Hollow et al (eds ) complexity and crisis in the financial system; critical perspectives on the evolution of american and british banking (2016)

She co- edited Financial Regulation in Crisis: The Role of Law and the Failure of Northern Rock Edward Elgar Financial Law Series, 2011 and is currently co- editing a research handbook e

Complexity and Crisis in the Financial System

Complexity and Crisis

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Contents

List of figures vii List of tables viii List of contributors ix Acknowledgements xv

Introduction: rethinking the crises–complexity nexus 1

Matthew Hollow

PART I COMPLEXITY AND CRISES IN FINANCIAL SYSTEMS

1 Financial innovation and the consequences of complexity:

Robert F Bruner, Sean D Carr and Asif Mehedi

2 Entrepreneurial failure and economic crisis: a historical

5 From tort to finance: Delaware’s sedative duty to monitor 121

Dalia Tsuk Mitchell

6 Demutualization and risk: the rise and fall of the British

Andrew Campbell and Judith M Dahlgreen

7 Directors in the dock: joint- stock banks and the criminal law

James Taylor

8 UK corporate law and corporate governance before 1914: a

James Foreman- Peck and Leslie Hannah

9 Effective risk management and improved corporate

governance 214

Roman Tomasic and Folarin Akinbami

FINANCIAL SYSTEMS

10 The historical development of the US government’s responses

Peter H Bent

11 From the mid nineteenth- century bank failures in the UK to the twenty- first- century Financial Policy Committee:

changing views of responsibility for systemic stability 261

T.T Arvind, Joanna Gray and Sarah Wilson

12 Financial reporting, banking and financial crisis: past, present

Figures

1.1 US banking crises, bank assets and GDP growth, 1834–2013 16

3.2 The number of UK banks/nominal value of UK national

4.1 British banking population: active firms, 1790–1982 99 4.2 British banking population: new firms, 1790–1982 99 4.3 British banking population: exits by merger, 1790–1982 100 4.4 British banking population: exits by failure and closure,

1790–1982 100

Tables

1.1 Case studies – innovations in financial instruments,

2.1 Crises originating in or impacting upon the UK, 1600–2007 412.2 Simple typology of the normal state of the economy and a

4.1 Other banking population estimates, 1844–1884 (England and

4.2 Other banking population estimates, 1884–1924 (England and

Contributors

Folarin Akinbami joined J.P Morgan as an Associate in February 2015

Prior to this, he was Lecturer in Commercial Law at Durham University, where he taught and researched Financial Regulation and Corporate Governance He was seconded to the Law Commission of England and Wales, as Team Lawyer, between October 2013 and June 2014, where he worked on the Fiduciary Duties of Investment Intermediaries project Prior to his appointment as a lecturer, he was a Post- Doctoral Research Associate in Durham Law School and the Institute of Hazard, Risk and Resilience (IHRR) at Durham University The research in this book was carried out while he was at Durham University and he is pleased to have worked on the Leverhulme Trust- funded ‘Tipping Points’ project at Durham He is also pleased to have co- authored a number of articles and chapters with Professor Roman Tomasic

T.T Arvind is Professor of Law at Newcastle Law School, having entered

academia after several years as a commercial practitioner He has lished extensively in the areas of legal history and private law His recent work has explored the connections and boundaries between the worlds

pub-of common law and regulatory action He is the author pub-of The Law pub-of Obligations: A New Realist Approach (in press), and the joint- editor, with Jenny Steele, of Tort Law and the Legislature: Common Law, Statute and the Dynamics of Legal Change (Hart, 2013) He was awarded the ICLQ

Young Scholar Prize in 2010 and the Society of Legal Scholars Best Paper Prize in 2009

Peter H Bent is a Marie Curie Early Stage Research Fellow in the

Department of Economics at the University of Oxford and a PhD student in economics at the University of Massachusetts, Amherst Before beginning his doctoral studies, he earned an MSc in Economic History (Research) at the London School of Economics and an MA in Economics

at the University of New Hampshire His current research focuses on the role that international capital flows played in financial crises during the classical gold standard era

Mark Billings is Senior Lecturer in Accounting and Business History at

the University of Exeter Business School He has previously held various

administrative and financial management positions in investment banking and business, and academic posts at the City University Business School, London, Sheffield Hallam University and Nottingham University Business School He is a graduate in economics and holder of an MSc in Financial Management from the Universities of Sheffield and London, respectively, and has been a member of the Institute of Chartered Accountants in England and Wales since 1985 His research interests are in banking, financial and accounting history and financial reporting, and he currently teaches undergraduate courses on corporate governance and auditing.

Ian Bond worked as an economist at the Bank of England for over 30

years His career included work on monetary policy (in particular as Head

of the Structural Economic Analysis Division and as a member of the Monetary Policy Committee secretariat), but was mainly devoted to finan-cial stability and prudential policy issues – latterly as Head of the Financial Resilience Division, a role which included responsibility for the  Bank’s payment systems oversight function and for the development of the Bank’s approach to the management of financial crises Since his retirement from the Bank, he has been undertaking research on the patterns of bank failure

in the UK since the end of the eighteenth century and on the structural and legislative changes associated with that experience He was a member

of the Advisory Council for the ‘Tipping Points’ project at the IHHR in Durham

Robert F Bruner is University Professor, Distinguished Professor of

Business Administration, and Dean Emeritus of the University of Virginia’s Darden School of Business A faculty member since 1982 and winner of leading teaching awards at the University of Virginia and within the Commonwealth of Virginia, he teaches and conducts research

in finance and management As a financial economist, Bruner is best known for his research on mergers and acquisitions, corporate finance

and financial panics His books, Deals from Hell and Applied Mergers and Acquisitions, have helped numerous practitioners and students toward suc- cessful transactions The Panic of 1907: Lessons Learned from the Market’s Perfect Storm, his book with Sean D Carr, attracted wide attention for

its discussion of the underpinnings of financial crises Bruner received a

BA from Yale University and his MBA and DBA degrees from Harvard University

Andrew Campbell is the holder of the Chair of International Banking

and Finance Law at the University of Leeds, UK He is a Solicitor of the Supreme Court of England and Wales and a Chartered Banker He has written extensively on international banking law and regulatory issues

and is a member of the Advisory Panel of the International Association

of Deposit Insurers He regularly acts as Consulting Counsel to the International Monetary Fund, Washington, DC and has advised govern-ments and drafted banking laws for a number of countries

Sean D Carr is an Assistant Professor of Business Administration at the

University of Virginia’s Darden School of Business and the Executive Director of the Batten Institute for Entrepreneurship and Innovation His applied research, which has examined entrepreneurial dynamics, social net-works, venture capital and financial crises, has resulted in award- winning books, articles, case studies, digital media and numerous teaching mate-

rials His work has been cited by The New York Times, The Wall Street Journal, the Financial Times, Newsweek, NPR and CNBC He is the co- author of The Panic of 1907: Lessons Learned from the Market’s Perfect Storm, with Robert F Bruner Previously, Carr spent nearly ten years as

a broadcast journalist with ABC News and CNN He has earned both a PhD in Management and an MBA from the University of Virginia; an MSc from Columbia University; and a BA from Northwestern University

