4.1.1 Assets Side: Financing Wars

Banks’ contributions to financing governments can be traced by analysing the asset side of balance sheets. Such investments are usually in the form of direct loans to governments or investments in government securities, which are part of a bank’s investment portfolio. While finding data on bank loan composition is challenging, data on banks’ investment portfolios are available in many cases.

Figure 4.4 shows the government securities at face value that banks held as a percentage of the total gross government debt. For the United Kingdom and the United States, data is available from 1910 to 1950. Data on Swiss banks and their government investments are available after 1924. All three data sets have various shortcomings. The amount of British treasury bills is based on estimates.Footnote ⁶ The US data covers federal government debt only, leaving states aside. The Swiss data includes bonds only. Short-term debt instruments, more specifically treasury bills (‘Schatzanweisungen’) and rescriptions (‘Reskriptionen’), could not be considered.Footnote ⁷ Direct loans to the Swiss government are neglected even though they were an important funding source.Footnote ⁸

Figure 4.4

Percentage of gross government debt held by banks, United Kingdom (1910–50), United States (1910–50), and Switzerland (1924–50)Footnote ¹²

Nevertheless, Figure 4.4 serves as a reference point for banks’ key position in financing government debt. British banks held up to 29% of the total British government debt during the First World War. This share dropped substantially in subsequent years. It rose again during the Great Depression and further increased after 1939. British banks’ share of government debt reached about 16% during the Second World War.

Government debt in US banks’ balance sheets grew rapidly during the First World War but was outpaced by the rapid increase of the total government debt, of which substantial parts were allocated outside the banks’ balance sheets. Until 1917, banks held about two-thirds of federal government debt. The banks’ share in government debt fell substantially in 1918, to about one-fourth. The share of government debt increased again from 1921 onwards. As a result of the Great Depression, US banks provided more than 50% of US government debt in 1936. In 1941, 48% of federal government debt was in the books of US banks.

In Switzerland, banks were also crucial lenders to the government.Footnote ⁹ Besides the commercial banks, the SNB was also a central creditor. It held most of the rescriptions during the First World War.Footnote ¹⁰ The SNB directly financed the government, which was not the case to such a large extent by the Second World War. The engagement of Swiss banks in public debt rose sharply in 1941, and by 1944 Swiss banks held about 17% of all government securities. This number, however, understates the actual contribution of Swiss banks to government financing. Considering all debt instruments (loans, treasury bills, rescriptions), the Swiss banks funded about a quarter of Switzerland’s government debt by 1945.Footnote ¹¹

What was the effect of government securities on banks’ balance sheets? Figure 4.5 shows the percentage of government securities compared to banks’ total assets in the United Kingdom, the United States, and Switzerland. In all three countries, banks were vital lenders to the government during wartime and – in the United Kingdom and the United States – also in the 1930s. By 1944, 62.2% of the total assets of British banks consisted of government debt. In the United States, this ratio peaked at 57.8% in 1945.

Figure 4.5

Government securities as a percentage of banks’ total assets, United Kingdom, United States, and Switzerland, 1910–50Footnote ¹³

The total assets of Swiss banks consisted of 11.5% government bonds in 1945. Considering all debt types (loans, rescriptions, bills) would increase the ratio to 18.5%.Footnote ¹⁴ Figure 4.5 also displays the share of government securities in the big banks’ balance sheets in Switzerland.Footnote ¹⁵ The big banks held comparatively more government debt on their balance sheets than other banks (17.8% in 1944).Footnote ¹⁶

Apart from being lenders to the government, the big banks were also involved in underwriting government securities. They formed a cartel with the Association of Cantonal Banks. Excluding the first war loan in 1914, the cartel was involved in all the government issuances during the First World War. In most cases, the cartel provided a firm commitment of underwriting. Thus, the banks were responsible for the risk of selling federal and cantonal bonds and bills to customers or other banks. The total volume underwritten by the cartel between 1914 and 1921 was about CHF 3bn.Footnote ¹⁷

The high ratios of government investments in all three banking systems show that banks were crucial lenders to the government. This raises the question of how banks increased their government debt exposure. From an accounting perspective, there are two ways: firstly, banks can reallocate assets. In that case, banks would have divested some assets and increased their exposure to government investments. Secondly, banks can increase total assets through investments in government debt, which also requires an increase on the liability side.

A reallocation effect on the asset side did not occur on a larger scale in the United Kingdom, the United States, or Switzerland. One of the largest balance sheet items on the asset side in all three banking systems was amounts due to customers, such as loans and advances. In wartime, the amounts due to customers usually increased, which supported the supply of capital for the war economy. However, government debt growth outpaced the growth of amounts due to customers substantially in all three countries during the two wars.

Within the short-term assets, however, there were some reallocation effects. In Switzerland, there was a rapid decline in foreign commercial paper investments. Treasury bills quickly replaced commercial papers during the First World War.Footnote ¹⁸ Similar effects were observed in London, where the declining share of commercial papers and the drop of investments in foreign credit went in hand with the growth of treasury bills during both World Wars.Footnote ¹⁹

4.1.2 Liabilities Side: Deposits and Capital Issuances

How was the enormous growth of government debt in bank balance sheets financed? On the liabilities side, customers’ deposits (due from customers) were the most relevant funding source. In the United Kingdom, deposits contributed almost 90% of the balance sheet total from 1910 to 1950. About 65–70% of the total liabilities in Switzerland and the United States came from customers.Footnote ²⁰ The United Kingdom’s higher share relates to statistical differences (no separate data on government deposits and interbank borrowing).

Table 4.2 shows the changes in volumes and percentages of the two most important items of the banks’ balance sheets during the two World Wars (1914–18/1939–45): deposits (liabilities) and government securities (assets). In all three countries, customers’ deposits grew substantially during the two wars and outpaced the growth of the balance sheet total. In terms of volume, the deposits grew more than the total of government securities. In the United Kingdom, for example, government securities held by banks grew by £391m during the First World War and £2.3bn during the Second World War. The deposits increased by £774m and £2.5bn, respectively.

