The collapse of the City of Glasgow bank in 1878 shifted the debate decisively Bagehot’s way. In one sense, this failure was evidence of the power of unlimited liability: no depositor lost a penny. But 80% of the bank’s shareholders were bankrupted and many made destitute. As the Economist observed at the time, “the share lists of most of our banks exhibit a very large – almost an incredible – number of spinsters and widows”.6 Bagehot’s incentive problem was real. Public and parliamentary opinion quickly shifted. The Companies Act 1879 facilitated conversion to limited liability. Between 1849 and 1889, the number of unlimited liability British banks fell to just 2.7 Even then, some of the incentive benefits of unlimited liability were preserved. Shareholder vetting remained in bank deeds. And in place of unlimited liability, UK banks moved to a regime of extended liability. This was the contingent capital regime of its day. Extended liability typically had two elements – reserve liability and uncalled capital. Under reserve liability, existing shareholders were liable for additional capital in the event of bankruptcy. By 1884, British banks had reserve liability of around three times their paid-up capital.8 This placed them on a similar footing to US banks, which had adopted a system of double liability in 1863.9 Reserve capital was augmented by a pool of uncalled capital. This could be tapped preinsolvency at the discretion of bank management. On average between 1878 and 1913, UK banks had uncalled capital larger than their called capital (Grossman and Imai (2011)).
A further important similarity between the emerging market experience and that of the peripheral euro area countries is that the external debt is denominated in a currency which the national authorities do not completely control. In emerging markets, so-called “original sin” – that is, a lack of credibility created by poor macroeconomic discipline in the past – implied that external debt was overwhelmingly denominated in US dollars. 8 In the euro area, debt is denominated in euros. Although this is obviously the currency of euro area countries, the single monetary policy aims at price stability across the euro area and thus cannot take account of national priorities deriving from fiscal or financial weaknesses in peripheral countries. By implication, neither in the emerging markets nor in the euro area periphery can the real value of the external debt burden be eroded by inflation or devaluation. Any attempt to devalue would simply raise the domestic burden of the external debt. Of course, this was precisely the point: by issuing debt in a currency which they could not control, the national authorities in the euro area “tied their own hands”. Before the crisis, they obtained a credibility gain that would lower overall funding costs and thus reduced the probability of a crisis. But when a crisis occurs, the external value of the debt burden cannot be reduced by devaluation. Differences between euro area and EME experiences While many of the experiences of the euro area periphery and the EMEs are similar, there are also important differences.