A special report from Lombard Street Research

Sovereign
Rescues
How the forgotten financial
crisis of 1914 compares
with 2008–2009

Professor Richard Roberts

Brian Reading

Leigh Skene
A special report from Lombard Street Research

Sovereign
Rescues
How the forgotten financial crisis of
1914 compares with 2008–2009

Professor Richard Roberts

Brian Reading
Leigh Skene

This special report is in two parts:

Then
In 1914 a storm broke over
globalised financial markets.
Financial historian Richard Roberts
has dug into the National Archives
at Kew, the Bank of England
Archives, the British Library and
sundry other sources such as The
Economist to analyse the crisis and
has unearthed an incredible story.

Now
In the second part, Brian Reading
and Leigh Skene draw parallels
with today’s crisis.
 Lombard Street Research 1

TH EN
EN

by Professor Richard Roberts

Professor Richard Roberts

is Director of the Centre for
Contemporary British History,
a research centre at the
Institute of Historical Research,
University of London.
2 Special Report : Sovereign Rescues

SUMMARY
The summer of 1914 witnessed the most perilous
crisis in the history of the City. Over the course of
little more than a week, London’s financial markets
ceased to function. The breakdown threatened
wholesale bankruptcy among specialist financial
2008

firms, as well as the collapse of the domestic banking

86.5x system. The onset of the systemic crisis was due to
1914

an abrupt adjustment to a new risk – a European

PRICES war – destabilising domestic and foreign participants
1914 : £1.00 in the world’s leading international financial centre
2008 : £86.50 and overseas counter-parties. Of course the threat
of a major war is a different context to today’s crisis,
2008

yet the breakdown of liquidity and confidence are

common features of the onset of both crises – in
1914 before a shot had been fired. In fact, the
312x
episodes have many resonances, both as regards
problems – global market contagion, the freezing of
1914

the money market, a credit crunch, toxic assets, the

SECURITIES impact of mark-to-market, recalcitrant bankers – and
1914 : 11.3 billion responses.
2008 : £3.5 trillion
The scale and scope of the 1914 crisis led to
unprecedented state intervention in the financial
2008

system. The authorities conducted a series of novel

initiatives to save the banks and revive the markets,
including contemporary forms of quantitative easing,
557x the removal of toxic assets from the market, and a
partial bail out of the banking system. The measures
proved successful - by late 1914 the City’s markets
1914

were operating once more and failures among

financial firms were minimal.
NOMINAL UK GDP
1914 : £2.54 billion. By then Britain was at war and the financial system
2008 : £1,443 billion.
had been put to work serving its saviour by funding
the war effort. Over the longer term, the emergency
measures to save the system laid the foundations
2008

of rapid wartime inflation. They also involved

substantial risk of loss by taxpayers. But, remarkably,
when the final account was done, the Treasury had
made a profit.
833x
1914

UK BANK DEPOSITS
1914 : £1.2 billion
2008 : £1 trillion (sight deposits)
 Lombard Street Research 3

THE FORGOTTEN CRISIS

The current crisis in the financial markets has greatly stimulated interest in financial history, insights being
avidly sought from past precedents. An episode that has been overlooked was the City’s financial crisis
of summer 1914. Obviously the circumstances then and now are significantly different – they always
are – but this forgotten chapter features some uncanny parallels in the development of the crisis and its
resolution. Perhaps its outcomes hold some lessons for today?

Breakdown
The murder of Archduke Franz Ferdinand, Austria’s heir-apparent, in Sarajevo on 28 June 1914 had
scant immediate impact on London’s financial markets. After all, there had been sabre-rattling between
Continental powers the previous three summers. Risk perceptions were abruptly transformed a month
later by an Austrian ultimatum to Serbia that became known to the markets on Friday 24 July – suddenly
the prospect of a European war was more than just a nightmare. Rattled investors dashed for cash with
heavy securities sales on Continental bourses.

Stock exchanges – all fall down

Subsequent days witnessed probably the first major episode of global financial contagion - the closure
of the world’s leading stock exchanges one after another as the scramble for liquidity swept across the
world. Friday’s news launched a week-long tsunami of selling. Overwhelmed, the Brussels, Budapest and
Vienna bourses, and Paris’s junior market, shut from Monday 27 July. Tuesday saw the closure of the
Madrid and Toronto markets. On Wednesday, Austria declared war on Serbia and the stock markets of
Amsterdam, Berlin, Montreal and St Petersburg shut up shop. On Thursday, Rome, Milan and Shanghai
followed suit. Friday saw the dominoes continuing to fall and Barcelona, Vancouver and Zurich as well as
all the South American exchanges capitulated.
The cascade of closures resulted in the London and New York stock markets becoming, according to
an observer: ‘the world’s dumping ground for the sale of stocks and shares.’ On Friday 31 July, for the
first time since its formation in 1773, the London Stock Exchange closed. The New York Stock Exchange
followed hours later. The Johannesburg, Adelaide, Melbourne and Sydney exchanges shut in following
days. In little more than a week, the world’s bonds and shares had become illiquid.

