A post today on the Federal Reserve Bank of New York’s Liberty Street Economics blog finds surprising parallels between the 18th century crisis, which wiped out more than 100 European banks, and the 2008-09 financial crisis in the global shadow banking system. Authors James Narron and David Skeie conclude by asking: “Can industry provide the leadership needed to ensure that credit crises don’t persist? Or will regulators need to step in and play a firmer role … ?”
Both crises involved overleverage and “fire sales” of assets that spread like, well, fires. Then and now, one borrower that got into trouble would sell assets as quickly as possible, dumping them onto the market and depressing the going price. That would harm the balance sheets of other borrowers that held similar assets, alarming their creditors and forcing them to conduct fire sales of their own.
In the 18th century the borrowing was via so-called bills of exchange. In 2008-09 it was via short-term repo loans backed by assets such as Treasuries (good) and mortgage-backed securities (not always so good). It’s called shadow banking because the repo lenders aren’t banks but money-market mutual funds, securities lenders, insurance companies, and pension funds.
The New York Fed’s blog post is a historical yarn that wraps in banks in Amsterdam, Hamburg, and Berlin, and one big blunder that triggered the whole mess. A merchant bank owned by the De Neufville brothers “entered into a speculative deal to buy grain from the Russian army as it left Poland,” the post explains. “But with the war’s end, previously elevated grain prices collapsed by more than 75 percent, and the price decline began to depress other prices.” Oops. Sounds a bit like what happened with subprime mortgages this time around.
The New York Fed isn’t the only bunch of central bankers poking around in 18th century European financial history. The Federal Reserve Bank of Atlanta published a working paper in 2012 on the same episode (PDF) called Responding to a Shadow Banking Crisis: The Lessons of 1763.
The New York Fed authors cite a study last year by colleagues who warned that “no established tools currently exist to mitigate the risk” of fire sales of assets following the default of a borrower in the repo market. That study focused on risks in the “tri-party” repo market, where a big bank acts as a go-between in a repo transaction, taking in the collateral from the borrower and handing over the loan from the lender. There are only two banks performing that critical function now: Dimon’s JPMorgan Chase and Hassell’s Bank of New York Mellon.
Frederick the Great of Prussia tamped down the fire sales of 1763 by imposing a payments standstill and organizing “some of the first financial-crisis-driven bailouts,” write Narron and Skeie. It’s not as easy in today’s complex markets. To keep fire sales from raging out of control, the authors of the earlier study wrote last year, dealers need to agree in writing before a crisis occurs on procedures for taking over assets from a failed dealer and selling them off in a slow and orderly way.