A Comparative History of Bank Failures

From Medici to Barings

Sten Jonsson

• Publisher: Routledge
• Year: 2019
• ISBN:
  9780429575624
• Edition: 1
• Topic: Economics
• Subtopic: Banks & Banking
• Index: Economics

Starting with Medici and Fugger and ending with Barings and Royal Bank of Scotland under neo-liberal de-regulation, the author gives an account of how a number of banks failed over a 500 year-period. The author offers an explanation of the leading ideas about the world and good society at the time, and summarizes this narrative using Streeck & Schmitter's three bases for regulation of society: Community (spontaneous solidarity), State (hierarchical control), and Market (dispersed competition).

The bank failures are presented in the context of social philosophies of the day (scholasticism, mercantilism, neo-liberalism, and libertarianism), and the changing business practices (Bills of Exchange, rents and financial instruments of various kinds). The dominating explanation of financial crises has been market-related. Here, the author argues that managerial failures are an important contributor. He demonstrates the failure of management to act on early signals such as existential risk, strategic stress syndrome, and lack of proper oversight by top management. The author encourages a return to ethical principles for banks, suggesting that his ethical aspect should be at the core of the credit process of banks in the future.

With its interdisciplinary approach, this book will be an important contribution to the discussion surrounding bank failures. It will interest any scholar looking at the origins of financial crises and will be particularly useful for post-graduate students of economic and financial history, banking, finance and accounting.

1 The problem with the role of banks

1:1 What this book is all about

Banks are different from other organizations in that they are particularly dependent on the goodwill and trust of their customers. Their business is to “translate” money between places, over time, and from short to long term. This means that they are particularly sensitive to context, be it business or norms of proper conduct.

I try to illustrate this by three bank failures in the context of war, emerging State administrations and scholasticism from about 500 years ago, and three cases from current times in the context of deregulation, financial crisis, neo-liberalism and libertarianism.

In the period between these failures the ideas of market price (“common estimate”), money supply, and enlightenment (science) set the stage for new approaches in the study of wealth and money. Mercantilism, promoted by pamphleteers, required a State bureaucracy to control and manage money flows. In modern times we wonder about the meaning of “bit-coin” and “flash-crashes”. Negative interest rate? What does that imply? The less money you have the better?

The book starts in Hell. That is where those who charge interest spend their afterlife. Dante told us that it is deep down in the lower parts, on smouldering hot sands. The Church Fathers and scholastics (mostly in Paris) were inspired by Aristotle, who built his views about fair price on the Free Will. Contracts are only valid if they have been entered into of free will by both parties. There was no conception of a market price. Langholm (1984) shows that the arguments of the scholastics only make sense under a no growth assumption. Without investment opportunities the interest is zero (as they are in equilibrium). A second version of scholasticism emerged in the texts by the “Doctors of Salamanca” (late 1500s) as they tried to explain why Spain was in decline in spite of the fact that treasure (silver and gold) flowed in to Sevilla by shiploads from “El Dorado” (America). The money supply is mentioned for the first time 200 years before it became fashion in Britain. Mercantilism and a managerial State monitoring the flows (and extracting taxes) was the solution.

I show how the Medici Bank crumbled because top management stopped paying attention to double entry book-keeping (which Cosimo, who built it all, had done) and was defrauded by branch managers, and also how Pedro de Morga went bankrupt in Seville in the second half of the 16^th century as the King resorted to “forced loans” and seizure of cargos (against IOUs) to finance his wars. He also stopped servicing the Crown’s outstanding loans several times. Pedro de Morga had made himself too dependent on the “court banks” commentators said.

One such “court bank” focusing on one customer, the Crown, was the Fugger Bank of Augsburg that, in a roundabout way, had attached itself to the Habsburg royalties and stayed loyal with the Catholic side to the bitter end of the 30-years’ war (17^th century).

The 19^th century, the Golden Age of merchant banks, saw Barings Bank prosper (always second after Rothschild). The action had moved to London and Barings served American customers in London. It managed through the wars, but met strategic problems with the Big Bang – how to acquire the necessary set of competencies for a complete portfolio of services when equity is tightly held by family. They chose to recruit a team of traders in Far East securities and got Leeson in the bargain. Like Medici, Barings was unable to discover internal fraud and the bank failed.

Royal Bank of Scotland failed on the basis of hubris as its leaders thought they could do no wrong, and entered into a deal the premises of which were no longer valid. The Icelandic banks failed because two of them thought they had found a new way of funding the banks by deposits (!) when the credit market pulled the brakes.