Table 4.2Changes in percent (nominal changes) and volume (in million domestic currency) of amounts due to customers, domestic government securities, and total assets, United Kingdom, United States, and Switzerland, 1914–18 and 1939–45¹

¹ Data: United Kingdom: Sheppard, The Growth and Role of UK Financial Institutions. Switzerland: Swiss National Bank, Die Banken in der Schweiz (annual issues 1906–2015). United States: United States. Bureau of the Census, Historical Statistics of the United States. Colonial Times to 1970, tables 581, 585, 640, 662.

The high share of deposits on the liabilities side and the rapid growth of deposits (in volume and per cent) highlight the crucial role of deposits when it comes to the balance sheet expansion during the two wars.

Why did customers’ deposits grow to such a large extent during the two wars? The high inflation rates during wartime, shown in Figure 4.3, substantially depreciated the value of money. Banks mainly deal with nominal financial instruments. Exceptions on the asset side are, for example, direct holdings of bank premises or real estate. The payments related to nominal financial instruments are fixed in nominal amounts. An increase in the expected inflation raises nominal interest rates, which translates into a change in the nominal value of a financial instrument.Footnote ²¹ Therefore, nominal balance sheet items adjust to inflation.

One of the drivers of inflation during the wars was the velocity of money. These effects were already understood and described during the First World War. The Economist outlined the driving forces behind the deposit growth in 1916: namely, four processes that can contribute to the increase of deposits: first, deposits grow if the country’s stock of gold is increasing and the gold is brought to the banks. This increases the cash on the asset side and deposits on the liabilities side. Second, deposits grow if the stock of paper currency is increased and the currency is paid in. Third, banks can create money by giving discounts, loans, and advances, which then create deposits. The fourth and last channel runs from banks buying securities to deposit growth. As banks invested in government securities, cash was transferred from the BoE to the government. British banks, therefore, held securities instead of cash. The government drew on the balance at the BoE and invested this capital in the economy. The companies that had received capital were depositing it into their accounts, which increased the volume of deposits.Footnote ²² The Economist heavily criticised the expansionary monetary policy of the government and the BoE and argued that private individuals would have to start investing in government securities more substantially to reduce inflation.Footnote ²³ The role of inflation as a driver of deposit growth during the two wars was also discussed in Switzerland.Footnote ²⁴

Besides inflation, various other reasons were frequently mentioned in the context of growing deposits. Both in the United Kingdom and Switzerland, it was argued that the public had a ‘liquidity preference’ during the two World Wars. In times of uncertainty and depressed securities prices, bank customers shifted their long-term investments into deposits, making their wealth more readily available.Footnote ²⁵ Other domestic effects, such as the liquidation of inventories at the beginning of the wars, might have also impacted the growth of deposits.Footnote ²⁶

Another relevant driver of deposits’ growth in Switzerland was foreign capital inflows. The SNB mentioned the stream of capital from abroad many times in its annual statistical publications during the First and Second World Wars. Whereas capital inflows were directly referred to as ‘tax flight capital’ during the First World War, such specific remarks were not made in later years.Footnote ²⁷ The SNB simply referred to it as ‘foreign capital inflows’.Footnote ²⁸ No figures available provide insights into the volume of foreign deposits during the two wars, even though the Independent Commission of Experts Switzerland attempted to make such estimates when examining Switzerland’s role during the Second World War.Footnote ²⁹ Switzerland was a stable financial hub in the turmoil of war, which was the basis for large financial transactions. The Swiss franc was a stable currency and the only currency in Europe which was almost freely convertible. Indeed, Swiss banks also participated in purchases of Nazi gold and provided credit to Germany, Italy, and the Allies. Moreover, banking secrecy – codified in the Banking Act of 1934 but already rooted in the Swiss banking sector since the end of the nineteenth century – certainly also attracted foreign funds.Footnote ³⁰

Changes in two components can lead to a rise of equity capital. New shares might be issued, or reserves increased. Figures 4.6, 4.7, and 4.8 show the paid-up capital and the reserves of Swiss, British, and US banks.

Figure 4.6

Nominal capital (paid-up) and reserves in CHF millions, Swiss banks, 1910–50Footnote ³³

Figure 4.7

Nominal capital (paid-up) and reserves in £ millions, British banks, 1910–45Footnote ⁴¹

Figure 4.8

Nominal capital (paid-up) and reserves in $ millions, US banks, 1910–50Footnote ⁴⁵

Swiss banks were hesitant with new capital issuances in the early years of the First World War. There were almost no recapitalisations from the summer of 1914 to 1916. The capital increases shown in Figure 4.6 are mostly related to banks that were newly included in the SNB statistics. It was only in 1916 that a more considerable amount of capital was issued (CHF 25m). The reasons mentioned for these issuances were the positive development of the economy after 1916 as well as growing deposits.Footnote ³¹ These capital increases had little effect on the capital/assets ratio.

The first years of the Second World War in Switzerland are comparable to the period of 1914 to 1916. Only two cantonal banks issued fresh capital in 1941. The big banks did not issue capital at all during the war. There were no formal constraints with regards to capital issuances during both wars. Especially during the Second World War, however, there was a widespread conception that banks should not lock up capital that could be used for sovereign debt. As an observer at the time put it: ‘Issuing capital during the war forbade itself’.Footnote ³²

Whereas almost no capital was issued in Switzerland during wartime due to informal constraints, the same happened in the United Kingdom due to formal restrictions. During the First World War, capital issuances had to be approved by the Treasury. In January 1915, the Treasury announced that ‘in the present crisis all other considerations must be subordinated to the paramount necessity of husbanding the financial resources of the country with a view to the successful prosecution of the war’ and that ‘it feels it imperative in the national interest that fresh issues of capital shall be approved by the Treasury before they are made’.Footnote ³⁴

The control of capital issuances was only one dimension of wartime control of financial resources. The export of capital was also severely restricted.Footnote ³⁵ The Treasury’s embargo had a substantial impact on the British financial market. In 1914, £512.6m were issued in the United Kingdom, of which £180.1m was not for the government. In 1916, £585.6m were issued, with only £31.5m left for non-government issuances. The figures diverged even more in 1917, with total issues of £1.3bn – of which all but £40.9m were government securities.Footnote ³⁶ After the war, the government attempted to maintain this capital control policy. However, a less restrictive regulation was eventually introduced, forbidding only capital issuances that could contribute to foreign capital purposes.Footnote ³⁷ The government withdrew the domestic ban on capital issuances in March 1919.Footnote ³⁸

During the Second World War, the British government again controlled private capital operations. Based on a Treasury Memorandum of Guidance that was issued on 12 September 1939, capital issuances were to be restricted to production and services related to defence, essential services (such as transport and food supplies), and export purposes.Footnote ³⁹ Moreover, the BoE asked banks to focus their lending on defence production, exports, coal mining, and agriculture. After the war, in May 1945, new capital issuances were allowed again, but only for reconstruction purposes.Footnote ⁴⁰

Figure 4.7 shows the paid-up capital and reserves of British banks from 1910 to 1950. During these four decades, there was only one major increase of capital, in 1919 and 1920.

