Capital City

London as a Financial Centre

Hamish McRae,Frances Cairncross

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781351337595
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Originally published in 1985, Capital City: London as a Financial Centre proves in depth analytical description of the financial institutions of the City of London. The book describes in detail the operations of the banks, the stock market, the insurance world and other bodies that make up the world's largest international financial centre. The book also answers a series of questions on the City's performance, accountability and honesty and explains how the City reached its present position, discuss its future.

ONE

How it all happened

The world's financial centre

On almost any measure you care to take, the City of London is the world's leading international financial centre. More international insurance passes through London than anywhere else. There are more foreign banks in London than in any other city. More international security business is done in London than any other centre. If anything, in the 1960s and 1970s London's dominance increased. The City established itself as the centre first of the new eurodollar market; and then of banking's greatest growth area, international medium-term lending.

To try to explain why the City's institutions work as well as they do – and to point out where they are failing – is the main purpose of this book. For part of the explanation one must naturally look at the way the various City institutions and markets operate today. But another part of the answer lies in the City's past: in how, over some three centuries, it evolved first as a centre for international trade and then for international finance.

The common explanation for the City's current international success is that it is an inheritance of the nineteenth century, of the years when sterling was the centre of the world money system, and when Britain was the world's major colonial power and first industrial nation. The City itself used to believe this. Before the 1967 devaluation of sterling it was widely argued that the prosperity of the City depended on world confidence in the pound. The truth was the reverse: it was the very controls used to prop up sterling that encouraged London banks to nurture the eurodollar market and thus lay the base for the City's post-war revival.

In fact the direction which the City's development was to take was discernible long before sterling was a world currency or Britain built up her Victorian empire. As for the industrial revolution, the City was involved only at one remove; indeed, it took place almost independently of the City. The prime influences on the early City were none of these. They were rather the peculiar economic and geographical position of London itself, and the enormous volume of government borrowing in the eighteenth century to pay for Britain's foreign wars. In the twentieth century the City has seen a return to the conditions of the eighteenth, in the sense that it has once again had to live on its financial skills.

The impact of London's commerce

The most remarkable thing about London in 1700 was its size. It was already the largest city in the world, with a population of some 600,000 and growing fast. This alone had far-reaching economic effects. Londoners had to buy their food from the rest of the country, thus putting cash into the hands of the farming population and allowing them to build up savings. It also meant that London developed as a market centre. Today Smithfield is still the largest wholesale meat market in the world. But how was it that well over half a million people found their living in London? London was not and never has been important primarily as an industrial centre. The answer lies in the international orientation of the City, and its trade: for an estimated quarter of the capital's working population depended for their livelihood directly on port work.

The port of London dominated the country's foreign trade. At the beginning of the eighteenth century some 80 per cent of England's imports and 70 per cent of her exports passed through London. London's traders needed ancillary financial services – and at the same time generated the capital which financed them.

They required commodity auctions to market their goods, ship auctions to buy and sell vessels. From the quayside and coffee-house auctions of the eighteenth century were to evolve the commodity futures markets and the Baltic Exchange of today. They needed to insure their ships and cargoes. English merchants had been able to insure their ships since Tudor days but there was no formal mechanism for introducing clients to underwriters. By the early eighteenth century a specialized profession of insurance brokers was emerging which collected the signatures of rich merchants prepared to underwrite marine insurance policies. By the middle of the century the brokers were meeting in Edward Lloyd's coffee house; by the end Lloyd's had its own premises and was operating very much as it does now.

Above all, these traders needed to finance their activities – and here is the origin of London's money market. The instrument used to finance both domestic and international trade, the bill of exchange, had been employed by Italian bankers centuries before.* The important development in the City in the eighteenth century was the system of discounting these bills – or exchanging them for cash at a discount-which greatly increased their attraction as a means of providing credit. To start with it was domestic bill finance that grew most quickly. But it in turn provided the mechanism which in the years following the Napoleonic Wars was to make the City the main centre for financing world trade: the international bill on London.

Bill finance developed largely as a result of Britain's peculiar eighteenth-century banking legislation. In 1708 the Bank of England had been granted a monopoly in joint-stock banking, which meant that other banks could only be partnerships. The number of partners in any bank was limited to six. This restriction made branch banking on any scale out of the question and in practice split English banks into two groups – a host of ‘country banks’ in the provinces, and a smaller number of ‘private banks’ mainly in London. Traces of both survive today: Barclays was formed out of a group of country banks, while Coutts and C. Hoare are directly descended from the London private banks.

