Gerschenkron on his head : banking structures in 19th Century Europe, North America, and Australasia

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3 0001 0021 1763 0 © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research

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EUROPEAN UNIVERSITY INSTITUTE, FLORENCE

DEPARTMENT OF POLITICAL AND SOCIAL SCIENCES

EUI Working Paper SPS No. 96/3

Gerschenkron on his Head:

Banking Structures in 19th-Century Europe,

North America, and Australasia

Da n ie l Ve r d ie r

WP 3 S 0

EUR

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No part o f this paper may be reproduced in any form without permission o f the author.

© Daniel Verdier Printed in Italy in March 1996

European University Institute Badia Fiesolana © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research

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Gerschenkron on his Head:

Banking Structures in 19th-century Europe, North America, and Australasia

Daniel Verdier

Department of Social and Political Sciences European University Institute

I am pleased to acknowledge the invaluable research assistance of Elizabeth Paulet. I thank Lawrence Broz, Robert Gilpin, Peter Hertner, Maurice Lévy-Leboyer, Michael Mastanduno, and Herman Van der Wee for their valuable comments and research sug gestions. I also thank Mr. Nougaret from the Crédit Lyonnais, Dr. Gabriele Jachmich from the Institut für Bankhistorische Forschung E.V., Dr. Francesca Pino from the Banca Commerciale Italiana, and Dr. Sbacchi from the Credito Italiano for kindly and generously responding to my requests for documentation. A revised version of this paper was delivered at the 1995 Annual Meeting of the American Political Science Association, The Chicago Hilton, August 31-September 3, 1995. The research on which this paper is based was financed by the Research Council of the European University Institute. © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research

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ABSTRACT

Gerschenkron on His Head:

Banking Structures in 19th-Century Europe, North America, and Australasia

Alexander Gerschenkron explained variations in banking structures in 19th century Europe—the fact that some countries like Germany and Italy had universal banks, whereas others, like Britain, France, or the United States, had specialized banks—by the timing of industrialization. I argue, instead, that universal banking rested on two necessary conditions: a fragmented deposit market and the existence of a liquidity guarantee. These two conditions were simultaneously met in regimes where the industrial, state-building center, and the agrarian, antistatist periphery co-existed in close balance. In contrast, where the agrarian periphery was too weak, the fragmentation condition was not met, whereas when it was too strong, the central banking condition was not met. Universal banking was an inverted U- function of the degree of centralization of the polity. The present hypothesis is tested against Gerschenkron's timing-of-industialization hypothesis on a crossnational dataset including 15 European, North American, and Australiasian countries.

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Gerschenkron on His Head: Banking Structures in 19th-Century Europe

Most modern banking structures were cast during nineteenth century industri alization. They varied between extreme specialization—as in Britain, where merchant banks, colonial banks, clearing banks, issuing banks, discounters, jobbers, stock brokers, and savings banks, each engaged in distinct financial activities—and the almost complete absence of specialization—as in Germany, where all these activities were indifferently handled by all large banks. My purpose is to explain variations in the degree of specialization of national banking structures.

Banking structures is a topic worth of consideration for two reasons. First, bank ing structures have distributional effects. Universal banks have been alternatively celebrated and blamed for channeling capital to large, concentrated industries at the expense of smaller ones. Specialized banking, in contrast, has been blamed for divert ing capital from industry at large. Second, banking structures have redistributional consequences as well. At stake in banking regulation is who pays for the cost of sol vency. Banks must guard against the risk of insolvency-when liabilities are due before assets can be realized. To guard against that risk, banking systems must build costly cash reserves. Banking structures differ as to how they distribute the cost of solvency. As we shall see in this study of the nineteenth century, in specialized structures banks and borrowers (firms) bore the cost of solvency, whereas in non-specialized structures such costs were unloaded on the unorganized groups of taxpayers and depositors. On account of their dis- and redis-tributive effects, capital markets are unlikely to function independently from political markets. The theoretical challenge is to assess the impor tance of this traffic: were differences in banking structures mostly shaped by variations

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in economic fundamentals, or did they merely reflect the relative political power of dis similar coalitions of interests?

Alexander Gerschenkron pointed to an economic fundamental.1 For him, bank- firm-state relations reflected capital availability at the time of industrialization. Although it has been faulted for its empirical imprecision, Gerschenkron's theory is still dominant. The proposition that industrial capital shortage made continental bank ing less specialized than British banking is widely shared among economic historians. Even political scientists now and then rely on Gerschenkron's theory to account for dis similarities in political institutions among capitalist countries.2

The purpose of this paper is to offer an alternative explanation. Rather than derive banking structures from an econom ic fundam ental—the tim ing of industrialization—I propose to derive banking structures from a political fundamental- the extent of state building. Rather than variations in the timing of industrialization, dissimilarities in political institutions shaped banking structures. Industrial capital scar city reflected, rather than caused, bank-firm-state relations.

More precisely, I argue that universal banking rested on two necessary condi tions: a fragmented deposit market and the existence of a liquidity guarantee. These two conditions were simultaneously met in regimes where the industrial, state-building center, and the agrarian, antistatist periphery co-existed in close balance. In contrast, where the agrarian periphery was too weak, the fragmentation condition was not met, whereas when it was too strong, the central banking condition was not met. Universal banking was an inverted U-function of the degree of centralization of the polity.

The paper begins by defining, and offering a measure of, the dependent variable- the degree of banking specialization—as well as recalling Gerschenkron's timing-of-'Gerschenkron 1962, 1968, 1977.

