Avoiding Moral Hazard:How the Banque de France Managed the Crisis of 1889

Pierre-Cyrille HautcoeurAngelo Riva

Eugene N. White

128,000 of the 200,000 lbs. of copper donated by Pierre-Eugène Secrétan

Work in Progress• We have nailed down most of the narrative

– Some secondary sources– Contemporary sources– Minutes of directors of BdF and other banks

• Just collected the data. Time for econometrics to clinch the argument– Stock prices– Bank balance sheets– Measures of conflicts of interest– Private bank capital

How does a central bank handle an incipient crisis?

• An outline of events• A firm outside of the banking system begins intense

speculation---buys assets on its balance sheet and takes derivative positionshuge exposure

• The firm has limited funds & borrows from the established banks

• Many senior bank officials have themselves invested in the firm—conflicts of interest

• Some of the bank officials are directors of the central bank---conflicts of interest

How does a central bank handle an incipient crisis?

• The market slowly begins to collapse• The firm’s capital begins to erode and the banks become

aware of their exposure as lenders and counterparties---huge potential losses

• Panic looms, private efforts to stop it fail because banks individual interests diverge

• Central bank steps in and organizes a “lifeboat” operation---orderly dissolution of firm, no panic sale

• After initial shock, markets are calmed, no crisis• But what of moral hazard? Central bank assistance blamed

for reckless behavior in the next 10 years

Oops…what I have just described is the 1998 crisis of LTCM

• Roger Lowenstein, When Genius Failed (2000): “Panics are as old as markets but derivatives are relatively new.”

• Peut-être• Crisis of 1889 very similar—but no reckless behavior

by banks in next 25 years (minor problem 1891 SDCC)

• Differences highlight how a central bank may be able to contain moral hazard in certain types of crises.

Run on the 2nd largest bank in

1889: the Comptoir

d’Escompte , a potential full-scale

panic(now owned by BNP

Paribas)

French Financial Crises have been ignored!!

Eugène Denfert-Rochereau’s fine building for the Comptoir d’Escompte

Monsieur Bagehot?What should a Central Bank do?

• In times of panic, lend freely at a high rate of interest on good collateral?

• National Monetary Commission (1910), Interview with Governor of the Bank of France.

• Q. “Does the amount and the character of credit granted to other banks depend on the amount and the character of their accounts at the Bank of France?”

• A. “There is no fixed rule, and although the balance of the account is not a matter of indifference, it is more especially the quality of the paper presented which fixes the extent of the credit. In periods of crisis in 1830, 1848, in 1870 in 1889, the general council of the Bank did not hesitate to come to the assistance of establishments which were in difficulties, but which held assets of unquestioned character and value, by extending to them the largest possible credits.”

• BUT 1889: 100 M FF loan to insolvent bank---the Comptoir d’Escompte---depositors made whole to avoid a general panic.

Background of the 1880s• Stock Market Crash and Banking Crisis 1882Recession. GDP

recovers peak 1888. • Bank profits and dividends decline. • Banking industry:

– (1) the large & small limited liability banks, ‘deposit banks,’ engage in commercial and investment banking. Leaders: CL, SG, CE, Paribas.

– (2) the private banks, the Haute Banque: merchant and investment banking, financed by capital: Rothschild, Hentsch, Pillet-Will

• No deposit insurance/implicit government. 1882, Union Générale fails

Background of the 1880s• The Banque de France: dual role

central bank & private bank• Haute Banque dominates Conseil Général,

government appoints Governor. • Monopoly of note issue• Thin Capital Relative to Liabilities• Huge gold reserves—does not feel obliged to change discount rate• Discounts only three name or well-

collateralized paper• Periodic renewal of chartergovernment

influence, notably small loan loss reserves, pay high dividends, open many branches

Background of the 1880s• Political Uncertainty:

• Third Republic: truly republican leaders had governed only since 1876.