The small size of the country banks precluded their granting large-scale loans, for they did not have the deposit base to carry them. But they could make funds available to traders and industrialists by discounting their bills of exchange, for these bills could, if necessary, be rediscounted – or exchanged for cash again – in London. Through the same mechanism country banks in surplus areas could employ their spare funds. Thus rich farmers and wealthy Londoners lent their cash to provide the emerging industrial areas with working capital. After 1800 there grew up a specialist group of ‘bill brokers’, who put the holders of bills of exchange in touch with people with sufficient cash to discount them. To start with they merely received a commission for this service. But by the mid-1820s some had developed into discount houses, carrying bill portfolios themselves and borrowing short-term funds from the London banks. In the late 1820s the Bank of England was resigning itself to the role of lender of last resort to these discount houses, and the money market structure that exists today was, in its essentials, complete.

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*It is still in common use today, as explained in chapter 3, pp.57-8.

By discounting bills of exchange the banks provided industry with working capital. They did not supply long-term funds on any substantial scale. Yet these funds were available. To see who borrowed them one has to look at the second feature that shaped the City in the eighteenth century – the continual calls from the government for money with which to fight Britain's foreign wars.

The effects of government debt

The sheer weight of the government's borrowing needs ensured that its debt dominated the capital market. By 1721, public debt already stood at over £50 million. From then until 1739 it declined slightly as the country enjoyed the last long period of peace of the century. Between that year and 1815 the country was at war for two out of every three years. By 1816 the debt had risen to £709 million. As Professor Morgan pointed out in a scholarly history of the Stock Exchange, ‘The debt, in relation to the national income and to the total value of property, must have been as great as that left by either the First or the Second World War.’*

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*E. Victor Morgan and W. A. Thomas, The Stock Exchange (London, Elek Books, 1962), p.43.

It was the government's need for funds that had led in 1694 to the foundation of the Bank of England, a chartered company, set up by a group of wealthy London merchants and financiers to lend money to the government. It was the country's first joint-stock bank and, thanks to the Act of 1708, the only one for over a century.

The Bank of England went on to become the government's banker. Before the government found its feet in the stock market, the Bank's major business was lending to the government. Later it handled the issue of government stock and subscriptions for Treasury bills. Loans to the government were paid in the form of Bank of England notes which were convertible into cash on demand (except for a period during the Napoleonic Wars) and soon comprised the bulk of London's note circulation.

However, the Bank's main preoccupation throughout the eighteenth century was making profits for its own shareholders. Besides its government business, the Bank of England acted as private banker to some of the larger London trading companies and merchants. True, in the second half of the eighteenth century, the Governors of the Bank first began to appreciate how much influence the Bank's policy could have on the economy. For a while, it began to act in effect as lender of last resort, running down its holdings of cash at times when money was tight. However, when the Bank's notes were temporarily not convertible during the Napoleonic Wars, the Bank found it could relinquish the responsibility for monetary policy which it had reluctantly assumed. It did not take it up again until the 1820s.

As the Stock Exchange developed in the eighteenth century, it was dominated by government debt. Even at the end of the Napoleonic Wars, it still dealt in very little else.

Government issues in the eighteenth century were floated by contractors, syndicates of merchants who drew up lists of would-be subscribers. The contractors would then bid competitively for the loan, for which the successful contractor would be liable even if some of the subscribers on his list defaulted. From this primitive form of underwriting developed the technique used in the earlier part of the nineteenth century for foreign loans. Some contractors for government loans such as Sir Francis Baring were merchants who turned later to raising funds for foreign governments.

By 1800 stock-broking had emerged as a specialized profession, the distinction between broker and jobber was recognized, and most present-day dealing techniques were already in use. The Exchange had been formally constituted and had acquired managers and trustees, the Official List and regular settling days. In 1802 it moved to permanent premises on its present site by Chapel Court.

Nineteenth-century international dominance

At the end of the eighteenth century it was still Amsterdam and not London which was the world's main financial centre. But London had already developed a number of sophisticated financial institutions – Lloyd's, the Stock Exchange and a money market through which savings and the demand for funds across the country were matched up. Substantial sums could be channelled into government debt. And thanks to the rapid growth of foreign trade passing through the port, London's international orientation had been firmly established.

In the nineteenth century the City was to become more than a purveyor of financial services. It acquired an international money market which attracted short-term funds from all over the world and invested them in finance for trade; and it developed a long-term capital market on which a large part of the funds for the industrialization of the rest of the world were raised. By the eve of the First World War the City had become the focus of the world's international financial system. Sterling, the currency in which both short- and long-term lending was denominated, was deemed as good as gold. And the Bank of England found itself the guardian of a truly international money system, the gold standard.

