the English provinces during this period, their right to issue bank notes was legally restricted from this point, so that there was a strong incentive to relinquish the right of issuance and develop further into deposit banks without the right of issuance: Growth potential could only be activated through accepting deposits, F. Capie/G. Rodrik-Bali, Concentration in British Banking, 1870-1920, in: Business History 24/3, 1982, pp. 280-292, here: p. 280; M. Collins, The Business of Banking: English Bank Balance Sheets, 1840-1880, in: Business History 26/1, 1984, pp. 43-58, here: p. 45. and at the same time their investment portfolios no longer had to be put together in such a conservative way as before.For the small community of both economists interested in 19th century economic history and historians specialized in monetary history, the criterion of the issuing of central bank money by a government-owned or chartered bank is not sufficient to define such a bank as a central bank rather than simply as a central bank of issue. From this perspective, a second necessary condition must be met: the role as lender of last resort for the financial market. C. Goodhart, The Evolution of Central Banks, Cambridge/ Mass. 1988, p. 86; F. Capie/C. Goodhart/N. Schnadt, The Future of Central Banking, Cambridge 1994, p. 15. Within this group there is, however, a debate about where the responsibility of a lender of last resort ends. The classical definition formulated by Walter Bagehot in 1873, can be summarized as follows: to avert panic, central banks should lend early and freely, to solvent firms, against good collateral, and at high rates, whereas good collateral is understood by Bagehot as „everything which in common times is good ‘banking security’”. W. Bagehot, Lombard Street. The Description of the Money Market, London 1873, p. 205. Lending early and freely meant, that “the rate should be raised early in the panic so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; [and that] advances should be made […] as largely as the public ask for them”. Ibid., p. 197. Taking this definition as the basis, evidence suggests that the Bank of England became a central bank during the 1870s – 1878 at the latest M. Collins, The Banking Crisis of 1878, in: Economic History Review XLII, 1989, pp. 504-527. –, although the Bank had not yet explicitly accepted its responsibility as lender of last resort. In a private letter to the economist Bonamy Price the Bank’s Governor (and merchant banker) Henry H. Gibbs explicitly rejected Bagehot’s notion of a minimum reserve. B. Price, Chapter on Practical Political Economy, London 1878, p. 519. See also L.S. Pressnell, Gold Reserves, Banking Reserves, and the Baring Crisis of 1890, in: C.R. Whittlesey et al. (Eds.), Essays in Money and Banking in Honour of R.S. Sayers, Oxford 1968, p. 182. An even more restrictive definition is taken by Nevin und Davis, who postponed the date to 1890 when the Bank of England organized a City rescue operation of the London merchant bank Baring Bros. Barings were from the point of view of both the Government and the majority of City houses too important to fail, as their collapse would probably have threatened the City’s position as the world’s financial centre and England’s position as the guardian of the international gold standard: It was „the turning point in the development of the cooperation between the Bank and the joint stock banks – traces of mutual jealousy and suspicion were now few. Such co-operation was crucial to the effective application of Bank control” E. Nevin/E.W. Davis, The London Clearing Banks, London 1970, p. 108. See also R.S. Sayers writings on the Bank, namely Bank of England Operations, 1890-1914, London 1936, pp. 116-127; and The Bank of England, Vol. 1, Cambridge 1975, pp. 28-65; Pressnell, Gold Reserves, pp. 219-224; E.V. Morgan, Theory and Practice of Central Banking, 1797-1913, Cambridge 1943, pp. 224-227; M. Collins, Money and Banking in the United Kingdom. A History, London 1988, pp. 167-171, 189-191; K. Dowd, The Evolution of Central Banking in England, 1821-1890, in: F. Capie/G.E. Wood (Eds.), Unregulated Banking. Chaos or Order?, London 1991, p. 159. or, to use Charles Goodhart’s terminology, the Bank had become a non-competitive actor on the London financial market. Goodhart, Evolution, p. 9.Admittedly it is questionable how far such a bailing out actually belongs to the role of a lender of last resort. Capie/Goodhart/Schnadt, Future, p. 65. That said, the opinion formulated by Thomson Hankey, Director of the Bank of England, in 1867 would probably find very little support today: “I should be sorry to see any interference to prevent persons overtrading or speculating. Let every one invest his own money as he pleases; let every one trade on what capital he pleases, borrow money at what rate and on what security he pleases; but the trading community must be taught […] that no such establishment as the Bank of England can provide ready money beyond a certain clearly-established limit, and that limit is the money left in their hands by their depositors”. T. Hankey, The Principles of Banking, Its Utility and Economy, London 1867, p. 25. Hankey’s statement was a response to the contemporary critique, formulated first and foremost by the Economist, of the mishandling of the crash of the London discount house Overend, Gurney & Co. by the Bank of England in 1866; and it was not simply the private opinion of a City merchant, but contemporaries considered Hankey’s statement rightly as a semi-official statement of the Bank’s Court of Directors. This fact, in turn, induced the editor of the Economist Walter Bagehot to write his Lombard Street.So let us remain with Bagehot’s definition of a central bank under the classical gold standard which is in essence widely upheld today, that „it is the proper function of the Bank of England to keep money available at all times to supply the demand of banks which have rendered their assets unavailable.“ Bagehot, Lombard Street, p. 83. The acceptance of this responsibility required, besides a specie reserve sufficient to safeguard convertibility, a substantial banking reserve (consisting of Bank of England notes and coin) to meet the demand of the market in times of panic and, as a second line of defence, a highly-liquid investment portfolio consisting of short-term loans und, even more so, of self-liquidating assets such as commercial bills of exchange.But did the Bank of England keep money available for this purpose? John Clapham and Richard Sayers, the two authoritative historians of the Bank of England under the classical gold standard, would probably have answered in the positive, and most of their successors too. A more sceptical view is held by J.H. Wood, A History of Central Banking in Great Britain and the United States, Cambridge 2005, pp. 109-113. However, the portfolio management of the Bank was unknown, both for contemporaries and for subsequent historians. They looked at the policy of the Bank as pursued during the last decades before the First World War and found no fundamental dissent from what Bagehot would have expected the Bank to do.I will argue in this paper that the gradual commitment to the duties of a modern central bank by the Bank of England during the last decades before the First World War, the acceptance of its role as lender of last resort in particular, is not as obvious as it seems to be: For the resources that would have been available to the Bank as lender of last resort to combat a severe financial crisis were much smaller than contemporaries had assumed. The Bank of England was a privately-owned bank from which shareholders expected dividend payments at a level that was not always easy to generate, and which required measures that were mostly incompatible with its role as lender of last resort.The balance sheet, as published by the Bank on a weekly basis, was the only publicly available source to assess the Bank’s willingness to organize its investment portfolio as conservatively