Tuesday, December 28, 2010

Lombard Street

Too Long to Read Summary: I read Lombard Street by Walter Bagehot. I learned that a powerful financial market requires a large amount of demand deposits. These accrue during times of political stability at institutions that specialize in monetary matters. The English Money Market (centered around Lombard Street and the Bank of England), was an example of such a powerful financial market. It's scale and efficiency allowed England to undertake great business ventures with speed and ease, and gave the entire nation a significant economic advantage. The cost of this power, however, was that a run on these deposits could utterly destroy all these financial institutions. Bagehot cautioned that all of this relied on the success of the Bank of England, a private institution that actually had a huge public role. In order to stay a panic, he urged that the bank of England lend freely to businesses and banks alike (perhaps at elevated interest rates). Failing to do so, or doing so hesitantly, would surely result in the destruction of the Money Market. Finally, he concluded that to run the bank in the interest of the public, the reserve should be kept above the public apprehension minimum (which can only be found by trial and error), and maintained by an experienced manager, who is overseen by a working committee of the board of directors, and supervised by a temporary but distinguished governor.

I first heard about Lombard Street while I was making my way through Friedman andSchwartz's "The Great Contraction" (something I've already posted about). Friedman referred to it as the seminal work on banking, central banking, and the money market. Naturally, I was curious. It was written by the 19th century English business analyst Walter Bagehot, and it is an exposition on the financial markets of Lombard Street in London, England (the 19th century Wall Street). Now, onto the book!


  • The money market is not abstract or obtuse, it is concrete and plain. If it appears abstract and obtuse, it is a failure of communication on the part of the analyst or writer.
  • In the 19th century, Lombard Street represented the greatest economic power and knowledge on the planet. Much more money could be raised and channeled than anywhere else in the world. Why? Because Lombard Street had the largest Money Market.
  • Money in the market (deposited in the banking system), is more powerful than cash balances in the hands of the public, because it can be intelligently and systematically supplied to borrowers.
  • Cash deposits lower the transactions costs of borrowing large sums of money to finance business undertakings.
  • Diversification of funds and specialization in lending further lower the transactions cost of loans, ultimately resulting in a lower general price level.
  • Easy access to financial capital makes it possible to seize business opportunities quickly, allowing for more competition in the economy.
  • However, easy access to financial capital (when there is asymmetric information), worsens principle-agent problems such as moral hazard.
  • Financial capital is much more mobile than other forms of physical capital, thus capital adjusts to more profitable trades quicker in nations that have larger amounts of financial capital.
  • A powerful financial market requires large cash deposits in banks, but a bank run on these cash deposits can destroy any financial market abruptly.
  • Bank reserves are meant to head off these panics, by reassuring the public. But the incentive of a bank is to keep as little of a reserve as possible, which may or may not be sufficient depending upon shifts in the public psyche.
A General View of Lombard Street

  • The institutions that make up a mature money market are: the cental bank, the private banks, the joint-stock banks, and the bill brokers.
  • Credit is loosely defined as a set of promises to pay resources loaned out, which are backed by the reputation of the party requesting the loan.
  • There are infinitely many possible systems of credit, but the main test of any credit system is its "soundness", or how confident the lender and borrower are collectively on the successful outcome of their arrangement.
  • In order to meet extraordinary and infrequent demands, such as bank runs or waves of loan defaults, banks must hold a certain amount of cash in reserve.
  • Most English banks in the 19th century kept their reserve with the bank of England, which was a private bank.
  • However, private banks have an incentive to keep their own reserves as low as possible, in order to maximize profits.
  • Thus, in the 19th century, the entire banking reserve of the English money market was in the hands of a private bank, who did not have the clear incentive to maintain a large enough reserve to meet its obligations as a private bank, and the oblations of all the other banks during a panic.
  • As the central bank, the Bank of England can use the interest rate it charges to control cash flows in the country. Higher interest rates slow business activity by making loans more expensive, lower interest rates speed it up by making loans less costly.
  • To address a banking panic, the central bank should lend freely at elevated interest rates.
  • To counter a drain on its cash reserve by foreign nations, a central bank should raise its interest rate, but also lend freely if there is a panic.
  • "A good banker will have accumulated in ordinary times the reserve he is to make use of in extraordinary times."
  • A panic generally starts with concerns about the solvency of minor businessmen and speculators. However, if banks refuse to lend to these parties so that the concerns can be addressed (if they are not valid), then the panic can spread to the banks.
  • If all creditors demand their cash at once, it will never be possible to satisfy their demands, and the banking system must inevitably collapse, but this is unlikely to occur.
  • As the holder of the banking reserve for the nation, the activities of the Bank of England are a matter of the public interest, although it is a private institution.
  • The Bank of England, as a private bank, has not acknowledged its public role as keeper of the reserve, and this might prompt it to be hesitant to lend during a panic, as a private bank would be inclined to do.
  • Lending hesitantly is the worst course of action during a panic.
  • Fundamentally changing this system of credit in England is impractical, but adjustments can be made to make it better, such as:
  1. Having the Bank of England (BOE) Acknowledge its role as the reserve publicly.
  2. Ensuring that the Board of Directors of the BOE have special training for their responsibilities.
  3. Taking steps to diminish the reliance of other banks on the reserve of the BOE.
How Lombard Street Came to Exist, and Why it Assumed Its Present Form

