Financial systems and development

Box 3.3 Financial swindles
i Swindles have taken many forms, from chain letters to upward. When the bubble burst and the share price
wildcat banking, from penny stock scandals to insider collapsed, the directors of the South Sea Company
trading. A typical swindle is the Ponzi scheme. It takes were held in breach of trust and ordered to make good
its name from Carlo Ponzi, a Bostonian of the 1920s. the losses of investors out of their own funds.
His idea was to lure investors by promising very high Penny stocks are stocks that sell for pennies but have
returns on the basis of a plausible but fictitious plan. great potential according to their promoters. Modern
He used the capital provided by latecomers to pay ear- swindlers use telemarketing (thanks to cheap longlier
investors. The scheme collapsed when the inflow distance phone rates and computerized telephone dialof
new money was inadequate to cover the outflow. ing) to reach thousands of people. By manipulating
Few swindles are pure Ponzi schemes. Most mix gen- stock prices and exaggerating the prospects of their
uine investment with insider trading. An early exam- companies, they induce greedy and gullible investors
ple of insider trading was the South Sea Bubble of to part with their money. When investors want to sell,
1720. John Bull and other managers of the South Sea the promoters pressure them not to; if the investors
Company borrowed from the company to buy its insist, the promoters may refuse to accept their sell
l shares. As share prices rose, they made excellent orders or to answer their calls. Today schemes of this
profits. But to prevent the bubble from bursting, the kind are operated on an international scale. Swindlers
company needed to raise capital at an accelerating rate are evidently part of the trend toward global finance.
and to see the price of its shares move continuously
eries of land, gold, and other natural resources; the conflicting requirements of providing support
technological breakthroughs; or economic deregu- to the system without bailing out imprudent or
lation. Sometimes financial swindles were the fraudulent banks.
cause, as in the first recorded insider-trading scan- After the Great Depression, governments in sevdal,
the South Sea Bubble of 1720 (see Box 3.3). eral countries introduced new regulations. The
Spectacular crises were common during the nine- toughest measures were taken in the United
teenth and early twentieth centuries. In 1816 and States. New rules prevented banks from holding
again in 1825 banks failed in England when they equities in industrial and commercial companies
were unable to redeem their notes or meet the on their own account, from engaging in investwithdrawals
of their depositors. In 1857 many ment banking, and from paying interest on debanks
collapsed in the United States. In 1866 the mand deposits. The Federal Deposit Insurance
failure of Overend, Guerney, one of the largest Corporation was created to provide insurance for
discount houses in the City of London, caused a depositors' funds, and the Securities and Excrisis
that had extensive repercussions throughout change Commission was set up to supervise the
the world. In 1873 major banking crises occurred in securities markets. Coupled with continuing reboth
Germany and the United States. In 1890, Bar- strictions on bank mergers and branching, these
ing Brothers, a British private bank that suffered measures constrained the growth of commercial
losses from underwriting a failed issue of Argen- banks, which remained fragmented and were untine
securities, came close to collapse. In 1931-33 a able to meet the long-term financing requirements
massive crisis devastated the banking system of of American business. Instead, these were largely
the United States. Banks in several European met by the securities markets.
countries also failed.
Other countries (including Canada, France, and
To contain the damage caused by such crises, Italy) also separated investment from commercial
central banks (notably the Bank of England and the banking and imposed maturity controls on the
Bank of France) developed the lender-of-last-resort lending and deposits of commercial banks. In confacility.
Initially, they acted as bankers to the gov- trast, neither Germany nor Japan (prior to World
ernment but not to other banks. Gradually, War II) prohibited universal banking, and in Britprompted
by the need to provide liquidity in times ain such measures were irrelevant because the big
of trouble, they evolved during the nineteenth commercial banks had specialized in deposit bankcentury
into bankers' banks. The development of ing of their own accord. Germany did enact dethe
lender-of-last-resort facility was bedeviled by tailed prudential controls, but universal banking
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