as expected, but it in fact disguised more than it displayed. An extremely conservative balance sheet management by its Court of Directors remains more or less unquestioned and must, as such, be taken for granted – at least so long as it was not possible to see behind the curtain of the published balance sheet.As regards the protection of the gold standard, that is, the redemption of the Bank’s notes into gold, the mechanism worked well after 1866, when the 1844 Bank Act and its limits to the fiduciary issue of Bank of England notes had been suspended for the last time before the First World War. As was stated above, the Bank needed a precious metal reserve that was regarded to be sufficient for that purpose by the informed public. The separation of the Bank of England into an Issue Department and a Banking Department in 1844 had installed an automatism that prevented the overissuing of bank notes by the Issue Department (see appendix). The problem that money was more than simply coins and bank notes, and that the growing amount of book money deposited at the commercial banks was not included in the redemption-protection-mechanism of the Issue Department never became acute during these final decades before the War.The reason for this success was the conduct of the Banking Department which brought the bank notes issued by the Issue Department into circulation. In order to have a certain room to manoeuvre in times of crisis the Banking Department kept a cash reserve, consisting mainly of bank notes convertible into gold at the Issue Department, that was substantially larger than the cash reserve of an ordinary commercial bank. Problems did not arise simply because of stable expectations of market participants, who reacted in a manner so that any stress upon the Banking Department’s reserve was immediately eased. The market or rather the economic journal press defined a minimum amount of that reserve. The closer the actual reserve came to that minimum, £10m in the 1870s, and later £15m and £20m respectively, the more likely became a decision of the Bank’s Court of Directors to raise the Bank Rate of discount. The London money market, in expectation of rising interest rates, acted accordingly. Finally, the higher interest rate level in London resulted in an influx of gold from abroad, so that the Issue Department provided additional Bank notes to the Banking Department and thus strengthened automatically the latter’s cash reserve.As Charles Goodhart has pointed out, this sequence of reaction demanded either a fairly tension-free relationship between the Bank and the financial intermediaries of the London money market, the big London commercial banks in particular, or the control of the market in order to enforce the market to follow its command in case of need. Goodhart, Evolution, p. 54. Both strategies, however, required certain preconditions. In the former case the central bank had to face the market as a noncompetitive, non-profit-maximising bankers’ bank and in the latter case the central bank needed a close contact with and even a strong hand in the market.A strong hand in the market meant that the Bank acted as an important creditor in the money market, at best as a backbone of the other financial intermediaries. However, discount houses and bill brokers were excluded from the Bank’s Discount Office in 1858 and the London based commercial banks did on principle not rediscount at the Bank. As a consequence, the Bank’s Discount Office was open more or less exclusively to non-bank customers, i.e. partly overlapping with the clientele of the commercial banks. Thus, if the Bank’s (re-)discount business was active enough to have a strong hand in the market, the commercial banks, who provided for a large part of the Bank’s interest-free Other Deposits, might no longer be prepared to release a substantial part of their liquidity reserve to a major competitor. Under the given institutional circumstances, the strong hand in the market and the role of a non-competitive bankers’ bank were mutually exclusive.Whether the Bank had the resources at its disposal to act as a major player on the money market or not, can only be assessed if the composition of the Bank’s Other Securities is known. If the Bank did not have a strong hand, because it had to have consideration for the commercial banks, the composition of the Other Securities must also be known, since, as Bagehot had stated, “the best palliative to a panic is a confidence in the adequate amount of the Bank reserve, and in the efficient use of that reserve”. Bagehot, Lombard Street, p. 207. A sine qua non of this confidence in the Bank’s willingness to overcome a panic was the trust also in the second line of defence, Charles Goodhart is very clear on this point, too, by demanding that “financial intermediaries providing payments services should hold only marketable securities”. Goodhart, Evolution, p. 96. a high-quality liquid and low-risk investment portfolio subsumed in the balance sheet item Other Securities. However, the rate of return on such a portfolio is low, so that the Bank must fulfil the second precondition for a central bank, as defined by Charles Goodhart who argued that “it was the metamorphosis from the <central banks’> involvement in commercial banking, as a competitive, profit maximizing bank among many, to a noncompetitive nonprofit-maximizing role that marked the true emergence and development of proper central banking.” Ibid., p. 9; see also Idem, Are Central Banks Necessary?, in: Capie/ Wood (Eds.), Unregulated Banking, p. 11.Whether this step had been undertaken in Britain already before the First World War, however, has only rarely been challenged. John Pippenger has for some time argued that the policy of the Bank of England before the First World War was still determined by “the conflict between its statutory and commercial duties. For example, an upswing in business activity tended to make earning assets more attractive as interest rates rose, but the increased activity also posed a threat to convertibility.” J. Pippenger, Bank of England Operations, 1893-1913, in: M. Bordo/A. Schwartz (Eds.), A Retrospective View on the Classical Gold Standard, 1821-1931, Chicago 1984, p. 209; see also M. deCecco, Money and Empire. The International Gold Standard, 1890-1914, Oxford 1974, p. 99; G. Ingham, Capitalism Divided? The City and Industry in British Social Development, London 1984, p. 164. This means that the Bank was prepared not to act according to its duties as a modern central bank when it felt a threat to its profit-earning capacity. In a very straightforward manner Pippenger criticized that “the conventional wisdom tends to forget that the Bank was private and had to pay dividends.“ Pippenger, Bank, p. 217. In a direct reply, Charles Goodhart rather defended the “conventional wisdom” by claiming that in the case of the Bank’s attempt to increase its market share in the discount business the profit argument only holds if the Bank sought to maximize profits, but as Pippenger admitted, the Bank was only concerned to maintain its profits. C. Goodhart, Comment, in: M. Bordo/A. Schwartz (Eds.), A Retrospective View on the Classical Gold Standard, 1821-1931, Chicago 1984, p. 224.The conditions for the production of profits, however, are not stable. They vary with the ebbs and flows of the business cycle, in the case of banks of issue especially with the variations of interest rates in the money market; and it is even possible that yields on certain classes of assets display a declining trend lasting longer than a normal cyclical movement of interest rates. A policy aiming to maintain the rate of profit may thus require measures for certain periods very similar to a policy aiming at the maximization of profits. Unfortunately, up to now nothing has been established about the conditions under which the Bank consistently generated a net profit of between £0.65m and £0.7m per half year. Only the intimate knowledge of the Bank’s reactions to changing market