Introduction

Chapters 3 and 4 discuss the two major or systemic banking crises that the UK banking system has had since 1800. The first major crisis occurred in 1825–6, when almost one fifth of the English banking system collapsed; the second major crisis was the Great Crash of 2007–8. In the period between these two crises, there were episodes of stress in the banking system and occasionally banks failed, but the banking system proved robust to the shocks that it experienced. Ultimately, we might ask why the British banking system was free of major banking crises between 1826 and 2006 and why it experienced major crises at the beginning and end of this period. This chapter describes how both major crises occurred in an environment of poorly capitalised banking institutions.

The stability of the banking system in the long hiatus between these two major crises was not due to the absence of shocks to the banking system, as discussed in the previous chapter. Rather, as argued in this chapter, the stability of the system appears to be associated with banks having adequate capital until the interwar period and the fact that, after this period, substitutes for adequate capital were available. In particular, it was of central importance to the stability of the British banking system in the period before the 1930s that contingent capital (i.e., capital that could be called up in case of bank failure) was available in the form of unlimited shareholder liability, uncalled capital and reserve liability. The latter two types of contingent capital were similar to the double-liability rules that existed in the United States until the 1930s, except that the liability faced by shareholders was decided on by individual banks rather than imposed by legislation.

Introduction

In Chapters 5 and 6, we discovered the following: (1) shareholder capital started declining during World War I and by the 1950s, it had reached exceptionally low levels; and (2) by the early twentieth century, the Bank of England and the Treasury were reluctant to see banks collapse; as a result, a policy emerged that meant that the banking system (and the major clearing banks in particular) were essentially insured by the Bank and taxpayers. As a consequence of these two developments, the potential for risk shifting was accentuated because shareholders (and depositors) stood to lose relatively little if their bank collapsed, with taxpayers ultimately bearing a substantial proportion of the downside risk. However, this chapter describes how bank regulation acted as a check on risk shifting by banks for four decades or more after 1939.

In this chapter, we perceive bank regulation as rules that constrain banks from risk shifting even if the stated or actual rationale for the rules is unrelated to constraining bank risk taking. Bank regulation takes three forms in this chapter. First, there is the informal and nonstatutory regulation of banks by the Bank of England, with the Bank making its wishes known through ‘nods, winks and raised eyebrows’ rather than regulatory edicts. Second, there is economic regulation, whereby banks are subject to nonstatutory controls as an integral part of the government’s monetary, credit and fiscal policies. Third, there is statutory regulation that is prudential in nature; that is, its rationale is to prevent banks from taking excessive risks.