• Threats by Monarchists and Bonapartists. • Scandals and Crises threaten Republic: 1882

crash, Bourse scandal, Panama Canal scandal. • Political rise of General Boulanger. Fears of a

coup by him peaked in January 1889 • Universal Exposition opening in May 1889 – the

centenary of the French revolution – Republicans see as a means to project the accomplishments of the Third Republic.

– Bond financed. – A scandal or a financial crisis--last thing that the

Republican government wanted in early 1889.

Cornering Copper• Attempt at worldwide monopoly-• Pierre-Eugène Secrétan, head of the Société industrielle et

commerciale des métaux (SM)----1887 directeur of a highly leveraged commodities company that used off-balance sheet derivatives to speculate in copper.

• 1887 agreement with Rio Tinto, Cape, Anaconda and other companies to restrict output to raise prices. Initially, gains some financial assistance from a shadowy syndicate of private bankers and investors

• £40 to £80 !!!!!!!!• SM is at the center. How can it pull this off? Borrowing and

esp. with the CEloans and esp. loan guarantees

Cornering Copper• SM had capital of only 50 million francs• (1) Buys existing copper stockpiles—goes into debt of 250 million

francs• (2) purchases of contracts with mines (one year) for forward contracts

for 96,600 tons of copper, if valued at £70 a ton =169 million francs.• If Secrétan’s scheme only involved metals companies, wealthy

investors and private investment banks large losses, but no banking crisis.

• But, Limited resources-so Secrétan seeks support of leading limited liability---leveraged commercial banks.

• Banks provide loans and guarantees for forward contracts, as market knows that SM has limited capital

• Primary target: CE, secondary target: Paribas

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From CL---the informed have some clues

Newly Collected Data• Daily copper prices in London and Paris• Daily prices and volume for French-owned,

British-owned and U.S.-owned copper mines and processing companies,

• Daily prices and volume for major banks and largest 30 companies on the Bourse

• Questions? Examine abnormal returns to see when public perceives scheme by SM to corner the copper market—SM, Rio Tinto

How to Ensnare the Banks?Work the Conflicts of Interest!

• Role of the Haute Banque and the Banque de France– Interlocking bank officers/partners/regents– Haute banquiers have proprietary (inside) information on their

own banks and the limited liability banks-----good?bad? …good: a form of high quality supervision

– But information asymmetries between the Regents---depend on honest disclosure by all members

– Conflicts of interest may be exploited if there are huge opportunities for private benefit (asset boom)

• Hentsch—Ch. BoD of CE, own banque, BPP and SM• Rothschild—own banque, regent, shareholder SM & Rio Tinto• Many other banquiers have ties to SM• Two of the three censeurs of the Banque were also on the board of

the CE.

Seduction of the CE• Eugène Denfert-Rochereau directeur (president) of the

CE [Denfert-Rochereau Metro stop? Belfort?]• Miraculously, the CE and CL are only two banks to

maintain dividends in depressed 1880s.• Henri Germain of CL—impressive traditional banking • CE: Earnings and dividends of CE grow—but only as

“other earnings” category grows—its off-balance sheet!!

French Bank Stocks

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Comptoir d’escompte: Earnings, Costs and Dividends By Semester

1878-1888

Applause for Denfert-Rochereau• CE Shareholders meeting March 1885, toast Denfert-

Rochereau’s success and his nomination to be an officer of the Legion d’Honneur

• “Vous voyez, Messieurs, malgré les circonstances difficiles ou se trouvent placeés les affaires financierees, commerciales et industrielles, la situation de notre Societe est satisfaisante. …..Il convient de nous en applauder et de reconnaitre que nous la devons au concours aussi eclaire que devoue du Conseil d’Aministration et a la direction a la fois experimentee et habile de M. Denfert-Rocherau…………Nous sommes heureux de vous dire en terminant que les services distingues de notre honore Directeur ont ete apprecies comme ils le meritent par le Gouvernement qui, sur la proposition du Ministre des Finances, l’a promu recemment au grade d’officier de la Legion d’Honneur. Vous vou joindrez a nous, je n’en doute pas, pour le feliciter sincerement de cette recompense si bien meritee”