2Katzenstein 1977, pp. 295-336. Kurth 1979, 1-34. Zysman 1983. Snyder 1991. Haggard, Lee, and Maxfield 1993. © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research

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industrialization hypothesis. The paper then develops the argument, first offering a typology of political structures, and then developing successively how each political structure fared with respect to the two requisites for universal banking, market frag mentation and the liquidity risk respectively. The paper ends by testing the political structure hypothesis against Gerschenkron's timing-of-industrialization hypothesis.

Banking Specialization: Definition and Measure

The dependent variable is the degree of specialization achieved in the banking sector—whether banks specialized in certain product lines or were jacks-of-all(- financial)-trades. In specialized banking systems some bankers lend long whereas others lend short. In universal banking systems, banks lent both short and long. The dependent variable can be represented graphically (Figure 1). Assuming that the average liquidity for the assets of a bank varies from 0 to 1, all the banks in a given economy can be represented by as many points on an average liquidity axis. The typi cal distribution of banks in a specialized system should be bimodal, while that of a non- specialized system, unimodal.

[ Figure 1 here ]

Measuring such a distribution, however, is not easy, as banks grouped assets with little respect for maturity and in ways that were not comparable across banks and countries. Furthermore, limited availability of bank accounts disqualifies random sampling. The measure of banking specialization must instead be proxied. Two equally imperfect proxies will be used: the equitv-liabilitv ratio, which sacrifices coverage to precision, and the equity-deposit ratio, which sacrifices precision to coverage.

Both proxies are calculated on liabilities instead of assets. The liquidity of a bank's liabilities is a good proxy for the liquidity of that bank's assets, since any

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serious mismatch between the two is bound, sooner or later, to end in ruin (through insolvency if assets are less liquid than liabilities, or through insufficient profitability in the opposite case). Liabilities offer the advantage over assets that, unlike assets, liabilities tended to be arranged by most banks in most countries according to liquidity—"capital" and "reserves" were very stable (they belonged to the bank), "inter bank deposits" and "positive current accounts," whether remunerated or not, were moderately stable (they were corporate accounts used to finance daily transactions), and "notes" and "deposits and savings accounts” were unstable (they were interest-bearing placements, which could be cashed right away, although with a penalty for term deposits).

A rough and simple approximation of liability liquidity is the equity-liability ratio—the ratio of capital and reserves to total liabilities. Stable and profitable banks typically finance long assets with their own resources (capital and reserves), and short assets with borrowed resources (notes, deposits). The relative importance of capital and reserves combined (let us call it "equity") should thus reveal the overall liquidity of the bank. Because capital and reserves were almost standard entries across banks and countries, the equity-liability ratio is easy to establish for a large population of banks and countries. The ratio, however, suffers one shortcoming: it assumes that all other liabilities are liquid, when in fact, as already seen, interbank deposits and positive cur rent accounts are more stable than notes, deposits, and savings accounts.

The second ratio corrects for this imprecision. It is the ratio of the least liquid resources (capital plus reserves) to the most liquid ones (deposits, savings, and notes, when any). I shall refer to it as the equity-deposit ratio.

To understand why we must include notes in the numerator of the second ratio, along with deposits, it is necessary to anticipate a bit on the next sections. Individuals did not start opening deposit accounts in banks other than savings banks til the

1860s-© The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research

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1870s. Prior to then, banks used to finance short-term lending (discount) by issuing their own banknotes. And thus, the first universal banking system to ever exist, the Belgian one in the 1830s and 1840s, combined note-issuing with industrial promotion. Similarly, the Crédit Mobilier that the brother Péreires fancied, but could not accomplish, was a mix of discounts, financed through note-(or look-alike bonds- )issuing, and industrial promotion, financed through capital and reserves.3 It is only after banks managed to attract individuals' deposits and central banks were created to monopolize note-issuing that deposits displaced notes in the financing of short-term lending—and that universal banking came to mean the mix of short-term lending, financed through deposits, and industrial promotion, financed through capital and reserves. It is on the latter type that this study focuses, in part because data availability improves toward the end of the period, and in part because there was only one clear instance of universal banking system of the former type—Belgium. However, not all countries had switched from the note-phase to the deposit-phase by the turn of the century, and not to the same extent; hence the need to devise a measure spanning two different epochs of banking.

Though more precise than the equity-liability ratio, the equity-deposit ratio, however, suffers from limited coverage. Banks did not always differentiate between current account deposits (for their corporate clients) and checking account deposits (for individuals), with the results that data are not always available.

The next step is to identify the banks for which to calculate the two ratios. The standard population is that of deposit-taking banks. With a few exceptions, deposit taking banks were either deposit banks (in specialized systems) or universal banks (in non-specialized systems); they were not investment banks. A well-known exception is France, where investment banks did take deposits-they are excluded from the present samples. 3Chlepner 1926, pp. 17-18, 414. © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research

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The last question is one of comparability. Would not different countries at dif ferent stages of industrialization exhibit diverse average investment maturities, with the result that what would have been considered as "short" here might have been con sidered as "long" there? The answer is in the negative. "Short" had the same meaning in every country for two reasons: first, short loans were designed to finance trade, in which all countries engaged. Second, depositors everywhere reacted alike to risks of bankruptcy—by running to the bank to withdraw their money. The risk afferent to immobilization being the same in every country, the panoply of tools among which banks could choose to provide against illiquidity was comparable across countries.

The equity-liability ratio and the equity-deposit ratio will thus be used to proxy the degree of specialization of a banking system. Specialization is a linear function of liquidity; this reflects the fact that investment banks are excluded from the national samples.

Results are shown in Table 1. As expected, the correlation between the two ratios is high (the Pearson coefficient between the equity-liability ratio and the log of the equity-deposit ratio is 0.85). The data track the overall sense of the historians: at one extreme, the specialized Anglo-Saxon banks (UK, Canada, and the USA), at the other the universal type (Germany, Italy, Austria-Hungary). The figure for Spain sug gests that Spanish banking in 1913 was an outlier, deserving special consideration—I will reserve the Spanish case for the end.

