One consequence of the financial crisis of 2008-09 has been renewed interest in the merits of contingent convertible debt as a mechanism for equity bail-ins at moments of acute financial distress. Should it fail, a financial institution's contingent bonds are automatically converted into equity shares. History suggests that convertible debt can help to preserve financial stability by limiting the spillover effects of individual financial institution failures.
A particularly revealing historical illustration of this advantage of contingent debt comes from the Scottish free banking era. From 1716 to 1845, the Scottish financial system functioned with no official central bank or lender of last resort, no public (or private) monopoly on currency issuance, no legal reserve or capital requirements, and no formal limits on bank size, at a time when Scotland's was a classic emerging economy with large speculative capital flows, a fixed exchange rate, and substantial external debt. Despite this, Scotland's banking sector survived many major shocks, including two severe balance of payments crises arising from political disturbances during the Seven Years' War.
The stability of the Scottish banking system depended in part on the use it made of voluntary contingent liability arrangements. Until the practice was prohibited in 1765, some Scottish banks included an "optional clause" on their larger-denomination notes. The clause allowed the banks' directors to convert the notes into short-term, interest-bearing bonds. Although the clause was seldom invoked, it was successfully employed as a means for preventing large-scale exchange rate speculators from draining the Scottish banks' specie reserves and remitting them to London during war-related balance of payments crises–that is, as a private and voluntary alternative to government-imposed capital controls.
Contingent debt also helped to make Scottish bank failures less costly and disruptive. If an unlimited liability Scottish bank failed, its shorter-term creditors were again sometimes converted into bondholders, while its shareholders were liable for its debts to the full extent of their personal wealth. Although the Scottish system lacked a lender of last resort, the unlimited liability of shareholders in bankrupt Scottish banks served as a substitute, with sequestration of shareholders' personal estates serving to "bail them in" beyond their subscribed capital. The issuance of tradeable bonds to short-term creditors, secured by mortgages to shareholders' estates, served in turn to limit bank counter-parties' exposure to losses, keeping credit flowing despite adverse shocks.
A particularly fascinating illustration of how such devices worked came with the spectacular collapse in June 1772 of the large Scottish banking firm of Douglas, Heron & Co., better known as the Ayr (or Air) Bank, after the parish where its head office was located. The Ayr collapsed when the failure of a London bond dealer in Scottish bonds caused its creditors to panic. The creditors doubted that the bank could could meet liabilities that, thanks to its reckless lending, had ballooned to almost £1.3 million. The disruption of Scottish credit ended quickly, however, when the Ayr's partners resorted to a £500,000 bond issue, secured by £3,000,000 in mortgages upon their often vast personal estates—including several dukedoms. By this means the Ayr Bank managed to satisfy creditors, at 5% interest, as the Ayr's assets, together with those of its partners, were gradually liquidated. In modern parlance, the Ayr Bank had been transformed into a "bad bank," whose sole function was to gradually work off its assets and repay creditors while the immense landed wealth of its proprietors' personal estates provided a financial backstop. Creditors were thus temporarily satisfied with fully secured, negotiable bonds, which were eventually redeemed in full, with interest.
We are unlikely today to witness a return to unlimited liability for financial institution shareholders. The extensive and effective use of contingent liability contracts during the Scottish free banking episode nevertheless offers important evidence concerning private market devices for limiting the disruptive consequences of financial-market crises. When compared to the contemporary practice of public socialization of loss through financial bail-outs, such private market alternatives appear to deserve serious consideration. Most importantly, perhaps, by encouraging closer monitoring of financial institutions by contingently liable creditors and equity holders, these private alternatives appear, in the Scottish case at least, not only to have made crises less severe, but also to have made them far less common.
This post is based on Tyler Goodspeed's doctoral dissertation, a revised version of which is under consideration at Harvard University Press under the title Legislating Instability: Adam Smith, Free Banking, and the Financial Crisis of 1772.