In the United States, the amount of bank capital in the banking system was much more volatile than in the United Kingdom and Switzerland. The changing capital was partly related to market entries and exits, and banks could still increase their capital. Figure 4.8 shows the capital and reserves in US banking from 1910 to 1950. During the First World War, capital and reserves gradually grew, at around 2.3% and 3.4%. The number of banks grew at about the same pace. The situation during the Second World War was different. The nominal capital remained stable, but the reserves grew steadily, averaging 5.1% yearly.

Despite the increase in bank capital, capital/ratios deteriorated, given the substantial growth of total assets during wartime. War financing was prioritised over capital adequacy. Adhering to strict capital ratios would have restricted war financing.Footnote ⁴² Therefore, the supervisors decided to suspend the use of capital ratios in 1942. The Comptroller of the Currency, the FDIC, the Board of Governors of the Federal Reserve System, and the Executive Committee of the National Association of Supervisors of State Banks issued a joint statement assuring banks that they would not take action against them due to investments in government securities or short-term loans to customers to purchase government bonds.Footnote ⁴³ The FDIC was even more specific, stating that banks with deteriorating capital ratios due to war financing would not be sanctioned.Footnote ⁴⁴

The war years were a period of extraordinary conditions, which left their mark on banks’ balance sheets in the United States, the United Kingdom, and Switzerland. Contemporaries in all three countries argued that balance sheets – and, with them, capital ratios – would return to ‘normal’ in peacetime. On a broader level, there was also the idea of returning to the pre-war economic system, most prominently represented by the gold standard. A normalisation in the banking sector meant that government debt and deposits would contract again. However, a transition to pre-war balance sheets and to a pre-war macroeconomic environment did not happen after either of the two wars or in either of the three countries. An economic recession followed the First World War. After the Second World War, Great Britain first dealt with reconstructing and reorganising the economy, while the United States and Switzerland rapidly entered a period of economic expansion.

4.2.1 Amalgamations Movement in England

From 1914 to 1918, the First World War led to an expansion of the balance sheet totals. Combined with the loss in the real value of the paid-up capital, it put the capital/assets ratio under pressure. Even though the macroeconomic environment was an essential driver of the capital ratios, it was not this process that raised interest in the capital of English banks in 1918. Instead, the rapidly growing market concentration of English banking – the amalgamation movement – led to inquiries about the adequacy of banks’ capital.

After the first establishment of joint-stock banks in England in the 1820s, the number of joint-stock banks grew rapidly for about six decades, reaching its high point in the 1880s with around 110 joint-stock banks.Footnote ⁴⁹ From the 1880s onwards, the structure of the banking system changed as larger banks started to take over smaller, mostly local or provincial and private banks. The characteristics of bank sizes of the merged banks changed with time, mainly because the number of small local banks diminished, and private banks based on a partnership model became almost extinct. From 1910 to 1918, larger banks started to merge among themselves. These banks often did not operate in different geographical locations, as had been the case before, but in the same overlapping regions. The concentration process culminated in a series of large mergers. In 1917, the National Provincial Bank amalgamated with the Union of London and Smiths Bank. In March 1918, Westminster amalgamated with Parr’s Bank. During the summer of 1918, London City and Midland merged with the London Joint Stock Bank, Lloyds amalgamated with the Capital and Counties Bank, and Barclays with the London Provincial and South Western Bank. In 1918, there were only twenty-six joint-stock banks left in England.Footnote ⁵⁰

Five major banks emerged from the amalgamation period: Barclays Bank, the London County Westminster and Parr’s Bank, Lloyds Bank, the London Joint City and Midland Bank, and the National Provincial and Union Bank of England. In 1918, these Big Five combined held more than four-fifths of the total assets of all banks in England and Wales.Footnote ⁵¹ Overall, nineteen amalgamations, involving thirty-eight banks, took place in 1917 and 1918.Footnote ⁵² With these large amalgamations, public opinion became increasingly critical towards the concentrated market and requests in favour of a regulatory intervention were voiced. Generally, there was a lack of trust towards the oligopolistic banking structure, which was usually referred to as the ‘Money Trust’.Footnote ⁵³

In February 1918, the Chancellor of the Exchequer appointed a Committee on Bank Amalgamations, also known as the Colwyn Committee.Footnote ⁵⁴ The committee was assigned to consider the effects of amalgamations and discuss potential legislation on this matter.Footnote ⁵⁵ The Colwyn Committee finished its report in May 1918 and outlined the advantages and disadvantages of amalgamations.Footnote ⁵⁶ One of the key findings of the report dealt with capital adequacy:

Banks reduced their capital through mergers when shares of a bank were paid in cash. In such a process, the shares of one of the two banks were cancelled. Other takeovers were achieved by paying old shareholders with fewer but more valuable shares of the surviving bank. The liabilities were then transferred, leading to a further leveraging of the new entity.Footnote ⁵⁸

The statement quoted earlier shows that the committee was aware of the problems of low bank capital. In addition, it emphasised the conflicting interests of depositors in safety versus shareholders in high dividends, confirming the view that capital was seen as a form of insurance for depositors. The Colwyn Committee also took a critical standpoint towards the reduction of uncalled liability. In an internal circular summarising the committee’s provisional impressions, this opinion became even more evident: the cancellation of uncalled liability was thought to reduce the security of depositors. According to the committee, further large amalgamations were not in the interest of the public – the only interests such amalgamations would have served were those of shareholders.Footnote ⁵⁹

