Academic journal article Law and Contemporary Problems

Competition in the Underwriting Markets of Sovereign Debt: The Baring Crisis Revisited

Academic journal article Law and Contemporary Problems

Competition in the Underwriting Markets of Sovereign Debt: The Baring Crisis Revisited

Article excerpt



An important topic in the literature on capital markets is the role of underwriters as gatekeepers. Underwriters are mainly used by investors to reduce information costs about new issues, thereby improving market efficiency. (1) They are called "reputational intermediaries" because they put their reputation at stake if a new issue turns out to be a failure. Underwriters also act as distributors of new securities, participate in most of the activities related to the pricing and selling of new securities, and give advice to both issuers and investors. Still, for practical purposes, they bear limited responsibility for failures and defaults in the case of sovereign debt. More recent sovereign defaults have involved issues that were equally distributed among all underwriters, with the result that the value of reputation has strongly diminished. (2) In addition, the regulatory framework in place and the emergence of rating agencies in the 1930s have dissolved the gatekeeping functions of these different actors. (3)

The nineteenth century is regarded as a period of high international financial integration, for capital could flow freely across international borders. Underwriting of bonds for foreign governments was an important business, and its expansion was interrupted only by World War I. Financial intermediaries fulfilled a role as sole gatekeepers because this was the only way international capital markets could operate; information asymmetries were high and thus merchant, or investment, banks were the only agents informally responsible for the success of investment in foreign securities. Of course, this system involved other risks such as potential conflicts of interest and occasional overlending during euphoric periods. The first episode of overlending began during the 1820s as the lending boom to the newly independent Latin American countries ended with a series of defaults and the sudden stop of capital exports from London, then the main financial center of the world. (4) A second lending boom occurred during the 1860s and ended similarly, this time with the international crisis of 1873, a second wave of defaults, and attempts by the British authorities to regulate their capital market. By then, a few financial intermediaries had differentiated themselves from the rest by their reputation, for they issued bonds that mostly avoided default. Among these merchant houses were the Barings and the Rothschilds. They also held by far the highest market shares, providing credibility to their gatekeeping function; a bad choice would have negatively affected their reputation and thus, their market power.

This article looks at the third lending boom episode, which took place during the 1880s and ended in 1890 with the so-called Baring crisis. Underwriters in Europe issued loans on behalf of Argentina's municipalities, states, and federal government. Competition pushed them to assume increasing risk exposure, which eventually led to Baring's bankruptcy in 1890 and the need for a rapid bailout orchestrated by the Bank of England. This prevented a banking panic in London but could not avert a sudden stop in capital exports from England to the rest of the world.

This article revisits the episode and focuses on the bargaining power of Argentina's federal government relative to that of the underwriting banks. In particular, it examines how the financial intermediaries' gatekeeping function eroded when faced with increased competition. The fiscal position of Argentina's government deteriorated during those years, mainly due to increased fiscal imbalances and the depreciation of the paper peso. Under normal circumstances, underwriters should have impeded Argentinean access to capital markets or at least hardened the terms under which Argentina could borrow. Instead, underwriters offered better terms and accelerated lending. To demonstrate this phenomenon, this article looks at two particular clauses in debt contracts. …

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