Mark Casson is Professor of Economics at the University of Reading and

Director of the Centre for Institutional Performance His recent

publica-tions include The Entrepreneur in History (with Catherine Casson, Palgrave Pivot, 2013) and Large Databases in Economic History (co- edited with

Nigar Hashimzade, Routledge, 2013) He has also edited two recent

refer-ence works on The History of Entrepreneurship (with Catherine Casson, Edward Elgar, 2013) and Markets and Market Institutions (Edward Elgar,

2011)

Judith M Dahlgreen qualified as a Solicitor of the Supreme Court of

England and Wales in 1988 and practised in England and Scotland in private practice and in the energy sector until 2001 She obtained an LLM from the University of Leeds in 2004 and has been a lecturer there ever since Her academic interests are in banking law, the law on retail financial services in the UK and Europe, and insolvency law She teaches banking law and company law to undergraduates and capital markets law to post-graduates and she supervises PhD candidates in areas relating to insol-vency law, banking law and the law on financial services She is a member

of the Centre for Business Law and Practice in the School of Law at the University of Leeds

James Foreman- Peck is the Director of Cardiff University’s Welsh Institute

for Research in Economics and Development and former President of the European Historical Economics Society He has been Economic Adviser at

HM Treasury concerned with micro- economic policy issues, particularly

public service delivery and procurement Previous posts include Professor of Economic History at the University of Hull, Visiting Associate Professor of Economics at the University of California, Davis and Fellow of St Antony’s

College, University of Oxford His books include A History of the World Economy: International Economic Relations since 1850, Public and Private Ownership of British Industry 1820–1990 (with R Millward, Financial Times/Prentice Hall, 1994) and, most recently, European Industrial Policy: The Twentieth Century Experience (edited with G Federico, OUP, 1999).

Joanna Gray is Professor of Financial Law and Regulation at Birmingham

Law School She has taught and supervised students at leading universities and has conducted training for clients in the legal, banking and finance sectors, the IMF, the Reserve Bank of India, the Turkish Capital Markets Board and the Moroccan Capital Markets Board She is the author of

Implementing Financial Regulation: Theory and Practice (Wiley Finance, 2006) She co- edited Financial Regulation in Crisis: The Role of Law and the Failure of Northern Rock (Edward Elgar Financial Law Series, 2011) and is currently co- editing a research handbook entitled State Aid

in the Banking Sector (with Francesco De Cecco and François- Charles

Laprévote) as part of the Edward Elgar Research Handbooks in Financial Law series She has written extensively for academic and practitioner jour-

nals such as the Journal of Corporate Law Studies, Capital Markets Law Journal and the Journal of Financial Regulation and Compliance.

Leslie Hannah is Honorary Distinguished Professor at Cardiff Business

School He has previously taught at Oxford, Essex, Cambridge, LSE, Harvard, Tokyo and Hitotsubashi and was Dean of the Cass Business School and Chief Executive of Ashridge Management College He has published extensively on the rise of the corporate economy, the electric utility industry, pension funds and internationally comparative business history His latest article is ‘A global corporate census: publicly- quoted and

close companies in 1910’, Economic History Review, May 2015.

Matthew Hollow is an Associate Lecturer in the York Management School

(UK) He holds a PhD (DPhil) in Modern History from Oxford University and has previously worked as a Research Associate on the Leverhulme Trust- funded ‘Tipping Points’ project at Durham University Research- wise, his main interests include: the history of commercial crime, risk and risk management, business ethics and shadow banking His most recent

book is entitled Rogue Banking: A History of Financial Fraud in Interwar Britain (2014).

Asif Mehedi is a Research Associate at the Batten Institute for

Entrepreneurship and Innovation in the University of Virginia’s Darden

School of Business His research interests include complex social systems, financial crisis and entrepreneurship Mehedi is a native of Dhaka, Bangladesh, where he worked in development finance He has also worked

on a development project to build the capacities of local small businesses

In this role, he partnered with industry associations and promising preneurs to design and execute growth initiatives with both social and eco-nomic objectives Mehedi received a BBA from the University of Dhaka and an MBA from the University of Virginia

entre-Dalia Tsuk Mitchell is a Professor of Law at The George Washington

University Her writings focus on the history of US legal and political

thought Her book, Architect of Justice: Felix S Cohen and the Founding

of American Legal Pluralism (Cornell University Press, 2007), won the

2007 American Historical Association’s Littleton- Griswold Prize for the best book in any subject on the history of American law and society Her current work explores the relationship between corporate law and theory and the development of the modern American state Representative arti-cles include ‘Legitimating Power: The Changing Status of the Board of Directors’ (2011), ‘The End of Corporate Law’ (2009), ‘Status Bound: The Twentieth Century Evolution of Directors Liability’ (2009), ‘Shareholders

as Proxies: The Contours of Shareholder Democracy’ (2006), ‘From Pluralism to Individualism: Berle & Means and 20th Century American Legal Thought’ (2005) and ‘Corporations without Labor: The Politics of Progressive Corporate Law’ (2003)

Ranald Michie is Emeritus Professor of History at the University of

Durham He is a recognized expert in the field of financial history, having produced numerous books and articles over a long career Among the most

notable of his books are: The London Stock Exchange: A History (1999) and The Global Securities Market: A History (2006), both published by

Oxford University Press More recently, he has been working on British banking history as part of the Leverhulme Trust- funded ‘Tipping Points’ project

John Singleton is Professor of Economic and Business History at Sheffield

Hallam University He obtained his PhD from the University of Lancaster

in 1986 Much of his early research, including Lancashire on the Scrapheap

(OUP, 1991) concerned the history of the cotton industry in the mid twentieth century Between 1993 and 2010, he taught in New Zealand and published extensively on aspects of New Zealand economic and financial

history, including Innovation and Independence: The Reserve Bank of New Zealand, 1973–2002 (Auckland University Press, 2006), of which he is principal author His most recent book is Central Banking in the Twentieth

Century (CUP, 2011) At present, he is working on a comparative history

of disasters since 1900 which will be published by Edward Elgar

James Taylor is a Senior Lecturer in History at Lancaster University He

received his PhD from the University of Kent in 2003 He has written widely

on the development of the corporate economy in Britain since 1720, ticularly from cultural and legal perspectives His articles have appeared in leading historical journals and his first two books received prizes from the

par-Economic History Society (Creating Capitalism, Royal Historical Society, 2014) and the Business History Conference (Shareholder Democracies, co-

authored with Mark Freeman and Robin Pearson, University of Chicago

Press, 2012) His third book is Boardroom Scandal: The Criminalization of Company Fraud in Nineteenth- Century Britain (OUP, 2013).

