How failure of stock brokers/banks in 1860s led to formation of Bombay Stock Exchange..(and history repeated with NSE 120 years later)

This blog had earlier posted on why and when Bombay overtook Calcutta as the leading financial centre of India. Most likely Bombay displaced Calcutta around late 1940s post Partition. However, Bombay was always chipping Calcutta’s share even at the beginning of 20th century. SO it was expected that Bombay will eventually takeover Calcutta in financial activity.

One reason why eventually Bombay was to takeover was Bombay had stock markets much before Calcutta. BSE started in 1875 and Calcutta Stock Exchange started 33 years later in 1908.

The question is how and why did BSE start? BSE website has some history but not much detailed.

I had earlier blogged about a coffeebook on SEBI history.  In the book, there is a very brief account of BSE history. It is just outright fascinating how multiple factors are behind formation of financial institutions and same is the case with BSE as well. And behind most institutions is the common thread of some or the other financial crisis.

Before share trading comes to picture, it was cotton trading which was the main economic activity in city of Bombay. The financing was provided by city’s indigenous bankers or shroffs (or sarafs) until Bank of Bombay is established in 1840. Gradually, some people started trading in shares of these cotton companies as well. The informal share market started much before the market was eventually organised which is also put story as well. As per the book, the first such informal trading was reported around Cotton Green area around 1840.

By the decade of 1840-50, six such brokers were recognised by banks and merchants. These brokers also dealt in bullion along with stocks. The number was small but still good enough to serve limited needs at that time.

Chief amidst these brokers was Seth Premchand Roychand. He entered the list of brokers in 1849 but soom rose to become the most prominent name. He was known by various names such as Cotton king, Napoleon of Finance and so on, They conducted business under a banyan tree in Horniman Circle which still stands today ( I think have gone by that tree a couple of times without being aware of its history).

By 1855, brokers increased to 40. Now, there were multiple such trading posts under banyan trees located around Fort area.

The number of brokers jumped to more than 200 following American Civil War (1861-65). The civil war led to rise in demand for Indian cotton which made Bombay such a frenzied place. Along with rising demand for cotton, demand for raising money via equities also rose leading to rise in share trading. These brokers became a widely respected community well known to bankers and police alike.

Broad rules were laid out for trading given rise in volumes. The seller broker was required to deliver the transfer deed to buyer broker. The latter would then  it signed from his client The transactions were settled over three kinds of cycles: daily, eight days and 3o days. The brokers opened 2 more areas for trading: Mandvi sugar market and crossroads of Medows Street and Rampart Row.

In 1965, the civil war ended and with it died all the euphoria. First, cotton prices crashed and along with all the financial cycle associated with cotton. The cotton companies closed, shares crashed and sharebroker business was hardly the same as just a while ago.

The damage was not just left to stocks but extended to banks as well. Apart from new cotton companies, there were several new banks which also opened in Bombay during the period. The banks lent easily to the brokers who invested these monies in stocks thus fuelling the mania even further.

Infact, even Bank of Bombay was brought in the mania. Premchand Roychand was the chief protagonist here. It is fair to say that Bank of Bombay was pretty much controlled by him during this period. He used loopholes which allowed him to borrow from Bank of Bombay against government securities and so on.

Thus, we had a vicious cycle where multiple entities were involved. Once the cycle was on an upswing, all the entities prospered. The cotton prices boomed leading to rise in valuation of cotton shares leading to easier loans from banks. Once the war ended things reversed and they all fell due to interconnections. These linkages have been shown as highly important in recent 2008 crisis but we must remember that they are as old as finance itself.

 

Thus, even banks fell along with stock brokers and cotton firms.

Infact in 1861 Indian banks were accorded limited liability principles. Till 1861, only Presidency Banks enjoyed limited liability. Rest all were unlimited which meant the partners/promoters had to face losses more than the value of their share. This limited liability was seen as a game changer for Indian banks. Thus several banks opened in Bombay looking at both the civil war opportunities and limited liability ruling.

But when much of valuation is based on pure speculation, law cannot help much. The banks closed down in large numbers in the Presidency. More importantly. it led to closure of mighty Bank of Bombay in 1868. Bagchi in his amazing State Bank of India History Volume One (1987) devotes significantly to this episode. There is another superb account by DE Wacha – Financial Chapter in History of Bombay (1910) which has lots of details on the Civil War and its aftermath crisis.

This banking crisis once again led Indian entrepreneurs to distrust opening banks (Tripathi and Jumani 2007). The tryst of Indian entrepreneurs with banking was not a good one in the 19th century. Earlier large number of banks had closed in Calcutta in 1830-40 period but that time lack of limited liability principle was blamed as the major reason. But in 1865 period, large number of banks failed in Bombay despite having limited liability principles. Thus, Indian entrepreneurs stayed away from banks only to open them again post Swadeshi movement in 1905 which was again met with failures (More on this later).

Coming back to 1865, one should not blame Premchand and brokers alone for the crisis. There were other factors as well. Bank of Bombay management was equally responsible for being highly irresponsible and giving up principles of Scottish banking on which Presidency banks were based. Without their compliance, Stock brokers could not have gamed the system.

Despite banks being equally responsible, onus of the crisis was mainly felt on the brokers. The remaining banks started to shun brokers. They even sent police to ensure brokers are not seen around bank premises. This led brokers to run from one place to another and finally settling in what is today called as Dalal Street. Despite the damage from the civil war crash, share business had caught the imagination of a large number of players. They realised that equity markets are a good avenue to raise capital and then trade in their shares.

However, this time around brokers decided that they should form an organisation/association to conduct their share business to give it more legitimacy.Thus was established an informal association called ” The Native Share and Stockbrokers Association” on July 9 1875.  They hired a hall in Dalal Street which till recently was known as Advocate of India Building.  Later the Association was formalised in 1887 with an Articles of Association. The Articles specified the purpose was to faciliate negotiation of sell and purchase of joint stock securities promoted through out the Presidency of Bombay. In 1895, the old BSE building was purchased for Rs 89,000.

This bit of history is just fascinating. The formation of BSE was due to crisis in share broking business.

Premchand again played a key role in formation of BSE. He was also quite an institution builder and gave back to both society and Bombay city. It is really nic to read recent article on his legacy (one, two). His firm – PRS Group – is still active having being formed in 1856!

More intriguing is that nearly 120 years later, in early 1990s we see history repeating itself. Once again, a group of brokers manage to speculate in stocks using money from the banks. This time the instrument was “bank receipts” which was to be invested in government securities but invested cleverly into stocks. Once again the brokers led by Harshad Mehta worked around a loophole to fuel speculation. Just that this time there was no cotton mania kind of thing. It was more like a scam.

The policymakers realised that how BSE had become too big and brokers creating havoc. This crisis led to germination of an idea to have another stock exchange which was promoted not by brokers but by institutions. This eventually gave birth to NSE as well. The events are covered in autobiography of GV Ramakrishna.

However, again the problem was not just due to stockbrokers. Once again the bankers were part of the game and without their consent, nothing would have been possible. The bankers in the scam have just been jailed after 35 years of the scam.

India’s financial institutional history is just so rich and deeply connected with involvement of multiple players…

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