conditions enables observers to assess whether the Bank of England had already undergone the metamorphosis from a competitive bank among many into a non-profit-maximizing central bank before the First World War.This paper will examine the question of continuity and discontinuity in the Bank of England’s understanding of its role in the money market before and after the publication of Bagehot's Lombard Street, as well as the significance of its crisis management during the Baring crisis for the final acceptance of its role as lender of last resort until the First World War, as shown by the Bank’s management of its asset portfolio in the unpublished internal balance sheets.1Portfolio Management Before BagehotAlmost every downswing in business activity resulted in a steep decline in the Bank’s customers’ demand for short-term loans and discounts. Each time the Bank responded by reallocating its asset portfolio, i.e., mostly by diversifying the composition of its investments. Apart from an abortive attempt to invest in mortgages in the early 1820s, the Bank invested only in Government stock up to the 1830s. Correspondingly, the return on its investment portfolio was relatively low. Since the income derived from the discount of bills of exchange was relatively stable throughout the 1820s and 1830s (only shifting from Threadneedle Street to the provincial branches), D. Ziegler, Central Bank, Peripheral Industry. The Bank of England in the Provinces 1826-1913, Leicester 1990, tab. 2.4, p. 18. the aggregate net profits were also stable, and the Bank was able to pay a regular dividend of 8 percent per year between 1823 and 1838. In 1839, however, the decrease in Head Office’s discount business forced the Bank to reduce its dividend to 7 percent. Additionally, in the early 1840s the profits derived from the provincial branches also decreased so that even the 7 percent dividend was threatened, and the Bank was in danger of having to pay the lowest dividend since 1787.Under these circumstances the Bank entered into a new market: it began to lend long-term, first to the leading English railway companies, and secondly to provincial municipalities (corporation bonds), where Bank of England branches were located. The advantage of such loans was twofold: they partly absorbed the ”surplus funds” set free by the decreasing demand for discounts and they yielded a higher return than the alternative of investing in Exchequer Bills and Government Stock. British Parliamentary Papers 1847/48, vol. 8, Secret Committee on Commercial Distress, part 3, evidence Morris and Prescott, q. 406. The price which the Bank had to pay was the lock-up of an increasing portion of its assets, because the credit period of the railway loans was between three and seven years, while the corporation bonds were granted as instalment loans, which were to be repaid by annual instalments over up to thirty years. In both cases there was almost no possibility of unloading this burden at the Stock Exchange.Shortly afterwards, the Bank Charter Act of 1844 officially freed the newly formed Banking Department of the Bank of England from any obligation towards the public and enabled the Bank even in its discount business to pursue a more profit-orientated policy. Consequently, the Bank strengthened its competitiveness by introducing a relatively flexible instead of a fixed rate of discount, which was adjusted to the conditions on the money market. This new competitive attitude allowed it to increase the turnover of bills of exchange in London by 1,000 percent in three months. Despite the significantly lower average rate of discount, the Bank already achieved in 1845 a higher income from this source than in 1843. When interest rates rose in 1846 and 1847, the interest received from discounts in London increased to £191,000 and £325,000 respectively (compared to £7,700 in 1843) so that in 1847 and 1848 the Bank was able to pay a dividend of 8 percent per year and in 1849 one of 9 percent per year.A higher portion of bills of exchange in the Bank’s portfolio naturally meant that the Bank’s profits became extremely dependent on general business activity, because both the turnover of bills and the rate of discount tended to move in the same direction. Consequently, in the early 1850s problems arose when demand fell off again and the interest received went down to £76,000 in 1852 (Head Office and branches). The absorption of the surplus funds by investing in loans for railway companies was obviously no solution, since the collapse of the credit demand from an average of £11.4m in 1847 to £3.6m in 1852 was too large to be offset by this channel. The Bank had already invested more than £3m in railway loans (or 12 percent of its interest-bearing assets) All data concerning the half-yearly balance sheets and profit and loss accounts are taken from Bank of England Archive (BofE), Stock Estimates (ADM 19). and the figure rose to more than £4m or 15 percent of the interest-bearing assets in February 1854 (see Table 1). By this time the Bank of England was probably the most important single creditor of a couple of railway companies. D. Ziegler, Das Korsett der Alten Dame. Die Geschäftspolitik der Bank of England 1844-1913, Frankfurt/Main 1990, p. 41 (n. 19).Tab.1Long-term Loans to British Railway Companies Held by the Bank 1842‒1854 (£000).DateAmountAugust 1842125February 1843475February 1844716February 18451,451February 18461,853February 18472,267February 18482,072February 18492,467February 18503,023February 18512,622February 18523,103February 18533,749February 18544,045Source: BofE, Stock Estimates.By the middle of the 1850s the Bank had almost doubled its holding of non-government investments compared with the early 1840s. Although most of them were lock-ups, the Bank kept to its strategy. The declining activity of the discount business after the crisis of 1857 was immediately offset by a further increase in investments (see Figure 1). The average holding of non-government investments in 1858 increased by about £2m (or 22 percent) in only one year. By this time, it consisted of aboutFig. 1Sample caption The Bank of England Portfolio 1845-1913 (£000). Source: Dieter Ziegler, Das Korsett der Alten Dame. Die Geschäftspolitik der Bank of England 1844-1913, Frankfurt/Main 1990, p. 31.– £3.5m in railway loans,– £2m in loans to local authorities (other than City Bonds),– £2m dock and canal company debentures,– £2m East India securities, of– somewhat less than £1m in City Bonds and of– £0.3m in loans on mortgages.Their aggregate portion of all interest-bearing assets made up more than 35 percent during the late 1850s and early 1860s.This portfolio composition enabled the Bank to keep the dividend at the attained level even during the years of cyclical downswing, especially since interest rates remained relatively high throughout the first half of the 1860s. Although there should have been no inducement for innovation, the Bank diversified its portfolio composition again, namely by Government Securities. This time, however, the choice was dictated not by the strain on the dividend, but most probably by a request from the Treasury which had guaranteed some foreign and colonial loans as well as a loan of the Metropolitan Board of Works and which was strongly interested in the success of these loans. See BofE, Committee of Treasury Minutes No. 40, 07.12.1892. In general, the Bank declined any government interference in its investment decisions, Examples can be found in D. Ziegler, Zwischen Gurney und Baring. Die Geschäftspolitik der Bank of England, 1867-1890, in: Bankhistorisches Archiv 12, 1986, pp. 67-95. but in this case the Bank accepted the request, because the Treasury offered an important inducement. The yield on these loans was substantially higher than the yield on Government stock. An exchange of these loans for a certain portion of British Government stocks in the Bank’s portfolio consequently meant a higher average return on Government Securities.This became an important factor during the