Role of the Comptoir d’Escompte• 1887—CE serves as banker to the copper syndicate• December 1887 CD signs first guarantee for SM future contract---

enhances mining companies confidence in SM• Denfert-Rochereau does not inform his board of directors until

March 1888. Some protest—one resigns---but board chairman is Hentsch—part of copper syndicate

• More support for SM at CE • (1) substantial on-balance sheet credits for warehoused copper • (2) vast off-balance sheet guarantees for the SM’s forward

contracts: 269 M FF for 1888, 242M FF for 1889, 244 M FF, for 1890---roughly equal to world output

• Paribas is also compromised by insider conflict of interest, but lower exposure

Empirical Questions

• When does the market perceive the danger to the CE and Paribas? Is the resignation of Seigfried recognized.

• Abnormal returns for these two banks and SM

What did the BF know and When did it know?

• Council of Regents---some members, probably Rothschild and others were aware and were involved to some degree, they had lent to the copper syndicate, bought shares in SM or Rio Tinto (R) etc.

• Supervision process: the “Vérification” recorded the credits outstanding to each borrower, basic capital, a simple rating and comments. The banks were divided up among the Regents who rotated surveillance of the borrowing institutions

• Feb 1888 Rothschild gives very favorable reviews to CE and SM:– SM “Affaire très sérieuse conduite avec intelligence.” – CE: “bon papier d’affaires, souvent court.”

Supervision

• Appears that it was completely missed. • [Another project is to see if BdF correctly

identifies problem banks, 1870-1914]

What did the BF know and When did it know?• Window for the BF on the CE: Discounted Copper Warrants• May 1888. Grants advances to SM on copper warrants up to 52

M FF. Asked by Girod (Bd. of SM, partner in bank with André who is a Regent). 40,000 tons, price £80 a ton, advance for only 65%, so safe as long as price above £52 a ton, and guaranteed by several banks, including CE. Intention not to be renewed.

• Price of copper stable, stock prices of SM and CE stable. • August 9, 1888, report on warrants: reach 26 M FF. Presented

by “maisons sérieuses” “la situation est donc regulière”. Regent Pillet-Will commented: the condition of the “Avances est absolument normale, il n’y a rien a en dire.”

Stock Prices, August 1888-March 1889

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Societe des Metaux Comptoir d'Escompte ParibasCredit Lyonnais Societe Generale SDCCBanque de France (1/10)

Could one detect statistically when SM and CE move apart from other metals companies and banks?

The Fall of 1888• Rising stockpiles of copper in warehouses• Sept 13 & Oct 4, 1888 Bank of England raises

discount ratesBF responds by raising its rate from 2.5 to 4.5%

• Price of SM peaks in 9/1888 at 975 falls to 900 in 12/1888

• BF increased worry about the warrants—increasing towards limit and renewals on the horizon---in October 25th discussion of the warrants: “le Conseil entend ces détails avec intérêt.”

Situation des Warrants sur cuivre au 31 Octobre

    Nov   Dec   Jan TotalAndré, Girod et Cie         22 1,901,900 1,901,900Banque de Paris et Pay-Bas 27 1,230,300 16 2,742,100 17 1,608,100 6,113,700          24 533,200  Comptoir d'Escompte de Paris 5 3,962,400 28 1,685,400 24 5,795,900 23,970,700

  19 2,440,500 28 990,800 25 1,409,000            29 5,312,700            27 2,371,000  Crédit Industriel et Commerciale 27 1,197,800 31 1,932,300     3,130,100Hentsch frères et Cie         25 2,000,900 2,000,900Société Générale 6 2,139,700         2,139,700Lécruyer et Cie 12 1,929,000     7 1,284,000 4,610,900  27 197,800 4 676,300 23 523,600  Lehideux et Cie 27 950,100         950,100Mirabaud, Paccuard, Puerarrt et Cie

        17 486,900 486,900

Thelier et Henrotte     13 1,054,100     1,054,100               Total   14,048,200   9,084,000   23,226,80