This was as much a result of the peculiar pattern of British trade and overseas investment as of the City's financial expertise. As Britain emerged as a major international trading power, the City's money market learnt to finance first Britain's own overseas trade, and then a growing volume of trade between third countries, which frequently never touched British shores. Britain's initial industrial leadership meant that the City's capital market found a demand for long-term funds in countries wanting to finance imports of British industrial products and to build up their own export sectors.

The international money market which emerged in the City during the nineteenth century revolved round three institutions: the merchant banks, the discount houses and the Bank of England. The merchant banks’ role in providing trade finance grew out of their own early trading activities. The instrument they developed, the ‘bill on London’, was merely an adaptation of the inland bill of exchange used by the country banks in the previous century. To make the bill of an overseas merchant, whose credit standing would not be known in the City, discountable on the London money market, a London merchant bank would put its signature on it, thus ‘accepting’ (i.e. guaranteeing) it. Once accepted by a merchant bank, a bill of exchange would qualify for the ‘finest’ rate of discount (or lowest interest charge) at a London discount house.

In 1832, Nathan Rothschild could already claim* that drafts on London were widely used to finance trade that never touched the UK and add, ‘this country in general is the Bank for the whole world . . . all transactions in India, in China, in Germany, in Russia, and in the whole world, are all guided here and settled through this country’. The discount houses, descendants of the earlier firms of bill brokers, continued well into the nineteenth century to discount inland bills passed to them by the country banks. But by the middle of the century the volume of inland bills was declining and the discount houses were becoming more dependent on overseas bills. To start with, the discount houses’ funds were provided by British lenders. But since London had the only money market where massive sums of money could be profitably invested for very short periods, by the middle of the century it was attracting funds from all over the world.

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*Before the 1832 Committee of Secrecy on the Bank of England Charter (Minutes, Question 4799), quoted by Wilfred King, History of the London Discount Market (London, Routledge and Sons, 1936), p.264.

The Bank of England's prime role in this international money market was as lender of last resort. From the late 1820s onwards it stood behind the discount houses prepared in extremis to re-discount the houses’ better-quality bills. Because the Bank was prepared to do this the houses were able to finance their massive bill portfolios with money that could be withdrawn virtually at a moment's notice.

The Bank of England was initially prepared to rediscount the houses’ best-quality bills (the ones on which default was least likely) because it was profitable. Slowly and painfully the Bank learnt that it could, through its function as lender of last resort, control the stability of the money market. It did so only after the City and the entire banking system had been shaken by a number of serious crises. The one which has seared itself most deeply in the City's memory occurred in 1866 when Overend, Gurney and Co., the largest discount house, failed with liabilities of £18 million. When the firm first got into difficulties, it appealed for help to the Bank of England. It was rejected, partly because of an old quarrel with the Bank, and partly because the Bank did not consider the bills in its portfolio to be of sufficiently high quality. When the house crashed, the Bank had to pay out £4 million in one day to try to prevent the panic from bringing down other City houses in its wake.

In the international long-term capital market, the two key institutions were the merchant banks and the Stock Exchange. The merchant banks had been set up mainly by foreign immigrants during and after the Napoleonic Wars. In the long-term capital market they issued the great majority of foreign loans. The earliest merchant bankers had already gained experience of floating large loans by raising funds for the British government, especially during the Napoleonic Wars when the size of the National Debt had bounded up. With the end of the wars, houses like Barings and Rothschilds were also raising funds for foreign governments. The English houses which should have been best placed to become successful merchant bankers failed almost to a man. The house of Boyd, Benfield and Co., which was with Barings one of the biggest underwriters of government loans in the Napoleonic Wars, disappeared apparently without trace, while a high proportion of the immigrant bankers survived. Of the fifteen accepting houses, the City's top merchant banks, all but one (Robert Fleming) are directly descended from banks formed by immigrants – and the original Robert Fleming was a Scot from Dundee.

The traditional explanation for the success of these foreigners in merchant banking and the British lack of interest is that the foreigners had a ready made network of overseas contacts. Certainly this was true in the case of Hambros or Rothschilds, or indeed the later arrival Morgan Grenfell, all of whom had brother banks in other capitals. But what of Brown Shipley, founded by the son of an expatriate Belfast merchant and a Delaware Quaker, or Marcus Samuel, set up by the son of a Dutch Jew, or S.G. Warburg, started by a Jewish refugee from Hitler's Germany? Or indeed why did the British merchants fail to take advantage of their perfectly adequate foreign contacts? It cannot be the complete answer. Perhaps simply being outsiders in the City makes people run faster. If so, the next generation of City financiers could include a...