Roman Tomasic  is an international corporate law scholar based in

Australia He was Chair of Corporate Law at the Durham Law School in the UK from 2007 until 2012 He remains a Visiting Professor of Company Law at Durham University and is currently employed as Professor of Law

in the School of Law at the University of South Australia in Adelaide. He has also served as Visiting Professor in law schools in Hong Kong, Malaysia

and China Tomasic was a founding editor of the Australian Journal of Corporate Law and has a strong interest in comparative company law He

has used empirical research methods in the study of corporate law and corporate governance both in Australia and East Asia He is pleased to have worked on the Leverhulme Trust- funded ‘Tipping Points’ project and co- authored a number of articles and chapters with Dr Folarin Akinbami

He is also a former Chair of the Australasian Law Teachers Association

Sarah Wilson is Senior Lecturer in Law at York Law School, UK She

read law at Cardiff Law School before studying Modern British History, gaining a MA (History) and PhD (History) She has held a number of posts in UK law schools Her recent publications in the sphere of financial

crime and financial/banking law and regulation include The Origins of Modern Financial Crime: Historical Foundations and Current Problems

in Britain (Routledge, 2014), a monograph providing a multi- disciplinary

analysis of financial crime from c 1830 to the present Sarah has recently published ‘The new Market Abuse Regulation and Directive on Criminal Sanctions for Market Abuse: European capital markets law and new global

trends in financial crime enforcement’ in the Journal of the Academy of European Law She is a longstanding contributor to Lloyds Law Reports Financial Crime and has helped to shape its new International Section.

Acknowledgements

First and foremost, sincerest acknowledgments need to be given to all the scholars and experts who have contributed chapters to this edited volume The quality and rigour of the contributions they have produced has been truly exceptional and the richness of the book you see before you is entirely down to their hard work and commitment to this project

Second, we would like to thank the editorial team at Edward Elgar ticularly Katy Roper, Fran O’Sullivan and Aisha Bushby) and acknowl-edge the help and assistance they have provided In addition, we would like

(par-to acknowledge the invaluable copy- editing and proofreading work done

by Krysia Johnson to get this volume into shape

Finally, from a personal perspective, the editorial team would also like

to acknowledge the financial support that was provided by the Leverhulme Trust to the ‘Tipping Points’ initiative at the Institute of Hazard, Risk and Resilience (IHRR) at Durham University It was thanks to the funding provided by this project that we were all able to branch out from our own respective disciplines and engage in truly interdisciplinary dialogue – thus, sowing the seeds for the volume you see before you

Introduction: rethinking the

crises–complexity nexus

Matthew Hollow

Crisis and complexity – since the turmoil of 2007–8, these two terms seem

to have been twinned together by economists, financial commentators and academics on an increasingly frequent basis (Caballero and Simsek, 2009; Christophers, 2009) Indeed, so common has this conceptual coupling become that one is now almost surprised to find an article or opinion piece about the financial crisis of 2007–8 that does not mention the word

‘complexity’ at least once in its analysis of the events leading up to the crash

Of course, it is worth pointing out that the financial crisis of 2007–08

is far from the first financial crisis to be described in this way Countless other crises – ranging from the Asian Crisis of the late 1990s to the 1929 Wall Street Crash – have also been (and continue to be) categorized as

‘complex’ events by many learned commentators (Kindleberger, 2000) Indeed, as far back as 1873, one can find commentators such as the influ-ential British journalist Walter Bagehot using such terms to describe these periodic episodes of financial upheaval (Bagehot, 1910)

What is notable about this most recent crisis, however, is the degree to which the events that unfolded have not only been described through the

lens of complexity, but also the extent to which they have been uted to complex processes (Blackburn, 2008; Davies and McGoey, 2012;

attrib-Leyshon and Thrift, 2007) Perhaps unsurprisingly, this tendency to blame the 2007–8 crisis on increased levels of complexity in the financial system has been particularly pronounced in journalistic circles, where it seems that it is now almost standard practice to preface any article or opinion piece on the crisis with some sort of (usually disparaging) comment about the ‘bizarreness’ or ‘indecipherability’ of modern financial markets

(Christophers, 2009) Typical examples in this respect include the Financial Times columnist, John Gapper, who has written how the ‘bizarre degree of

complexity in financial markets was bound to lead to trouble’,1 or the New York- based financial commentator, Lee C Buchheit, who in the after-math of the crisis suggested that: ‘We have reached the point where some

financial engineers have managed to baffle even themselves Along the way, though, they seemed to have befuddled their boards of directors, risk management committees, lawyers, accountants, customers and regulators’ (Buchheit, 2008, p 24).

In a similar but slightly different vein, there has also been a growing number of calls for economists and financial regulators to pay more atten-tion to the ideas and methods of complex system theorists (Duit and Galaz, 2008; Gilpin and Murphy, 2008) Underpinning such calls is a belief that, in today’s increasingly interconnected financial market, such tools will not only allow governments and regulators to make better- informed decisions, but will also hopefully help them better understand the poten-tial (unintended) consequences of their actions (Goldin and Vogel, 2010; Haldane, 2009; May, Levin and Sugihara, 2008)

Given this strong and pervasive interest in issues of this sort, we felt that

it was both timely and necessary to produce a text that would not only provide a more in- depth assessment of the relationship between financial crises and complexity levels in financial systems, but would also critically interrogate the way in which these sorts of terms have been used by schol-ars and financial commentators in recent years Although we did toy with the idea of producing a text written from a global perspective, we eventu-ally decided to narrow the geographical focus of this book down to the US and UK financial markets The rationale for this US–UK geographical focus was as follows: first, New York and London have, historically, been the two most important financial centres in the global economy (Ferguson, 2001); and, second, the origins of the current global financial crisis can most obviously be linked back to developments in the financial sectors of these two countries (Casey, 2011)

We also decided that, if we wanted to fully probe the nature of the relationship between crises and complexity in the US and UK financial markets, we would need to try to break free of traditional disciplinary boundaries and look at these issues from a wider and more holistic per-spective To achieve this goal, we consciously brought together as wide

a range of academics as we could from across the disciplines of law, history, economics and business – each with their own unique perspec-tives on the events of 2007–8 and the evolution of the US and UK finan-cial systems more generally Together, they have helped us to produce a book that is not only remarkably wide ranging, but – as the following summary demonstrates – also truly interdisciplinary in both its scope and content

