British Economic History

''It has been claimed that Britains financial institutions were too oriented towards overseas investment between 1870 and 1914 and that this led to the neglect of domestic industry. (a) Examine whether British industry could gain sufficient funds from the financial sector. (b) Consider whether an alternative institution, such as the investment banks found in Germany, was needed to improve British industry.''

Introduction
Overseas investment,and most particularly,capital exports,is one of the most interesting and important historical phenomena of the period 1860-1914.Paish,in order to define the magnitude of these capital exports,estimated that the total stock of overseas British assets just before First World War,was not less than 4 billion pounds,the one third of the British wealth. Never before or since,has one nation invested so much of its national income to capital formation abroad. The reasons for this preference to foreign investments are controversial. However,in the late nineteenth and twentieth centuries there were two streams of though concerning why financial institutions and individuals had turned to overseas investment. The first one,is that foreign investments had higher returns than the domestic ones,but there is a dispute here about whether these funds were pushed out because the domestic rates of return were fading or because the rates of return abroad were higher. However,when in 1982 Edelstein examined a sample of 566 home and overseas ,first and second class,equity,preference and debenture securities,he proved that returns from foreign investment were higher. More specifically,for some sub-periods between 1870 and 1913,overseas first and second class investments yielded annually 5.72% while the equivalent percentage for domestic investments was 4.60%.The second reason for investing abroad is represented by J.A. Hobson's work and has to do with the distribution of the national income. What Hobson supports,was that too little of Britain's national income was allocated to wage earners,who did most of the nation's consumption and most of the income was distributed to property owners. Consequently,there was too little consumption and too much savings,or in other words too much money available to be invested. Since property owners were assuming that domestic investment had lower returns,these money,in a way,had to be channeled abroad. Thus,it seems that there is a rationality in this movement of funds to foreign investments,or in other words that there are no biased markets against domestic investment. What is not clear,are the consequences to the domestic British industry of this massive transfer of funds. Some argued that if these funds had been invested domestically,they could be used to develop new technologies and new industries while others worried that these funds invested abroad contributed to making Britain's competitors more powerful. For the latter however,Keynes as a supporter of the theory of the supplementary and not competitive markets,held the view that ''our investments have been directed towards developing the purchasing power of our principal customers,or to opening up...our main sources of food and raw materials''. On the other hand,those that disagree with Keynes support that this increasing purchasing power,eventually ended up to enhance the old traditional British Industries and the newer segments of the British Industry were inadvertently starved of demand during their first years,with consequent results on the growth rates of British per capita incomes. In this context of massive capital exports,in order to see if there were sufficient funds from the financial sector for the industries,it would be better to distinguish old well established industries,from the new small and medium sized ones.

Industrial gains from the financial sector

Throughout the period we are looking at,we are seeing greater concentration and amalgamation of the clearing banks. Since these clearing banks,after these amalgamations,had at their disposal a lot of resources that they were dispersed all over the country,one would expect that these massive branches would diversify and would take more risks,but formally this did not occur. It seems that the centralization and concentration of the banks led to less flexibility,less lending to the industries. Banks' practices became more centralized and a lot of decisions were dictated from head officers in London which meant less freedom for the managers that now were acting more like rule driven ''by the book''.On the contrary,during industrial revolution,managers had more freedom. In practice,the bankers during the industrial revolution were mixing in social circles with families that owned the big industries and although not officially,they extended a long term credit,what was called to be a permanent overdraft. While moving to the 19th century,banks are becoming much less likely to be offering long term credits,partly because of the centralization mentioned above and partly because of the conservatism. Michael Collins1 looked at the records of Lloyd's and what he found out,was that in a local level, there was still a continuous existence of this permanent overdraft throughout the late Victorian period. Formally this was not allowed by the central officers of the banks,but at a local level,managers still could exercise their discretion in calling in long-term loans for industries,although that in principle short finance was the strategy of banks towards industries. Nevertheless,this short finance must not be underestimated. Through this kind of finance,banks facilitated the trade and gave the opportunity to industries to pay back their suppliers when they would have sold their goods. However,British banks did not play the same role that investment banks played in Germany and which deliberately invested in long term projects. Furthermore,it seems that the demand for funds from the big established firms was not bigger from what British financial institutions were offering. The old,well established industries were happy and satisfied with the existing provision of financial support and they had retained profits that they could invest in fixed capital if they wanted to. These old-established industries had networks and friends,that they could count on them,when they did have investment requirements. In general,during this period there was no extra demand for capital from these old-established industries,but what is not clear is how small medium-sized industries got the financial support that they required. In order to examine this,it would be prudent to examine to what extend medium-sized industries were financed from an alternative way of financing,the stock exchange. After 1880 more industrial firms converted to public companies,and this gave them more security and raised their extra capital as a way to get more financed into industry. However,as Mathias has pointed out,almost 60% of the capital that goes into industries during this period is actually used to buy the shares of the original owners. Original owners get their financial <<compensation>> for selling their original shares,in order to to buy a landed estate and retire to a new life of leisure and so the investment does not go to new industries but to the already existing ones. By 1885 only 5-10% of major industrial firms converted to limited liability and by 1913 the share of industrial firms on the Stock Exchange of London was 8%,which was a tiny proportion of the Stock Exchange business. Furthermore,the most of these shares belonged to the old established industries such as cotton,iron and steel manufacturers and this is another evidence that there was not much investment going to new industries like cars,chemicals and electrical engineering. In general,the London's Stock Exchange as an alternative way of providing industries with funds,had a little involvement in financing the domestic industry. Only 10% of the needs of the domestic industry was found on the London's Stock Exchange and this 10% was equal with the 3% of what was sent abroad annually. In this context,is very difficult for small and medium sized industries to get financed by the Stock Exchange. The cost of launch on the stock exchange is very high and only large companies can bear it,but the newer small and medium-sized companies will find it much more costly. Let's take for
1

