Backstory: The collapse of Presidency Bank of Bombay in 1868

The collapse of banks like Punjab and Maharashtra Co-operative Bank (PMC) and Madhavpura Mercantile Co-operative Bank in the last two decades is a grim reminder of the ever-present danger to the financial system from such failures. Sadly it is hardly a new phenomenon.

One of the oldest such incidents took place over 150 years ago when the Presidency Bank of Bombay (PBB) collapsed, leading to the first big shock to the nascent banking system in the country.

In 1867, PBB which had been set up by the East India Company before it lost all its rights in the country following the mutiny of 1857, found itself in the midst of a self-created crisis. Well-run and well-managed till then, it had been overleveraging itself even as Bombay became the emerging center of cotton trade. The start of a civil war in the US in 1861 affected the supply of cotton from the country, then the biggest supplier to Europe, leading to a depression in England which is now termed the Lancashire Cotton Famine.

But while Britain suffered, the sudden opportunity spelt good times for India which emerged as the biggest supplier of cotton to the East and the Orient. From around 30 percent in 1861, India’s share of Britain’s raw cotton imports jumped to 67 percent by 1864.

In the wake of the boom, scores of cotton companies set up shop in Bombay to cater to the requirements of the British. This also drove a huge demand for capital which banks like PBB were only too happy to meet since interest rates were high and profits from the business were booming.

Predictably many of these loans were not backed by sufficient collateral or were given against the shares of the borrowing companies. In the speculation spree, the shares of these companies were also scaling new highs which meant they could pledge ever larger numbers for loans. Also in 1862, the British Parliament passed the Companies Act which extended limited liability to all incorporated entities. This meant that banks like PBB which till then had to operate with extreme caution owing to their unlimited liability, were now free to relax their strict lending norms. The “limited liability mania” that was unleashed by the act had far-reaching consequences including for the banking sector in India.

Meanwhile in 1865, the civil war in the US ended and the country resumed normal supplies of cotton. Suddenly there was a glut of the commodity for export to Europe. The situation in India was exacerbated by a famine in 1866, which led to many cotton farmers turning to growing foodgrains. Overnight, many companies that had sprung up in Bombay faced extreme financial distress and their shares tanked. Many of them went into liquidation leaving their lenders including banks, holding dud paper.

PBB, which had continued giving out loans even after the market tanked, bore the brunt of the meltdown and eventually collapsed leading to its liquidation in 1868. A new Bank of Bombay was established that year but the story of bank failures continued with hundreds of bankruptcies reported by the time of independence in 1947.