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A brief history of... business collapses

Updated Thursday 17th September 2009

Devendra Kodwani, Lecturer in Finance at The Open University Business School shows the parallels between the bank crisis and previous business meltdowns. Can we learn any lessons?

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Ione Mako: You are listening to the Open Finance series on "Lessons from History" from the Open University Business School. My name is Ione Mako and today we’re taking a historical look at banking and finance collapses with Devendra Kodwani, Lecturer in Finance at the Open University Business School. Hello, Devendra.

Devendra Kodwani: Hello.

Ione Mako: Now, humans are notoriously bad at learning from history, but are there some lessons that we should have learnt by now?

Devendra Kodwani: Yes, unfortunately, the current financial crisis is not the first one and, although I don’t like to say it but I have to say, it might not be the last one we’ll see.

Because, if you look at the root of these financial crises, whether now or in history, partly they are driven by certain institutional and market forces, and partly they are driven by the human nature to search for extraordinary profits, look for opportunities where they may not exist and so on. So there has been a lot of talk and discussion in the literature about the 1930s Great Depression. In the recent past, we had the dotcom bubble episode in the early 1990s.

So those are, they are written out there and people know about them. But let me give you some examples older than the 1930s going back into the late 18th, 19th century. In 1860, the British cotton textile industry imported most of its cotton from the US cotton suppliers, and in 1861 there was this civil war declared by the Southern states in the US. The rebellious states declared they would not supply cotton to British manufacturers, and they were hoping that the British would recognise their independence in return. But the British Government chose a different option; they went to the cotton suppliers in India.

So, really, this created an extraordinary opportunity for the cotton growers in India because the demand from the British cotton textile industry was huge, so there was this rush of investments in the cultivation and trading of cotton in Western India. Almost all the trading houses and the agency houses that operated in that period in India, most of them owned by the British, Scottish and the English firms, invested heavily in this industry. Obviously this required capital and finance from the financing and banking industry, who were only happy to oblige.

Now, this is an example of again over-optimism, like housing prices, where you have entrepreneurs and the finance industry rushing into an opportunity. I’ll come back to this in a second, but, before that, let me move to Eastern India where, in Calcutta, we had a similar boom in the jute industry and the Viceroy, trying to help the British textile industry, came out with an order which encouraged the entrepreneurs to buy wastelands in Bengal at a very cheap price, and they’ll up that into cotton cultivating fields. But the Bengal lands are hilly and wet. They’re not really ideal for cotton growing. So most of these entrepreneurs bought those cheap lands and started tea plantation companies there.

So again you had this over-optimistic view of the tea plantation business where again investors, small investors from England and India, mainly company officials, invested their savings into plantation companies, and supported by the banking and finance industry. Come 1865, we had the end of civil war in the US, the cotton growers of the US have started recapturing their cotton markets, and it created this huge fall of market for the Indian suppliers of cotton. And all the people who had invested money in that, including the banks and finance industry, started losing heavily, and the news of the end of the Civil War arrived in India on 1st May 1865 and in October we had the collapse of the Bank of Bombay, the first one to go down, and then soon after many other banks went down.

Now, let me quickly give one more example of this over-optimism that comes around. World War One created a huge demand for domestic goods in India for two reasons: one, the imports from the UK and other European countries were difficult to come into India; and two, armies needed to be fed and supplied with goods. So that again created demand for all kinds of goods and services, and no entrepreneurs and existing businesses lost the opportunity. They jumped into all kinds of variety of businesses, they diversified into unrelated area, and banks again financed those things. And these new businesses were actually called “war babies”.

Now these war babies fell sick as soon as war was coming to an end, and all these banks who had supplied money to these war babies started feeling the heat of it, and between the period 1913 and ‘17 there were as many as 87 bank collapses in the subcontinent.

Ione Mako: Those are some very graphic examples that I wasn’t aware of from history, thanks very much.

Devendra Kodwani: Alright.

Ione Mako: So what are the similarities between then and now?

Devendra Kodwani: I think a big similarity is in the entrepreneurial behaviour. They not only get excited about an opportunity, but they'll rush in, and there’s a kind of herd mentality, not only among the entrepreneurs but even among the financiers because everybody wants a pound of flesh when it is, well, you know, growing, so one bank, another bank and the whole industry follows them, so that’s the similarity, and we found that not a single major bank in the US or the UK were untouched by the housing prices.

The other similarity is human nature. We are still, having seen so many bubbles and collapses and panics and crashes, we still forget over time that there are no quick profits; there are no large profits which can be sustained for a very long period of time. It’s a logic of market economy that super profits, extra normal profits, cannot be sustained for a very long period of time. But we don’t seem to believe that principle of economics and keep forgetting and get overexcited, invest, burn our fingers, come out, forget, invest and burn our fingers again.

Ione Mako: Those are some of the similarities, then. What about the differences between then and this time round?

Devendra Kodwani: I think there are a few differences. The first one, which is very obvious from the textile example, is that the impact of the collapse of textile and subsequent finance and banking in India in the 1860s was very localised.

So, although the trigger off point was global development in the US, end of civil war, but the impact was localised. And I think the reasons for that were because the banks at that time, most of the time, mobilised funds from the private investors and shareholders, and when they made risky decisions they were not taking depositors’ money to invest in long term risky projects, so that was one major difference. The other was that of size. The banks were not that big. They were not globally integrated financial institutions.

So, if a bank went down it did not cripple the rest of the economy which is a big difference in today’s world because we could see the impact of all governments, major governments of the world, trying to protect the banks because they were worried that, if banks went down, the whole economy would come to a standstill. Another big difference I think is on the individual compensation system that the bank managers… executives are quite distinct from the owners, and their rewards system is geared towards taking more risks because they’re interested in the short term profits and maximising their bonuses and incentives, which was not the case in the late 19th and early 20th century, and I think that difference in the way the bank executives are compensated is quite a different phenomenon which we observe in the current crisis and how it has been responsible for extra risks that banks have been taking.

Ione Mako: So what does all that mean for recovery now?

Devendra Kodwani: For the recovery, it may take a good few years. If I were to go back to my historical example of the textile industry, for example, we know textile is a commodity which should have long-term demand in any economy, but it went down in India, the Western part of India, and it took them seven years, eight years before new units or the old ones were being revived, and this was the one sector which took so much time.

Now, in the present crisis, we are looking at a global deeper recession, deeper crisis than what was a sector-specific crisis, but less than it seems. it’s going to be slow, and what we are trying now, I’m aware of the stimulation packages and the government interventions into the banking and other sectors of the economy. They’re trying to revive the demand. But I remain cautiously optimistic because, you see, the economics is governed by a principle of unintended consequences.

So we may plan certain things, the Government may plan things, but then, as we saw, the Viceroy’s plan of encouraging cotton cultivation did not result in cotton cultivation in 1860. So, I don’t know, the policies that we are adopting now will necessarily result into the similar kind of outputs that governments are intending to achieve. I think that we cannot ignore the unintended consequences principle so we have to wait and watch this space. But I think it’s going to be a good few years before we see the recovery at the global level.

Ione Mako: Thanks very much, Devendra.

You’ve been listening to the Open Finance series on Lessons from History from the Open University’s Business School.

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