046,359,000

Monitoring Continues  October 31,

1888November 8, 1888, leading presentations

January 17 1889

March 7, 1889

André, Girod et Cie 1,901,900 1,900,000 1,836,000 1,835,000Banque de Paris et Pay-Bas 6,113,700 6,100,000 5,885,500 5,582,900         Comptoir d'Escompte de Paris 23,970,700 28,100,000 30,034,000 31,771,200                           Crédit Industriel et Commerciale

3,130,100 3,100,000 2,988,200 1,782,000

Hentsch frères et Cie 2,000,900 2,000,000 2,000,900 2,000,900Société Générale 2,139,700 2,100,000 2,066,800 0Lecruyer et Cie 4,610,900 4,500,000 4,233,800 3,813,200         Lehideux et Cie 950,100   950,100 0Mirabaud, Paccard, Puérari et Cie

486,900   454,300 414,700

Thelier et Henrotte 1,054,100 1,000,000 1,054,100 1,054,100         Total 46,359,000 50,480,300 51,503,700 48,255,000

Feb 1889: BF reduces amount willing to lend per ton from 1300 FF to 1110 FF

Desperation of the SM• Secrétan needs for capital to continue buying increasing copper

output• Organizes Compagnie auxiliaire des métaux (CAM), January

1889, funded with 40 million francs of capital ---SM to take 59% of the shares

• Hope: CAM gain access to the discount window of the Banque de France.

• Refused---bank seems the sham• End of January 1889, the CAM stops buying copper for future

delivery and by March 1 all purchases ceased • For cash Secrétan sell his shares in SM and Rio Tinto—they fall.• Copper price £80 until late February---£76 on March 2

“Affaire des Warrants”• Other banks refuse to renew signatures on SM copper

warrants—CE substitutes for them.• February 27, Governor interviews Girod (CE) and Joubert

(Paribas) about the “Affaire des Warrants.” Banque considers renewing advance but collateralized at a price of £44 a ton.

• At Rothschild’s suggestion, Banque sends telegrams to U.S. mines to determine willingness to renegotiate prices.

• March 1 interview of Denfert-Rochereau by Governor—provides detailed information on CE balance sheet and exposure--the true insolvent condition of the CE was revealed to Governor & Regents.

• Denfert-Rochereau commits suicide March 5—heavy run on CE begins

Was there a true danger of a general panic? Share Price Declines

No Reason for BF to Intervene?

March 1 to 8 Month of March

CE -43.3% -87.6%

Paribas -10.8% -21.2%

CL -6.5% -9.3%

SG -0.5% -2.1%

SDCC -0.6% -8.2%

BF 2.2% 3.5%Also, daily data from SG---no evidence of run on CE spreading

Abnormal Returns & t-statsalpha beta F Adjusted R2 26-Feb 27-Feb 28-Feb 1-Mar 2-Mar