Mark-to-market shuts the London Stock Exchange

On the eve of the First World War the London Stock Exchange was the world’s largest and most liquid
securities market. The rules of the exchange imposed a strict division of activity between two types of
member, brokers and jobbers. Brokers acted as agents on behalf of buyers and sellers. Jobbers made a
market in particular securities, quoting buy and sell prices to brokers.
Brokers had modest capital requirements, but jobbing involved holding a stock of securities which
required substantial working capital. The funds, totalling £80 million, were borrowed as short-term
call loans from banks, both the major domestic banks and foreign banks with branches in London. The
banks’ loans to jobbers were collateralised by the securities they funded, plus an element of margin. The
collateral securities were regularly marked-to-market and if the price went down, firms had to provide
increased margin or sell the security and repay the loan. The system operated satisfactorily in normal
markets, but, as a banker put it: ‘the delicate financial mechanism of modern London had never been put
to the test of a European war.’
The deluge of selling orders sent securities prices plummeting. Confronted by a relentless one-way
market, jobbers stopped dealing, as in the stock market crashes of 1929 and 1987. ‘Many jobbers soon
declined to “make prices” at all, or at any rate insisted on learning which way a broker wished to deal
before quoting a price,’ recorded The Times. ‘Others made very wide quotations, so wide in fact as to
4 Special Report : Sovereign Rescues

check the desire to enter into a bargain in all but the most determined sellers.’
The price falls triggered margin calls from the banks. Moreover, the banks, especially foreign banks, were
calling in their call loans to boost their liquidity. Either way, jobbers disastrously found themselves being
forced sellers in a market without buyers. Seven firms failed on Wednesday 29 July and the following
day saw the closure of several more. To forestall further failures, the management closed the exchange.
This halted the ruinous write-downs since there were no longer quoted prices to serve as mark-to-
market benchmarks. While closure undoubtedly saved many stock exchange firms from failure, it created
significant liquidity problems for investors as well as compounding the array of problems facing the banks.

The London money market – key to London’s ‘greatness’

The Stock Exchange drama was paralleled by less publicly visible breakdowns in London’s money and
foreign exchange markets. The key to London’s ‘greatness’, the word used by a contemporary, as a
financial centre in 1914 was the unrivalled scale and liquidity of its money market. This was a wholesale,
over-the-counter market among banks that they used for funding and treasury management purposes.
Participation in the London money market was the foremost reason why foreign banks maintained
branches in London.
The key instrument traded in the money market was the sterling bill of exchange arising out of
international trade transactions (typically of three-month maturity). It was estimated that such sterling
commercial bills financed 90% of British trade and 50% of world trade. These bills also served as the
major means for the settlement of international obligations (shipment of gold was an inconvenient
alternative) leading to substantial overlap between the bill market and the foreign exchange market.
On the buy-side the foremost purchasers of bills were domestic and foreign banks. Bills formed an
important part of banks’ liquid reserves. The money market was served by a set of intermediary firms - the
discount houses – that acted as brokers and jobbers (combining the roles). They enjoyed privileged access
to discounting (purchase) facilities for their holdings of bills at the Bank of England. The discount houses
funded their bill portfolios by call loans from domestic and foreign banks collateralised by the bills.

The Accepting Houses

The negotiability of a commercial bill was enhanced by its endorsement by an ‘acceptor’ – a firm or bank
which guaranteed payment to the holder upon maturity in case of default by the debtor. Acceptance
business was the specialisation of a set of City firms known as accepting houses (later called merchant
banks). By 1914, the banks had also developed a significant accepting business, encroaching on the
business of the accepting houses; the respective magnitudes were estimated at £60m (£5.2bn)* and
£100m (£8.7bn)*. *(These and further bracketed figures give today’s values.)
The elite accepting houses, such as Barings, Rothschilds and Schroders, had modest private capital bases,
estimated in 1914 at £20 million in aggregate, much smaller than the capital and reserves of the banks
with their extensive branch networks. The accepting houses individually provided bill guarantees on an
acceptances/capital multiple usually in the range of two-to-six times, according to perceptions of market
conditions and an individual firm’s appetite for risk. An occasional default on remittance by a client was a
normal business hazard but a conjunction of non-remittances could wipe out a firm’s capital and bring it
down, as happened repeatedly in nineteenth century trade cycle crises.

Money market seizes up

Faced by the possibility of a substantial interruption to remittance from overseas, from Monday 27 July
(the day the world’s stock markets began to fall like dominoes) London acceptors stopped guaranteeing
new bills. The interruption to the accustomed flow of trade credit from the London money market quickly
exacerbated payment and settlement problems throughout the international financial system that relied
on this liquidity. In effect, as outstanding bills matured, London acceptors were withdrawing loans from
around the world of an estimated £3m (£260m) each working day. This contributed to a critical shortage
of liquidity in overseas foreign exchange markets; as sterling bills rapidly became unobtainable, remittance
 Lombard Street Research 5

to London became impossible. Thus even solvent and willing debtors were unable to make cross-border
payments. Well before the Stock Exchange closed its doors on Friday 31 July, the London money market and
the foreign exchange market had ceased to operate.
The interruption of remittance to London by overseas debtors in respect of maturing bills led a prominent
merchant banker to confide the imminent insolvency of his own firm and seven other accepting houses –
around one-third of the sector. The failure of an acceptor rendered worthless its default guarantee in respect
of all outstanding bills in the market that bore its name. This compromised the value and negotiability
of these bills, increasing the risk and impairing the liquidity of the bill portfolios of the discount houses
and banks. A widespread failure among the accepting houses conjured the prospect of the collapse of
the money market, additional casualties among the accepting houses and discount houses, and a further
weakening of the banks.