In its official report, the committee was more diplomatic and stated that arguments against further mergers outweighed those in favour. It proposed legislation that required governmental approval for amalgamations by the Board of Trade and the Treasury, which should be advised by a Statutory Committee. Regarding larger amalgamations of banks with overlapping territories, the committee suggested prohibiting such mergers.Footnote ⁶⁰ Despite these proposals, a law on bank amalgamations was never introduced, even though a bill was forwarded to Parliament in 1919.Footnote ⁶¹ The government opted for informal arrangements with the banks instead of introducing statutory banking legislation.Footnote ⁶²

However, the informal approach to convince banks of the importance of higher capital levels was successful. The fact that the government appointed a new Advisory Committee in the summer of 1918 to analyse pending mergers certainly helped.Footnote ⁶³ The committee did not have legal power, but the government could provide de facto power to the committee based on the embargo for capital issuances introduced at the beginning of the First World War.Footnote ⁶⁴

The clear stance of the Amalgamations Committee – and later also the Advisory Committee – against further leveraging through mergers triggered bankers to strengthen their capital position.Footnote ⁶⁵ The fact that a war-related increase in deposits had led to an additional leveraging of the banking sector further raised awareness among bankers.

In 1919 and 1920, the paid-up capital of English banks grew by about £20m, reaching £72m by the end of 1920. In 1920, The Economist noted that ‘the danger of allowing this ratio [capital/deposits] to fall to so low a figure is being realised by bank directors’. One year later, The Economist stated:

Despite these increases in the paid-up capital, the capital ratios grew only moderately. In 1918, the capital/assets ratio was 5.8%. The ratio grew slightly to 6.4% in 1920, even though the total assets also grew. During the second half of the 1920s, the ratio remained at the 7% level. However, this was primarily due to the contracting balance sheets of the British banks between 1920 and 1925. The capital/assets ratio never returned to pre-war levels above 10%.

4.2.2 During and After the Second World War: Banking Without Capital

Economist and historian Richard Sidney Sayers wrote this sentence in one of the most popular banking textbooks of the twentieth century. Modern Banking was first published in 1938 and issued in several editions up to the 1970s. Sayers argued that English banks had a long track record of stability and had built up substantial hidden reserves. If it came to the capital, the author was more concerned about foreign than domestic banks:

These sentences were printed in the sixth edition of Modern Banking, published in 1964. In the first edition of the textbook in 1938, Sayers avoided the topic of capital altogether.Footnote ⁶⁹ He viewed liquidity as the primary source of stability in banking. This view was representative of the perception of liquidity and solvency after the Second World War.

The topic of capital and capital adequacy also received little attention in the media. Both The Economist and The Bankers’ Magazine had frequently discussed such topics before the war. Building up capital was seen as part of the progress of the British banking system, enhancing its resilience. The annual article in The Bankers’ Magazine discussing the evolution of the capital/deposits ratio was no longer published after the war, having until then been published for more than four decades. Later articles in The Bankers’ Magazine on the capitalisation of banks were mostly descriptive, simply announcing changes in the structure of the capital or capital issuances. The same applied to articles published in The Economist and, in contrast to the aftermath of the First World War, the idea of returning to pre-war capital ratios was not expressed in either of these two key publications.

Scholars’ lack of interest in the topic of solvency, as well as the lack of media coverage, have to be viewed against the policy environment at the time. As discussed, the amount of government debt was high, and so was the share of government debt in the banks’ balance sheets. One of the central goals of monetary policy after the Second World War was to ensure capital supply for government debt. Therefore the banks, as sources of finance for the government, were highly affected by the government’s repressive monetary policy.Footnote ⁷⁰

Instead of statutory regulation – as, for example, in Switzerland and the United States – British banking regulation was exercised informally and flexibly through the BoE. This informal supervision was guided by moral suasion and the ‘Governor’s eyebrows’.Footnote ⁷¹ Cash and liquidity ratios were the crucial tools in the BoE’s supervisory practice. The cash ratio ensured that banks held a certain amount of their deposits at the BoE. The liquidity ratio forced banks to hold large amounts of cash, money at call, bills of exchange, and British government bills. This led to a high share of short-term government debt in banks’ balance sheets. The cash ratio was set at 8% and had to be adhered to daily between 1946 and 1971, while the liquidity ratio ranged around 30%.Footnote ⁷²

With such a focus on liquidity, there was little room for capital requirements. The goal of monetary policy to ensure demand for short-term government debt, enforced through informal control and liquidity ratios, was often believed to conflict with capital requirements.Footnote ⁷³ It was not surprising that no capital issuances took place in such an environment. No bank raised new capital during the Second World War, even though the capital/assets ratio fell from 5.7% to 3.0%. By 1953/4, capitalisation reached a low point at 2.3%. Barclays and Midland had even lower capital/assets ratios (1.9% and 2.1%, respectively, without hidden reserves).

Capital ratios were rapidly shrinking at the beginning of the 1950s. Were the banks reckless, not worrying about the deterioration of their capital resources? After all, banks frequently referred to shareholders’ and depositors’ interests when issuing capital until the First World War. Moreover, there seemed to be an agreement that banks would need to strengthen their capital position between 1918 and 1920. Was the depletion of capital a sign that all these ideas had disappeared?