[ Table 1 here ]

Figures for 1890, in conjunction with 1913, reveal a trend toward greater deposit banking (the two exceptions, Norway and Spain, are difficult to interpret, and probably an artifact of measurement). From 1850 until 1913, joint stock banks in every country were on a similar trajectory from investment (crédit mobilier') banking toward deposit

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banking. Explaining cross-national variations in banking structures in 1913 is tantamount to explaining differences in national rates of change.

The Timing of Industrialization

Alexander Gerschenkron authored the most ambitious explanation so far offered for why banking structures differed across nations.4 The more capital was needed in the shortest amount of time, he argued, the less could equity markets cope with the task of allocating long-term financial capital; instead, banks and state had to step in. Hence the "orderly system of graduated deviations from [the first] industrialization":

The more backward a country, the more likely its industrialization was to proceed under some organized direction: depending on the degree of backwardness, the seat of such direction could be found in investment banks, in investment banks acting under the aegis of the state, or in bureaucratic controls.5

More precisely, British industrialization was self-financed, manufacturers ploughing back profits into their own factories; French industrialization (the 1850-1870 spurt) was financed by investment bankers, who raised long-term capital and lent it to factories; German industrialization was financed by universal bankers, intermediating between depositors and factories; while Russian industrialization was financed by the state, intermediating between taxpayers and foreign lenders on the one hand, and banks and factories on the other.

4One cannot easily do justice to Alexander Gerschenkron's contribution without recalling the debates of the fifties between Marxists and non-Marxists (especially W. W. Rostow) on what it takes to industri alize and on whether industrialization engineers convergence among national economies. This, I will not do, as my goal is not to survey the extent of the contribution of a great thinker, but to isolate the few aspects of his work that are most relevant to my specific task.

5Gerschenkron 1962, p. 44. My emphasis. © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research

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Several factors were responsible for the "organized direction” typical of late industrialization. Economies of scale, first. No single investor, Gerschenkron argued, had the capacity to finance large-scale, capital-intensive projects, which were character istic late industrialization; only capital pools, mostly banks, could. A second rationale is sociological. The society of the late industrializer missed standards of honesty and mechanisms for the enforcement of contracts that are usually required for the normal working of the market; dealings had to be reserved to an elite of honorable individuals. Politics, in Gerschenkron's argument, entered the picture as ultimate substitute for the missing requisites: the state stepped in if the banks were unable to meet the demand for industrialization.

Gerschenkron cast his argument at such a high level of abstraction, that critics had no difficulties in pointing to historical exceptions. Among those, there is the obvious fact that not all backward economies did industrialize.6 Then there are cases (Italy and Austria) that exhibited the traits of late industrialization, despite the fact that their big spurt, by Gerschenkron's own admission, petered out. Finally, there is Den mark, an economy that grew faster than Germany in the prewar decades, developed universal banking but no large-scale, capital-intensive industrialization.7

More damaging than isolated cases of empirical lack of fit, is the absence of decisive evidence for the occurrence of capital scarcity in some instances where ‘Gerschenkron himself grappled with the Bulgarian case, coining for the occasion the notion of "missed opportunity":

...it is one thing to expect that, had a great spurt of industrial development occurred in Bulgaria, it would have in all likelihood proceeded under the strong tutelage of the state. It is quite another to assume that the great spurt was "bound" to occur. Gerschenkron 1962, p. 234.

7Paul Bairoch's (1993, p. 8) data for 1890-1913 show a 2.3 percent annual growth in GNP per capita for Denmark against 1.7 percent for Germany. On Denmark, see Gerschenkron 1962, pp. 16, 361.

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Gerschenkron explicitely claimed there was such scarcity. Few historians accept the idea that there was a capital shortage in Prussia in the first half of the 19th century-in fact, Prussia exported capital.8 Surely, this capital was not readily available for industry, investors preferring instead government bonds. It is in that sense only that there was a scarcity of capital available for industry in those countries.

Gerschenkron's explanation and the one propounded here agree on one thing: universalism was a reflection of capital scarcity. Yet they differ on the origins of such scarcity. While Gerschenkron argues that capital scarcity reflected backwardness and/or a spurt of industrial development, I will argue that it reflected market frag mentation.

Since Gerschenkron laid out his theory, there has emerged an additional potential explanatory variable—information asymmetry. The central idea is that in conditions of information asymmetry, banking monopolies are more efficient than equity markets.9 A financial intermediary can monitor a firm's management more effectively than a small saver, because economies of scale in the acquisition of information lowers information-gathering costs for the former. Moreover, a universal banker can do the monitoring better than a commercial banker, because the former has more dealings with, and thus disposes of more information about, management than the latter. There fore, equity holders are better off delegating monitoring to a mixed bank. With information asymmetry being steeper in backward than in advanced countries, one could thus explain why British banking differed from its continental equivalent.

However, information asymmetry as an explanation runs into questions of insuperable complexity. Since there is, to some extent, information asymmetry in all banking structures, including the British one, then universal banking is always more 8Barrett Whale 1968, p. 11. Tilly 1967, p. 156. Schmoller 1904, Vol. n , p. 182. Hansen 1906, Vol. I, pp. 580-6. Beckerath 1954, pp. 7-14.

9See for example De Long 1991. Hoshi, Kashyap, and Scharfstein 1990. Lamoreaux 1991.

