History is full of bubbles, booms and busts, corporate collapses and crises, which illuminate the present financial world. At Stewart Investors we believe that an appreciation of financial history can make us more effective investors today.
City of Glasgow Bank Collapse (1878)
In October 1878 the doors closed at the City of Glasgow Bank (CGB), one of Scotland’s largest financial institutions. CGB’s demise, which was the biggest banking failure in the UK until the global financial crisis of 2007/8, highlights a number of issues around investing in bank shares.
Founded in 1839 at the beginning of the Victorian Age, CGB’s growth, like the British economy, was rapid. By the 1870s it had the third largest branch network in the UK, taking deposits mainly from Glasgow and its hinterland, and lending to local business concerns.
In June 1878, the Bank appeared to be in sound financial health; the directors announcing a reasonable dividend and reporting equity of 13% of assets.1 However, by September, rumours were circulating that CGB was in difficulties. The wholesale lending market was becoming reluctant to provide funds. CGB decided to seek support from other Scottish banks, but after an independent audit of its accounts, this was refused, forcing it to cease trading.
Concentrated loan book
From an investment perspective, CGB was a very poor quality company. The loan book was highly concentrated, with just four borrowers accounting for 75% of total loans at the time of collapse. These four were all local businesses deeply involved with Indian and Australasian trade: James Morton & Co., John Innes Wright & Co., Smith Fleming & Co. and James Nicol Fleming.2
In essence, CGB had become a vehicle for funding a small group of mainly Scottish-Indian business concerns, applying Scottish depositors’ money to a risky portfolio of corporate loans.
For example, James Nicol Fleming and his brother John ‘Bombay Jock’ Fleming established the Elphinstone Land & Press Company to reclaim land from the sea as part of the development of Bombay’s port.3 This sizeable project appears to have been funded by loans from CGB.
In addition to its lending business, the Bank had a highly concentrated investment portfolio, focused on a few foreign assets, principally shares in the New Zealand & Australia Land Co., as well as bonds and shares of the US railway company Western Union. At the time of the collapse, these investments were all substantially under water.
Management acted as disastrous stewards of the shareholders’ capital. Described by one historian as ‘mediocrities and men of straw’4, a number of the directors were outright rogues, simply using the Bank to feather their own nests.
After the collapse, the accounts revealed liabilities exceeded assets by the substantial sum of £5.2m (£455m in today’s money)5 – three times larger than reported equity. The management had been misleading shareholders about the true state of the balance sheet, using fraudulent accounting to boost assets and hide liabilities.
The Bank’s general manager, Alexander Stronach, and one of the directors, Lewis Potter, were found guilty of falsifying the Bank’s balance sheet. Several of the directors, including Potter were leading members of the Free Church of Scotland. They had also manipulated the Bank’s share price and falsely stated the amount of gold it held.6
Potter and Stronach were given 18-month prison sentences and five other directors were imprisoned for eight months. This was only the second imprisonment of directors of a British joint stock bank. However, the paltry length of the sentences did not satisfy an indignant public.
Impact on unlimited liability
The collapse of CGB caused a short-lived panic in financial markets, especially among Scottish banks. Share prices declined sharply over the short-term, but the bankruptcy did not cause a major banking crisis in the UK, and most of the Scottish banks recovered quickly. However, the crash did have a large impact on the economy of the west of Scotland with over 500 bankruptcies directly attributable to CGB’s liquidation.7
There was one significant feature of the collapse which made it very different from the banking collapses of the recent global financial crisis. Shareholders of CGB were exposed to unlimited liability. As a result, the full weight of the crash did not fall on tax payers as in 2008, but on the 1,819 shareholders of the bank.8 At the end of the liquidation process only 129 shareholders and 125 shareholder trustees remained solvent.9 Most of GCB’s branch network and staff were taken over by the Royal Bank of Scotland.
Limited liability, the legal structure under which most listed-companies operate today, limits the losses of shareholders to the amount of initial investment. However, unlimited liability means that, if the company goes bust, shareholders are compelled to make up the difference between assets and liabilities. They can lose substantially more than their initial investment.
The liquidators made two calls on the shareholders to cover the shortfall; in November 1878 demanding £500 per share (£44,000 today), followed by a second, larger call for £2,250 (£206,000 today) in April 1879. These were very substantial sums of money, particularly for the small shareholders whose suffering was widely reported in the press. Their distress resulted in fundraising events and the establishment of a relief fund which had received £379,670 (£34m today) in donations by 1882.
The demise of CGB marked an important point in the history of listed banking companies. Unlimited liability completely disappeared in its wake, although it did survive in some areas of the financial world, such as insurer Lloyd’s of London. From one perspective, however, unlimited liability proved successful. It restricted collateral damage from the bank collapse to a small group of shareholders, who, it could be argued, should have known about the risks. Limited liability banking, of course, did not stop the excessive risk taking which caused the global financial crisis in 2008.
At Stewart Investors we believe that banks are highly cyclical companies and significant care must be taken when investing in them. Such businesses face particular challenges when their peers and clients are carried away by the prevailing fashion. Close attention should be paid to the quality of a bank’s stewards - both the controlling shareholder (preferably a family) and its professional managers.
A bank should use a broad base of customer deposits, and lend only a portion to a carefully chosen and diversified group of borrowers. High risk investment banking and trading activities might be better undertaken by unlimited liability partnerships.
Quality of management is vital. The example of City of Glasgow Bank highlights the risks for investors of management who do not act in the interests of all stakeholders. Finding companies with careful stewards at the helm is one of the most important things we do as investors.
Image attribution: The Trial of the Directors of the City of Glasgow Bank at Edinburgh sourced from the STV article here.
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