Some banks had already expressed concerns about their capital position before the Second World War. In 1937, for example, the Westminster Bank considered its capital too low. Comparing ratios with the other Big Five banks, the General Manager of Westminster Bank (Sir Charles Lidbury) noted internally that their own capital/deposits ratio was lower than that of the other big banks and that Westminster paid comparatively higher dividends. On the one hand, Lidbury pointed out that banks should issue capital in periods of ‘cheap money’ and, therefore, the time was right to issue capital. On the other hand, he also referred to various problems arising from a possible capital issuance. In his view, it seemed difficult to adequately compensate new shareholders without ‘watering down’ the ‘preferential position’ of existing shareholders. Westminster eventually decided against a capital increase.Footnote ⁷⁴

During the Second World War, several banks attempted to raise new capital. Between September and December 1943, the National Provincial, Midland, and Lloyds Bank all approached the Governor of the Bank of England, Montagu Norman, to discuss capital issuances. The governor replied to National Provincial that they ‘must abandon the idea’. Norman argued that if ‘£5/6 million were needed for one bank, the total for all banks might be £40 million or £50 million’, adding that ‘it seems impossible that a proposal of this kind could be allowed for a single bank’.Footnote ⁷⁵ The argument that the capital issuance of one bank would trigger the other banks to recapitalise was frequently used in later years. It was always presented along with a brief calculation showing the total amount of capital that would be tied up by all the banks if they were to capitalise. The BoE would not have allowed such resources to be withdrawn.

Further attempts to raise capital and reorganise their capital structure were made after the war by the National Provincial (1946), District Bank (1946, 1949), Barclays (1948, 1949, 1953), Martins Bank (1953), and Midland (1958). The banks usually argued that capital was needed to protect depositors. In order to demonstrate the need for additional capital, they compared their capital with the fixed assets (premises, investments in subsidiaries and associated companies) they held. A frequently made argument with which the BoE did agree was that fixed assets should not exceed the capital.Footnote ⁷⁶ The difference between capital and fixed assets was later known as ‘free resources’. The ratio between ‘free resources’ and deposits was called the ‘free resources ratio’. Thus, a new ratio emerged from the supervisory practice of the 1950s. The previously used capital/deposits ratio had lost importance in discussions between the BoE and the banks.

According to the BoE, issuing new capital in the post-war period ‘was completely out of the question under existing conditions’.Footnote ⁷⁷ ‘Existing conditions’ referred to the credit squeeze of the 1950s. In the view of the BoE, capital should be used for the ‘productive’ industry.Footnote ⁷⁸ Moreover, the BoE considered liquidity to be much more important than capital from a depositor’s point of view.Footnote ⁷⁹ The bank also noted that depositors did not seem to worry about low capital/deposits ratios:

Despite postponing new capital issuances by the banks, the BoE was not completely ignorant of the importance of capital. In 1946, the bank told the Committee of London Clearing Bankers that they should be prepared to raise capital once the time was right.Footnote ⁸¹ The time for capital issuances came in 1958, when all of the Big Five were finally allowed to raise capital.Footnote ⁸² As a result, the average capital/assets ratio grew from 2.6% in 1957 to 3.2% in 1959.

The BoE also discussed the importance and role of capital internally. It was clear that priority was given to liquidity ratios. On the issue of solvency, however, there was a range of opinions. In 1958, the bank’s Chief Cashier surmised that ‘even in the Bank of England we are beginning to believe that Capital plays little or no part in a soundly based banking structure’.Footnote ⁸³ At the same time, internal reports at the bank discussed that long-run targets for capital/deposits ratios should be between 5% and 7%.Footnote ⁸⁴ However, such deliberations never materialised as formal or informal minimum capital standards. Instead, the British system continued on a path of informal supervision with a clear focus on liquidity.

4.3.1 After the First World War: Back to Normal?

Towards the end of the First World War, there was a widespread sentiment in Switzerland that economic conditions – and, with that, banks’ balance sheets – would return to pre-war conditions once the war was over. By 1918, the SNB expected that deposits would contract and that ‘the [capital/liability] ratios should, therefore, perhaps improve again by themselves over time’.Footnote ⁸⁵ Contemporaries took a similar perspective and referred to the abnormally inflated balance sheets of banks as a result of the war economy.Footnote ⁸⁶ And two of the big banks – Credit Suisse and the Swiss Bank Corporation – commented in their annual reports of 1917 that their large total assets and deposits were only a temporary phenomenon and would soon be shrinking again.Footnote ⁸⁷

Once the war was over, it became clear that macroeconomic conditions would not normalise immediately. The post-war economic depression reached its high point in Switzerland in 1922 with high deflation and high unemployment rates. Moreover, asset prices had been falling and capital markets were not able to absorb large capital issuances at the time, which restricted Swiss banks’ capacity to refinance through capital issuances.Footnote ⁸⁸

At the international level, the monetary disorders after the war had consequences for the Swiss financial centre, leading to large-scale foreign capital inflows in Switzerland. Against expectations and the adverse domestic economic development, the balance sheet totals and deposits of Swiss banks did not contract after the First World War. Total assets grew by 6.6% between 1918 and 1922 (1.6% p.a.). Deposits even increased by 15.6% (3.4% p.a.). This growth reinforced the belief among the Swiss banking sector that capital issuances could not be postponed any further, given ‘the unfavourable capital/liability ratio’, as concluded by the SNB.Footnote ⁸⁹ Moreover, the SNB noted that ‘the uncertain outcome of the current depression and the need to counter it as a precaution really cannot be stressed enough’.Footnote ⁹⁰

The Swiss banks started issuing capital once they realised that their balance sheets would not contract but grow due to foreign capital inflows.Footnote ⁹¹ Between 1918 and 1922, Swiss banks increased their paid-up capital substantially, by CHF 389.3 m (+20%). The capital was increased despite difficult economic conditions, and even though distressed prices at capital markets led to very low share premia. In addition to the nominal capital raised, only CHF 13.3m could be added to the reserves as premia.Footnote ⁹²

Even though capital increases after the First World War were substantial in absolute terms, they had little impact on capital/assets ratios. The average capital/assets ratio of all Swiss banks grew from 13.1% in 1918 to 13.6% in 1922. For the big banks, the impact was more substantial. Their ratio increased from 14.8% to 17.5%. However, it was only a short-term recovery. The rapid growth of deposits as a key component of liabilities also continued in later years. From 1922 to 1929, the deposits of Swiss banks grew on average by 6.6% per year. The deposits of the big banks even increased by an average of 10.5% p.a. Foreign capital inflows were a substantial driver of this growth.

