Credit-Anstalt Redux

Is Britain courting a replay of Credit-Anstalt’s collapse during the 1930s?


Not long ago, Gordon Brown was boasting before Parliament that he had “saved the world.” It didn’t take long for the hollowness of the British premier’s claims to be exposed. With U.K. banks revealing ever greater losses and the government’s finances becoming ever more stretched, Britain looks to be vulnerable to a “triple crisis.” That’s when a banking crunch is accompanied by a collapse in the currency and in the government’s finances.

This type of crisis is relatively common in emerging markets, but no large developed economy has suffered such a fate since the 1930s. In the past few months, however, Iceland showed how a triple crisis plays out. The gradual decline in the local stock market and the krona turned into a rout after the markets refused to believe the government’s guarantee of Icelandic banking liabilities. This was followed a collapse of the currency, rising interest rates and a surge in inflation. Capital controls followed.

Attention has now turned to the precarious position of what some wags are calling “Reykjavik-on-Thames.” Professor Willem Buiter of the London School of Economics draws some disturbing parallels between the U.K.’s position and Iceland’s. During the boom period both countries experienced lax banking regulation and a loose fiscal policy. Both enjoyed real estate bubbles and built up excessive household debt — the ratio of debt to disposable income in Iceland reached a mammoth 210 percent, and the Brits weren’t far behind at 170 percent. Both Iceland and Britain ran persistent current-account deficits and acquired large external debts and vast bank assets relative to GDP. With liabilities equivalent to 700 percent of GDP, Iceland’s banks were too large to save.

Yet Iceland is a tiny country, with a population of about 300,000. In my view the financial crisis that broke out in Austria in 1931 provides a more intriguing comparison. In May 1931 the Credit-Anstalt bank, Austria’s biggest, informed the Austrian government that it had lost 140 million schillings, or about 85 percent of its equity, the previous year. The authorities quickly agreed on a reconstruction plan for the Credit-Anstalt, with the Austrian National Bank and the Rothschilds providing fresh capital. The original shareholders stayed in place, their shares only slightly diluted. Initial reactions to the plan were favorable.

In his book The Credit-Anstalt Crisis of 1931, historian Aurel Schubert points out that the bank doubled its balance-sheet leverage over the course of the 1920s. By 1931 its ratio of debt to equity stood at 11 times. This might seem modest by contemporary standards, but Schubert maintains that the “inadequate capital base . . . [was] a fundamental cause for its insolvency in 1931.” The bank had been weakened by an ill-timed merger, in October 1929, with the similarly named Boden-Credit-Anstalt. Distinguished City banker Sir Robert Kindersley of Lazard Brothers later described the bank’s management as “extravagant and incapable.”

The Credit-Anstalt’s reliance on foreign funding proved to be another source of frailty. In the late 1920s foreign capital had been attracted to Austria by the country’s relatively high interest rates. The Wiener Börsen-Kurier, Austria’s leading business newspaper, referred to these inflows as “credit inflation.” This “fundamental instability” was exacerbated, according to Schubert, by “the fact that these short-term credits were tied up in long-term assets.”

Despite the bank’s initial recapitalization in the summer of 1931, the public remained unsettled. Runs started on the Credit-Anstalt and on other Austrian banks. The central bank sprang to the rescue, violating its own charter by discounting the Credit-Anstalt’s credit notes. The government then moved to guarantee all of the bank’s liabilities. Unfortunately, “the formulation of the guarantee was unclear and did not provide the desired effect,” writes Schubert. Too few people believed that a state with a budget of roughly Sch1.8 billion could shoulder some Sch1.2 billion of dubious bank liabilities.

The government guarantee of the bank’s debts and the central bank’s liberal discounting of its credit notes undermined confidence in Austria’s currency. “The state and the national bank,” wrote British economist Nicholas Kaldor at the time, “have thus involved themselves in obligations from which . . . inflation can be the only way out.” A speculative attack on the schilling started.

Despite the central bank’s raising interest rates to 10 percent in the summer, the schilling lost about 40 percent of its value on the foreign exchanges. By October the game was up, and capital controls were introduced. When the Credit-Anstalt’s losses were finally tallied, they amounted to more than a billion schillings. The public’s initial mistrust was fully vindicated.

In today’s financial drama the role played by the Royal Bank of Scotland resembles that of the Credit-Anstalt. Like the Austrian bank, RBS was laid low by an ill-fated acquisition made just before the crisis broke. Its then-management was reckless and overambitious. RBS’s ratio of assets to tangible equity soared to a massive 60 times, according to Credit Suisse. The bank also lost heavily on its foreign loans. British banks in recent years have been dependent on foreign wholesale funding, which was attracted by the relatively high rates available in the U.K. Like the Credit-Anstalt, British banks experienced a growing mismatch between long-term loans and short-dated wholesale deposits.

When the British government launched its bank bailout last October, Prime Minister Brown received widespread praise. Yet the public mood has grown more somber since the January revelation that RBS lost £28 billion ($39 billion) last year and requires more capital. People are questioning whether the government can really afford to guarantee bank liabilities equivalent to 440 percent of Britain’s GDP. The balance sheet of RBS alone is nearly four times larger than the annual budget of Whitehall. The press smells blood. Headlines warn that Britain is on the edge of bankruptcy.

The pound fell rapidly in the foreign exchanges after the announcement of RBS’s stupendous loss. Sterling’s weakness is easy to understand. The U.K. government is set to produce enormous deficits for years to come, and the Bank of England has turned to printing paper to acquire dodgy loans. It’s conceivable that these moves will have inflationary consequences at some stage. And it is not clear where Britain’s growth will come from, as its economy has in recent years become overly dependent on the financial sector for profits, employment growth, tax receipts and overseas earnings.

After dropping to an all-time low in early January, gilt yields have begun to climb. The markets may be starting to wonder whether the British government’s credit is any better than Austria’s in 1931. To date, Prime Minister Brown has taken the soft option in his handling of the crisis — borrowing to spend and cutting rates. Yet if the U.K. suffered a currency crisis, the government could be forced to raise rates to defend the pound. And if a funding crisis arose, Brown would have to embark on a program of austerity to placate the bond markets. Britain may not be finished, as veteran investor Jim Rogers told the BBC it was. But the Brits may well be facing a great deal of pain ahead.

Edward Chancellor is the author of Devil Take the Hindmost and a senior member of GMO’s asset allocation team.