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efficient than British-type specialized banking. How then to account for the existence of specialized banking? A successful comparative explanation, of course, would have to look at the downside of universal banking.10 It involves two monopolistic relations, one between the bank and the equity holder, the other between the bank and the firm, and these monopolistic relations are sources of inefficiency for both equity holders and firms. Moreover, universal banking carries with it the additional risk of insolvency.11 Whether the monopolistic and solvency drawbacks merely balance or completely dwarf the informational advantages of universal banking is not something that can be adjudi cated a priori. A model able to handle such complex accounting must be built, and the empirical estimates that would help us calibrate the various effects must be made. No such model exists yet, and the fact that information asymmetry is not directly observ able may turn the process of calibration into guesswork. All these difficulties make information asymmetry an unlikely contender to capital scarcity. Finally, even if the explanation could be built as a plausible contender to G erschenkron's, like Gerschenkron's, it would be subject to the objection that information asymmetry, like capital scarcity, may bave been an endogenous variable. I now turn to a line of argu ment that would suggest that such was the case.

Pluralist and Corporatist Political Structures

Political structures can be of two kinds-pluralist and corporatist—depending on whether the unit of political representation is the individual or the group. A pluralist polity is one in which the unit of political representation is the individual; encompass ing groups of any kind, be they factors, ethnies, locales, regions, or any other ter ritorial subset enjoy no special political rights. Although individuals may form (inter 10Among those who have begun to do that, Jeremy Edwards and Klaus Fischer 1993.

n This point is developed below.

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est) groups to defend more effectively their personal interests, in the absence of any official recognition, the formation of these groups is subject to the dilemma of collec tive action, with the well-known result that only relatively small and concentrated groups ever manage to organize, and never for very long.12

In contrast, a corporatist structure grants political rights to encompassing groups. This may take the form of a government setting up a system of so-called "neo- corporatist" concertation between organized labor and organized capital, as it existed recently in countries where social-democracy was dominant;13 or the form of federal ism, that is, the privileged representation of territorial subsets, often through the con traption of powerful second chambers; or of "consociationalism," a government of elites each representing different ethnic groups in society.14 In all these cases, state recognition gives the leader of each encompassing group power over the allocation of state resources, effectively guarding the groups against the dilemma of collective action. The legitimacy of a corporatist system lies in its capacity to maintain a fair balance between groups, through means of logrolling, proporz. lotizazione. clientelism.

The protagonists of political representation in the last century belonged to one of two categories-the state-building center and the antistatist periphery. In the industri alizing West, the center was industrial, including the new, large, vertically integrated firms while the periphery was agrarian, constituted of land-abundant areas with small, indigenous firms, embedded in, and serving the industrial needs of, local areas.15 In Britain and France, where state formation was early and complete by the century, the pluralist principle dominated. Elsewhere, where state formation instead was late or incomplete, as such was the case with empires, federal states, or states whose party 1201son 1965.

13Schmitter 1981. 14Lijphart 1977.

15Workers did not form an autonomous group yet, but were either part of the capitalist center or o f the agrarian periphery depending on who employed them. See Lipset and Rokkan (1967).

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system was cleft by a center-periphey cleavage, the polity rested on bargains, brokered between leaders of pre-organized groups, arranged along class or territorial lines.

The political representation of the agrarian periphery in corporatist systems took two forms depending on the strength of the relative weakness of the center. Where the center was very weak, the agrarian periphery was represented territorially, through a powerful high chamber to which each locale appointed its own delegates. In contrast, where the center was weak, yet threatening enough to require the periphery to collec tively organize in order to check centralization, the agrarian periphery was represented functionally, that is, through an agrarian political group, be it a party, a faction of a conservative party, or a transpartisan parliamentary bloc. In other words, functional (or class, or partisan) representation was a weaker form of representation of agrarian peripheral interests than territorial (or federal) representation. I will refer to the func tional variant as "moderate" corporatism and to the territorial variant as "excessive" corporatism.

The territorial variant of corporatism took the institutional form of the federal, democratic state-Switzerland, the United States, Canada, Australia, and New Zealand. The functional variant did not take any definite constitutional form; in Scandinavia, it materialized in the form of a third, agrarian party, arbitrating between conservatives and liberals (later on socialists). Elsewhere, it took the form of an informal agreement between capitalists and agrarians, mediated either by an authoritarian ruler, as in Holland-Belgium before 1830 and Germany and Austria-Hungary after 1870, or stal wart politicians, as in Spain and Italy at the turn of the century.16

Distinct representational principles generally have distinct redistributional con sequences. In the pluralist model, the relative importance of state and market is governed by the extent of rent seeking. Rent seeking features tenure-maximizing 16The instances of functional corporatism will be further detailed below, in the discussion o f central banking. © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research

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government officials selling policies (called "rents") to wealth-maximizing individuals in exchange for political support. Rents are monopoly rents, redistributing income away from the unorganized to the cartelized. Only individuals whose interests are suf ficiently concentrated for them to overcome the dilemma of collective action and to lobby politicians directly can extract significant rents. The rest of the people subsidize rents.

In the corporatist model government officials also grant favorable policies to groups in exchange for political support. These policies, however, are not rents in the redistributional sense of the term. With most individuals enrolled in one of the con tending groups, almost everyone has to pay for the policies, with the result that the invisible redistributive effect, the one which, in the pluralist model, operates surrep titiously at the expense of the unorganized, is close to nil in the corporatist model. Rather than rents, these policies are better understood as "market s h a r e s each group obtaining exclusive authority over the allocation of resources in a particular market or geographic area.

Rent seeking and market competition (typical of pluralism) characterized bank- state relations in pluralist regimes. Pluralist governments shunned from systematic intervention, being content with granting privileges to individual banks, privileges which these banks would use to thwart competition from other banks. The standard outcome was the centralization of all privileges into one so-called "central bank,” enjoying a monopoly of note issuing, at the expense of other banks and forms of bank ing. The centralization of rents destroyed peripheral forms of banking (nonprofit and local) and opened commercial banking to market competition, since all banks, except for the central bank, had to compete by means of cost cutting and product innovation. Able to successfully check any further governmental extension of the central bank's privileges beyond that of note-issuing, joint stock banks after 1860 used product

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innovation (demand deposits) to weaken the market power of the note-issuing monop oly.