In the three recent cases, the background social philosophy was neo-liberalism and to some extent libertarianism. These ideas stem from the debate in Vienna over how to design a new (German-speaking) State after the defeat of the Double Monarchy in the First World War. Activist economists, inspired by the Austrian school represented by, primarily, Friedrich von Hayek, legitimized a practice of giving policy advice promoting liberty, market solution, and monetary activism. Libertarianism, backed by big business, went a step further and invested in lobby institutes and the training of anti-big-government activists.

And here we are in 2018 with cyber-wars, super-fast transfer of capital across the globe, authoritarian governments, and a general democratic confusion. What next?

1:2 A social science world view

This chapter is inspired by Josef Schumpeter (1954), Deirdre McCloskey (2006, 2010, 2016), and Wolfgang Streeck & Philip Schmitter (1985). By Schumpeter because he dared to apply quite a wide set of perspectives on the development of ideas in his majestic book History of Economic Analysis. ¹ One indicator of this book’s greatness is the fact that reviewers of the book, almost to a man (no women mentioned) judged the book brilliant, even if they had some severe points of criticism – see Perleman’s Introduction to a later edition that he starts with a quote from one of the reviews:

There is, as we shall see, much in this book which is redundant, irrelevant, cryptic, strongly biased, paradoxical, or otherwise unhelpful or even harmful to understanding. When all this is set aside, there still remains enough to constitute, by a wide margin, the most constructive, the most original, the most learned, and the most brilliant contribution to the history of the analytical phases of our discipline which has ever been made.

(Viner 1954, pp. 894–5)

One frequent complaint among reviewers was that Schumpeter did not pay enough respect to US and British contributions. Perleman mentions that Schumpeter considered Adam Smith “a small potato” in the general flow of theoretical ideas. Grice-Hutchinson (2015) makes a similar argument by pointing out that the first five chapters of his Wealth of Nations is a repetition of texts from the School of Salamanca more than 200 years earlier. So, a somewhat “wider perspective” might be in order after all, even if many of the faults Viner mentions necessarily follow from the adoption of Schumpeter’s manner of perspective. The inspiration is, as it were, in a Nietzschean way, to trace concepts and conceptions back to, if not their origins, to earlier articulations in different contexts. It is self-evident, is it not, that all theoretical statements are articulated in a particular context with a particular code of conduct and particular problems. Only mathematical and logical statements can be said to be context free (even if most of them are surrounded by assumptions about the nature of the variables under consideration (continuous, random walk, normal distribution, etc.)).

Schumpeter (1954), thus, maintains that we should pay attention to those particular contexts in which all theoretical ideas are articulated. He also argues that progress was often made when scholars tried to sort out new problematic situations – he even has a chapter on “Consultant Administrators and Pamphleteers”, i.e., when scholars and wise practitioners argue diagnostics as well as therapeutics for an ailing economy. One cannot help getting the impression that Adam Smith, who valued his Theory of Moral Sentiments (1759) higher as a scholarly work, looked upon Wealth of Nations (1776) more like a pamphlet – arguing the case for a certain policy (Otteson 2002), by compiling existing “academic” arguments to a well written and convincing text. This close interaction between scholarly work and practices of old seems to have been lost in some quarters nowadays – or has it? The libertarian tactic of sending out messengers from George Mason University (or other think tanks) to nearby Washington, with the purpose of influencing policy as well as appointments in the judiciary, is an indirect way of pamphleteering that should not be ignored. The context in which diagnostics and therapeutics are discussed today is quite different from those old days. Still we can learn from the arguments presented then.

One thing that is different is that large organizations are managed with a much higher debt than was usual at the time when most of our theoretical underpinnings for judging business practices were developed (for example Austrian economics). This – debt – puts banks in a more central role in the economy than at any time before. They used to be family businesses with few employees and remained so through the Golden Era of merchant banks in the 19^th century, up to today’s global, enormous organizations with huge sums of money at their disposal (mostly “other people’s money”) that can be transferred to any part of the world in a split second – no longer any need for “Bills of Exchange” to be transported by ship for 90 days between Antwerp and Genoa! Now, perhaps, more attention to credit management is needed, and less to return on equity. Banks are chiefly funded by credit from other banks. Bank runs in their classical form do not happen anymore. The financial sector now generates a large part of the GNP in advanced countries, mostly by trading in financial papers (promises that if X happens, I will pay the bearer Y) – a form of gambling outsiders might say (MacKenzie 2006; Mackenzie & Spears 2014), but advanced science – according to insiders with Black & Scholes (1973) to prove it. That proof is built on the assumption that prices of options move randomly (random walk), and the mathematics used was intended for calculations of the movement of molecules in gases. We should be, and we are, impressed by scientific progress in new areas!