PART I: COMPLEXITY AND CRISES IN FINANCIAL

SYSTEMS

As many readers of this volume will no doubt be aware, in the last few years there has been an extraordinarily wide variety of (often contra-dicting) explanations put forward to explain the global financial crisis

of 2007–8 (see Jickling, 2009; Lo, 2012; Pinnuck, 2012) From a critical perspective, however, one thing that has tended to be lacking in most of these accounts is any real sense of historical or longer- term perspective regarding the events of 2007–8 (Daunton, 2011; Hsu, 2013) This has been problematic not only in the sense that it has made it hard for readers to get any real sense of the historical significance of this most recent crisis, but also in the fact that it has made it that much harder to accurately compare and contrast this crisis with previous ones (Kobrak and Wilkins, 2011).Tackling this continued lack of historical insight into the events of 2007–8

is one of the underlying goals of the first chapter in this edited volume, written by Bruner, Carr and Mehedi Unlike most contemporary accounts, their contribution does not just focus on the immediate short- term causes of the crisis of 2007–8, but rather tries to understand the longer- term dynamics and forces that have contributed to the seemingly timeless cycle of crashes, panics and crises in the US banking sector At the heart of their argument

is something that they call the ‘Innovation–Complexity hypothesis’ In simplified terms, this hypothesis posits that, under certain conditions, the introduction of new innovations to the financial sector can increase the likelihood of crises occurring by amplifying complexity levels in financial markets To test the validity of this thesis, they provide six micro- case studies

of previous banking crises in the US – revealing how financial innovation of one form or another has been present during each episode Based on these findings, they conclude that, whilst innovation by itself may not always cause crises, it does tend to heighten complexity and uncertainty in financial markets (which, in turn, increases the risk of crises occurring)

Building on this theme of innovation and crises is Casson’s entry on entrepreneurial failure and economic crises in the UK Like Bruner, Carr and Mehedi, Casson adopts a long- term historical perspective in his work, going back as far as the Tulip Mania of the seventeenth century in order to understand the underlying trends and patterns at work in the UK market Amongst the key issues that he sets out to investigate is the question of why market participants behave as they do both during and in the build- up

to economic crises To achieve this goal, he adopts a novel approach based upon applying theories of entrepreneurship to a range of quantitative and qualitative sources Ultimately, what this approach demonstrates is that – contrary to much perceived economic wisdom – the origins of economic

crises can often be traced back to real economic factors (most notably poor investment choices and overvaluations of new innovations).

Similarly long- term in its approach to the crisis of 2007–8 is Michie’s chapter, which provides the third entry in this first section The primary focus of Michie’s chapter is on the changing demographics of the UK and,

to a lesser extent, US financial systems over the course of the modern and early modern eras To measure these changes, Michie utilizes a series of newly created databases that chart the total number of UK banks, build-ing societies and savings banks on an annual basis, as well as a number

of pre- existing datasets on the US financial sector, to produce a series of population timelines What Michie concludes from these results is that, like most complex ecosystems, financial markets are inherently fragile enti-ties that can be hugely (and often negatively) affected by external stimuli Leading on from this finding, he also suggests that governments and regu-lators ought to give more thought to the impact that their regulations and legislations have upon the dynamics of these financial ecosystems

Complementing Michie’s demographic investigation is the following entry by Bond Like Michie, Bond’s interest is in the long- term evolution

of the British banking sector and, in particular, the manner in which its population has changed over time In order to assess these changes, Bond has developed a new and – compared with previous efforts – much more comprehensive database that not only tracks the total numbers of banks in the UK, but also the annual entries and exits from the market Thanks to such robust data, he is able to draw out the key characteristics of different eras in British banking history and identify the long- term processes that have shaped – and continue to shape – the UK banking sector

PART II: LEGISLATIVE AND STRUCTURAL

CHANGES IN THE FINANCIAL SECTOR

Alongside the question of who exactly was to blame, one of the subjects that continues to feature heavily in discussions about the financial crisis – particularly in the popular press – is the issue of why so few of those involved in the catastrophic events of 2007–8 have faced any form of crimi-nal prosecution or legal sanction (Rakoff, 2014) Central to these debates has been a general sense of unease about the current state of financial regulation, with many taking the current lack of convictions as a sign of impotence on the part of lawmakers in the US and the UK: ‘Despite the financial crisis and the spate of mis- selling scandals, we still have not seen anybody sent to jail Is that because nobody ought to go to jail, or because there is a fundamental failure in the sanctions regime or the legal system?’2

The result of this increased focus on the level of shady behaviour in the

US and UK financial markets has been an upsurge of interest – both demic and popular – in questions relating to the role and value of financial regulation (Goodhart, 2008; Moloney and Hill, 2012) Particularly appar-ent in this respect has been the increased level of interest that has started

aca-to be shown in the hisaca-torical roots of the regulaaca-tory frameworks that were

in place in the US and the UK at the time of the crisis, and whether or not there was anything notable that changed in the years prior to 2007–8 (Wilson and Wilson, 2013)

This second section of the book provides a welcome complement to this burgeoning body of work by offering up a series of readings on the various legal and legislatives changes that have taken place in the US and

UK financial sectors over the past two centuries Amongst the key tions that it asks are: have legislative changes had any impact upon the stability and security of the US and UK financial systems? Why were there more prosecutions for fraud and financial crime in the past? Are modern (complex) financial systems inherently harder to regulate?

ques-The first chapter to deal with these fundamental issues of power and control is Mitchell’s insightful analysis of the changes that have taken place

in US corporate law (particularly with respect to notions of directors’ duties) since the late nineteenth century To investigate these changes, she

focuses on a number of landmark US cases – including Briggs v Spaulding (1891), Graham v Allis- Chalmers Mfg Co (1963) and In re Caremark International (1996) – each of which reveals something about the changing

role of the corporation in the US in modern times Ultimately, what she concludes is that, although in recent years the US courts may have adopted

a rhetoric of care and responsibility (primarily to reassure shareholders about the competency of their executives), what has really been happening

is a gradual erosion of corporate liability and responsibility in favour of a greater emphasis on unrestrained free- market growth

Another chapter that critically engages with the raft of free- market reforms that have been passed in the UK and the US since the 1980s is the following entry by Campbell and Dahlgreen, which focuses on the history

of the building society movement in England and the legislative changes that have shaped its structure since the nineteenth century Conceptually, the authors’ main goal is to try to understand why and how so many build-ing societies opted to demutualize during the late twentieth century and what impact this has had on the stability of the UK financial sector In the end, what they suggest is that, whilst the original concept of the permanent building society may have been somewhat outdated by the 1980s, the basic idea of providing working- class savers with a safe and protected place to deposit their earnings still remains as relevant as ever

The next chapter by Taylor then shifts the debate somewhat by ering the role that the criminal law (and the threat of criminal sanctions) played in regulating the UK financial sector during the nineteenth century

consid-As Taylor himself points out, this is an area that has generally received little attention from banking historians, most of whom have tended to focus their attentions instead on the major legislative changes that took place during this era What Taylor skilfully shows, however, is that, though the number of convictions may never have been especially high, the crimi-nal law did still play an integral role during this era (particularly towards the end of the century) in both regulating the behaviour of market partici-pants and preserving the stability of the banking sector as a whole