Market sharing and state regulation (typical of corporatism), in contrast, charac terized bank-state relations in corporatist regimes. Corporatist governments granted rents to almost all existing banks, including those serving the needs of the agrarian periphery—nonprofit or local. Each bank belonged to one of two groups, the banking group of the center, dominated by the joint stock banks, and the banking group of the periphery, dominated by savings banks in the functional variant of corporatism, or by local commercial banks (of which some enjoyed issuing rights) in the territorial variant. The relative market share of each group was not left to market forces, as such was the case in the pluralist setting, since market forces would have inevitably led to the domination of the periphery by the center, an outcome which, given the corporatist make-up of the state, was politically unacceptable. Market shares, instead, were administered by the state, according to standards of fairness and political expediency. The corporatist state sought to maintain a kind of balance between banking groups through a mix of policies including (1) protection of the market share of the local com mercial and/or nonprofit banking sector, and (2) the granting of central banking (defined as last-resort lending) to the profit banking sector in functional corporatism.

Pluralist states did not use either policy tool, with the result, as I will show, that the nonprofit and local commercial sectors vanished and central banking (notwithstand ing the existence of a "central bank”) did not materialize until after World War I.

Universal banking, I now show, was the result of the two policy tools combined. Only the simultaneous pursuit of both policies could yield the two requisites of universal banking, that is, the fragmentation of the deposit market and the existence of a liquidity guarantee. © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research

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The First Requisite of Universal Banking: Fragmentation of the Deposit Market It is necessary first to recall the banking structures that Western countries inherited from the early part of the century as well as the secular trends to which capi tal markets were subjected. The first half of the nineteenth century was the era of pri vate bankers and savings banks. While the Barings, the Rothschilds and their like catered to the needs of governments and the wealthy, savings banks were nonprofit organizations, created by philanthropic individuals or local governments to instill the saving habit among the urban poor.17 The two markets were separate, resorting to dif ferent financing techniques: private bankers used their own resources, augmented with those of their direct clients, in order to, primarily, issue government bonds. Savings banks, instead, took the savings of a great number of individuals, investing the pro ceeds into safe, government paper.

By mid-century private bankers got involved in the financing of railways first, and the new industries soon after. Throughout Europe, private houses joined efforts to establish investment banks (crédits mobiliers! and, when the legislation permitted, joint stock banks with limited responsibility. Savings banks also went through a major reorganization. Strained by the general depreciation of government paper, which they were obliged to carry, they were the object of stepped up regulation, placing them under the tutelage of central (France, Belgium) or local (Germany, Austria-Hungary, Denmark) governments.18 The mid-century also saw the creation of mutual credit societies-nonprofit cooperatives-created by artisans, merchants, and small business, to whom the joint stock banks would not lend. Mutual credit societies also developed in rural areas, among local farmers, alongside long-established mortgage associations.19 17Chlepner 1926, p. 96. Nygren 1983, 42. Bom 1983, 109-110. Polsi 1993, 193

18Hansen 1982, 582 and after. In Italy, this reorganization occurred in 1876. l9On German credit cooperatives, see Guinnane 1995.

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Mid-century industrialization radically transformed the way the haute banque financed its assets. Until then, there were only two major ways of procuring capital in large quantity—note-issuing, which in many countries already was, or about to become, the monopoly of a central bank, and equity. The widespread pratice of opening indi vidual deposit accounts for checking and savings purposes, as we know it today, did not exist yet-payments, and savings as well, often took the form of cash. As the bene fits of industrialization began to penetrate deeper into the middle strata, however, the demand for deposit accounts, short and long, grew to a point that it became thinkable for bankers to finance lending with deposits taken from numerous individuals with whom they had no prior or other dealings. The motivation was profit, as deposits were less costly to remunerate than equity. The emergence of deposits revolutionized bank ing, causing a global trend toward deposit banking. Even though most of them had been created in the wake of mid-century industrialization to operate as investment banks tcrddits mobiliersl. joint stock banks rushed to reap the new bonanza.

However, joint stock banks did not manage the conversion to deposit banking with uniform ease and to the same extent. The unleashing of what used to be the dis tant haute banoue into deposit banking threatened to throw the local commercial banks and the nonprofit sectors, savings banks especially, out of business. Left to the inter play of market forces, the joint stock banks would have swept the field, drawing depositors from savings banks and mutual credit societies, taking over local commercial banks, and forcing the rest out. The general surge in deposits threatened the unification of two banking sectors which, until then, had been kept separate—banking for the wealthy and the territorially concentrated, and banking for the less wealthy and for the dispersed-under the exclusive auspices of the newly created joint stock banks, at the expense of the old, government-supported local, nonprofit banks and the local commer cial banks. Where joint stock banks were allowed to develop unhindered, they turned

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into deposit banks, developing dense networks of local branches, and leaving the busi ness of investment banking to institutions especially created for that purpose—trustee banks, investment banks, the stock market. They abandonned the field of investment banking altogether in order to match the maturity of their assets with that of their newly-gained short liabilities. The outcome was specialized banking. The nonprofit sector languished, surviving only in the form of postal savings or other government savings banks established by, and for the profit of, the central government; and local commercial banks fell to vertical concentration.