  • To begin deposit banking, it is necessary for a large amount of people to come to trust a small amount of people with their money.
  • Many of the large banks of Europe, including the BOE, began as organizations to make loans to governments, or as keepers of high quality currency, or as institutions for channeling funds abroad. Adam Smith has a good account of this in "The Wealth of Nations".
  • Deposit banking also requires a large circulation of bank notes, which are seen as reliable. This requires a prolonged period of social and political stability, in conjunction with the other factors. This was the case in England after the Glorious Revolution in 1688.
  • The status of the BOE as the government's bank, it's monopoly grant of limited liability, and its historical monopoly over the printing of bank notes conspired to make it the central reserve bank of England.
The Position of the Chancellor of the Exchequer in the Money Market
  • If the government does not keep its own finances, and instead uses a bank, then the money market becomes vital to the public interest, and some form of government intervention is inevitable.
  • Under a perfectly competitive banking system, where the government kept its own finances, there would be a great number of banks all keeping their own reserves.
  • However, when the government favors one bank with its finances, it has natural advantages over other banks, and it generally becomes much larger than other banks, with greater security based on public backing.
  • This is how the Bank of England, as a private bank, came to be the reserve bank of the English Money Market. Other banks rely on the BOE as their reserve instead. This generates a number of problems, namely:
  1. Since the banking system is depending on a bank which can call on the state for aid, it is likely that this system will be taken advantage of more than a totally private system.
  2. The total level of reserves is lower than under a totally private system, because the BOE only sees fit to keep reserves to secure their own losses, not the losses of the entire banking system.
  3. The stability of the banking system rests essentially with one private board of directors, who are obligated only to their shareholders. There is no acknowledgement of the public role with the BOE has to play in monetary policy.
The Mode in Which the Value of Money Is Settled in Lombard Street
  • The value of money, like other goods, is settled by the laws of supply and demand, only the particulars vary.
  • Banks with monopoly power of the currency can alter short-term interest rates, but not average rates.
  • If a bank with monopoly power of the currency increases the money supply, and thus lowering the short-term rate of interest, the consequence is a rise in prices, with three consequences;
  1. It makes everyone want to borrow money (because it has become more expensive to perform the same level of business).
  2. As asset prices inflate, people are able to borrow more money against them, in nominal terms.
  3. If the price rise is confined to one country, it stimulates imports, as domestic goods become more expensive relative to foreign goods. Thus, currency is sent out of the country.
  • Since banks can control short-term, but not average interest rates, they have some control over the volatility of the business cycle. If the banks manage the rate of interest poorly (by having a large standard of deviation from the mean), the business cycle will be more violent.
Why Lombard Street Is Often Very Dull, and Sometimes Extremely Excited
  • Shocks to the economy, especially negative ones, can lead to an increase in preference for more liquid assets, which can freeze credit markets.
  • Classical Economics does not emphasize the importance of the transactions costs of time in the market, namely that ideally:
  1. Goods should be exchanged as quickly as possible.
  2. Producers and consumers should be able to locate each other as soon as possible.
  • However, as the number of market connections utilized and relied upon widens, the power of positive and negative shocks is magnified.
  • A functioning credit market cuts down on the amount of time required for transactions.
  • When deposits are long term, the bank can channel them to expand credit. This fuels business activity.
  • Gradual inflation and good credit are associated with the expansion of business, while deflation and credit freezes are associated with contractions. However, growth driven only by rising prices is transitory.
  • Business expansion based upon increases in productivity are real by volatile, and transitory expansion based upon higher prices ultimately only results in a redistribution of wealth to those who raise their prices first.