Run on the banks and the Bank of England

The breakdown of the money market and the stock exchange, and the threats to the discount houses,
accepting houses, brokers and jobbers posed a series of problems for the banks that summed to a serious
menace to their solvency. On the asset side, the banks experienced a drastic reduction in liquidity and value.
First, except for their holdings of cash and gold, the banks’ liquid assets - call loans to the discount houses
and stock exchange firms, and their holdings of commercial bills - were unmarketable or unrecoverable.
Second, the banks’ holdings of securities were unrealisable. Third, they faced the prospect of having to pay
out on account of bills for which they had acted as acceptors but had not received remittance (the same
problem as the accepting houses). A senior banker warned the Chancellor that almost seven-eighths of
banks’ assets were ‘frozen up.’ For the banks of England and Wales as a whole, locked up and potentially
unrecoverable supposedly liquid assets (call loans + commercial bills) amounted to 2.5 times capital and
reserves (3.2 times including liability for acceptances).
On the liabilities side, the bulk of funding came from deposit accounts that were repayable on demand.
For the banks as a whole, demand deposits were six times greater than available liquid assets (cash + gold
+ Treasury bills). The alarming deterioration in the banks’ financial position and their vulnerability to a run
on deposits led the leading banks to make a joint proposal to the Treasury. To boost their liquidity they
proposed that they should deposit the £15 million of gold they held as reserves in return for £45 million
of new Bank notes. This would have doubled the £44 million Bank notes outstanding. While this scheme
was being devised and negotiated, the banks hoarded their gold. Instead of the usual practice of paying
withdrawals by depositors in £1 gold sovereigns, the everyday circulating currency, they paid them in Bank
of England notes.
The London Stock Exchange closed on Friday 31 July. The summer Bank Holiday happened to fall on
Monday 3 August, in the midst of the crisis. The days leading up to this major public holiday always
saw substantial withdrawals by depositors to meet holiday expenditures. Payment to depositors in Bank
notes, whose minimum denomination was £5 (£432.50 today), was not only inconvenient for the public
but aroused anxieties about banks’ solvency. Recipients of the £5 Bank notes took them to the Bank of
England to be cashed into £1 gold sovereigns. This resulted in queues outside the Bank from Thursday 30
July, presenting an unfortunate impression - a run on the central bank. Widely reported in the press, the
lines helped to trigger the start of a run on the British banking system. As the holiday weekend began
on Saturday 1 August the run claimed its first victim, a London bank with a dozen branches and £2.4m
(£207m) in deposits.
Doing his rounds of the City, financial editor Sir George Paish was told by the general manager of Lloyd’s
Bank, the biggest British bank with deposits of £107m (nearly £1bn in today’s money), that a general run on
the banks was underway. He recalled that:
I hurried round to the Bank of England and there found an immense queue waiting to cash their notes…
Hundreds and hundreds of people waiting as patiently as possible to see if their money was still safe!
A taxi took me to Downing Street to see Mr Lloyd George (the Chancellor).
“There is panic in the City,” I said, “and something has to be done about it.”
6 Special Report : Sovereign Rescues

SAVING THE BANKS

Buying time – the longest-ever Bank Holiday

The financial meltdown, against the background of a looming European war in which Britain might
become a belligerent, necessitated state intervention to save the banks to secure the country’s payments
and credit mechanisms. But saving the banks could not be separated from saving the money market and
the Stock Exchange, particularly as it was to these markets that the government would have to turn for
war finance. Thus it was essential to minimise failures both among the banks and the specialist City firms
that made the wholesale financial markets function.
Crisis meetings took place day-and-night at the Treasury from Friday 31 July to Thursday 6 August, a week
that saw Britain’s entry into the war on 5 August. Since, astonishingly, neither the Treasury nor the Bank
of England had any contingency plans for war, one of the authorities’ first acts was to extend the Bank
Holiday for a further three days through to Friday 7 August, Britain’s first and only four-day Bank Holiday,
buying time to work out what should be done.

The crisis team

The quest for solutions to the financial crisis was animatedly led by David Lloyd George, then Chancellor
of the Exchequer, supported by Treasury officials notably Sir John Bradbury, Governor of the Bank of
England, Sir Walter Cunliffe and two friends, Sir George Paish and Lord Reading. Paish, a leading financial

David Lloyd John Maynard Sir George Rufus Isaacs

George Keynes Paish Lord Reading

and economic commentator, had acted as an adviser to Lloyd George since 1909. Reading, a future
Viceroy of India, was a barrister who had specialised in City cases and had recently joined the Cabinet as
Lord Chief Justice.
Also hovering around the Treasury during the crisis meetings was 31-year old John Maynard Keynes.
Summoned for advice by a Treasury official friend, Keynes arrived at Whitehall from King’s College,
Cambridge, in his brother-in-law’s motorcycle sidecar on Sunday 2 August. He wrote several briefing
notes on aspects of the crisis that he believed were influential, but there is no documentary record of his
presence at meetings. Moreover, he did not secure the hoped for appointment as economic adviser, the
position having gone to Paish. Keynes eventually joined the Treasury in 1915 as Paish’s assistant. Paish
maintained that Keynes’s recruitment was in preparation for his return to journalism, but Keynes had a
different recollection: ‘After a few days I came to the conclusion that Paish was barely in his right mind
Not long afterwards he had a complete nervous breakdown.’
 Lombard Street Research 7

Crisis conferences and credit crunch

The crisis conferences focused on four main subjects: the convertibility of the pound into gold; payments
moratoria; the protection of the banks against a run when they reopened; and Bank Rate. As regards
convertibility, the bankers favoured suspension but Paish and Keynes argued strongly for its retention and
Lloyd George eventually accepted their advice. A month-long moratorium on payments was proclaimed
covering most payments, except for wages and, inevitably, taxes. The need for this arose principally from
an acute credit crunch that resulted from the drastic restriction of lending by the banks to preserve their
funds against a run on deposits.