There are no exact figures for the volume of foreign deposits transferred to Switzerland during and after the First World War. Contemporaries estimated that about half of the deposits flowing to the Swiss banks in 1929 were transferred from abroad (about CHF 440m).Footnote ⁹³ Gottlieb Bachmann, Head of Department I of the SNB from 1925 to 1939, estimated the total volume of foreign funds by the end of 1929 to be between CHF 1–1.3bn.Footnote ⁹⁴ Domestic and foreign deposits in Swiss banks reached a volume of CHF 9.4bn in 1929.Footnote ⁹⁵ Foreign capital inflows led to a further increase in the total assets, which in turn contributed to the deterioration of the capital/assets ratio. In 1929, the capital/assets ratio of all Swiss banks was 12.1%, while the ratio of the big banks fell to 14.0%.

Compared to the period before the First World War, these ratios were substantially lower. The perception of ‘adequate capital’ had changed substantially. Before the war, a capital/liability ratio of about 30% (c/a ratio = 23%) was considered adequate for the big banks.Footnote ⁹⁶ After the First World War, contemporaries viewed a capital/liability ratio of about 20% as the new standard for the big banks.Footnote ⁹⁷ The standard ratio for banks focusing on savings and mortgages was in between 9% and 10%.Footnote ⁹⁸ The SNB was not worried about these new conventions, highlighting that the reserves had increased substantially since the end of the war and that the Swiss banks held more liquid assets, which would require less capital.Footnote ⁹⁹

4.3.2 The Importance of Formal Capital Requirements

The early 1950s mark the end of two conventions that had directed the capital policies of Swiss banks for a long time. Firstly, the group of the big banks no longer had the highest capital ratio of all the banking groups in Switzerland.Footnote ¹⁰⁰ Traditionally, the argument had been that the big banks conducted comparatively (to other banks) riskier business and therefore required more capital. However, with high shares of government papers in their balance sheets and sharply increasing amounts of deposits during and after the war, the business model of the big banks had changed. Moreover, the importance of direct industrial investments decreased. Secondly, and certainly related to that, the rules of thumb that had been used as a reference for capital adequacy were abandoned. Before the First World War, the big banks had frequently issued new capital in order to maintain a certain capital ratio. After the First World War, a capital/liability ratio of about 20% for big banks was accepted by the SNB. In 1945, the capital/assets ratio of the big banks was 11.0%; it had dropped by 4.4pp during the war. The combined capital/assets ratio of all banks stood at 10.5%.

After the Second World War, the idea of returning to pre-war capital levels did not exist. In contrast to the aftermath of the First World War, the economic conditions were fundamentally different. Switzerland was in an economic upswing and the balance sheets of the Swiss banks grew rapidly. Between 1945 and 1950, the average annual growth rate of the balance sheet totals was 5.5%, while the economy grew on average by 8.0% p.a.Footnote ¹⁰¹ Despite these economically favourable conditions, there were very few capital issuances in the post-war years. Between 1945 and 1950, Swiss banks issued new nominal capital of only about CHF 110 m (7% of the paid-up capital). The two largest big banks at the time – the Swiss Bank Corporation and Credit Suisse – did not increase their nominal capital in the years after the war at all.Footnote ¹⁰² Why did banks not consider a return to pre-war capital levels?

Firstly, the legacy of the Great Depression still influenced the post-war banking structure. The Second World War brought the period of restructuring and consolidation among the big banks to a halt. This process, which also affected the capital structure of the banks, had been triggered by the Great Depression. Once the war was over, one of the first items on the agenda of the banks was to deal with the legacies of the 1930s.

The Swiss Volksbank had to be rescued by the federal government in 1933.Footnote ¹⁰³ The government held 50% of the Volksbank’s capital. Not long into the war, however, the bank considered its capital to be too high and aimed to pay back the government’s capital. However, the Volksbank postponed the transaction until after the war.Footnote ¹⁰⁴ The Volksbank’s primary goal after the war was to become independent again and to start reducing the Swiss government’s capital share, which happened between 1947 and 1949.Footnote ¹⁰⁵ By 1945, the bank’s capital/assets ratio was 10.5%. In 1950, the ratio was 7.6%.Footnote ¹⁰⁶ Being the outcome of a long-planned capital reorganisation, it can be assumed that the management of Volksbank perceived a capital/assets ratio of roughly 7% to 8% as adequate.

Another bank from the group of big banks, Bank Leu & Co., had to be restructured in 1936 and again after the war. The bank reduced its capital and re-issued new shares in 1945. The increase of the capital was related to the write-down of foreign investments made before the war. Two other banks, the Basler Handelsbank and the Eidgenössische Bank, were also heavily invested in German loans and securities during the 1930s and never fully recovered from their losses. The Basler Handelsbank was taken over by the Swiss Bank Corporation in 1945.Footnote ¹⁰⁷ The Eidgenössische Bank was taken over by the Union Bank of Switzerland (UBS) in the same year. UBS increased its nominal capital for that purpose by CHF 10 m to CHF 50m.Footnote ¹⁰⁸ Nevertheless, the capital/assets ratio of the Union Bank of Switzerland fell to 7.1% in 1950, and the ratio of the Swiss Bank Corporation to 7.6%.

Another legacy of the Great Depression and the war years was the low dividends for shareholders. Traditionally, Swiss banks aimed for stable dividends. The target dividend was usually met by augmenting or releasing internal or published reserves.Footnote ¹⁰⁹ A case in point is Credit Suisse, which paid a dividend of 8% from 1895 to 1933.Footnote ¹¹⁰ The ‘traditional 8%’ became a benchmark for the big banks. Besides Credit Suisse, Bank Leu & Co., the Swiss Bank Corporation, the Eidgenössiche Bank, and the Basler Handelsbank all paid a dividend of 8% in 1930. The Union Bank of Switzerland paid 7% and the Swiss Volksbank 5%.Footnote ¹¹¹ The losses of the 1930s forced banks to cut their dividends to between 0% and 5% (1935). A sharp reduction in foreign business in 1939 led banks to lower dividends even further – on average, by another percentage point.Footnote ¹¹² It was not until 1952 that Credit Suisse and the Swiss Bank Corporation reached the 8% level again. The Union Bank of Switzerland paid 8% from 1956 onwards, and the Swiss Volksbank paid 8% only after 1960.

