Capital III, Chapter 31 - Part 4

But, as capital developed, and the size of these discount houses swelled, they were induced to provide funds not just on traditional securities, but on “dock warrants of merchandise (storage bills on commodities in docks), and next on bills of lading, representing produce not even arrived in this country, though sometimes, if not generally, secured by bills drawn by the merchant upon his broker. This practice rapidly changed the whole character of English commerce. The facilities thus afforded in Lombard Street gave extensive powers to the brokers in Mincing Lane, who on their part ... offered the full advantage of them to the importing merchant; who so far took advantage of them, that, whereas 25 years ago, the fact that a merchant received advances on his bills of lading, or even his dock warrants, would have been fatal to his credit, the practice has become so common of late years that it may be said to be now the general rule, and not the rare exception, as it was 25 years ago. Nay, so much further has this system been carried, that large sums have been raised in Lombard Street on bills drawn against the forthcoming crops of distant colonies.” (p 498)

In part, the reason for this, as has been witnessed more recently, is a search for yield. The period of the 1840's was a period of high rates and masses of profit that reduced interest rates. To obtain higher yields, it was necessary to invest in ever more uncollateralised and risky debt. But, by its nature, this in itself encourages ever more risky behaviour, not just by lenders, but also by borrowers.

“The consequence of such facilities being thus granted to the importing merchants led them to extend their transactions abroad, and to invest their floating capital with which their business has hitherto been conducted, in the most objectionable of all fixed securities-foreign plantations — over which they could exercise little or no control. And thus we see the direct change of credit through which the capital of the country, collected in our rural districts, and in small amounts in the shape of deposits in country banks, and centres in Lombard Street for employment, has been, first, made available for the extending operations in our mining and manufacturing districts, by the rediscount of bills to banks in those localities; next, for granting greater facilities for the importation of foreign produce by advances upon dock warrants and bills of lading, and thus liberating the 'legitimate' mercantile capital of houses engaged in foreign and colonial trade, and inducing to its most objectionable advances on foreign plantations." (Economist,November 20, 1847, p. 1334.)” (p 498)

The individual who places their savings with their local bank, therefore, believed that it was being used to provide funds for local businesses etc. that they may have known, and whose prospects they could monitor. In fact, money had flown off into the global financial system, out of not just their control, but that of their banks.

Meanwhile, in respect of these larger banks, through which the funds were channelled, they were prone to considerable swings in their deposits. At one moment, their deposits may be swelled considerably, as they received the payments for the purchase of railway shares, for example. Because the railway companies did not use these funds immediately, for the purchase of productive-capital, they sat with these banks for prolonged periods, facilitating their further lending. But, then, when the railway companies did come to engage in the purchase of of productive-capital, it was on a large scale, causing a sharp reduction in those deposits.

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