next depression. By the late 1860s the guaranteed loans made up more than 50 percent of the Bank’s Government Securities. Additionally, after the crisis of 1866 the railway companies came under heavy pressure and had to offer very high rates of interest for the prolongation of their loans. Both developments resulted in the highest average return on the Bank’s portfolio for the whole period under review (see Table 2). On the other hand, the decrease in the credit demand was felt even more strongly than before, since it followed a long-lasting period of very high demand (see Figure 1). Additionally, its impact on the Bank’s earning capacity was aggravated by an extremely low interest rate level which was only partly offset by the high average return on the Bank’s investment portfolio. Consequently, the dividend came under pressure again. To invest the surplus funds in railway loans was obviously not desirable because of the general uncertainty concerning the financial situation of even the first-class railway companies. P.L. Cottrell, Railway Finance and the Crisis of 1866, in: Journal of Transport History 3, 1975/76, pp. 20-40, here: p. 29. The Bank had to look for an alternative. The debenture bonds of Indian railway companies carrying a state guarantee of interest payments were some sort of natural alternative in this situation: a new step in the Bank’s portfolio diversification was taken. It should be noted that this decision met serious opposition amongst the directorate. As there were some directors who were connected with British railway companies by kinship relations, it is very probable that these persons fought for additional assistance for British companies (see BofE, Court Minutes No. 90, 11.07.1867), while the then Deputy Governor Crawford was chairman of the East India Railway Co., which was the first Indian railway company connected with the Bank in this way.Tab. 2Average Return on Assets Held by the Bank of England, 1865/66-1889/90 (%).PeriodShort-term SecuritiesGovernment InvestmentsOther InvestmentsAssets Total1865/66-1869/704.53.54.24.01870/71-1874/753.63.454.03.71875/76-1879/803.353.53.83.61880/81-1884/853.63.33.63.51885/86-1889/903.43.453.63.5Source: BofE, Stock Estimates.By 1870 the English capital market was not yet perfected. Diversification of the investment portfolio consequently meant a serious lock-up of resources. Of all banks in England, the Bank of England, the central bank of issue, had most probably the highest portion of lock-up assets in its portfolio. By the late 1860s it had invested in between £12m and £13m lock-up securities, that is,– about £6.2m in Metropolitan Board of Works loans; £4m of this amount was guaranteed by the Treasury (instalment loan not traded at the Stock Exchange; duration until mid-1880s). The rest was an ordinary non-Government loan (to be repaid by annuity until the late 1890s). In 1869 the Treasury forced the Bank to convert at least a substantial part of these loans into the new Metropolitan Consolidated Stock. Despite the improved marketability of the Stock (compared to the loan) the Bank was not prepared to meet the Treasury’s wish voluntarily, because the Stock's rate of interest was lower. Finally, however, the Bank agreed “upon public grounds as far as it may be in the directors’ power to do so with proper regard to the interests of the Bank”. See BofE, Secretary’s Letter Books (G 23), 03.11.1869.– about £3.3m in railway debenture bonds;– about £0.9m in dock company debentures;– about £0.7m in canal company debentures;– about £0.7m in corporation bonds (excluding the above-mentioned Metropolitan Board of Works loan and the more marketable City Bonds);– about £0.5m in Indian railway company loans.In sum, the illiquid and not readily available portion of all assets (including cash) made up a total of between 35 percent and 40 percent. The masse de manoeuvre was very small indeed and the Bank had to be most careful as regards its role as lender of last resort. A Bank of England director, having this portfolio composition in mind, might not have argued in a different manner than Director Hankey did in 1867. Even when the Bank increased its contribution to high-powered money held by the private sector, See T. Ogden, An Analysis of Bank of England Discount and Advance Behaviour, 1870-1914, in: J. Foreman-Peck (Ed.), New Perspectives on the Late Victorian Economy, Cambridge 1991, pp. 306-309; M. Collins, The Bank of England as Lender of Last Resort, 1857-1878, in: Economic History Review XLV, 1992, pp. 145-153. the market had every reason to believe the directors that this was no predictable action in the case of liquidity crises. The relief during the mid-nineteenth century crises The Bank’s lending activities must not be regarded as a relief action which was effectively helping the whole market, but applied only to a small segment. Other segments were excluded by certain institutional constraints (as regards the conditions on which the Bank was prepared to lend) and on credit rationing on the part of the privileged segment. See Collins, Banking Crisis of 1878, pp. 504-527; D. Ziegler, The Banking Crisis of 1878. Some Remarks, in: Economic History Review XLV, 1992, pp. 137-144. depended, in fact, on the commercial banks’ willingness to increase their own reserves at the Bank of England. If the banks were forced to resort to their reserves deposited at the Bank of England themselves, the impact on the Bank’s lending activities would have been disastrous.2Did Bagehot Matter? The “Greatest Investment Bank in the World” 1873‒1900During the 1870s and 1880s the English capital market developed very quickly. Railway companies and local authorities in particular converted their debts into marketable debenture stocks. Less risk, however, meant a lower return for the investor. The average nominal yield on railway debenture stocks, for example, fell decisively during the last quarter of the 19th century. It was most probably the fear of a lower return on its investments as well as the risk of a fall in the market price of such stocks that prevented the Bank from unloading its lock-ups as fast as possible. Although such conversion was to be expected from the protector of Sterling convertibility – not to speak of a lender of last resort for the London and provincial money markets –, it was only the success of the debenture stocks in the market that finally induced the Bank to convert its lock-up securities into marketable stocks. The stocks’ success put the railway companies in a very strong position when they negotiated the prolongation of the old loans. The Bank could either accept the conversion of loans into stock or had to agree to a lower rate of interest. Otherwise, the railway companies would have repaid the loan and prepared the issue of additional stock in the market. See S. Broadbridge, Studies in Railway Expansion and the Capital Market in England, 1825-1875, London 1970, pp. 97-98; Ziegler, Gurney, pp. 79-82.As a result, the declining return on the Bank’s aggregate portfolio put the dividend under pressure again (see table 2). Additionally, the structural crisis of the bill of exchange as means of payments and credit, which began in the mid-1870s, S. Nishimura, The Decline of the Inland Bill of Exchange in the London Money Market, 1855-1913 Cambridge 1971, pp. 24-25. led to an immediate collapse of the discount business. Contrary to the commercial banks, this development could not be offset by an increase in short-term loans because of the Bank’s strict regulations concerning the terms of such loans. As early as in 1877 the portion of the short-term securities in the Bank’s portfolio had fallen to 17 percent of all interest-bearing assets – the lowest figure for 25 years. It may be seen as an emergency action that the Bank invested £3.3m net in stocks in 1876 and thus increased its investment portfolio by more than 13 percent in less than two years (see Figure 1). As a supplementary measure the Bank introduced a special rate of discount for sole customers