Wherever they could, nonprofit and local sectors reacted, and in those countries where they enjoyed strong political support, that is, in corporatist regimes, they managed to retard the joint stock banks' inroad into savings deposits. Nonprofit bank ing enjoyed government support in systems of functional representation (moderate cor poratism), while local commercial banking emjoyed similar support in systems of ter ritorial representation (excessive corporatism). State intervention through the granting of rents as diverse as tax-free status, subsidies, government-guarantee for bonds, monopoly over the issuing of small notes, or limitations on branch banking and other territorial protection against market competition, allowed these peripheral forms of banking to maintain their activities.20 Since nonprofit banking and local commercial banking were in competition for local deposits, depending on which was protected, it tended to crowd out the other.

State protection of local or nonprofit banking fragmented the market for individ ual deposits. Although local commercial banks would often open clearing and deposit accounts with the center commercial banks, therefore investing in the financial center part of the deposits that they had drained from their local clienteles, such practice was bound to be residual and strictly limited to what was required to interbank compensa 20Marz 1984, p. 39. Deeg 1992, 77. Hansen 1982, 590. Polsi 1993, 234, 249.

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tion, as it earned very little.21 The fragmentation was equally pronounced in the case of nonprofit banks, where, in some cases, double intermediation was not even a pos sibility. In countries of Germanic background, less so in Italy, savings banks and mutual credit societies created their respective clearing systems, first at the regional level, then at the national level, separate from the profit sector.22 In all cases, the deposits collected by local and nonprofit banks were "lost" for the center banks.

Deposits being the main and ever growing resource for banks, the fragmentation of the deposit market, where it obtained, not only sanctioned and reinforced the frag mentation of the financial system between a money center and its periphery, but also of industry at large into two separate industrial orders: that of large, national firms and that of small, local firms. The fragmentation of the deposit market sanctioned and reinforced the duality of the industrial process, which students of industialization have recently rediscovered in Germany, Denmark, Italy, and so on, with a national track featuring large, concentrated, vertically integrated companies (the "autarkic industrial order," in Gary H errigel's terminology), and a regional track featuring small, decentralized, locally-embedded companies (the "decentralized industrial order”).23

The fragmentation of the capital market was conducive to universal banking. The causal mechanism was an instance of Adam Smith's famous theorem that the division of labor is limited by the extent of the market.24 The joint stock banks were on a secular trajectory running from investment banking, when they exclusively catered to new and concentrated industries, toward deposit banking, when they would mostly cater to small depositors. If frozen in mid-course, these center banks were bound to 21Only in the United States, where national banks were required by federal regulations to keep part of their assets frozen in the form of reserves, did it make economic economic sense for banks to deposit these sums in money center banks.

22Deeg 1992, p. 69, 81, 84, 94; Marz 1984.

«Herrigel 1996, pp. 1-2. Building on the pioneering work of Piore and Sabel (1984), the literature on industrial dualism is now voluminous. For two recent contributions, see Deeg (1992) and Herrigel (1996). «Smith 1976, p. 21. © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research

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cater to a wide clientele of large, industrial depositors, while local commercial or non profit banking would comer the market for smaller depositors. Unable to fully capture the field of deposit banking, joint stock banks were forced to keep relying on their own resources to a broader extent than pure deposit banks. Consequently, they could not vacate the field of investment banking, a more profitable, though riskier business, because of the greater cost of their resources. In contrast, the opportunity to drain the periphery from its savings was the driving force behind British and French joint stock banks' rush toward deposit banking and the consecutive consolidation in these two countries of specialized banking.

This is how universal banking coincided with a very close association between banks and industry, in both center and periphery.25 In the center, first, joint stock banks kept close relations with large firms. Hampered in their capacity to collect indi viduals' savings, the joint stock banks of Belgium, Germany, Austria, Italy, and to a lesser extent Switzerland, Denmark and Sweden were naturally forced to maintain a strong presence in industry, in which they found both their most profitable lending opportunities and their most abundant sources of deposits.26

In the periphery, second, local banks collected local deposits which, for lack of other options, they were inclined to invest in the area where they were located. Local firms, meanwhile, found local banking houses more reliable, though dearer, than joint stock banks. This was true with respect of local commercial banks, but of savings banks and credit societies as well, which followed the financial needs of their local clients by progressively expanding their banking activities in the bordering realms of commercial and investment banking. The rationale is easy to intuit. By keeping joint stock banks out of entire regions, social strata, or sectors of activity, and thus de facto turning peripheral banks into local monopolies, state intervention created the need for “ Levy 1935. “ Riesser 1911. © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research

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peripheral banks to fill in. The most dramatic consequence was the transformation of the private nonprofit sector into regular commercial banks. In Scandinavian countries first, and Germanic ones then, savings and credit associations expanded their activities to commercial banking in relation to their own clients.27 The growing competition of the non-profit sector was generally opposed by the joint stock banks, denouncing the unfair advantage enjoyed by non-profit banks, but was ratified by legislators and state regulators who were favorable to the non-profit sector and their clients.28

In contrast, deposit banking as it developed in Britain and France, led banks to estrange themselves from industry, in both center and periphery. In the center, banks could not afford to immobilize liquid deposits into illiquid placements, but were driven instead to emphasize safe and short placements, in the form of either commercial paper or government-guaranteed bonds. Firms relied on equity and plown-back profits. In the periphery, second, the joint stock banks diluted the depositor-creditor coupling, by transforming local banking into the collection of local resources, which would then be channelled to, and invested in, "center investments," especially government paper, stock market call loans, and rediscountable commercial paper.29

Universal banking brought bankers and industrialists together into a coherent cap italist class, although it excluded from the class its peripheral elements. Specialized banking, in contrast, brought the capitalist periphery under the aegis of the center, but split the capitalist class into bankers and investors or, more generally, product (or sec tor) lines.

A look at the crossnational data on the market size o f nonprofit banking (unfortunately no equivalent data on local commercial banking are available) confirms 27Hansen 1982, p. 583, 589. Feldman 1991, 69; Deeg 1992, 73-79. Michel 1976. Nygren 1983, 33, 43- 44. Nordvik 1993, 69; Egge 1983, 281.