Building on the themes and ideas raised by Taylor is the final chapter

in this section by Hannah and Foreman- Peck Like Taylor, Hannah and Foreman- Peck choose to focus on the role that the law – in this case, company law – played in regulating the behaviour of market participants

in the UK between 1845 and 1914 What they show is that laws such as the Companies Clauses Consolidation Act of 1845 (supplemented by moral codes and other private order reinforcements) did actually play a signifi-cant role in regulating the corporate economy during this era This, in turn, leads them to suggest that what is needed to deal with the regulatory prob-lems thrown up by the crisis of 2007–8 is a rigorous application of the law, employed in conjunction with a similarly tough ethical framework

The final chapter in this section is provided by Tomasic and Akinbami

As in many of the other chapters in this volume, their underlying aim is to try to understand why so many banking organizations failed to predict or foresee the financial crisis of 2007–8 To do this, they predominantly focus

on the relationship between risk management and corporate governance

in financial markets, looking not only at the role of risk in the financial industry, but also exploring some of the various risk management failures that took place in the UK financial sector (notably at Northern Rock and HBOS) both during and in the build- up to the global financial crisis of 2007–8 Ultimately, what they conclude is that effective corporate govern-ance can go a long way towards achieving more effective risk management

in the financial sector

PART III: MANAGING AND REGULATING

COMPLEX FINANCIAL SYSTEMS

Whilst the emphasis in the first two sections of this book is predominantly

on the historical roots of the crisis of 2007–8 (and the evolution of the US and UK financial systems more generally), the focus in the third and final

section of this volume is much more centred on the issue of how best to respond to and deal with such disruptive events Unsurprisingly, this is a research area in which there has been a lot of activity since the crisis of 2007–8 (Posen and Changyong, 2013; Taylor, 2009) Alongside issues of corporate governance and corporate accountability (Sun, Stewart and Pollard, 2011), a great deal of this work has been focused on the role of central banks and whether, in today’s complex and increasingly globalized financial system, they are still capable of effective action in times of crises (Davies and Green, 2010; Eijffinger and Masciandaro, 2012).

What the chapters in this third and final section all try to do is enhance and broaden our understanding of how best to respond to the unique challenges that are posed when financial and/or banking crises take place

in complex financial systems Getting this process started is Bent, whose entry on the history of the US government’s responses to economic and financial crises forms the first chapter in this section In terms of its structure, his work is organized in a chronological fashion, with the initial sections looking at the government’s responses to the crises of the late nineteenth and early twentieth centuries, and the latter sections focusing more on the crisis of 2007–8 Amongst the key points that he touches upon

in his analysis is the issue of whether or not governments ought to play

an interventionist role in the financial system and how far rising levels of complexity in the financial sector have affected the government’s ability to respond to financial crises

Complementing Bent’s chapter is the next entry by Arvind, Gray and Wilson, which provides a detailed comparison of mid- nineteenth- century legal responses to bank failures in the UK and the more recent regulatory response to the crisis of 2007–8 Methodologically, the authors’ analysis expertly weaves together historical and legal approaches, looking not only

at the events surrounding the various crises under discussion, but also at the legal narratives and moral frameworks that built up around each of these debacles In the end, what they show is that, despite the huge struc-tural differences between modern finance and nineteenth- century finance, there are still a number of important lessons that can be learned from how the Victorians responded to banking crises

Offering another historically orientated approach to financial crises is the following entry by Billings, which examines the changing relationship between financial reporting, banking and financial crises in the UK during the twentieth century Conceptually, his entry is motivated by a desire to understand whether or not the ending of nondisclosure by the ‘Big Five’

UK banks and the subsequent introduction of fair value accounting (FVA) has actually helped enhance the stability of the UK financial sector by making it more transparent Overall, what he concludes is that, whilst FVA

may be beneficial to certain markets, the unique and complex nature of the banking industry makes it much harder to apply a single financial report-ing framework capable of satisfying the needs of every stakeholder.Concluding this section is the final entry of the volume by Singleton, which uses the Disaster Management Cycle (DMC) framework to examine and understand different responses to financial crises Used primarily for responding to natural disasters, the DMC framework provides an interest-ing lens through which to approach financial crises in that it shifts the focus onto the stages through which disasters unfold and develop As Singleton convincingly argues, this not only helps highlight possible areas of weak-ness in crisis response strategies, it also makes it easier for economists and those working in the natural sciences to compare notes and share ideas.

FINAL REMARKS

Before we embarked upon this book project, we were all well aware of the many challenges and pitfalls inherent in trying to pursue an interdiscipli-nary research agenda (Montuori, 2013; Strober, 2011) Yet, at the same time, we were also aware that, if we were ever going to start unpicking the nature of the relationship between financial crises and complexity levels

in financial systems, we would need to ask questions and deal with issues that did not sit comfortably within any one academic discipline The only option, therefore, was to eschew the traditional disciplinary boundaries and take on the challenges that inevitably accompany any attempt to produce a fundamentally interdisciplinary piece of work

The book that you see before you is the end product of our efforts in this respect As you will see, we have resolutely stuck to our original cross- disciplinary research agenda, bringing together a range of academics and practitioners from across the disciplinary backgrounds to look in more depth at the historical and institutional aspects of the relationship between financial crises and complexity levels in the US and UK financial sectors Taken together, their respective contributions have helped to produce a book that not only challenges many often taken- for- granted ideas about the nature of financial crises, but also offers something truly unique to the flourishing literature on the long- term causes (and consequences) of the global financial crisis of 2007–8

1 Gapper, J., ‘King’s Men Must Put Themselves Together Again’, Financial Times, 19

September 2008.

2 Statement by Andrew Tyrie before the Parliamentary Commission on Banking Standards,

17 January 2013, q.2626, available at: www.publications.parliament.uk/pa/jt201213/ jtselect/jtpcbs/c606- xxiv/c606xxiv.pdf [accessed 28 November 2014] For more on the seeming ineffectiveness of the US and UK regulatory authorities, see Gray and Akseli (2011), Green, Pentercost and Weyman- Jones (2011) and MacNeil and O’Brien (2010).

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Complexity and crises in financial systems

by itself is not a sufficient condition to precipitate systemic vulnerability

Instead, we observe that complex financial systems may fall out of librium with the introduction (or adoption) of novel financial instruments, institutions or markets – that is, financial innovations Such innovations have the potential, we suggest, to amplify negative dynamics within complex systems and, under certain conditions, may result in significant adverse consequences

equi-Drawing from the growing body of literature that applies concepts from the study of complex adaptive systems to economics (for example, Arthur, 2014) and financial markets (for example, Beinhocker, 2007; Sornette, 2003), this chapter explores two interrelated features of complex financial systems that may serve as the mechanisms by which innovation can induce financial instability: tight linkages and information flows The system- like architecture of the banking sector often creates opacity that makes it dif-ficult for information to flow freely when trouble occurs; also, a complex system creates tight linkages whereby the trouble itself can quickly spread

These features are not static but dynamic, and they appear to intensify with the arrival of innovations: new, complex instruments, institutions and markets further contribute to uncertainty and exacerbate the overall fragility of the system.