Given the low dividends after the war, it seems that the banks either opted in favour of their shareholders’ interest or thought that they could not place enough shares in the market given the low dividends. Instead of issuing shares, the banks increased dividends first. This process would have certainly been more difficult, if not impossible, the other way around.

Secondly, hidden reserves reduced the need for immediate capital issuances after the war. While capital ratios might not have been growing, hidden reserves (not represented in public figures) probably were. The extent of the hidden reserves after the war is unknown. It is likely that the Great Depression diminished most of the hidden reserves since only two of the big banks – Credit Suisse and the Swiss Bank Corporation – managed to get through the crisis without being forced to reduce their nominal capital. Many other banks used most of their hidden reserves and large parts of their published reserves.Footnote ¹¹³ As asset prices increased after the war, hidden reserves started to accumulate substantially.Footnote ¹¹⁴ The actual capital rose with the increase of the hidden reserves. This build-up of hidden reserves cannot be detected in published accounts, but it certainly strengthened the solvency of the banks.

Thirdly, new regulation replaced existing conventions on capital ratios. Bank capital was first regulated on a national level in Switzerland in 1934/5 with the Banking Law and the Banking Ordinance. According to the Banking Law, a bank’s capital would have to be in an ‘appropriate’ proportion to its liabilities.Footnote ¹¹⁵ The Banking Ordinance further specified minimum capital requirements.Footnote ¹¹⁶

The introduction of written rules certainly contributed to the demise of informal conventions on what amount of capital was perceived as adequate. The optimal amount of capital was discussed at times in the annual reports of banks and regularly in the statistical publications of the SNB. After the 1930s, however, the topic was not covered as frequently anymore. If capital was mentioned in the annual reports of banks or by the SNB, it was only in the form of a short note that the banks met the capital requirements.Footnote ¹¹⁷

Another vital part of the capital legislation was that it allowed lower capital requirements for liabilities invested in mortgages and government debt. This rule shows that the regulators aimed to adjust capital requirements to the credit risk of the assets. The more nuanced view on capital and risk coincided with structural changes in banks’ balance sheets at the time. During the war, the share of government debt in balance sheets grew. After the war, the big banks substantially increased their share in short-term loans to companies and later in mortgages. Short-term loans bore less risk than direct holdings of companies. Moreover, holding direct investments in companies had lost importance during the inter-war years.Footnote ¹¹⁸ The geographic diversification of loans also increased. Foreign investments had been particularly skewed towards Germany until the 1930s. As for mortgages, these were thought to be of low risk as the land was collateralised.Footnote ¹¹⁹ Overall, lower risks through shorter maturities, diversification, and secured assets meant that a bank would require comparably less capital – and both regulators and banks were aware of that.

The SNB also did not seem to be concerned by the falling capital/assets ratio, outlining that the structure of the assets had changed, and the fact that both the liquidity and the capital ratios of the big banks were substantially above the statutory requirements.Footnote ¹²⁰

4.4.1 From Deposits to Assets: A New Supervisory Focus

The FDIC was the last federal bank supervisory agency to highlight the relevance of the 10% capital/deposit ratio in its annual report in 1936. In the same year, the FDIC also stressed that a sufficient capital should have ‘due regard for the quality and character of the assets’ in 1937.Footnote ¹²⁶ The FDIC repeated the statement regarding the quality of assets in various ways in the following years. In 1938, the FDIC referred for the first time to a capital/liabilities ratio of 10% as a ‘working rule’, rather than a capital/deposits ratio.Footnote ¹²⁷

After 1938, the FDIC shifted its focus to the so-called ‘quality of assets’. It was the first of the three supervisory agencies to change from deposits to assets. The FDIC provided a nuanced view on sufficient capital by deducting cash and government debt from the banks’ total assets when discussing capital adequacy during the 1930s and 1940s. The ratio of capital to these adjusted assets was commonly known as the capital/risk-assets ratio. However, the FDIC was careful not to term this comparison a ratio and hesitant to refer to a specific minimum requirement. The FDIC was concerned that banks could use the new capital ratio as an argument against necessary capital increases.Footnote ¹²⁸ Thus, the term ‘risk assets’ was publicly avoided until 1945, even though the FDIC considered the riskiness of assets.Footnote ¹²⁹

The Comptroller of the Currency and the Board of Governors of the Federal Reserve seemed to go through a similar evolution as the FDIC, but adopted the idea of ‘risk assets’ much quicker. Throughout the Second World War, both agencies had acknowledged the growth of deposits and the change in the asset structure among banks, and had introduced an alternative measure for sufficient capital. The Federal Reserve was the first of the three supervisory agencies to use the term ‘risk assets’ in its 1943 annual report. It calculated risk assets by deducting cash, reserves, amounts due from banks, and government securities. The FED argued that the capital/risk-assets ratio was higher than it was before the war, and, thus, the banks were well capitalised.Footnote ¹³⁰ The OCC started using the term ‘risk assets’ publicly in 1944. Similar to the statements by the FED, the OCC referred to the falling capital/deposits ratio and underlined that this picture changes once the risks of the assets are considered. By the end of the Second World War, all three federal agencies used a capital/risk-assets ratio.

Despite developing a new methodology for capital adequacy, the federal agencies were concerned about the evolution of capital in banking given that the war was coming to an end. The OCC stated that ‘more capital is one of the primary needs of the banking system’ and that it would be necessary to ‘protect the further expansion of liabilities and of risk assets which can be foreseen in the postwar period’.Footnote ¹³¹ Once the war was over, the FED and the OCC urged banks to re-examine their capital situation. It was expected that deposits and holdings of government securities would decline, which would require additional capital.Footnote ¹³²

In reviewing its policy towards capital adequacy, the OCC announced in 1949 that it had placed more emphasis ‘on capital in relation to several factors, particularly competence of management, and volume and quality of assets’. As a rule of thumb, the Comptroller used a ratio of ‘capital funds to loans and investments other than United States government securities’. The Board of the Federal Reserve, too, referred to a capital/risk-assets ratio when assessing the capital of banks.