Bank Rate hikes – ‘a mouldy old precedent’

At the onset of the crisis, Bank Rate (the minimum rate for discounting bills) was 3%. Demands on the
discount houses led them to discount a vast volume of bills at the Bank; between Saturday 25 July and
Friday 31 July (as the world’s stock markets closed, one after another, and worldwide liquidity dried
up) the Bank’s holdings rose from £13 million to £40 million – an unprecedented three-fold increase in
the course of a week. The Bank responded on Thursday 30 July by raising Bank Rate from 3% to 4%.
The closure of the Stock Exchange the following day led to further pressure on the discount houses,
prompting an avalanche of discounting. Trying to catch up with the market and following orthodox theory
Bank Rate was hiked to 8%, the highest rate for 40 years.
On Saturday 1 August, the Governor sent a letter to the Chancellor specifying recent heavy demands
on its resources and alerting him to the precipitous drop in the Bank’s gold reserves, from £27 million
on Wednesday 29 July to less than £11 million. He warned that unless the government gave the Bank
permission to issue notes in excess of the legal limit, the procedure used in the crises of 1847, 1857 and
1866, the Bank would shortly be obliged to curtail its facilities. He promptly received a letter signed by the
Prime Minister and Chancellor authorising the Bank to exceed the legal issue conditional on a minimum
Bank Rate of 10%, following the precedent of previous crises. Thus on Saturday 1 August Bank Rate was
hiked again, from 8% to 10%.
The authorities were following established practice for dealing with a financial crisis: make funds liberally
available at a penalty rate. Yet the sudden and unprecedented leap in Bank Rate, from 3% on Thursday
morning to 10% on Saturday afternoon, at the height of the crisis, astounded the market and observers.
Keynes castigated the ‘violent movement’ for undermining confidence by causing ‘great alarm’ to the
market and the public. Likewise, financial commentator Hartley Withers condemned the authorities’ knee-
jerk actions for exacerbating the crisis: ‘a most untimely shock to the public’s nerves…merely for the sake
of blindly following a mouldy old precedent.’

Treasury notes – quantitative easing with attitude

In fact, neither the 1 August letter to the Governor nor the bankers’ scheme to deposit gold at the Bank
was made operational. They were superseded by a novel departure – the creation of a parallel note issue
by the Treasury, not the Bank. Probably the most compelling reason was to appropriate the seignorage
revenues. But also the Bank, which printed its own notes, was unable to promise to meet the delivery
deadline, but De La Rue, the Post Office’s printer, was able to do so for the Treasury in three days using
postage-stamp paper. The new Treasury notes quickly became known as ‘Bradburys’.
The Treasury note scheme authorised possible drawings by the banks of up to £225 million (20% of their
liabilities). This was a hefty five-fold increase on the £44 million Bank notes outstanding, and more than
doubled the £200 million total of notes and currency outstanding or in circulation. In fact, the initial issue
was only £13 million, partly because of problems with printing and distribution; however, by the end of
the year £38 million was in circulation. With the Treasury note issue and the general moratorium in place,
Bank Rate was reduced to 6% on Thursday 6 August
8 Special Report : Sovereign Rescues

Day of reckoning –
reopening of the banks
Friday 7 August saw the end of the extended
Bank Holiday. Their tills primed with shoddily
printed new Treasury notes, the banks opened
for business. But the feared run did not
materialise. Next day Bank Rate was cut to 5%,
a level at which it stayed for the next two years.
In fact it was purely nominal; henceforth, short-
The ‘Bradbury’ Pound Note term rates were determined by the Treasury bill
rate and long-term rates by War Loan.
The ‘Bradbury’ One Pound note was issued
by the Treasury to alleviate the 1914 liquidity The public quickly took to the new Treasury
crisis. It was called a Bradbury because it notes, which were issued in convenient £1 and
was signed by Sir John Bradbury, permanent 10/- denominations. This led to a reflow of
secretary to HM Treasury. Hitherto there had circulating gold sovereigns into the Bank. Its gold
only been Bank of England bank notes and reserves were further boosted by large deposits
gold sovereigns in circulation, plus silver specie of foreign gold seeking a safe haven.
coins down to a thru’penny bit, and token Between 7 August and 15 December 1914, the
coins of a penny, ha’penny and farthing. Bank of England’s gold reserve soared from £26
The lowest denomination Bank note, £5, million to a record £73 million. The threats of
would be worth £432 today. Bank notes were an internal or an external drain were over. But
convertible into gold sovereigns at the Bank of plenty of problems remained, most pressingly the
England worth £87 in today’s money. banks’ illiquid balance sheets and the consequent
credit crunch being inflicted on their customers.
A Bradbury was declared legal tender for all
payments and was also convertible into gold
at the Bank of England. Like the US civil war
‘Cold storage’ - removal of toxic
Greenbacks, Treasury note issues were a resort bills from the money market
to the printing presses – the equivalent of
quantitative easing. With noteworthy recent resonances, the revival
of the money market was believed to be the key
both to the restoration of the banks’ financial
health and getting credit flowing again. The
obstacle was the large volume of unmarketable and potentially valueless bills for which remittance had
not been received from foreign debtors – the toxic assets of the day. However, it was expected that the
war would be short and that the money market problem was principally one of liquidity rather than
solvency. ‘Most of these bills are good and were the machinery of credit to be restarted the means of
meeting them would soon be forthcoming’, Paish advised Lloyd George on 6 August. ‘All that is needed is
the machinery for and the means of holding the bills until the money is received to pay them.’
A few days later Lloyd George launched an initiative to remove pre-war bills (accepted before 5 August)
from banks’ balance sheets and the money market. Under the ‘cold storage’ scheme the Bank of England
would buy pre-war bills, being guaranteed against loss by the Treasury. The price was 5% (Bank Rate) of
value to maturity, with the funds coming from the Treasury note issue. The accepting houses remained
liable for their bills on maturity – but the liability was removed from the market and concentrated at the
Bank of England. Bankers Magazine reported that the money market was ‘staggered’ by this courageous
and comprehensive move.
The money market in July 1914 comprised £450 million of finance and commercial bills, plus £15 million
of Treasury bills. Of the former, an estimated £350 million were ‘prime’ bills – endorsed by a leading
accepting house or major bank. These comprised an estimated £210 million of finance bills (issued by
banks for funding) and £140 million of commercial bills, the latter being the ‘approved bills’ eligible for
 Lombard Street Research 9

discount at the Bank under the cold storage scheme. In the event, the Bank discounted £120 million of
bills. This amounted to a startling 86% of eligible bills, reflecting the banks’ desperation for liquidity, and
26% of the entire money market.