This chapter is an exercise in inductive research Drawing from tives about six consequential American banking panics beginning in 1792,

narra-we seek to frame and embellish a hypothesis that, under certain conditions, innovation in financial instruments, institutions and markets2 amplifies complexity in the financial system, which in turn increases the propensity

for financial crisis and economic distress We call this the Innovation– Complexity hypothesis Using the foregoing theoretical lens through which

to understand the impact of endogenous system complexity, we explore how financial innovations interact with that complexity over time, thereby amplifying systemic risks

In the discussion of the recent Global Financial Crisis, the role of financial innovation features prominently The role of innovation in the preceding financial crises, however, has been largely ignored Through six micro- case studies, we aim to draw sharper inferences about how innova-tion in the US banking sector might be a common contributing factor in the occurrence, severity and duration of financial crises

THE LONG VIEW: FINANCIAL CRISES RECUR

First, let us begin with a description of our outcome variables A financial crisis is an episode of severe threat to the stability, safety and soundness of the financial system in the economy A crash, or sharp decline in security

prices, often precedes or coincides with a financial crisis, though many crashes have occurred without a corresponding financial crisis A crash

may also occur at the end of an asset price bubble – rapid growth in asset

price over a short time – to correct overvaluation of assets A financial

crisis typically includes a panic, in which depositors and lenders

franti-cally seek to withdraw their money from institutions and markets, though the panic may be only one episode of the longer period of instability A

financial crisis usually triggers or aggravates an economic recession, though

many recessions have not featured financial crises A financial crisis mences with some kind of economic shock and ends when financial market conditions return to normal

com-Here, we focus on banking crises – the kind of financial crises where

a large number of banks become unable to meet their obligations to depositors and lenders because of illiquidity or insolvency A widespread loss of confidence among depositors and lenders and the resulting panic

often cause or precipitate large- scale bank failures, measured either in the number of insolvent banks or in the aggregate value of insolvency From

1814 to 1914, the US saw 13 banking crises Generally, those crises lowed periods of robust growth and occurred in the context of a recession – although not every recession featured a banking crisis

fol-The founding of the US Federal Reserve in 1913 ameliorated but did not prevent banking crises thereafter In fact, the century since has witnessed three major episodes of financial crisis: 1930–34, 1987–89 and the Global Financial Crisis commencing in 2007 In each of these periods, the number and/or dollar value of financial institutions seized by regulators far over-shadowed the trickle of seizures under normal conditions From the long view, the kinds of events that may precipitate financial crises are more notable by their absence than their appearance

THE INNOVATION–COMPLEXITY HYPOTHESIS

Complexity has been endemic to the modern financial system since its liest days If we consider the evolution of the financial system over time,

ear-we observe an ever- growing number of financial institutions Moreover,

as we see in Figure 1.1, the overall scale and scope of the banking system grew steadily, punctuated by an almost regular cadence of banking panics and financial crises

Growth in the number of components alone does not translate into

greater complexity What matters more is the increase in types of those

com-ponents For example, the founding of many of the same types of banking institutions does not necessarily make the financial system more complex

However, as the financial system evolves, many new types of institutions

(and instruments and markets) may emerge This constant evolution and change is what increases heterogeneity in the system Our argument is that this heterogeneity, the result of a continuing gale of financial innovation, makes the financial system more fragile and vulnerable to distress

This observation alone, however, does not explain how innovation within

a complex adaptive system can trigger instability We suggest that tion can amplify the problems associated with two key features of complex systems: tight linkages and information flows First, the very existence of

innova-a tightly linked complex system meinnova-ans thinnova-at trouble cinnova-an trinnova-avel; the ties of one financial intermediary can easily extend to others (Allen and Gale, 2000) Second, the complexity of a financial system heightens the possibility of information asymmetry, where some participants are infor-mationally disadvantaged relative to others, potentially resulting in adverse behaviours

Total bank assets per dollar annual real GDP

Innovations can make such a dynamic system, or a part of it, even more opaque and less easy to understand This may happen when a new type of instrument or institution is so complex in its features and functions that its effects on counterparties, and the system as a whole, are hard to assess The consequent information asymmetry in such a system results in heightened uncertainty Such lack of transparency in a tightly coupled system is par-ticularly dangerous, because, while the components are interdependent in such a system, the extent of the interdependence is not visible Moreover, during the run- up to a crisis, it becomes difficult to contain the cascade of failures, because regulators and institutions, with restricted visibility, fail

to identify the channels of the failures’ propagation

LINKAGE SO THAT TROUBLE CAN TRAVEL

Fundamental to the definition of a system is that its parts are linked

and interact Thus, it is in a household heating system (the furnace and thermostats interact in a feedback loop), the digestive system (the body’s organs are interdependent and operate for the benefit of all) and the tel-ecommunications system (a network increases in utility as connectivity with other people increases) A financial system has similar characteristics: the various intermediaries (banks, trust companies, brokerage firms) are lenders and creditors to each other by virtue of the cash transfers that they facilitate

In any system, trouble will spread unless shock absorbers exist to stop it Today, the safety buffers for the financial system would include the Federal Reserve, the International Monetary Fund, the Bank for International Settlements, the World Bank and central banks around the world The key question is whether the safety buffers in existence at various periods in time are adequate to prevent the spread of potential shocks Adequacy is defined relative to the size of the available assets and their liquidity versus the size of liabilities and the probability of the shocks, which the buffer is meant to absorb Over time, the size and complexity of the economy may outgrow the sophistication of static financial safety buffers (Bookstaber, 2007)

An important insight from the field of system dynamics is that systems can also display surprising nonlinearities – this means that orderly systemic structures may produce unpredictable behaviour Feedback loops, time delays and other factors affect the behaviour of entire systems In recent years, the study of complex systems has evolved into an advanced interdis-ciplinary field.3 The application of concepts from system dynamics to the study of financial markets is relatively new

Charles Perrow (2009), a sociologist who studied some major structure accidents (for example, in power systems and nuclear facilities), argued that complex and tightly coupled systems are inherently vulnerable

infra-to accidents (the ‘normal accident’ theory) By complexity, he denoted the possibility of unexpected interactions among system parts resulting in a local failure Tight coupling allows the local failure to cascade throughout the system The financial system is similar to large infrastructures in that they both share complexity and tight coupling, and so financial crisis is, if not inevitable, hard to evade