4.4.2 Categorising Assets According to Risk

Even though all three agencies used capital/risk-assets ratios from the late 1930s, they did not publicly communicate specific quantitative capital requirements. Initially, the federal bank supervisory agencies considered a minimum capital/risk-assets ratio of 20% as sufficient.Footnote ¹³³ After the Second World War, supervisors often used benchmarks for comparing capital ratios of banks. Such benchmarks could consist of certain bank types or banks in a certain region. Banks below such averages would receive more attention from bank examiners.Footnote ¹³⁴ Such an approach is – of course – problematic if the average of the benchmark is constantly falling.

One of the weaknesses of the capital/risk-assets ratio was certainly its inability to account for different degrees of risk: the two categories were either no risk (government securities, cash) or risk (everything else). Bank supervisors and other experts were well aware of this deficiency. By 1945, for example, the FDIC had discussed various factors that should be considered when assessing capital adequacy, most notably the types of assets and their expected losses. But the FDIC noted that ‘it has not been found practicable to devise a formula which would take into account all these factors’.Footnote ¹³⁵ Yet such a formula emerged in the following years.

In supervisory practice, however, bank examiners had already developed more sophisticated approaches to assess asset quality. Moreover, federal and state banking supervisors held various conferences between 1934 and 1938 – often at the request of the Secretary of the Treasury – aiming to create uniform standards for banking supervision. Two vital subjects were the definition of capital and the valuation and classification of assets. Already early on in 1934, the supervisors agreed on a concept for classifying loans into four different risk categories.Footnote ¹³⁶ The guidelines for loans were further developed and extended to securities in 1938, and led to a joint statement by the Secretary of the Treasury, the FED, the FDIC, and the OCC. The agreement defined four different securities groups:Footnote ¹³⁷ Group I was dedicated to ‘obligations in which the investment characteristics are not distinctly or predominantly speculative’. Obligations with ‘distinctly or predominantly speculative characteristics’ were assigned to Group II. Group III covered obligations in default and group IV concerned stocks.

Beyond the different risk groups, the 1938 joint agreement also defined how the securities were to be valued by bank examiners. One key issue at the time was that fluctuating bond prices would have a negative impact on the so-called ‘net sound capital’ ratio of a bank if such bonds were valued at market prices. Before 1938, the net sound capital was usually calculated by deducting the difference between the value of a security in the bank’s book from the market price. This approach led to a high volatility in the capital ratios of banks, which bank supervisors at the time wanted to avoid. The problem was solved by allowing banks to value group I securities (government securities or obligations with high ratings) at book value or at cost, as they were not purchased for speculative reasons. For Group II, an 18-month average of the market price was used. Only securities in Groups III and IV were valued at market prices.Footnote ¹³⁸

The evolution of new measurements for capital adequacy was also accompanied by various publications of academics. One of the leading voices in academia on capital in banking was Roland Robinson, professor of finance at Northwestern University and president of the American Finance Association in 1953. In 1941, Robinson reviewed the evolution of the capital/deposit ratio as a supervisory requirement in an article in the Journal of Political Economy. His article provided several suggestions and became a reference for many later publications. Robinson criticised the capital/deposits ratio by referring to the role of capital as a protection against asset losses. The probability of such losses would depend on the quality of assets and have no connection to the deposits. Moreover, Robinson concluded that the risk of assets varies to a great degree, from riskless cash to risky loans, and he argued that capital ratios for a bank mostly active in the money market should be different to those for provincial banks with a high undiversified credit risk to agriculture and industry. Robinson’s main contribution was to suggest different capital requirements for each asset category on a bank’s balance sheet.Footnote ¹³⁹ The idea, however, must have already circulated earlier: John T. Madden, director of the Institute of International Finance of New York University, went in a similar direction in 1940.Footnote ¹⁴⁰

Discussions on how to measure capital adequacy continued into the 1950s. Contributions on the topic usually focused on three questions: (i) should there be one uniform capital/risk-assets ratio for all banks?; (ii) who should determine the risk of an asset (banks independently or supervisors); (iii) what kind of ratios could be used in practice?Footnote ¹⁴¹

In 1952, the Illinois Bankers Association suggested a further developed version of the capital/risk-assets ratio. The proposal was based on a report by Gaylord Freeman, a banker and later chairman of the First National Bank of Chicago. Freeman argued that each bank would have to list all its assets and simulate the crisis of the 1930s. A deviation of the price from the price in the bank’s book would then be deducted from the bank’s capital. The proposal also came with several categories of assets and their potential losses, based on the experience of the Great Depression. Loans, for example, had a potential loss of 10%, municipal bonds of 20%.Footnote ¹⁴²

Another suggestion in 1952 was brought forward by the New York FED. It suggested six risk categories for assets. Each category was assigned a certain percentage of required capital. No capital was required for the riskless category I (cash, government securities with a maturity less than five years and other ‘secure’ assets). Category II required 5% capital, category III 12%, category IV 20%, category V (defaulted bonds, stocks) 50%, and category VI (fixed assets) 100%. Assigning weights to all these categories leads to a required capital, which could then be compared to a bank’s actual capital. Each bank should hold between 100% and 125% of the required capital.Footnote ¹⁴³

The most advanced model of the 1950s was developed by the Board of Governors of the Federal Reserve. The ‘Form for Analyzing Bank Capital’ became known as the ABC formula and was used into the 1970s.Footnote ¹⁴⁴ Similar to the approach by the New York Federal Reserve Bank, the ABC formula categorised assets into different groups. These groups ranged from cash to high-risk securities. The FED already differentiated between credit risk and market risk, assigning weights to different asset classes for each risk category.Footnote ¹⁴⁵ The sum of these risk-weighted assets (a term not used at the time), led to the required capital, which could then be compared to the actual capital of a bank.Footnote ¹⁴⁶ The expected range of that ratio was 80–120%. If a bank fell below the 80% threshold, the Federal Reserve would further examine it. Compared to earlier proposals, the ABC formula featured several novelties: it considered the relationship of assets (correlations) and a potential lack of diversification. The ABC form also assessed the liquidity of a bank and specified higher capital requirements for banks with inflows and outflows of deposits. Additionally, the form considered potential liabilities for a bank active in trust activities.Footnote ¹⁴⁷