Essential features of the 1825 crisis

Problems of adverse selection in the London credit markets arose in intensified form during the 1824–1825 bubble on the London stock market. Yields for the various funds comprising British national debt – EIC stock, Bank of England stock, and the various perpetual annuities mostly in the Three Percent Consols – moved apart after the pressures of war finance had abated. Especially striking is the initial convergence and then wide dispersion of yields on the various Latin American government bonds. Clearly, information asymmetry, always present in financial markets, became especially severe in the London markets in the years leading to the crash of 1825. Asymmetric information is the usual situation where borrowers know more about the actual investment projects they are carrying out than do the lenders. Lenders, knowing this, charge a premium proportional to the uncertainty they feel about the borrowers and the projects in question. Charging risk premiums on loans, however, creates the problem of adverse selection – higher-quality borrowers are reluctant to pay the high interest rates imposed by the market and withdraw while lower-quality borrowers are willing to accept higher rates and to default in case of failure. In an expanding market, which the London Stock Exchange certainly was in the boom years 1806–1807 and again in the early 1820s, the availability of loanable funds at premium rates will attract lemons to the market (e.g. Mexican mines), and discourage borrowing by sound enterprises (e.g. Brazilian diamonds). High-quality borrowers revert to internal sources of funds or to a compressed circle of lenders who know their superior quality and are willing to extend credit at lower rates.

In the case of British firms in the 1820s, the compressed circle of knowledgeable, low-interest lenders was the web of country banks that had arisen in the past three decades. The continued access of high-quality firms to credit, however, depended in each case upon the continued liquidity of the small, local financial intermediaries. Their willingness to continue lending at preferential rates was limited increasingly by the risk of withdrawals by depositors wishing to participate in the high-interest, high-risk investments available in the national financial market.