The basis for tight coupling in the financial system is the financial tract, which is one of those fundamental inventions that changed the tra-jectory of society’s economic progress By its very function of transferring

con-an asset from one party to con-another con-and simultcon-aneously creating a promise for future payment, a financial contract tightly connects two actors within

a system Certain instruments and institutions can turn that link into a dependency, whereby one entity’s survival depends on that of another Moreover, these contracts create a chain of dependencies, making an entity

in one part of the financial system dependent on another entity several degrees away in another part of the financial system

Financial institutions are particularly tightly linked within the system by means of inter- firm transactions and deposit- taking The financial system was international as early as the Renaissance (for example, the Fuggers and the Medici), in the sense of institutions in different countries being linked through transactions and deposits Kindleberger and Aliber (2005) noted that over time the waves of financial crises have had a strong inter-national dimension to them because of such linkages

PROBLEMS OF INFORMATION

The other relevant aspect of complexity for financial systems has to do with the opacity of information Complexity within a financial system prevents all participants in the system from being equally well informed (Caballero and Simsek, 2009) This results in information asymmetries that can prompt irrational behaviour, thereby triggering or even worsening a financial crisis (Kindleberger and Aliber, 2005) Information asymmetries

may lead to the problem of adverse selection, whereby better- informed

people might exploit the poorly informed

Economists Douglas Diamond and Phillip Dybvig (1983) have gested that bank panics are simply randomly occurring events Bank runs occur when depositors fear that a random externality will force the bank into costly and time- consuming liquidation To be last in line to withdraw

sug-deposited funds exposes the individual to the risk of loss Therefore, a run occurs simply from the fear of random deposit withdrawals and the risk for the individual of being last in line.

Diamond and Dybvig said that a run on a bank occurs when tors rush to withdraw their deposits because they expect the bank to fail

‘deposi-In fact, the sudden withdrawals can force the bank to liquidate many of its assets at a loss and to fail’ (1983, p 401) The mismatch of liquidity between a bank’s assets and liabilities – a mismatch allowed by conven-tional demand deposit contracts – leads to the self- fulfilling concerns of the depositors about bank failure The run is merely one of two possible equilibria in a conventional bank The occasional banking crisis, they suggest, is therefore both random and inevitable

Other scholars, however, strongly contend that bank runs and ensuing panics are neither random nor inevitable, but are a consequence of the uneven distribution of information among actors within the system Calomiris and Haber (2014), for example, have disagreed with the inevi-tability of bank runs, citing examples of countries where banking crises are rare (for example, Canada) In their view, the propensity of crisis in a banking system is determined by ‘the way that the fundamental political institutions of a society structure the incentives of politicians, bankers, bank shareholders, depositors, debtors, and taxpayers to form coalitions

in order to shape laws, policies, and regulations in their favor – often at the expense of everyone else’ (Calomiris and Haber, 2014, p 4)

Thus, bank runs may result from asymmetric information: the problem

of adverse selection can motivate panic selling or the withdrawal of deposits Calomiris and Gorton (1991) suspected that runs could begin when some depositors observe negative information about the value of bank assets and withdraw their deposits Then, other depositors follow suit, being unable to discriminate perfectly between sound and unsound banks and observing a wave of withdrawals A run begins In a world

of unequally distributed information, some depositors will find it costly

to ascertain the solvency of their banks Thus, runs might be a rational means of monitoring the performance of banks – a crude means of forcing the banks to reveal to depositors the adequacy of their assets and reserves

Calomiris and Gorton (1991) reasoned that if the information try theory were true, panics would result from real asset shocks that would cause a decline in the collateral values underpinning bank loans They found that panics tended to follow sharp declines in the stock markets and that they tended to occur in the spring and autumn They also reasoned that the resolution of a bank panic would result from the elimination of

asymme-an importasymme-ant aspect of the information asymmetry: gaining clarity as to

which banks were solvent or insolvent would slow down or stop the runs

on solvent banks

Empirical research gives some support to the asymmetric tion theory over the random withdrawal theory, but the findings are not uniformly supportive Studies have considered how well information asymmetry explains panics by looking at whether deposit losses predict panics, whether the yield spreads between low- and high- risk bonds peak

informa-at the panic, and whether real declines in the stock market are greinforma-ater in panic years than in non- panic years – generally, these findings affirm the information asymmetry view (Mishkin, 1991; Carlson, 2005)

Taleb (2012) has argued that opacity in a financial system allows system participants to hide the consequences of their actions and thus creates per-verse incentives for those participants to take undue risks He has therefore suggested that ensuring financial system participants’ ‘skin in the game’ through aligned incentives would be much more effective than a myriad of regulations in making a financial system less fragile.4

Drawing from these ideas, our study explores how innovation might enlarge the theory of complexity and information asymmetry Along with regulation, innovation, which is a more spontaneous phenomenon driven

by market incentives, is a source of change in the banking system When such change adversely affects the system, vulnerability increases and a banking crisis becomes more likely

LOOKING FOR EVIDENCE: SIX MAJOR US

BANKING CRISES

In the following section, we offer six micro- histories of banking crises in the US to explore the plausibility of the Innovation–Complexity hypoth-esis Here, we seek to suggest some of the ways in which innovations in financial instruments, institutions and markets may have contributed to an amplification of systemic risks during each of these periods

The Panic of 1792

The US’s first major episode of financial instability provides us with three examples of how innovations in instruments, markets and institutions may have amplified systemic complexity and contributed to a crisis In this case, the innovations were: the issuance of restructured bonds by the US government (instruments); the creation of a trading market for US bonds (markets); and the founding of the Bank of the United States (institution).With the close of the Revolutionary War (1787) and the replacement of

the Articles of Confederation by the new Constitution (1789), Secretary

of the Treasury Alexander Hamilton turned to modernize the financial system of the young US In the course of 24 months, he submitted to Congress three landmark reports that contained innovative (and conse-quential) recommendations for reform Among them was the creation of

a more liquid and orderly market for US government debt through the

establishment of a sinking fund, whereby the government could engage in

open- market refunding operations (that is, borrow money to repurchase debt) when economically advantageous

Another key recommendation was the establishment of the first Bank of the United States (BUS) This provision would create a central bank in the

US that would establish a uniform national currency, assure the soundness

of the currency through capital market operations and oversee the safety and soundness of the private banks in the country A particular novelty of this plan was that the public could buy shares in BUS with gold, silver and the newly refunded US bonds

Within a year, the restoration of public credit and the successful ing of BUS spurred a bull market in US bonds and in shares of BUS This reflected rising confidence in Hamilton’s restructuring programme and in the credit of the US government New banks were organized and finan-cial market liquidity grew However, the new environment also stimulated speculative excesses

found-In late 1791, William Duer and a circle of co- investors organized a pool

of funds to speculate on the initial offering of a new bank in New York City and on US bonds Duer had been an Assistant Treasurer of the US, serving under Hamilton, and was a close acquaintance Hamilton was unaware of Duer’s speculation Borrowing from banks in New York and from BUS in Philadelphia, Duer’s pool invested in bank shares and government debt, seeking to corner the market In January and February 1792, the pool operated profitably Inflated with his own success, Duer borrowed more heavily to take personal investment positions outside of the pool