in Threadneedle Street BofE Court Minutes No. 100, 31.01.1878 and 14.02.1878. in order to halt the decline in the number of clients, which had similarly fallen since the early 1870s. Number of discounters in Threadneedle Street in 1871: 438 and in 1876: 276. BofE, Special Discount Committee Reports (C 35 No. 4). In the medium term, however, this measure provided no significant relief for the discount business. Between 1878 and 1883 the special rate was only rarely charged. See BofE, Special Discount Committee Reports (C 35 No. 4 and C 35 No. 5). By the late 1870s the Bank of England had become ”the greatest investment bank in the world”, as the Bankers’ Magazine rightly surmised in 1880. Bankers Magazine Vol. 40, p. 903. It is not known on what data this claim was based. The only conceivable sources are likely to have been either a whistleblower from Court of Directors’ circles or among those Bank clerks who were in charge of the accounts or simply stock market rumours. In any case, officially accessible sources cannot have been the basis for this claim.Investment in railway stocks, however, would have meant that the decline in the average return on the investment portfolio accelerated. A new step in the portfolio diversification was inevitable. Up to the mid-1870s the Bank had always declined requests for lending to colonial governments. Exceptions were only made when the British Government was prepared to guarantee these loans. Under the circumstances of the moment, however, the directors abandoned the Bank’s rule to lend long-term only to debtors on which the Government or at least Parliament had some influence and decided to invest £1m in bonds of seven colonial governments (such as Cape of the Good Hope, Canada and Victoria). BofE, Court Minutes No. 99, 28.09.1876. This margin was quickly exceeded and in 1883 the Colonial Government Securities in the Bank’s portfolio had already reached the level of the Railway Securities with a share of 8 percent of all interest-bearing assets. In 1885 its portion made up 12 percent, by this time the largest single item of all non-(British-)Government investment (see table 3).Tab. 3Colonial Government Loans Held by the Bank of England, 1877‒1885 (£000).DateAmountFebruary 18771,162February 18781,290February 18791,203February 18801,312February 18811,400February 18822,307February 18833,048February 18843,044February 18854,218Sources: BofE, Stock Estimates.The reason for this particular step in the Bank’s portfolio diversification was twofold. First, the return on these bonds was significantly higher than the return on those debenture stocks the Bank had invested in during the first half of the 1870s (including the converted loans). The profit motive behind this decision becomes obvious from the fact that from about the mid-1870s the Bank bought only second rank railway debenture stocks, in which it had never invested before and which, moreover, yielded a higher return compared to the old-established ones. Secondly, the creditor relations with colonial governments opened up a new source of income, because from the late 1870s the colonial (bearer) bonds were converted into (registered) stocks. This meant that the colonial governments needed a London bank for the issue and management of their debts. In their view, the Bank of England with its unique prestige and with its long-lasting experience in the issue and management of the British and Indian Government debts was certainly a well-suited bank for these services. This held especially for the 1880s when the Treasury prohibited the intermediation of the Crown Agents in the issue of colonial loans in order to demonstrate the exclusive responsibility of the dominions for their debts. T. Schilling, London als Anleihemarkt der englischen Kolonien, Stuttgart 1911, p. 38. In this particular situation, dominion governments might have thought that only the Bank of England acting as the issuing house for their loans could make good this enforced (and costly) stipulation.The Bank’s first customer was the New Zealand Government for which it had issued a loan already in 1878. A few years later it managed the conversion of different loans into the newly created New Zealand Government Stock. Until the mid-1880s the Bank acted as the issuing house for the New Zealand, New South Wales and Queensland Governments and even for some larger provincial towns such as Liverpool, Birmingham, Nottingham, Swansea, Hull and Wolverhampton. BofE, Capital Issues (C 16 No. 1). The gross income derived from debt issue and management rose from less than 15 percent of the Banking Department’s gross profit to more than 20 percent in the second half of the 1880s. Additionally to the profit-taking achieved by the selling of the railway debenture stocks in which the Bank had invested in the mid-1870s and which had undergone a slight but steady price appreciation, BofE, Stock Estimates, Profit and Loss Accounts; Ziegler, Gurney, pp. 88-91. these new sources of income more than offset the substantial decrease in the interest received from discounts and short-term loans. Consequently, despite the lowest business activity of the discount offices in London and at the provincial branches the Bank paid the highest average dividend during the 1880s compared to all other decades of the period under review.From the late 1880s, however, the investment bank scheme entered into a crisis, since the return on all asset classes in which the Bank was prepared to invest had decreased significantly. The Bank could, therefore, create additional surplus funds neither by a continuous reduction in the discount business nor by the selling of investments in order to realize an extra profit from price appreciation. Secondly, from the late 1880s and especially since the Baring crisis in 1890, the demand for new colonial (especially Australasian) loans in London fell off. Equally, the gross profit derived from the issue of these loans decreased while the gross profit derived from debt management stagnated. In this situation the Bank had two options: either a new portfolio diversification (such as the purchase of American railway bonds or British railway shares) resulting in a higher average return on the investment portfolio, or the return to a bank of deposit portfolio structure (i.e., an increase in the proportion of bills of exchange and short-term loans).In the late 1880s the Bank was obviously not prepared to take the risk of investing in securities the short-term price fluctuations of which were substantial and in 1888 the special rate of discount was introduced at the provincial branches and both the Chief Cashier at Head Office and the branch agents were granted discretion in the fixing of short-term loan rates. BofE, Court Minutes No. 110, 26.01.1888. Additionally, the Bank began to lend on the Stock Exchange at first on customers’ account only (1890) It is not yet clear, when the Bank began to lend on the Stock Exchange. Sayers found evidence even for 1882 (Bank of England, Vol. 1, p. 20). More important than such early cass, however, was the ‘Hampshire County Council Agreement’ of 1890, because from then on the Bank lent on customers’ account with its own full responsibility for repayment. See Economist 22.02.1890; J. Clapham, The Bank of England, Vol. 2, Cambridge 1944, p. 346. and later (1893) its own (“surplus”) funds, too. Finally, in 1890 bill brokers and discount houses were allowed to re-discount at the Bank, provided the bills did not have more than 15 days to run, at the discretion of the Governor. BofE, Court Minutes No. 113, 24.07.1890.In contrast to the interpretation in this paper, which at this point follows John Clapham's account from 1944, Clapham, Bank, p. 357. Richard Sayers in his three-volume history of the Bank of England from 1976 sees the (re)admission of the bill brokers and discount houses to the rediscount at its Discount Office as a decisive step towards assuming responsibility for the functioning of the London financial market: “The days of isolationism […] were