But the credit crunch continues…

With yet further uncanny echoes of today, the Chancellor made clear to bank representatives that he
expected that the removal of their illiquid bills potentially at taxpayers’ expense would result in greater
lending to commercial clients. But it didn’t happen. ‘Banks’ position not improved’, reported Paish. ‘Things
are not improving. Do not find any disposition to do business at all. Joint stock bankers not moving at all.’
Addressing the House of Commons two weeks after the launch of the cold storage scheme, Lloyd George
recounted the complaints he was receiving that the banks were still withholding credit. ‘If the Government
and the country are prepared to take risks, they must take risks as well,’ he thundered, warning that: ‘It
may be necessary to take stronger action. A good deal depends upon the banks.’

REVIVING THE CITY

The continuing credit crunch and the idleness of the money market necessitated the extension of the
moratorium for a further month to 4 October. Moreover, a month into the crisis, it was plain that yet more
had to be done to get the credit mechanism functioning again.

Accepting houses bail out

Negotiations got underway between the Treasury and the Accepting Houses Committee (forerunner of
the London Investment Banking Association), an industry association formed on 10 August 1914 by 21
City merchant banks to represent their interests The accepting houses remained ultimately liable for their
pre-war bills and were thus in no position to grant new acceptances. On 5 September the Chancellor
announced yet another initiative to get the City moving. The Bank of England would advance funds to
acceptors to repay pre-war bills on maturity, with the government guaranteeing the Bank against loss.
The advances would cost borrowers 2% above Bank Rate, a steep rate, but recovery would not be sought
until one year after the end of the war.
In total £74 million was advanced to acceptors under this scheme. Much was used to pay off cold
storage bills in the hands of the Bank; by late November 1914 its holding of such bills was down to £12.5
million (from £120 million). As conditions stabilised, creditworthy acceptors found that it was cheaper
to borrow from the banks than to pay the government 7% interest, resulting in substantial pay-offs of
pre-war advances. By August 1915, the outstanding aggregate pre-war bills held by the Bank and pre-war
advances provided by the Bank, both under taxpayer guarantee, had fallen to £40 million.

Resumption of overseas remittances

The fall in the value of pre-war bills (held either by the Bank or owed to acceptors) from £120 million
to £40 million was due to a resumption of remittances from abroad in autumn 1914, particularly from
American and British Empire debtors. A key development was the opening of a Bank of England account
at the Canadian Finance Ministry in Ottawa that overcame the difficulties of shipping gold in wartime.
By mid-November the sterling-dollar exchange rate, which had swung violently in the pound’s favour
reflecting the dearth of sterling, was back to the pre-war parity.
An arrangement with the Russian government in March 1915 led to repayments of £8 million on account
of Russian bills. Thereafter, the remaining unpaid pre-war debts were largely owed by German and
Austrian debtors from whom no remittance could be expected until after the war.
10 Special Report : Sovereign Rescues

Easing of the credit crunch and the end of the moratoria

The provision of Treasury notes and the discounting of
the pre-war toxic bills made the banks awash with cash.
This had the desired result; the credit crunch began
to ease from late-September. ‘As confidence revives’,
reported The Economist, ‘the banks begin to look
around for chances of employing their large Bank of
England balances on remunerative terms.’ Yet the revival
New York Times 14 October 1914 © New York Times, reproduced by permission.

of commercial bill business was agonisingly slow – in

October it was only 5% of the pre-war level. Nonetheless,
a gradual thaw was underway and on 4 November, three
months after its imposition, the moratorium was lifted.

Re-opening of the Stock Exchange

Green shoots of returning confidence were also
manifested in securities trading. With the Stock Exchange
closed, cash dealings were conducted in the street,
in brokers’ offices or City hotels. Enterprising auction
houses undertook sales of securities, while the Daily
Mail launched a small-ad section for buyers and sellers.
Growing activity demonstrated that confidence, and
prices, were recovering. The reopening of the Stock
Exchange on 4 January 1915 marked the end of the
financial crisis of 1914. The financial markets, most City
firms and the banks had survived the emergency. But
they had by no means returned to ‘normal.’ They were
now part of the national war effort serving a single all-
powerful client – the state.
 Lombard Street Research 11

OUTCOMES AND PERSPECTIVES

The system saved

The authorities’ bold and imaginative responses to the crisis saved London’s financial system. The existing
structure - the money market, with its discount houses and accepting houses; the stock market, with
its brokers and jobbers; and the banks - was preserved. (However, within that framework there were
significant shifts in how business was conducted.) Since maintaining a functioning financial system was
the authorities’ foremost objective, their endeavours must be deemed successful.
Furthermore, there was a surprisingly small number of failures among individual City firms and banks. The
crisis saw the failure of just 17 stock exchange firms, out of several hundred, and a single, small, bank.
All the accepting houses survived, though many were mothballed for the duration. After the war several
smaller firms combined, including Governor Cunliffe’s firm, or were wound up. Again, the authorities’ aim
of preventing the failure of banks and other financial firms was achieved.