BF -0.015 1.116 239.3 0.28 -0.79121 0.250643 0.355595 0.313523 1.472134

0.022 0.072 -1.42304 0.450797 0.639559 0.563891 2.647723

BEP 0.001 0.955 132.6 0.178 0.355348 0.330972 -0.16838 0.939045 0.656818

0.03 0.083 0.5561 0.517953 -0.26351 1.469554 1.027884

PARIBAS 0.023 1.39 208.7 0.255 -0.36668 0.609838 -0.37823 1.010037 0.223888

0.03 0.096 -0.45276 0.908568 -0.15041 -0.45175 -1.66197

CE 0.004 0.383 49 0.073 -1.94788 -0.01539 -0.07113 -3.58739 -10.9364

0.017 0.054 -4.61583 -0.03646 -0.16855 -8.50093 -25.9156

CL 0.012 1.433 610.6 0.502 1.378625 -0.46839 -0.12465 0.568684 1.653328

0.018 58 3.119061 -1.05971 -0.28202 1.286615 3.740562

SDCC 0.005 1.173 80.2 0.117 -0.01153 0.124876 -0.37506 1.314375 1.24401

0.04 0.131 -0.01143 0.123762 -0.37172 1.302652 1.232914

SG -0.002 0.289 25.1 0.038 -0.40202 -0.00659 0.355388 -1.12198 0.309727

0.018 0.058 -0.90342 -0.01481 0.798625 -2.5213 0.696016

BP -0.009 1.297 45.9 0.069 1.668447 -0.02955 -0.21832 0.817305 0.684163

0.06 0.191 1.098385 -0.01946 -0.14373 0.538055 0.450404

Abnormal Returns & t-stats4-Mar 5-Mar 6-Mar 7-Mar 8-Mar 9-Mar 11-Mar

BF -0.0472 1.48905 1.754724 0.442082 4.822883 0.485936 5.141677

-0.08489 2.678147 3.155979 0.795112 8.674251 0.873985 9.247621

BEP -1.0536 -0.2429 -0.18368 -0.91524 2.446839 0.627189 2.255526

-1.64883 -0.38013 -0.28745 -1.4323 3.829169 0.981517 3.529775

PARIBAS -1.78987 -1.22388 -0.65777 2.86188 -1.03782 0.262397 -4.72575

-1.37677 -1.85465 -1.5671 3.17108 -11.6182 -0.84762 -14.5007

CE 1.534824 -2.65785 -5.74086 -2.98243 -26.9405 -17.9339 -25.0018

3.637024 -6.29822 -13.6039 -7.06737 -63.8401 -42.4974 -59.246

CL -0.50181 1.0264 0.255345 -0.15805 1.535455 3.169419 1.122622

-1.13532 2.322172 0.577705 -0.35758 3.47388 7.170631 2.539869

SDCC -0.63395 0.617617 0.276114 0.114406 6.41348 0.766588 5.106195

-0.6283 0.612108 0.273651 0.113386 6.356274 0.75975 5.060649

SG 0.867448 -0.24864 0.517462 0.112597 -0.0328 -1.24527 -2.90539

1.949322 -0.55875 1.162836 0.253028 -0.0737 -2.79836 -6.52896

BP -1.16038 -0.49304 0.501691 0.505349 3.491532 0.862154 4.410509

-0.76391 -0.32458 0.330277 0.332685 2.298572 0.56758 2.903561

The Lifeboat• March 7, 10 pm: Minister of Finance summons heads of

banks and BF to night meeting---CE must receive 100 M FF before opening or it would stop payments—ends at 2 am

• March 8: Governor Magnin convenes regents at 9 a.m.---banks open at 10 a.m.: “La chute du Comptoir d’Escompte serait le coup le plus funeste qui pût être porté aux intérêts du commerce français” and “La responsabilité que la Banque encourra peut être fort lourde…garantie morale”

• 100 million FF loan to CE against “all its assets” with bank syndicate + board of CE providing guarantee for losses to BF up to 20 million FF----assured that there will be no more

The Lifeboat• Furious debate of Regents---stop panic v. against

statutes of BF• Fernand Raoul-Duval observes guarantors were

“notoirement engagés dans le syndicate des cuivres.” He was “extrêmement frappé” by the Governor’s presentation.

• Vote 11-4, one vote more than required supermajority• Frederic Pillet-Will resigns in protest• Another 40 M FF loan required with another 20 M FF

guarantee

Was the CE insolvent?: It had capital of 80 MLiquidators seek to cancel Forward Contracts of SM

Loan LossLoss on

GuaranteeTotal Loss

March 1 Declaration of D-R 29.3 115.9 145.2

April 13 Declaration of Secretan 54.5 115.9 170.4

April 29 Liquidators 81.6 115.9 197.5

Who provides the guarantee?• Conseil d’administration of the CE 2,500,000• Rothschild frères 3,000,000• Banque de Paris et des Pays-Bas 2,200,000• Banque d’Escompte 1,000,000• Bon. Hottinguer 1,000,000• André et Girod et Cie 1,000,000• Crédit Foncier 2,000,000• A.J. Stern et Cie. 1,000,000• Heine et Cie. 1,000,000• Crédit Mobilier 1,000,000• Hentsch frères 1,000,000• Société générale 500,000• Credit lyonnais 1,000,000• Goguel et cie 300,000• Mallet freres 300,000• Vve Kinen et Cie 200,000• Vernes et Cie 300,000• Credit industriel et commercial 300,000• Banque Ottomane 600,000