over, and it was now the policy of the Bank to make firms in the market more reliant on facilities at its Discount Office. In doing so, the Bank added something to its earning capacity, but this was an incidental result, not the object of the changes.” Sayers, Bank of England, p. 34.The immediate reason for this reform, however, was not the directors’ attempt to “control the market”, but rather a motion of the most important “commercial banker” amongst the Bank of England directors. In June 1890 Thomson Hankey, who had “never abandoned the circumspect attitude that had been criticized by Bagehot” (John H. Wood), Wood, History, p. 111. proposed to abandon the practice of publishing the Bank rate of discount. According to the practice of its competitors, the Bank should discount at individual (= flexible) rates. Hankey’s objective was not only the reconstruction of the “bank of deposit” portfolio, but, as it had been 25 years ago, that the Bank of England should become an ordinary bank of deposit itself. Although the directors were not prepared to follow their colleague in such a radical manner, they set up a “Special Committee to consider the management of the discount business.” BofE, Court Minutes No. 113, 12.06.1890. This Committee proposed the bill brokers’ reform to the Court of Directors only one month later, as an alternative device of “getting discounts”. BofE, Court Minutes No. 113, 24.07.1890.The sequence of events gives every reason to believe that this decision formed a major part of a set of reforms with the primary objective of increasing the Bank’s competitiveness. As Sayers himself admitted elsewhere, the flexibilization of the discount rate was nothing more than an attempt to “avoid the loss of income”, resulting from its inflexibility. Sayers, Bank of England Operations, p. 2. Similar comments were made about the Bank’s lending to the stock market. Idem, Bank of England, p. 20. Indeed, there is no reason to believe that the bill brokers’ (re)admission, enacted “at the same time”, was, as Sayers put it, “intended to give the Bank rate fresh significance” Idem, Bank of England Operations, p. 3.. If anything, all named measures showed the opposite to a special concern to regain a strong hand in the market and, even worse, they were a major obstacle for a better cooperation with the commercial banks, the funds of which were needed to build up a higher central bank reserve.In the medium term, however, the reforms of 1888-1890 did not work as well as it was expected. After a relatively short period of remarkable success, The success, however, was partly due to the high interest rates during the aftermath of the Baring crisis as well as to a £4m loan for Barings as part of the City rescue operation. See Bankers' Magazine Vol. 57 (April 1894), p. 595 and Vol. 58 (October 1894), p. 530. when the interest received from bills of exchange and short-term loans made up more than 25 percent of the Banking Department’s gross profits in 1890-1893 (compared to between 10 percent and 15 percent during the 1880s), demand fell off again. Since the Bank was forced to sell investments in order to make room for the short-term securities in 1890 and 1891, the reduction in the credit demand in the mid-1890s resulted in the Bank’s most serious profit crisis for the whole period under review. Contrary to the 1880s, the remaining investment portfolio was all too small The income derived from investments was as low as about £660,000 in 1894/95 compared to more than £lm per year in the 1880s. BofE, Stock Estimates, Profit and Loss Accounts of the respective years. to make up for the reduction of income derived from short-term securities. Only the provincial branches were able to avoid a collapse similar to that which occurred during the late 1870s and mid-1880s, Ziegler, Central Bank, tab. 2.16, p. 61. while in London the turnover of bills was as low as during the mid-1880s. Moreover, the interest payments received were even lower, since interest rates were below their former depression levels. It was only the mobilization of hidden reserves that enabled the Bank to keep its dividend at some 4 percent to 4.5 percent per half year. The net subsidy in the two half-year-balances ending August 1894 and February 1895 was £100,200 (or 14% of current gross profits) and £109,900 (or 16% of current gross profits) respectively. (Ziegler, Korsett, tab. 5, p. 64). The most important single source for these subsidies was a profit of £143,900 derived from dealings in Liverpool 3.5% Stock and accumulated since 1881 (BofE, General Ledger Supplements).In 1895, however, these resources had been used up without any prospect of improvement. Even further relaxations of the regulations concerning the terms for the re-discount of bill brokers’ bills (extension of the duration of bills rediscounted to 30 days) BofE, Court Minutes No. 116, 08.02.1894. had almost no impact. Consequently, the Bank reacted as it had reacted for decades in such situations: it invested, and in this particular situation even more heavily than before. The interest-bearing assets in the Bank’s portfolio increased by £11.5m (or 35 percent). Although the Bank continued its attempts to increase its competitiveness (extension of the duration of bills re-discounted to 63 days and the introduction of an official Stock Exchange rate) BofE, Court Minutes No. 118, 23.05.1895, 25.06.1895 and 05.09.1895; Sayers, Bank of England, p. 20. the investment bank portfolio structure was restored. As in former cases this growth was accompanied by a diversification of the Bank’s portfolio. Because of the extremely low interest rate level all fixed-interest-bearing investments fetched uniquely high prices. Investment in these classes of securities consequently meant first an extremely low return on the Bank’s funds and secondly a very high risk of price depreciation when interest rates rose. On the other hand, by the mid-1890s equity stocks such as railway shares paid relatively poor dividends and were thus quoted at relatively low prices. When interest rates rose, the Bank could also expect an increase in business activities so that companies were expected to pay higher dividends with corresponding effects on the share prices. These considerations might have induced the directors to part with the Bank’s (and English banks’ in general) C. Goodhart, The Business of Banking, London 1972, pp. 127-141; see also J.J. Madden, British Investment in the United States, New York 1985, p. 85. tradition not to invest in equity, as they decided to purchase about £0.5m (market value) ordinary stocks of three leading British railway companies. BofE, Court Minutes No. 118, 19.09.1895. Additionally, the Bank invested in more than £3m foreign state loans These investments were only meant as a temporary employment of a special deposit. BofE, Stock Estimates; Morgan, Theory, p. 208. so that the importance of the 1895 portfolio diversification can be regarded as second only to the decision to lend long-term to English railway companies in 1842.3Ostensible Strong Hands and Disguised ProfitsWhen the depression was over in 1897 the reforms of the years 1888 and 1890 proved to be fully as important as the Bank had expected. Demand for discounts and short-term loans rose significantly during the cyclical upswing of the late 1890s and remained high throughout the years after the turn of the century until the First World War (Table 4).Tab. 4Composition of Interest-Bearing Assets of the Bank of England Banking Department (%).186118861911British Government Securities36.542.531.036.542.531.0Other Securities- Railways16.511.25.6- Docks, Canals etc.9.33.84.1- Corporation6.911.87.6- India7.78.12.6- Colonial/Foreign Governments-10.010.2- Loans on Mortgage1.4--41.844.930.1Advances on Securities2.88.920.2Bills Discounted19.03.618.821.812.539.0Source: BofE, Stock Estimates.The interest received from this source increased to more than 35 percent of Banking Department’s gross profits (1906 and 1907: the highest figure since the 1860s), and only