28No such universalization occurred among savings and credit associations in countries where the state declined to protect banking in the periphery. There, the non-profit sector limited itself to its initial format. "Cottrell 1992. Bouvier 1968. © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research

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the hypothesis that state intervention in favor of nonprofit banks had no trivial impact on the respective market shares of the profit and nonprofit sectors (savings, credit societies, and postal service). Where savings and cooperatives were left unprotected, they got the smallest share of the market: 19 percent of total deposits (excluding central bank) in Britain, out of which 14 percent of postal savings; 9 percent in Canada, out of which 4 percent of postal savings (Table 2). In contrast, where the non-profit sector was promoted by the state, it dominated the field: 78 percent in the Austrian part of Austria-Hungary, out of which 6 percent of government bank savings; 73 percent in Italy, out of which 32 percent of postal savings; and 67 percent in Germany, all pri vate. The divergence is as stark when expressed in total assets; the total assets share of the non-profit sector was in percent: Canada: 2; Britain: 10; Italy: 49; Germany: 65 (no data are available for Austria).

[ Table 2 here ]

In sum, universal banking was forced upon joint stock banks by the fragmentation of the deposit market. This fragmentation was caused by state protection of nonprofit banking. However, the fragmentation of the capital market does not constitute the whole story. Although conducive to universal banking, the lack of access to peripheral banking did not always lead joint stock banks to universal banking—wit the cases of the U.S., Canadian, Australian, New Zealandese, and Norwegian banks. A second condi tion had to be met as well for this to happen: central banking. Universal banking is an unsustainable form of banking, unlikely to last for very long without the liquidity guarantee of a central bank.

The Second Requisite of Universal Banking: Central Banking

Specialized banking, in and of itself, is a stable equilibrium; universal banking, however, is not. This is the lesson that governments drew from the Great Depression.

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There would be no need to belabor the point had apologies for universal banking, usually building upon information asymmetry models, not resurfaced.30 According to that literature, information asymmetry about firms' profitability makes mixed banking (the act of combining short with long assets) a more efficient form of investment than specialized banking, with long term finance allocated through the stock market. This result, I show, is not very robust. In the following, I sketch the reasons for why, under additional conditions of generalized imperfect information about bank-asset liquidity, banks should specialize.

Consider indeed the two balance sheets of two imaginary mixed (non-note issuing) banks in Figure 2. Bank "A-'s balance sheet is clear: half of the assets are liq uid, the other half is illiquid. Each type of asset is proportionally financed by liquid and illiquid liabilities. Bank ”B'"s balance sheet is unclear: only a fifth of the assets are illiquid and a fifth are liquid. The other three-fifths are neither illiquid nor liquid (nor in-between)—they could be either depending on whether the financial market is buoyant or stagnant. If buoyant, the bank can easily liquidate these assets; if stagnant, it can't sell but at an unacceptable loss. In other words, the degree of liquidity of the assets in the gray area is a positive function of the business cycle. The reverse is true on the liability side. Again, one-fifth of the liabilities are illiquid (capital), one-fifth liquid (acceptances, checks dues), and three-fifths illiquid or liquid depending on whether lenders are optimistic or pessimistic about the economic outlook. The prospect of a buoyant market makes lenders willing to keep their money in the bank, whereas the prospect of a downturn incites them to liquidate their deposits. The degree of liquidity of the liabilities in the gray area is a negative function of the business cycle. In sum, variations in the business cycle force the liquidity of assets and liabilities in opposite directions.

30See for example De Long 1991. Hoshi, Kashyap, and Scharfstein 1990. Lamoreaux 1991.

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23 [ Figure 2 here ]

If we now ask whether "A" and "B" should specialize, then it is clear that "A" need not specialize. In the worst situation, it will have to reimburse all depositors by calling on all its debtors. The solvency of "A”, thus, is not affected by changes in the business cycle. "B"'s solvency, in contrast, is affected by the business cycle. When the economy is booming and the financial markets are flushed, "B" finds itself with lots of liquid assets being financed by lots of stable (illiquid) liabilities—it is potentially losing money, for not making an optimal use of its liabilities (like "D"). In contrast, when a crisis is pending and the financial market chills, then that same bank is now insolvent; four-fifth of its liabilities are liquid whereas four-fifth of its assets are frozen (like "C").

Bank "B" cannot easily guard against the risk of insolvency because no one can forecast the degree to which the next crisis will melt liabilities and freeze assets; it depends on the intensity of the crisis. A small chill may merely realign assets and liabilities along the fifty-fifty line, making "B" like "A"; a bigger chill will cause insolvency. Further, once started, the panic develops its own dynamic. "B” does not know what a priori could be a safe ratio, and neither does the investing public, with the result that "B" is shunned by risk-averse depositors.

The reasoning, so far, has borne on imaginary banks. It remains to determined whether tum-of-the-century practice was closer to type "A” or to type "B". Did most assets and liabilities of mixed banks fall into the gray area? The answer is in the posi tive. In their attempt to attract business, banks engaged in product diversification on both sides of the balance sheet. They developed new instruments with variable liquidity. Discounts were progressively replaced by advances on current accounts, sub stituting for a rigid 90-day loan one that was flexible and could effortlessly be prolonged. Advances against stock exchange securities could be temporary or

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permanent, depending on the health of the stock market; while deposits with all kinds of terms could all be withdrawn at a moment's notice against a penalty of which the amount reflected the length of the otherwise-due advance notice. Hence, current accounts, advances, and deposits were both elastic and sensitive to the business cycle.

