An Important Lesson About Banking From the Panic of 1873

By Markets Fool.com

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The cliche that "offense wins games, but defense wins championships" is just as applicable to banks as it is to sports. This follows from the fact that in order to maximize returns over multiple credit cycles, it isn't enough that a bank avoids making mistakes itself; it must also protect itself from the errors of others.

While you can see this by looking at any banking panic of the past two centuries, the Panic of 1873, which incited an economic depression lasting twice as long as the Great Depression of the 1930s, is particularly revealing on this point.

The Panic of 1873
To an observer today, the early 1870s wouldn't be entirely unfamiliar. Like the Internet bubble of the late 1990s, or the housing bubble prior to the financial crisis of 2008-2009, the United States at the time found itself in the midst of a surge in economic activity fueled by the furious expansion of railroads.

At the helm were some of America's greatest industrial magnates. Instead of Mark Zuckerberg, we had Cornelius Vanderbilt. In place of Jeff Bezos, we had John D. Rockefeller.

As in any bubble, the issue at the time was that railroads had been overbuilt and were leveraged to the hilt, as banks lent freely to the industry in an effort to capitalize on its westward expansion following the completion of the transcontinental railroad in 1869. Making things worse, the biggest players looked to a single customer, Rockefeller's Standard Oil, for a purported 40% of all cargo shipments.

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These dynamics left the railroads vulnerable to two things. First, a rise in borrowing costs would make their debt burdens unmanageable and tip the weakest among them into bankruptcy. Second, a decision by Rockefeller to reduce shipments if freight costs rose in response to higher borrowing costs. The railroads, if you'll excuse a small pun, were caught between a rock and a hard place.

As Vanderbilt observed at the time:

I'll tell you what's the matter -- people undertake to do about four times as much business as they can legitimately undertake. [...] There are a great many worthless railroads started in this country without any means to carry them through. Respectable banking houses in New York, so called, make themselves agents for sale of the bonds of the railroads in question and give a kind of moral guarantee of their genuineness.

The first of these weaknesses triggered the panic itself; the second exacerbated its depth and duration. When western farmers started withdrawing funds from banks in the autumn of 1873 to cover the costs of harvesting and transporting their crops, money tightened. And when money gets tight, borrowing costs rise.

One of the most respected investment banks of the day, Jay Cooke & Company, was the first to fall, succumbing to the weight of millions of unmarketable shares in the Northern Pacific Railroad. Cooke's bankruptcy set off an indiscriminate run on the nation's banks, leading to hundreds more failures before the crisis subsided in 1879. And the run was intensified by the fact that many New York-based firms relied on that generation's equivalent of hot money -- interest-bearing deposits from correspondent lenders in the country's interior.

The anatomy of a panic
What's important to appreciate for our purposes is that banks faced different threats at different stages of the crisis. The first stage was associated with insolvency, stemming from imprudent risk management. That's what brought down Cooke's firm. The second stage was associated with illiquidity, deriving from imprudent asset and liability management -- i.e., an over-reliance on volatile funding sources. This is what triggered the lion's share of the subsequent failures.

What's also important to appreciate is that this same two-tiered structure holds true today. In the energy-induced crisis of the early 1980s, the infamous Penn Square Bank in Oklahoma City failed because it underwrote bad loans. This eventually led to a run on Chicago's Continental Illinois, the nation's seventh biggest bank at the time, which failed for want of liquidity despite being solvent.

You can think of these two stages as the credit stage and the contagion stage, respectively. To survive the first, as I've discussed elsewhere, a bank must maintain prudent credit standards during the upswing of the credit cycle. To survive the second, a bank must shore up its balance sheet with stable funding sources -- ones that are either unable (long-term loans) or unlikely (retail deposits) to flee in the event of a panic.

It's for the latter reason great bankers like JPMorgan Chase's CEO Jamie Dimon obsess over the notion of a "fortress" balance sheet. "We operate in a risky business, and having a fortress balance sheet is a strategic imperative, not a philosophical bent," Dimon wrote in 2007. "It is a critical differentiator for us -- especially in uncertain times."

Judging by JPMorgan's performance in the financial crisis of 2008-2009, Dimon is absolutely right. While the bank took a drubbing from analysts prior to the crisis for being overly conservative, it emerged from the turmoil as the biggest bank in the country -- and the undisputed leader of the industry. It was so strong, in fact, that it was able to absorb not one, but two of its less prudent competitors, who would have otherwise been nationalized.

What exactly does a fortress balance sheet entail? It means a bank can get cash when it needs to. It means a bank doesn't over-rely on the short-term money market for funds. And it means a bank has more than enough capital and earnings power to confidently pound its way through the next downturn of the credit cycle, an inverted yield curve, or any other threat that comes the industry's way.

Defense wins championships
The takeaway is that great banking is about more than asset growth, revenue, and profitability margins. There's no question that these are important. However, they are offensive strategies that will only bolster a bank's top and bottom lines in between the intermittent but not infrequent panics that besiege the industry.

Equally important, if not more so, are the defensive tactics banks employ to protect themselves from these cataclysms. And none is more important than a fortress balance sheet. This must be an obsession. It must always be present. It's the ultimate defense.

The article An Important Lesson About Banking From the Panic of 1873 originally appeared on Fool.com.

John Maxfield has no position in any stocks mentioned. The Motley Fool owns shares of JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.