9 - Fractured insurance

Summary

Bagehot describes how the Bank of England should use its reserves to stem bank panics. His rule was to lend generously, at higher than existing market interest rates, to any bank needing reserves. This dictum is that the Bank should act as the lender of last resort. To do this the Bank needs to keep gold reserves both for the money supply and for some fraction of the deposits of the entire private banking system, such as an apprehension minimum of 37 per cent, in his example.

Bagehot says this minimum level is arbitrary, subject to change and something of an art to identify. But, regardless of the minimum fraction of reserves that are held in relation to deposit liabilities, the total reserves held are fewer than they might otherwise be because the Bank of England acts to pool all the reserves together. The Bank pools risk so that it can direct reserves to banks in sudden need, so each private bank's reserves that are held at the Bank are smaller than if there were no such central bank, as in France and the United States at the time. Speaking of the joint-stock banks, Bagehot (1873: 107) says: “Not only did they keep their reserve from the beginning at the Bank of England, but they did not keep so much reserve as they would have kept if there had been no Bank of England.”

Therefore, the British system of banking circulated more capital than other countries. In contrast, the “natural” banking systems of France and America at the time were designed around each bank keeping sufficient reserves to ward off its own individual bank failure. This natural, traditional system is equivalent to self-insurance by each bank rather than the pooling of risks of reserve demands into a central bank, as the Bank of England did. Bagehot (1873: 107) writes: “I have tediously insisted that the natural system of banking is that of many banks keeping their own cash reserve, with the penalty of failure before them if they neglect it. I have shown that our system is that of a single bank keeping the whole reserve under no effectual penalty of failure. And yet I propose to retain that system, and only attempt to mend and palliate it.”