Fragility of the financial system

In 1914, as again recently, the fragility of the international financial system astonished everyone. The
breakdown occurred before a shot had been fired and before Britain had decided to enter the war. ‘It
came upon us like a thunderbolt from a clear sky,’ wrote Hartley Withers. ‘The fury of the tempest was
such that no credit system could possibly have stood up against it.’
Then, as today, the severity of the breakdown made the state the only agent that could prevent systemic
collapse and widespread bankruptcies. The necessity of doing so justified the then wholly unprecedented
scale and scope of state intervention in the City. The £120 million of toxic pre-war bills bought by the
Bank of England was equivalent to 5% of pre-war GDP and 65% of government current expenditure; the
£74 million of loans to the accepting houses amounted to, respectively, 3% and 40%.
The Chancellor maintained that he acted not to preserve the financial markets and their participants for
their own good, but for the common good: to finance food and raw material supplies from overseas;
to sustain business activity, especially the export industries, to avoid large scale unemployment; and to
protect the country’s payments system and thus, among other things, the government’s ability to raise tax
revenues. With Britain’s entry into the war on 5 August, maintenance of a robust financial system became
a crucial part of the national and allied war effort.

Saved system used for state requirements

Having saved the financial system, the state promptly made use of it for its own purpose - to fund the
war effort. The Treasury notes, introduced as an emergency measure to prevent a bank run, and the ‘cold
storage’ scheme for the removal of toxic bills from the money market to help the banks and discount
houses, soon resulted in the banks being awash with cash. Thus, conveniently, they possessed the means
to purchase the ensuing flood of Treasury bills and bonds to finance the war. The first issue of Treasury
bills, doubling the amount outstanding from £15 million to £30 million, took place less than a week after
the introduction of the cold storage scheme with more every few weeks. Then in mid-November, despite
the Stock Exchange being still shut, Lloyd George launched ‘the largest loan ever raised in the history
of the world,’ a £350 million War Loan bond issue – 14% of GDP and equivalent to 190% of pre-war
government annual expenditure.
Of course, this was just the start. Over the course of the war the volume of Treasury bills outstanding in
the market rocketed from £15 million to £1.1 billion in January 1919. Long term public debt rose from
£620 million to £7.4 billion. The pointer for today is less the prodigious increase in government debt –
there was a war to fund of course – than the opportunity a crisis provided for the state to assume the
direction of the financial system for its own ends.
12 Special Report : Sovereign Rescues

Inflation
Initially it was believed that the war would be ‘over by Christmas’, but as it dragged on the Treasury notes
proved a virtually unlimited source of funds for the government. Furthermore, once things had settled
down, the boosts to the banks’ cash base facilitated a significant expansion of bank credit.
At the start of the war UK narrow money, much more important for economic activity than today, totalled
£170 million. At the end, in November 1918, with £295 million Treasury notes outstanding, coin and
notes in circulation totalled £470 million, almost a threefold increase. The outcome was a 125% increase
in retail prices (140% wholesale prices) over the war period – in stark contrast to decades of pre-war
price stability. The inflationary impact of today’s quantitative easing remains to be seen, but the turn-
of-the-millennium vision of the ‘death of inflation’ appears as much a part of a bygone golden age as
antediluvian gold standard certainties must have done in the throes of the Great War.

How much did the government guarantees cost taxpayers?

Paish told Lloyd George that the cost to taxpayers of the cold storage scheme might be as much as £50
million. That was the sum the Chancellor suggested to parliament in November 1914, observing that: ‘the
total losses upon the whole of these transactions will not be equal to the cost of a single week of carrying
on the War, and it saves British industry and commerce from one of the worst panics.’ The Economist was
more pessimistic, putting the downside of the government guarantees at potentially £50 million – £200
million, depending on whether the war lasted for a short or long period.
No public account of the cost to taxpayers of the government guarantees was ever presented. During the
war the subject was regarded as a state secret; afterwards, public interest had moved on. So the answer
has to be sought in the archives. In 1915, the Treasury paid the Bank £40 million in respect of holdings of
outstanding discounted bills and advances to acceptors. Thereafter, when the Bank received payment in
respect of a discounted bill or an advance to an acceptor, the Treasury received reimbursement. By 1916
outstanding discounts and advances had fallen to £31 million. On 31 August 1921, the ‘official’ end of
the war, they were down to £15 million. Provisions of the Versailles Peace Treaty facilitated repayment of
the bulk of outstanding German and Austrian pre-war debts (plus interest). Finally, an internal Treasury
account of the mid-1920s calculated that the Exchequer had received repayments (including interest) from
the Bank totalling £46 million.
Thus in the final reckoning, taxpayer guaranteed support for the financial system through the Bank during
the crisis of summer 1914 netted the Treasury a nominal profit of £6 million. It was a remarkable - and
hitherto entirely unknown – final punctuation point to an extraordinary episode.
 Lombard Street Research 13

NOW

by Brian Reading and Leigh Skene

Brian Reading was economics advisor to

the former Prime Minister Edward Heath
and was the first Economics Editor of
The Economist magazine, before moving
into consultancy in the late 1970s.
He makes regular comment on topical
issues in his Required Reading diary on the
Lombard Street Research website.