  • Since the health of Lombard Street, the Bank of England, and the Money Market, are intimately connected with the health of business in England (even more so due to BOE's status as a reserve bank), the public should realize how their own fates are tied to the prudent conduct of these financial institutions.
How the Bank of England Has Approached It's Duty as a Reserve Bank
  • The Bank of England, as of the publication of the essay, had never publicly acknowledged its role as a reserve bank.
  • Furthermore, no public authority seems to have taken an interest in the BOE's role either.
  • Finally, many economic scholars have preached the virtues of a hands off approach to the banks, which upon further consideration, is clearly against the interests of the nation.
  • "Men of business have keen sensations, but short memories, and they will care no more next February for the events of last May than they now care for the events of October 1864".
  • The supply of loanable funds is more sensitive, in the short term, to expectations about the future, than is the demand for loanable funds.
  • In a panic, the goal of a reserve bank should be to loan freely to all businesses that would be otherwise considered sound during ordinary times, not just to the banks, because they will only hoard the funds.
  • A board of directors is not usually quick to respond to urgent situations.
  • Managers rely mostly on their experience, their knowledge of theory is often antiquated. Even without knowledge of theory, they must act on experience, because timid managers are often behind and ultimately ruined.
  • Banks cannot replenish their reserve during a panic, and it is often impossible to raise more capital by selling stock.
The Government of the Bank of England
  • Boards are often composed of successful capitalists utilizing their leisure time.
  • The executive management in a bank should not be a rotating position, experience and consistent policy are important, although entrenched interests can be a concern.
  • To counter the concern of entrenched interests, the governor of the bank should be appointed and rotated, but the day to day management should be undertaken by a long-term subordinate.
  • In the end, banking should be more about caution (and less about risk) than ordinary commerce.
The Joint Stock Banks
  • In banking, there is a premium generated by longevity in the business.
  • Banking requires at the utmost: attention to detail, prompt decision making, and the ability to make decisions on a case by case basis.
  • Far more money is often lost in banking due to errors and incompetence than fraud, because there are limits to the size of fraud.
  • Joint stock banks are becoming more popular, and will be the ultimate form of banking eventually due to their ability to raise capital.
  • A board that oversees a joint stock bank should have a fixed working committee that is always in session, for the purpose of reviewing the major actions of the management.
The Private Banks
  • Private banks used to be dominant in England, but they are unable to achieve the scale of joint stock banks.
  • Private banks also have more difficulty with finding good management, which damages confidence in their longevity.
  • Thus, private banks have been and continue to be phased out by joint stock banks, and one day might disappear entirely.
The Bill-Brokers
  • Bill-Brokers act as intermediaries between banking capitalists and borrowers, deriving a premium or profit from their proximity and knowledge (Coase Theorem).
  • Credit is not a direct function of wealth, it also involves history and reputation.
  • Bill-Broking was originally about the soundness of the bills being traded, as the industry has grown, it has become more about the credit of the bill-broker. Consequently, he/she must now pay interest on the funds they use to broker bills.
  • Thus, bill-brokers now have a greater opportunity cost to maintaining their funds, which puts them in a precarious position during a credit freeze.
Principles to Regulate the Amount of Reserve Kept by a Central Bank
  • The size of the reserve depends on the size of the liabilities, but also on the probability of withdrawals within certain time horizons.
  • Rigid rules to the size of a reserve are dangerous in a dynamic business environment. They can hurt the profitability of banks, and even ruin them under certain circumstances.
  • Publishing of Bank Balance Sheets can go a long way to promote prudent conduct and provide assurance to the public.
  • There seems to be some variable "apprehension minimum" to the size of the reserve of a bank, below which the bank drastically increases the probability of a bank run.
  • In the end, the reserve should be kept above the apprehension minimum (which can only be found by trial and error), and maintained by an experienced manager, who is overseen by a working committee of the board of directors, and supervised by a temporary but distinguished governor.

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