Deirdre McCloskey (2006, 2010, 2016) works in the same spirit as Schumpeter, conscious of the unavoidable influence of the context on academic as well as on other work. She claims that economics cannot explain the extraordinary economic growth in the 19^th century, some of it, yes, but most of it, no. There was a “hockey-stick” effect of very rapid growth then, and – she claims – it was bourgeois ideas, virtues as well as a sense of equality, not capital or institutions, that explain it. The bourgeoisie believed that man can form his/her own destiny through entrepreneurship and diligence. You are no longer “born” into your station in society. It is ideas rather than capital; dialogue, debate, maybe even “language games” (in communities) that form our conception of what is possible and proper. For an economist from Chicago like McCloskey that is pretty unorthodox. New perspectives open up – there are a number of explanatory hypotheses that have not been tested yet, simply because we do not know how to measure certain phenomena.

Cooren (2010) places passion at centre stage in action (speech is also action) and argues that there is a gap between rationality and action – the courage to take the plunge – to risk making a fool of oneself – by going into action on the basis of this incomplete information. That gap is bridged by passion. Here the age-old virtues come in, since that passionate step needs to be taken on moral grounds. McCloskey (2006) lists seven virtues (Love, Hope, Faith, Justice, Courage, Prudence and Temperance). The first three are the “warm” ones stemming from Christianity, while the four others are “cold” calculating, deliberating ones coming from the Enlightenment and the Ancient Greeks. When the bourgeoisie found their dignity, and considered themselves equal to the hereditary aristocracy that had dominated everything on account of their land ownership, they applied entrepreneurship to the host of ideas from science and engineering that could be exploited for the good of a growing number of customers. It may have been these ideas that fired the passion for business with inventors at work on every corner of society. Those inventors must have thought a lot about how to get their product to market, even if the inventing was their core activity. Banks must have received lots and lots of proposals – merchant banks – and large volumes of goods were flowing in from overseas!

Both Schumpeter (1954) and McCloskey (2006, 2010, 2016) are scholars that take a historical perspective to find the “origins” of some of our theoretical short-comings. They both stress the development of ideas in a dialogue between “theory” and “practices”. I bring with me from them the significance of ideas in crises, and cannot help recognizing support for this view in Milton Friedman:

Only a crisis – actual or perceived – produces real change. When the crisis occurs, the action taken depends on the ideas that are lying around.

(Friedman 1982, preface )

With all those ideas lying around, individuals and organizations, like banks, need some tools to help them structure and orient themselves, in order to stabilize a changing world. (I will call those tools principles.) The logics that these principles generate when applied in context are called social orders, and serve to regulate proper conduct. Rules, norms, habits – there are many conceptions of these tools of judgement. Rhetoric is required when you need to persuade others of the merits of your new idea. Applying principles means following rules.

Streeck & Schmitter (1985) have developed a three-pronged conception of social orders, sometimes called corporatism. We live by rules, not least in language (Wittgenstein 1953), and there are different approaches to rule-making that will constitute social orders. They are always present when society is framed and re-framed – note the Friedman quote above – but one of them can usually be seen as dominating – crises may shift the balance. The individual in such entangled social orders will have difficulties to cope with the overflow of principles – which ones are the appropriate ones to apply to this particular situation? One can only refer to Merton’s (1968) “strain theory” which tell us that in situations characterized by “complexity and contradiction” there is an increased demand for ideology, i.e., guidance as to what values/principles are relevant in constructing action. My pre-conception is that the sources of such guidance (ideology production) varies over the centuries, with dominance for religion over a very long period up to around 1600, and the social order that this generated fits the Community type given by Streeck & Schmitter (1985).

Community (spontaneous solidarity) represents an approach where good arguments carry the day. Learned people (professionals) are able to interpret situations and apply the appropriate general rules to the particular case – like doctors do when they diagnose the patient and recommend the most suitable therapy considering all relevant circumstances. The priest, rabbi, or imam gives the individ...

Table of contents

• Cover
• Half Title
• Series Page
• Title Page
• Copyright Page
• Table of Contents
• List of figures
• Preface
• 1. The problem with the role of banks
• 2. Community as centre of authority: Banks are squeezed between the necessities of business, power politics, and the afterlife
• 3. Transition from regulation by State to regulation by Market
• 4. Market as ideology – toward the financial crisis of 2008
• 5. Concluding remarks
• Index