History and the Great Crash

From the long-run perspective developed in this book, it is relatively easy to understand why the 2007–8 crisis happened. Although popular opinion places the blame at the feet of reckless bankers and their huge bonuses, these are only symptoms of a much deeper problem. This book argues that bankers simply respond to the prevailing incentive structures – the culture of greed and excessive compensation were simply endogenous to the institutional setting.

The concept of risk shifting is endemic to banking and has had to be addressed by bankers, depositors and governments from earliest times. Until the interwar period, risk shifting in the United Kingdom was curtailed by the fact that bank shareholders had not only invested substantial amounts of capital in banks, they also were liable beyond what they had paid in through unlimited liability, reserve liability or uncalled capital. There was a substantial decline in this contingent capital, as well as paid-up capital relative to deposits or bank assets, during the interwar era and the 1940s. However, the low levels of capital and contingent capital that were reached in the 1950s did not concern the Bank of England, the Treasury or depositors. Why not? Quite simply, from 1939 onwards, the banking system was in lockdown due to financial-repression policies put in place to reduce the huge debt incurred fighting World War II.