Guarantee Syndicate Members

Bank Capital (millions FF)

20 M for 100 M

Conseil d'administration of the Comptoir d'Escompte 80 2,500,000Rothschild frères 500 3,000,000

Paribas 62.5 2,200,000Banque d'Escompte 65 1,000,000Baron Hottinguer ? 1,000,000André et Girod et Cie 10 1,000,000Crédit Foncier 155 2,000,000A.J. Stern et Cie. 25 1,000,000Heine et Cie. ? 1,000,000Crédit Mobilier 40 1,000,000Hentsch frères ? 1,000,000Société générale 200 500,000

Did the BF assignment lifeboat guarantees according to liability or

capacity to pay?

How to measure conflicts of interest?Interlocking Directorships

• The interlocking directorships can be described as a weighted network, where the unit of observation or vertex is the bank.

• They are connected by “edges,” which represent the number of individuals who hold a directorship or senior management position at two connected institutions. A senior management positions includes the directeurs (presidents), sous-directeurs (vice-presidents) and censeurs (internal auditors).

• Almanach, annual reports etc. we construct a graph of this network. As can be seen, some banks are highly connected, while others are relatively isolated.

How to measure conflicts of interest?Interlocking Directorships

• In network analysis, the identification of the most central nodes in a system is a key issue.

• Question of which banks were most closely tied by interlocking directorships and were most likely to exploit the conflicts of interest. This question is essentially what is the most important bank in the network.

• Degree centrality or Degree. In the weighted network here, it is the sum of all the edges connected to vertex from other vertices

• Eigenvector centrality The idea behind this measure is that a well connected node has more influence.. Calculate the eigenvalues of the adjacency matrix which is an n by n symmetric matrix (n = number of banks) and the elements are the number of connections between I and j banks

Bagehot or Lifeboat Operation?

• Just collected weekly balance sheets of Banque de France, 1870-1914

• Will use time series to determine if there was more than normal liquidity added to the market beyond the credit to the CE, controlling for seasonality, end of month settlement at the Bourse, & interest rates

End? Partial recovery of copper prices helps• SM—liquidated—Secretan 3 months in prison

– Contracts with mines annulled in French courts (not English)– Board pays 2.5 M FF fine– Pay all creditors holding collateralized debt---43% of unsecured debt by 1894– Continue manufacturing—sell off this part as Compagnie francaise des metaux for

18 M FF

• CE– New Comptoir national d’escompte de Paris (CNEP) established. 40 M FF capital,

half paid-in– Founders shares to previous shareholders and underwriting banks– Public confidence restored, capital flows in

• BF– All loans 100M + 40M FF paid back?---though bank must wait and hold copper.

CA of CE must provide 50 M FF– Minister sends bill to Parliament for early renewal of its charter

Danger of Moral Hazard?Did RescueFuture Risk-Taking?

Penalties and Purges• Suicide Denfert-Rochereau/Secretan 3 months prison• CE Conseil d’Administration assessed 50 M FF by

liquidators who vigorously pursue all—including Hentsch who tries to conceal property

• Two conflicted Censeurs (internal auditors) of BF are dismissed

• Paribas dismissed conflicted board members and censeur.• Girod disgraced, Andre breaks off partnership• Success? only one minor bank failure and no runs until

World War I. • 25 years of “calm”

Did banks eliminate conflicts? Did they reduce risk

• Almanachs—1883, 1885, 1889, 1891, 1893• Monthly Bank Balance Sheets• Riva: Anecdote: sous-gouverneur De Lattre (1973-74):

He was in charge of the banking supervision; a bank sent a balance sheet where total assets was different from total liabilities..; he called the president of the bank to tell him of this problem. The president of the bank replied: "mais cher Monsieur, est-ce bien nécessaire?"

•