Leigh Skene is a Canadian who has been

involved in financial markets ever since he
first purchased equities when he was a
teenager. He rose to become Head of Fixed
Income Trading, then Chief Economist, at
investment bank Burns, Fry and Company
(now BMO Nesbitt Burns).
Since 1980 he has been an independent
economic consultant specializing in
financial markets.
14 Special Report : Sovereign Rescues

SUMMARY
Professor Roberts’ summary of similarities between
1914 and now - global market contagion, the
freezing of the money market, a credit crunch, toxic
assets, the impact of mark-to-market, recalcitrant
bankers - can be supplemented by listing differences.
Obviously the shocks were different. Derivatives were
not an issue in 1914. But then, as now, counter
party risk was a major factor.
The 1914 episode was primarily a liquidity crisis.
Toxic assets resulted from the collapse of the
international payments system. Balance sheets were
solid and most toxic assets reverted to good assets
when the system functioned once again. Even claims
on Germany and Austria mostly proved sound at the
end of the war! The measures taken were classic
textbook solutions to a liquidity crisis and their
implementation beyond reproach.
Today we have mainly a solvency problem. The
international payments system has not collapsed
(because it’s a non-system and can’t collapse?). The
shadow banking system collapsed because private
sector balance sheets were bubble-bred trash and
this will cause continuing problems until the toxic
assets are written off. Equity must be rebuilt so that
most entities can pay their debts in good times and
bad. That could take several years.
The jury is out whether, over the longer term, today’s
emergency measures to save the system will spawn
rampant peacetime inflation. War necessarily creates
excess demand. But today’s problem is inadequate
world demand. When recovery gets under way,
government will need to tax more and/or spend less
to keep inflation at bay. Will they have the courage
to do so? Markets fear they will not. But by raising
rates they can abort a recovery, thereby negating
their own fears. The parallel is the paradox of
individual thrift leading to less saving.
 Lombard Street Research 15

Breakdown
The 1914 shock was clear and can be precisely dated. The current crisis began in August 2007 in one
sector of the market, securitised sub-prime mortgages. Officialdom declared it would be contained. Many
forecasters did not expect it to spread. It did. The penny then dropped and the Fed changed its stance.
In March 2008 it encouraged J P Morgan Chase to rescue Bear Stearns with a cut-price buy-out. Fannie
Mae and Freddie Mac’s problems added to the unease. It was still felt that major institutions were too
large to fail. The big and probably mistaken shock was when Lehman Brothers was allowed to go under
in September 2008 (although insurer AIG was bailed out). This was when counter party risk became a
clear and present danger. As such, Lehmans possibly ranks with the 1914 shock. But at the same time the
markets reacted adversely to TARP (the Trouble Assets Relief Programme). It was a liquidity solution to a
solvency problem and mishandled to boot.

Financial market closures

Naturally stock markets suffered collateral damage. But unlike 1914 (or 1929) there have been no major
market closures. Other markets as good as closed – inter-bank, money markets, collateralised securities
of all kinds. Collateralised debt obligations (CDO) issuance fell by 95%. The only markets that effectively
closed were the auction securities market and the non-bank asset backed commercial paper market in
Canada. Neither was officially closed. Elsewhere risk premium rocketed. The 1914 scramble to sell stocks
and shares was matched by the scramble for liquidity due to the collapse of exaggerated expectations of
the shadow banking system.

Mark-to-market more dangerous today

In Britain the institutional separation between jobbers and brokers disappeared following the ‘big bang’.
In the US there was no such institutional separation between jobbers and brokers. Their separate roles
remained within investment banks. Bear Stearns, for example, was engaged in both investment banking
and brokerage activities. A universal bank, such as J P Morgan Chase, includes commercial banking that
generates funds from deposits. An investment bank relies on wholesale money markets for funds. Indeed
the original 1933 Glass-Steagall distinction was that investment banks dealt only in capital markets and
commercial banks took retail deposits and made retail loans. When the crisis first broke, it was seen (and
treated) as one of liquidity, due to wholesale markets freezing up. But mark-to-market losses soon made it
clearly one of solvency. Investment banks borrow against collateral. This makes them vulnerable.
Mark-to-market in 1914 had serious but limited consequences. Jobbers were forced to put up more
margin as stock prices collapsed. Hypothetical mark-to-market losses now affect commercial banks’ risk-
weighted Basel capital ratios. Moreover the effective closure or lack of markets for derivatives make the
whole system more exposed to systemic failure. While sub-prime mortgage credit default swaps (CDS)
initiated the credit problems, excessive leverage was the primary factor in turning a problem in a tiny
corner of financial markets few people had even heard of prior to 2007 into a systemic meltdown. Most
toxic assets are the result of structured finance. The main contribution of derivatives to toxic assets came
from CDS embodied in CDO. AIG for example came unstuck by insuring through CDS many sub-prime
mortgaged-based CDO.

Parallels with Accepting Houses

The parallel today with the 1914 Accepting Houses is bankers acceptances and trade credit from banks.
Much the same thing happened to trade credit in the late autumn and winter of 2008 as happened in
1914, even though the foreign exchange markets remained normal. Monolines have also got into the
business of insuring debts. These are companies that originally insured municipal bonds, but branched
out into insuring collateralised debt obligations and the like. They are called ‘monolines’ because that
is the only business they are allowed to do. Regular insurance companies, called ‘multiline’ do casualty,
life etc. insurance but not bond insurance. The monolines have small capital relative to the value of the
bonds they insure. Nonetheless they were AAA rated and thereby lent this rating, for a fee, to municipal
16 Special Report : Sovereign Rescues

