Exploring Economic History

with Palgrave Macmillan

Survival in a Changing World

History is often used in an attempt to make sense of current events, but our understanding of past events is too often constrained by established viewpoints that do not necessarily have a firm foundation based on evidence. This is particularly the case with financial history. To help in the formulation of current policy, a better understanding of history of the banking sector is required.

In considering the development of this sector it is too easy to assume that those firms that have the extensive surviving records must be representative of the sector as a whole. However, caution must be exercised as information about failed and long-forgotten firms will usually provide a much fuller, richer insight. An understanding of the causes of failure is essential to explain the reasons for survival.

Before the First World War, British merchant banks bestrode the world. Some of these firms were regarded as being at the heart of the British financial establishment - Rothschilds, Schroders, Hambros, and Barings. In 1931, the Committee on Finance and Industry described the merchant banks as “highly specialised” and of “world-wide standing”. However, by the end of the millennium the merchant banking sector had to all intents disappeared. What happened to this once thriving sector?

The answer lies in the merchant banks’ response to the tough economic climate of the 1920s and 1930s. They had become pre-eminent in a world of fixed exchange rates, free trade and the unfettered mobility of international capital. Their international outlook had to adapt to a shift towards floating exchange rates, trade protectionism and restrictions on capital movements.

At the beginning of the twentieth century, the Bank of England had a close relationship with the leading merchant banks. Together they might rightly have been considered as the City establishment, but the growing strength of the joint-stock banks represented a powerful emerging force. By 1914 the merchant banks had already lost market share in their main activities. The war simply highlighted existing weaknesses in many merchant banks, especially a lack of capital, a narrow geographical focus and fragile organisational structure often based on family partnerships.

Contrary to what is often assumed, there was limited support given to the merchant banks during the interwar period. A number of traditional firms that had for a long time been part of the City establishment were allowed to fail. New banking ventures were also encouraged to fill gaps in the market left by the weakened merchant banks. The Bank of England adopted a pragmatic approach – commercial judgement ruled rather than sentiment or tribal loyalty. The primary aim of the Bank of England was to safeguard the domestic banking system – Britain’s role as an international financial hegemon was of secondary importance.

The rise of New York as an international financial centre added to competitive pressures faced by the merchant banks, but some of these firms were already closely involved in American banking. However, increasing international competition, especially in the financing of Germany in the late 1920s, gradually introduced unsound practices into the international money markets. Some of the British merchant banks adopted high risk strategies to maintain their market share, and consequentially faced failure by the early 1930s.

Again contrary to much of the historiography, the merchant banks had been actively involved in the domestic economy before the 1930s, providing finance in the form of acceptances. More importantly, however, they were involved in issuing long-term capital for domestic industry and as a result became involved in industrial rationalisation, providing corporate finance advisory services.

The merchant banks, as well as other specialist issuing houses, also became involved in providing equity finance to domestic industry and commerce through specialist investment vehicles, including investment trusts and, by the late 1930s, unit trusts. These activities, together with the provision of investment advice to private clients, resulted in the significant growth in the investment management operations of some merchant banks.

There was a common theme underlying the changes. The survivors gradually transformed their businesses away from higher-risk, capital-intensive activities towards lower-risk, advisory or agency services. This transformation did not happen in a smooth pattern as in many cases lessons needed to be learnt the hard way with many firms failing.

Such changes would, of course, not guarantee survival, strong financial controls and better risk management were also vital. However, the themes identified in the interwar period continued to unfold in the second half of the twentieth century. The failure to compete against the global investment banks in the late 1980s and, most notably, the collapse of Barings in 1995 indicate that some firms had forgotten the lessons of the interwar period. However, some firms such as Schroders and Rothschilds have not, and so survived and continue to thrive.

Brian O’Sullivan is a Visiting Research Fellow at King’s College, London. He is currently Chief Operating Officer of a specialist asset manager, Thomas Miller Investment. Previously he was a Senior Vice President at State Street Bank. He is a Fellow of the Institute of Chartered Accountants.