The appearance of these new instruments further compounded the difficulty by making balance-sheets practically useless in revealing the actual solvency of a bank, all the more so that they were regularly window-dressed to hide profits from shareholders and fraud the fisc. To the extent that official reporting became the basis for internal accounting, assessing the actual liquidity of assets became intractable for both insiders and outsiders. Contemporaries could only tell post facto, after crises weeded out insolvent banks. The impenetrableness of balance sheets removed an important means that bankers needed to elicit their clients' trust—the capacity to commit to certain liquidity targets. Absent such a commitment, depositors could not but suspect that mixed banks were placing the interests of the industries in which bank directors had vested interests above those of the banks' depositors.

Universal banking was therefore unstable. The unpredictability of crises, com bined with the sensitivity of most assets and liabilities to the business cycle, made universal banks unprofitable during booms and insolvent during slumps. Specialization à la française was a more stable equilibrium. Following a couple of notable crashes, banking strategies in France forked in two opposite directions-investment banking and deposit banking.31 Investment banking implied the placement of long-term resources into high profit, high risk ventures. Revenues were irregular, but average profits and dividends were high. The bank would only take deposits from reliable depositors, mostly its correspondents and partners in issuing syndicates and the few companies in which it held long-term participation. In contrast to investment banking, deposit bank-3ISee Bouvier 1968; Lévy-Leboyer 1976.

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ing thrived on sight deposits collected from the masses of small savers through thick networks of bank branches. The bank would invest these deposits in short-term, self- liquidating credits to commerce and industry, and in the promotion of government (or government-guaranteed) issues. The placement of safe paper among its wide clientele of small depositors would also earn the deposit bank lucrative commissions. Profit margins were slim, but volume was massive and revenues were regular. Investment banks would maintain close, long, and personal relations with borrowers; deposit banks were content with hands-off, short, and mediated contacts. These opposite forms of banking were more stable than mixed banking. Investment banks were not subject to depositors' runs, since they had no depositors outside a small network of reliable clients; while deposit banks were not subject to runs either, because most of their assets were kept in cash, rediscountable paper, government bonds, money at call, and other disposable assets.

From the foregoing analysis it follows that the existence of universal banking can only be found in the existence of a non-market mechanism that tided banks over in periods of financial emergency by maintaining the liquidity of their assets. That mechanism took the form of a central bank engaging in the practice of lending of last resort (central banking). A central bank could guarantee the liquidity of bank assets by accepting to rediscount commercial paper at all times, at reasonable rates. By keeping bank assets liquid, the central bank would then keep liabilities stable, as depositors' fear of insolvency would diminish. Runs on banks would not materialize.

Although most of the countries studied here had central banks in operation by 1913 (the United States, Canada, Australia, and New Zealand excepted), not all of them engaged in lending of last resort with the same equanimity. In fact, one can say that until 1900, there was an almost inverse relation between the age of a central bank

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and that of central banking-the older the central bank, the later a bankers' bank. This is the point of the next section.

The Origins of Central Banking

Central bank and central banking are nowadays synonymous. However, central bank, a bank with a note-issuing privilege of some sort, and central banking, the institutionalization of lending of last resort, have quite different origins.32 Initially, central banks were the protagonists of the pre-19th century "fiscal-military states," the story of a quid pro quo between self-maximizing financiers worried about the state encroaching their property rights, and warrying princes anxious about cash.33 The prince granted a rent to a syndicate of wealthy individuals in exchange for easier and more regular access to finance. Central banking, in contrast, became universal in response to the Great Depression of the 1930s. In-between, from 1815 until 1914, cen tral banking was adopted in some countries only. These were the countries where the fiscal-military model was side-tracked by considerations of a domestic order. The most important question for corporatist states confronted with the advent of democratization was not to finance war, but to maintain peace and order in the face of threats of class conflict and territorial secession.

Not all corporatist regimes adopted central banking, however. On the one hand, central banking was the just price that corporatist regimes paid to elicit support from large banks, negatively affected by the promotion of peripheral banking. (In countries of specialized banking, bankers had no really felt need for central banking until the unprecedented crash of the 1930s elevated last-resort-lending to the status of a dogma.) 32The present definitions are borrowed from Goodhart 1988.

53The 'fiscal-military state' category is borrowed from John Brewer 1989, and North and Weingast 1989. © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research

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On the other hand, not all corporatist regimes could adopt central banking. Central banking had redistributional consequences favoring the center at the expense of the periphery. As a result, whenever the periphery was strong enough, it prevented central banking. I further develop these points.

Central banking had negative redistributional consequences of two types on the periphery. First, central banking siphoned off resources into the profit sector. By making deposits safer than they would be otherwise, central banking allowed mixed banks to attract more deposits for the core, at the expense of peripheral sectors.

Second, central banking externalized the burden of solvency. In the fiscal- military model, where the central bank resisted from extending a sweeping liquidity guarantee to joint stock banks, the cost of solvency was indirectly borne by the joint stock banks, in the form of precautionary reserves and a large number of assets kept relatively liquid in cases of an emergency. Since the banks had to shun long-term immobilization so as to remain liquid, potential borrowers (firms) had to look for long term credits elsewhere (investment banks and the equity market), for which they paid the full market price for long-term capital. Consequently, user assumed their own sol vency risk, firms by borrowing long and dear, and banks by lending short and on thin margins.

The redistributive implications of central banking were rather different. The liquidity guarantee extended by the central bank disinclined commercial banks to build cash reserves, as the central bank was pledged to rediscount commercial and financial paper under almost any circumstances. Commercial banks could afford a greater share of illiquid, yet profitable assets; while investment banks could afford to enter into the less profitable, but more stable, field of commercial banking. The banks' greater readiness to immobilize their assets might also benefit borrowing firms if competition among banks led them to dissipate the extra profits among their clients.