Much like the world today, the period from 1870-1913 (known as the first era of globalisation) was marked by increased trade, significant cross-border financial flows, unrestricted migration and sophisticated financial markets. London was the centre of the financial world with the markets for bonds large, liquid and supported by timely financial information. At that time Barings had reached the pinnacle of its success by being the largest investment bank in London, and perhaps the largest in the world.
But it was in 1890 that Barings entered into a crisis situation, in an economic climate similar to what Lehman Brothers experienced on September 15th, 2008. Initially the fall of Lehman largely pointed to microeconomic explanations such as managerial moral hazard, faulty risk models and regulatory failure. However, later macroeconomic explanations behind the collapse also came to the forefront. These focused on the fundamental imbalances in the US or global economy.
In a recent research seminar at the Bartlett School of Construction and Project Management, the macroeconomic view of the global financial crisis was also advocated using the historical counterfactual of the Baring crisis. The seminar, ‘Macroeconomic Stability, Contagion and Failure to Save Lehman: A View from the Baring Crisis on the Global Financial Crisis’, delivered by Dr Nathan Sussman, used the historical case point of the Baring crisis to help identify the importance of macroeconomic factors. Through studying this historical case study he also attempts to answer a fundamental question: what can we learn from a severe banking crisis that did not turn into a great recession? It is important at this point to delve into how the Baring crisis occurred in 1890 and the lessons one can derive from the episode for today.
The Baring crisis of 1890
Like its rival Rothschilds Bank, Barings was a privately-held company not listed on the London Stock Exchange. It underwrote sovereign debt for numerous foreign governments. Between 1885 and 1890, the exposure of British investors to Argentinian bonds doubled from 1.7% to 3.4% of GDP. During the same time period, the volume of bonds handled by Barings also burgeoned from £5.5 million to £18 million.
With an influx of capital flows in the Argentinian economy, the increased liquidity precipitated speculation in real estate funded by Cedulas mortgage-based loans. These mortgage-based loans were tradable and ended up on European stock markets in large quantities. With Cedulas based on inflated land prices and supported by liquidity derived from foreign investment, a crisis was inevitable. In addition to this, provincial governments in Argentina amassed debt at an increasing rate. Politically also, Argentina faced a volatile situation with a revolution breaking out in the country in 1890. All these factors led to a stark decline of capital inflows to Argentina and the price of Argentinian bonds in London to sharply decline.
Consequently, the Argentinian government called in the money and the Russian government which held large deposits with Barings withdrew almost £5 million. Any further attempt to recall additional deposits in 1890 would have led the bank to fail. Barings approached the Bank of England, and the Bank, comprehending the systemic importance of the institution to the overall financial industry, provided liquidity to Barings. With the above sketch of a historical crisis episode, what are some of the similarities and differences between this episode and that of the fall of Lehman during the global financial crisis of 2007-08?
Comparing the two crises
Studying the crisis episodes offers some similarities and highlights some crucial differences. Both crises emerged in a macroeconomic environment characterised by low interest rates and high levels of liquidity. Both crises were precipitated by a run-up in underlying asset prices followed by a sharp decline. Despite the similarities, the onset of the financial crises led to markedly different macroeconomic and financial outcomes. Barings was provided liquidity support by the Bank of England whereas Lehman was not bailed out by the FED. This led to the Baring crisis being short-lived, lasting for a mere three days, which did not drag the world into a severe recession.
On the contrary, Lehman was allowed to fail which some academics and policymakers believe exacerbated the financial crisis in the sub-prime market and resulted in a full fledged global liquidity and banking crisis.
Moreover, the authors argue that other fundamental differences lie in the manner international investment is organised today, the degree of co-movement of financial assets, and the macroeconomic stability of the core of the financial system. Had the financial core been as unstable historically as the US is today, the actions of the Bank of England would not have sufficed. The authors draw an important conclusion that future financial stability lies in addressing the fundamental imbalances in the US economy so as to make the ‘financial core’ of today as stable as the financial core of yesterday.