M.Collins,Banks and Industrial Finance in Britain 1900-1939 (Macmillan 1991)

example the chemical company Alkali. Alkali in order to set up,spent as an initial investment 5,000 pounds,an amount that was gathered by friends and not by the stock exchange. But when the Stock Exchange wants issues of more than 1 million pounds,these small,medium sized companies are too small to be of interest. Furthermore,the commission on the exchanges on the Stock Exchange was 6-10% with a minimum cost of around 20,000 pounds,four times more the 5,000 pounds that Alkali spent as an initial investment. Consequently,it was very costly for a small,medium sized company to float on the stock exchange and when this occurred,companies had to make high returns in order to be profitable for their shareholders. In addition,the estimations for the provincial stock exchanges are not more optimistic. Even by 1914 the provincial Stock Exchanges were not providing more than 10-15% of the domestic industrial needs. People did invest in these provincial Stock Exchanges,but these Stock Exchanges channeled these money to the Stock Exchange of London which in turn used it to invest in government bonds and in other usual investments abroad. Concluding, it seems that with some exemptions,like Rolls Royce that got financed by the Stock Exchange,industries were financed by friends,family and local networks and not from the formal institutions. Cottrell confirms this,since he finds,that two third of the industrial finance comes from within 10 miles.

Could investment banks improve British industry?

In general,one of the problems that new investors were facing,was the lack of information about the financial status of the industries. From the early 19th century,British banks developed a good information system about their industrial clients and they used it in order to provide both long and short term finance for them. However,after the expansion of some industries,long term finance was very risky for the banks and their depositors. This,in combination with the banking crisis of the 1870s made banks very cautious and less involved in long term finance. Ventures now,had to rely more on professionals and on London's issue firms in order to decide where to invest their money. As Kennedy argues,there were only a few honest company promoters and in most of the cases they offered little or no aftercare for the firms or sectors that they had assisted. The problem here is that because these promoters and the original owners were overstating the value of trademarks and goodwill in order to get higher share prices,the investors were getting lower returns from their investments and thus they were getting discouraged to invest again. On the contrary,investment banks had much information for their clients. Investment banks,like those in Germany,were involved in long term finance. In order to achieve this,they had a very closed involvement with the firms and consequently they knew much information about their financial position. Investment banks tended to get involved in a particular sector of industry and employed specialist advisors that could see whether an industry was technologically advanced or if a firm was either viable or not. Furthermore,investment banks were insisting that they were the sole lenders. Firms could not take more than one loans from different banks,but because of this,investment banks were willing to offer extra help to their clients in difficult times and offer them funds for long term investment projects. Being a sole lender,investment banks could have correct judgment about the viability of a firm. Also,investment banks could help firms to enter on the Stock Exchange. Since an investment bank had always had good information,if a firm was being financed by an investment bank,this essentially meant that this firm was a good firm and people were investing on it. As we mentioned above,investment banks got involved in the German industry and in the late 1980s got involved in the American industry as well. However,as Edwards and Ogilvie mention,investment banks were responsible only for the 25% of investment in Germany,they were not involved in areas crucial for industrialisation like railways and also,they were not that evident in industries like iron steel and chemicals.80% of the investment of iron steel industries,came from their retained profit and not directly from these investment banks,while many large chemical firms

were set up from private funds like those in Britain. So,it seems that these investment banks in Germany were not of crucial importance. Finally,it seems that investment banks could not help British industries. The involvement of investment banks in the American industry coincided with the merger movement,a movement whose outcome was the significant increase in the power of monopolies,based on protective tariffs. It seems that investment banks were keen on investing in such countries,like Germany and USA,where the monopolies were powerful and the returns of an investment were super-normal. On the other hand,Britain was unattractive to investment banks. The firms were really small,really competitive and in the same time not protected by the competition from abroad. Investment banks tried to set up branches in Britain in the early 1860s and 1870s but they were unsuccessful. It seems that firms did not want the type of financial arrangement that they were offering and that they did not accept the idea of the sole lender with the high charges and interest rates. As Edelstein mentions,there was no demand for investment banks in the UK and albeit being a gap between financial institutions and small,medium sized industries in Britain,it is not clear that investment banks could fill that gap.

Conclusion
A massive export of capital takes place during the Victorian period. However,old established firms had not higher demand than what the financial sector was offering. When they had extra investment needs,they were filling the gap by their retained profits or by borrowing from friends and local networks. In some extend,the same applies for the new medium-sized industries,which nonetheless faced difficulties in getting financed from the Stock Exchange. However,it seems that investment banks would not be the most appropriate solution for this.

Bibliography
1. The Cambridge Economic History of Britain,Volume 2 ,chapters 9,10 2. Handouts of the lecturer,Dr.Sara Horrell

3. M.Edelstein, ''Foreign investment and accumulation,1860-1914'' ,in Floud and McCloskey (eds) (1994) 4. S.Pollard,''Capital exports 1780-1914:harmful or beneficial?'',Economic History Review,1985