once did it fall below the 20 percent-margin (1909: a margin which was only once surpassed during the years of the investment bank). Contrary to its first attempt to reconstruct the bank of deposit portfolio in the early 1890s, the Bank could keep its investment portfolio and consequently increased its interest-bearing assets by an average of £8m (or more than 20 percent).It was a substantial increase in the private sector deposits that enabled the Bank to pursue such policy. One reason for this development was the Bank’s success in attracting higher commercial bank deposits. The Bank argued – and was supported by the Treasury – that it defended convertibility and needed thus both a strong hand in the market and a high central bank reserve. This was to be achieved by additional non-interest-bearing funds deposited by the commercial banks at the Bank of England. Pressnell, Reserves, pp. 208-219; Sayers, Bank of England, p. 60. The structure of the Bank’s portfolio, however, shows that these funds were only partly used for central bank purposes such as a higher reserve. Instead, they were mainly used to increase the gross profits of the Bank of England.Higher profits, however, did not result in higher dividends as in the 1880s. Instead of distributing between 98 percent and 102 percent of its net profits, Ziegler, Gurney, appendix, p. 95. the Bank transferred each half year up to several hundreds of thousands of pounds to an account Unappropriated Profits, which was kept separate from the Rest of undistributed profits in the published balance sheet and which remained, therefore, invisible for the public, including the Bank’s shareholders. This accounting operation enabled the Bank to re-build the hidden reserves which had been used in the early phase of the depression and, to put it pointedly, the Unappropriated Profits became de facto a dividend equalization account. In absolute terms and following its former practices the Bank had been able to distribute 5.25 percent to its proprietors for the half year ending September 1899 and at the turn of the following five half-years even 5.75 percent each. Yet, there can be no doubt that an increase in the Bank’s dividends would have strengthened the arguments of the commercial banks which claimed that the Bank had become unfairly competitive in the market. From their point of view, being induced to deposit additional funds at the Bank of England meant providing ammunition for a most serious competitor. An impressive account is given in R. Fulford, Glyn's 1753-1953, London 1953, pp. 212-217. See also F. Schuster, The Bank of England and the State, Manchester 1906, p. 28. For the reaction of country bankers, see Goodhart, Business, p. 180 (n. 15).Had the Bank of England really been concerned to act as a non-competitive, non-profit maximizing central bank, it could have liquidated its investment holdings and thus have created sufficient funds to meet its obligations as demanded by the contemporaries, i.e., the protection of both Sterling convertibility (until war conditions would have rendered this task impossible even with a substantially larger reserve) and the liquidity of the money market(s). The Bank’s investment portfolio was built up in times when the Bank was unable (or unwilling) to invest its funds in short-term securities and it could thus be liquidated when this inability (or unwillingness) had gone. During the first decade of the 20th century the Government Securities and the investments amongst the Other Securities made up about £15m each. Such an amount of investment was in no way necessary to fulfil central bank obligations. For its open market operations, an instrument to make the hand in the market even stronger, the Bank used a maximum of a few millions, mostly of Government Securities. Clapham, Bank, pp. 295-296.The Bank’s investments – altogether about two thirds of all interest-bearing assets of the Banking Department – were only used to level the extremely fluctuating yields on the short-term securities’ portfolio and to employ surplus funds; in short, they were used in order to keep the dividend at between 8 percent and 10 percent per year. This was true even before the First World War, since the final step in the Bank’s portfolio diversification was undertaken in 1912. But this time it could not even be argued that it was a depression creating surplus funds which forced the Bank to look for employment. On the contrary, it happened during a cyclical upswing when private sector deposits increased by an unusually high amount of about £5m and when demand for discounts and short-term loans increased by the usual amount of about £2m. Contrary to its pretended policy, the Bank did not use the additional funds to increase the central bank reserve but rather purchased new investments. The reserve only rose by about £0.5m, while the investment portfolio increased by about £1.8m and was diversified by colonial non-government stocks and bonds of Canadian and US railway companies (see Table 5).Tab. 5Colonial and Foreign Investments Held by the Bank of England 1908-1914 (£000).DateColonial GovernmentForeign SecuritiesColonial non- Gov. SecuritiesUS-Railroad BondsFebruary 19082,768262--February 19094,534754--February 19104,379790--February 19114,148678--February 19125,5221,217318-February 19135,0359141,058860February 19147,3859851,0301,223Sources: BofE, Stock Estimates.Contemporaries were not in a position to detect this policy. Since the Bank’s balance sheet summarized such different items as short-term loans, bills of exchange and non-(British-) Government investments, many of them hardly marketable in times of crisis, under one head (Other Securities), contemporaries might have thought that an increase in the Other Securities had resulted from a larger demand for short-term loans and discounts – from the strong hand. If they had known the real reason for the unsatisfactory impact of the additional deposits on the central bank reserve, no doubt, indignation would have been general; especially if they had known the impact on the Bank’s gross profits. In 1912 and 1913 the Bank wrote off altogether £1.35m on its investments. About 70 percent of this enormous figure, which was almost equal to a yearly dividend, were financed out of current profits, and in 1914, in addition to a transfer of £200,000 to the Unappropriated Profits, the Bank paid a dividend of 5 percent or £727,640 for the half year ending February 1914.4ConclusionThis paper attempted to show that the conventional wisdom needs revision. This holds especially for statements such as: “Though nothing can be proved from the statistical evidence, the available figures are at least consistent with what the Bank said it was doing and with what the contemporary commentators said it was doing.” Sayers, Bank of England, p. 43. or: “As the Bank's profits did not significantly increase, one can […] suppose that this represented resignation on the part of the Bank that profits now had to take second place.” Dowd, Evolution, p. 193 (n. 62).Statements like these benevolently overlook that the Bank of England was a privately-owned joint-stock bank that paid an annual dividend to its shareholders that was more than double the interest rate on the British national debt (consols). This meant that Bank of England stock was seen by investors as an attractive alternative to the consols at hardly any higher risk. Bank of England stock was not an object of speculation but was readily acquired by wealthy husbands and fathers as a retirement provision for their wives or unmarried daughters. It is therefore no exaggeration to describe the stability of the dividend as a socio-political task for the upper middle class of British society.Of course, the Bank of England was not an ordinary joint stock bank, but as the government's bank, important privileges had been conferred on it, which, however, could also be withdrawn again thanks to the regular renewal of its charter. Accordingly, it could not pursue an aggressive business policy to