bond issuers. When defaults soared monolines, such as Ambac, belatedly had their ratings reduced. They
thereby dropped the ratings on the billions of bonds they insured. Their fees were no longer worthwhile
and so business collapsed.
The1914 Accepting Houses played a major role in foreign exchange markets. Monolines do not. But just
as the failure of an Acceptor in 1914 rendered worthless its default guarantee on all outstanding bills
that bore its name, the collapse of a monoline has major systemic consequences for state and local debt
market.
Credit default swaps are a market variant of insurance that did not exist in 1914. These perhaps have
raised a greater systemic threat than monolines. AIG, one of the world’s largest insurance companies,
went into selling CDS coverage for banks and on collateralised debt obligations on a big scale. It was AAA
rated and therefore needed to put up no collateral. But when it was down-graded it was called on to
provide collateral to counter-parties and suffered a severe liquidity crisis. This then transferred the lower
ratings to the insured securities. AIG had to be serially bailed out by the US government. Nonetheless
the CDS market has been wound down by about 60% with remarkably few losses. Markets cleared the
Lehman CDS for a net loss of $5.2 billion rather less the $270 billion some had forecast.
Rating agencies seem to have played no part in the 1914 crisis, but were a major factor in today’s crisis.
The first, founded in the US by John Moody in 1909, initially covered the American bond market.

Runs on the banks and the Bank of England

The run on Northern Rock was widely reported as the first in Britain for over a century. It was not. There
were bank runs in 1914, as Professor Roberts shows, and at least one bank failure.
Northern Rock suffered both a liquidity crisis on the liabilities side through its dependence on wholesale
funds and a solvency crisis on the asset side through the poor quality and rapid growth in its mortgage
loans. This was the modern day equivalent of the lack of asset side liquidity. The Rock’s business model
guaranteed it would run into trouble unless house prices rose forever. The gold standard ensured no bank
in 1914 had a bad business model, although not taking a possible war into account was a bad business
decision every bank made. Their complacency about war echoes the recent complacency that the financial
system had eliminated risk.
The government took the Rock into public ownership – aka nationalisation – that hardly seemed an
option in 1914. Then the injection of liquidity into the system by the loan of Bank notes against gold and
the issue of Treasury notes of much smaller denominations. This smacks of quantitative easing. A major
difference is the 1914 financial crisis did not morph into an economic recession with adverse feed-backs.
The stimulus of the Great War meant no lack of demand.
 Lombard Street Research 17

Saving the banks

1914 was a systematic crisis requiring state intervention. The banks were closed in an extended bank
holiday. There have been no such closures today. Doubtless the 1914 authorities, lacking any contingency
plans, needed time to think out what to do. They did a lot better than what was done recently. Equally it
is doubtful whether in 2007 there were contingency plans to deal with the burst house price bubble and
subsequent sub-prime debacle.

The crisis team

The dramatis personae in the current crisis largely cross the Atlantic to Washington – Hank Paulson/Tim
Geithner, Ben Bernanke and currently Lawrence Summers and Paul Volcker. In Britain it is Mervyn King and
Alistair Darling. There is no Reading as an advisor this time, hence the mess.

Bank rate hikes – ‘a mouldy old precedent’

In 1914 the Bank of England automatically supplied liquidity through the discount houses. They were
hammered by the withdrawal of bank loans. But the Bank behaved as a market (not surprisingly since
it was a private company). It raised interest rates to 10%. Today liquidity stresses are indicated by the
difference between market and policy rates, as policy rates have been cut to next-door-to-nothing. But
the ‘mouldy old precedent’ – in a financial crisis make funds liberally available at a penalty rate, lives on.
The terms under which British banks have been helped out have been penal. This makes the crisis worse.
Banks are given an incentive to shrink balance sheets in order to escape the harsh terms of government
bail-outs – not merely interest rates (UK rather than US) but also the loss of freedom of action (e.g., over
pay).

Treasury notes – quantitative easing

In 1914 there was quite literally a resort to the printing presses. But it was not immediately to finance
government spending. In a liquidity crunch, credit crisis and payments moratorium, there was an
inevitable flight to cash as a means of exchange. The numbers here are as astronomical as today’s. First
there was the liquidity injection that involved a potential doubling of money in circulation. The banks were
supplied with cash equal to 20% of their liabilities.
Then the banks were bailed out with what amounted to creating a bad bank, the ‘cold storage’ scheme’
whose liabilities were guaranteed by the taxpayer at one remove, via the Bank of England. It wasn’t
actually a ‘bad bank’. It was storage of basically good assets that couldn’t provide the anticipated cash
flow. That’s a lot different from structured debt based on NINJA mortgages. This tackled the liquidity
solvency issue. But there was no moral hazard involved. Banks, acceptance houses, brokers and jobbers
had not behaved irresponsibly. The system was saved from a shock not of their making. This was not a
credit default crisis akin to sub-prime mortgages. Debtors had the ability to pay but were deprived of the
means to pay. Indeed, as Professor Roberts shows, the taxpayer ended up in pocket.

The system saved?

The speed and magnitude of the 1914 British government’s reaction to the crisis was remarkable, almost
unbelievable, given the slow and hesitant reactions to today’s crisis. Even so, it is noticeable that the credit
crunch was slow to ease.
18 Special Report : Sovereign Rescues

Outcomes and perspectives

Here is where the stories of 1914 and 2007-09 part company. The 1914 system survived but was then, as
Professor Roberts points out, used to finance the war. Banks became awash with cash. Public sector debt
rose to approaching 300% of GDP. Inflation took off for the first time in a century. To regard this inflation
as a purely monetary phenomenon is ridiculous. Of course, it could not have happened if the money
supply had not exploded. But that was never an option.
Wars cause inflation by raising demand while reducing ordinary supply. Major peacetime inflations were
unknown before 1970, except in the aftermath of war amongst the defeated or in unstable developing
countries such as in Latin America. Arguably Britain was unstable in the 1970s when union power seemed
to make it ungovernable. Perhaps today it is merely ungoverned.
Lombard Street Research 19
20 Special Report : Sovereign Rescues

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