Plain vanilla bank runs are as old as fractional reserve banking itself, and usually happen just before or during an economic and financial collapse, when all trust (i.e. credit) in counterparties disappears and it is every man, woman and child, and what meager savings they may have, for themselves. However, when it comes to shadow bank runs, which take place when institutions are so mismatched in interest, credit and/or maturity exposure that something just snaps as it did in the hours after the Lehman collapse, that due to the sheer size of their funding exposure that they promptly grind the system to a halt even before conventional banks can open their doors to the general public, the conventional wisdom is that this is a novel development (and one which is largely misunderstood). It isn’t.
As the NY Fed’s blog (whose historical narratives are far more informative and accurate than its attempts to “explain away” the labor force participation collapse) recounts, the first tremor in the shadow banking system took place not in 2008 but some 250 years ago… during the Commercial Credit crisis of 1763, whose analog today is the all too shaky and largely unregulated core shadow banking system component: Tri-Party Repo.
From the NY Fed blog, by James Narron and David Skeie:
Crisis Chronicles: The Commercial Credit Crisis of 1763 and Today’s Tri-Party Repo Market
During the economic boom and credit expansion that followed the Seven Years’ War (1756-63), Berlin was the equivalent of an emerging market, Amsterdam’s merchant bankers were the primary sources of credit, and the Hamburg banking houses served as intermediaries between the two. But some Amsterdam merchant bankers were leveraged far beyond their capacity. When a speculative grain deal went bad, the banks discovered that there were limits to how much risk could be effectively hedged. In this issue of Crisis Chronicles, we review how “fire sales” drove systemic risk in funding markets some 250 years ago and explain why this could still happen in today’s tri-party repo market.
Early Credit Wrappers
One of the primary financial credit instruments of the 1760s was the bill of exchange—essentially a written order to pay a fixed sum of money at a future date. Early forms of bills of exchange date back to eighth-century China; the instrument was later adopted by Arab merchants to facilitate trade, and then spread throughout Europe. Bills of exchange were originally designed as short-term contracts but gradually became heavily used for long-term borrowing. They were typically rolled over and became de facto short-term loans to finance longer-term projects, creating a classic balance sheet maturity mismatch. At that time, bills of exchange could be re-sold, with each seller serving as a signatory to the bill and, by implication, insuring the buyer of the bill against default. This practice prevented the circulation of low-credit-quality bills among market participants and created a kind of “credit wrapper”—a guarantee for the specific loan—by making all signatories jointly liable for a particular bill. In addition, low acceptance fees—the fees paid to market participants for taking on the obligation to pay the bill of exchange—implied a perceived negligible risk. But the practice also resulted in binding market participants together through their balance sheets: one bank might have a receivable asset and a payable liability for the same bill of exchange, even when no goods were traded. By the end of the Seven Years’ War in 1763, high leverage and balance sheet interconnectedness left merchant bankers highly vulnerable to any slowdown in credit availability.
Tight Credit Markets Lead to Distressed Sales
Merchant bankers believed that their balance sheet growth and leverage were hedged through offsetting claims and liabilities. And while some of the more conservative Dutch bankers were cautious in growing their wartime business, others expanded quickly. One of the faster growing merchant banks belonged to the de Neufville brothers, who speculated in depreciating currencies and endorsed a large number of bills of exchange. Noting their success (if only in the short term), other merchant bankers followed suit. The crisis was triggered when the brothers entered into a speculative deal to buy grain from the Russian army as it left Poland. 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. As asset prices fell, it became increasingly difficult to get new loans to roll over existing debt. Tight credit markets led to distressed sales and further price declines. As credit markets dried up, merchant bankers began to suffer direct losses when their counterparties went bankrupt.
The crisis came to a head in Amsterdam in late July 1763 when the banking houses of Aron Joseph & Co and de Neufville failed, despite a collective action to save them.
… or 10% of US GDP. What can possibly go wrong.