maximise profits, but had to meet the government's expectations to a minimum extent. Seen from this perspective, a business policy could be expected that was primarily committed to making a profit, but which had to be so moderate that no serious offence could be taken at it. In this respect the business policy of the Bank of England was highly successful during the whole period under review.Three times since the reform of the Bank Charter Act of 1844, most recently in 1866, the Banking Department's banking reserve (bank notes and coin) had been insufficient to meet the market's demand for credit. A race to the bottom set in in each case. In anticipation of credit restrictions, the demand for credit continued to swell, while banks, discount houses and City merchants simultaneously withdrew deposits. The banking reserve was thus squeezed from two sides, by the demand for credit (Other Securities) on the one hand and the loss of bankers’ balances (Other Deposits) on the other. The government then suspended the Bank Charter Act and with it the limitation of the fiduciary issue, whereupon the situation quickly calmed down, especially since the bank rate of discount had been raised to 10 percent.Once the crisis of 1866 was over Walter Bagehot argued that the Bank should maintain a much higher banking reserve than before, even in quiet times, so that no doubts would arise about the Bank's ability to provide the market with sufficient liquidity. In 1866, the banking reserve had fallen from about £8.8m in March to £0.9m at the end of May. But a higher banking reserve was only possible at the expense of interest-bearing Other Securities, which in turn had to be kept as liquid as possible to be able to replenish the banking reserve if disaster threatened. In addition to the lower share in the bank's assets, this meant a low average interest rate for the Other Securities. But that was precisely the problem from the Bank’s point of view, which Bagehot did not know, or at best could have guessed.At the beginning of the 1840s, Other Securities, apart from quantitatively insignificant mortgages, consisted exclusively of good commercial bills of exchange and short-term loans, which were mostly granted against bills of exchange and British government securities. The portfolio was therefore highly liquid, as it consisted mainly of self-liquidating assets and short-term loans covered by self-liquidating assets. The short-term loans against government securities were probably to be regarded as a service provided by the government bank, as it would have been a strange signal if the bank of the Government had not accepted Government bonds as collateral. The problem was, however, that by the beginning of the 1840s this portfolio no longer ensured a sufficient return to secure the targeted annual dividend. The Bank therefore began to grant longterm loans to English railway companies, which on the one hand earned a much higher interest rate than short-term loans and discounts and on the other hand could fill the gap left by the money market’s low demand for credit. For in view of low interest rates and a Bank rate of discount that was not in line with the market, the Discount Office had very little to do.The Bank Charter Act of 1844 changed the situation insofar as the Bank rate of discount could now be set more in line with the market and the Discount Office was again fully stretched, so that the profit situation initially improved again. By the spring of 1846, discounts and advances had roughly tripled, while the banking reserve was below the initial value of September 1844. The share of the banking reserve in the bank's assets had fallen from 28 percent to 20 percent during this period. At the beginning of 1866, the share of the banking reserve was still at about the same level. In Bagehot's opinion, this should change urgently.After the publication of Lombard Street in 1873 the Bank seemed to have followed Bagehot’s advice, but the increase in the banking reserve observable by contemporaries was bought by a significant deterioration in the liquidity of the Other Securities, which was not displayed to contemporary observers. In each cyclical downturn with low interest rates and low demand, the Bank responded with ever new investments under the Other Securities. By the 1880s, the proportion of lock-ups among the Bank’s assets had risen to such an extent that Bankers' Magazine made the assertion that the Bank of England might now have become the largest investment bank in the world. While the banking reserve oscillated around a share of 20 to 25 percent of total assets in the second half of the decade, that is, only slightly higher than in Bagehot's time, the share of discounts and advances was no longer even one third of the Other Securities. At this point, the Bank of England was at least as far removed from its commitment to keep money available at all times to supply the demand of the money market as it had been in 1866.At the beginning of the 1890s, however, the Bank of England changed its policy. The banking reserve increased, both in absolute and relative terms, as did the share of discounts and advances in Other Securities. The conventional interpretation is that this was an attempt to increase the strength of Bank rate in order to control the market, to have a strong hand in the money market. In fact, looking at the Bank’s decision-making process and considering the medium-term developments, it was rather the attempt to increase the competitiveness of the Discount Office, as the investment bank portfolio had proved to be a dead end.The Bank was indeed successful in its reactivating the Discount Office, but at the same time it annoyed the London based commercial banks, on whose deposits it was dependent. The more active the Bank of England became in the money market, the less willing the commercial banks were to cede the Bank of England their cash reserves free of interest. In the end the dance on the razor's edge was only partly successful, as the commercial banks left only a decreasing part of their cash reserves to the central bank. Instead, 46 English commercial banks, led by the London & Midland Bank and the Union Bank of London & Smiths Bank, jointly built up a decentralised gold reserve, which was managed independently of the Bank of England. Its size was estimated at around £35 million in 1913, T. Seabourne, The Summer of 1914, in: F. Capie/G.E. Wood (Eds.), Financial Crises and the World Banking System, London 1986, pp. 77-119, here: pp. 80-82. whereas the bankers’ balances deposited at the Bank of England at the time averaged just over £25m.As long as the London based commercial banks did on principle not rediscount at the Bank of England so that the Bank’s Discount Office was open more or less exclusively to non-bank customers, the central bank and the commercial banks were competitors. Consequently, the strong hand in the market and the role of a non-competitive bankers’ bank lending in the last resort were mutually exclusive. The commercial banks’ decentralised cash reserve proves this more than clearly. This shows, however, that the conventional wisdom argues one-sidedly by being too much oriented towards the contemporary interpretation predicating on an insufficient data base. Rather, the long-term analysis of the Bank of England's business policy since the 1844 reform shows that even during the last 25 years before the War, the profit motive remained the guiding principle for the directors of the Bank of England; or, to put it more bluntly, it was the directors’ concern for a stable dividend that appears to have prevented the metamorphosis of the Old Lady into a non-competitive, non-profit-maximizing central bank before the First World War.

Journal

Jahrbuch für Wirtschaftsgeschichte / Economic History Yearbookde Gruyter

Published: Nov 1, 2022

Keywords: Bank of England; Lender of last resort; gold standard; Walter Bagehot; Goldstandard; G 01; G 11; G 18; N 13; N 23

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