Hamilton sought to prick this asset bubble, an extremely delicate tion and a subject of intense debate among central bankers and their critics some 223 years later Watching the spiralling security prices in the spring

opera-of 1792, Hamilton ordered BUS to constrict its lending, especially to speculators Because BUS could call in credits to other financial institu-tions, this action had a systemic impact In early March, the upward price momentum stalled By 20 March, the leading series of US bonds had fallen

25  per  cent in price in two weeks Consequently, William Duer and his circle defaulted on their debts on 8 March – the failure of this prominent group cast a pall over confidence in the economic recovery and over the stability of banks, including BUS Investor and business failures mounted

Hamilton recognized that panic could unravel the financial fabric he had carefully knitted over the previous two years and commenced open- market purchases and lender-of-last-resort commitments He engaged in active

jawboning (moral suasion) with a circle of influential bond dealers to get

them to act collectively with the Bank of New York in arranging bank credit on securities collateral Because of Hamilton’s month- long active intervention, the effect of the financial crisis on the real economy of the

US was minimal

Of course, the financial system of the 1790s was much simpler than today’s in both the number and types of financial institutions Nonetheless, this crisis illustrates that even a nascent financial system can exhibit the characteristics of a complex system: unpredictable and nonlinear interac-tions leading to emergent system- level instability Hamilton’s innovative scheme – that the price of BUS shares could be paid with US bonds – created an inadvertent interdependence between the two instruments Consequently, it was difficult to assess the risks and value of these instru-ments; the wild swings in securities prices in the first year of BUS evidence this difficulty

In such an environment of unpredictable dynamics, Duer’s lenders lacked an appreciation of the risks he was taking, but continued to lend to him, relying solely on his reputation Duer’s privileged knowledge of the workings of the new financial system also created information asymmetry between him and his lenders about the risks of his investments, a situation that he was initially able to exploit All this created a chain of dependence spanning BUS, Duer and his fellow speculators, a large number of banks and individual lenders who lent to these speculators, and the depositors of those banks These dependencies and asymmetries tested the resilience and flexibility of the nascent financial system The Panic of 1792 suggests that even in relatively simple contexts, innovations in instruments (US govern-ment debt), institutions (BUS) and markets (trading in US bonds and BUS shares) can contribute to the creation of an asset bubble and its eventual bursting

The Panic of 1873

The events of 1873 present more examples of how novel developments in financial instruments (asset- backed bonds), institutions (national banks) and markets (secondary trading markets for railroad bonds) may have pre-cipitated a serious banking crisis Again, they suggest how innovation may adversely affect a fragile, complex system

Following the cessation of the Civil War in 1865, the US economy expanded sharply Railroads, financed by bonds, expanded their trackage

at a rapid pace without much regard for immediate demand This sion was a result of liberal inducements offered by the Federal Government

expan-in the form of land grants to the railroads Thus, expan-investors expan-in railroad bonds looked to the collateral value of the granted land for comfort in the face of the risky railroad expansions However, the value of the land depended in turn on an assumption that the presence of the railroad would stimulate the settlement of land by farmers, the establishment of towns and cities, and vigorous economic development that would assure growing railroad revenues All of this presumed that the railroads would lay tracks

to economically attractive lands But, by definition, ‘overexpansion’ meant

that railroads were laying tracks to marginally attractive, or even tive, regions This suggested a cynical game of expansion simply to acquire land grants in order to sell bonds and get cash to lay more track Sooner

unattrac-or later, bondholders would stop the music and the system would crash.The market for railroad bonds, however, slowed down in the summer of

1873, as foreigners in particular started to shun investment in railroads Europe endured its own financial turmoil, with the Vienna Stock Exchange crashing in May of that year following several years of overexpansion of the economies in central Europe

Two notable financiers of railroads failed in the first half of September

1873 And on 18 September, the collapse of Jay Cooke & Co., after a failed underwriting of Northern Pacific Railroad bonds, triggered full- blown panic In an environment of distrust and uncertainty, the banks called

in loans en masse Numerous banking and brokerage firms failed in the following few days The New York Stock Exchange, in an unprecedented move, closed for ten days from 20 to 30 September

On 20 September, the New York Clearing House Association promptly and decisively set up an arrangement – the issuing of Clearing House Loan Certificates, a quasi- currency, to member banks against various securities – that essentially made the association a lender of last resort and successfully contained further cascading of bank failures in the city.While the overinvestment in railroad construction was an important contributor to the banking crisis, one complementary cause lay in the fundamental structural vulnerability of the banking system of the day Two innovative features of the system – interest- paying bankers’ deposits and national banks – are particularly relevant in the discussion of this vulnerability

The practice of paying interest on demand deposits started in the 1830s but accelerated after the Civil War The interior banks, which operated in agrarian economies and thus had a seasonal liquidity cycle, held demand deposits (known as bankers’ deposits or bankers’ balances) with banks in the large cities, especially in New York, during the summer months In the

autumn, following the harvest as crops moved by rail to the coastal cities, money flowed back to the interior banks, producing a general environment

of monetary stringency in the east and west Not all banks participated in this practice, but those that did engaged in speculative investment in the form of call loans, which earned a return on the bankers’ deposits

Further incentive for the bankers’ deposits came from a provision of the national banking laws that allowed interior banks to keep three- fifths of their legal reserve with the banks in 15 designated reserve cities In turn, these banks in the reserve cities could keep half of their legal reserve with banks in New York City This pyramid structure introduced both opacity and tight coupling in the system The banks in the system did not have full transparency of this tiered structure of bankers’ deposits and of the cascade of failures that could play out in adverse circumstances This opacity also exacerbated information asymmetry, as interior banks had little understanding of the risks certain New York banks were taking with the deposits that came from the interior When trouble occurred, the tight coupling of the banks across the three tiers enabled the channeling of trouble from one part of the system to another

In 1873, seven of the 60 New York banks held 70 to 80 per cent of all bankers’ deposits in the city Because of this significant concentration, these seven banks (all of them paid interest on bankers’ deposits) were, in Harvard Professor Oliver Sprague’s (1910) words, ‘directly responsible for the satisfactory working of the credit machinery of the country’ (Sprague,

1910, p 15) Before the crisis, bankers’ deposits had already started to flow to the interior banks to finance the purchase and transportation of a particularly plentiful harvest that autumn; those seven banks found them-selves short of the required reserve This contributed to the breakdown of the credit machinery after the collapse of Jay Cooke & Co

of this crisis

Some historians date the onset of the crisis from two prominent ruptcies: the Philadelphia & Reading Railroad on 20 February 1893 and National Cordage on 5 May The overall volume of bankruptcies in 1893