No System of Bank Acceptances and the Absence of an Open Discount Market
[274]The weakness of our banking system as compared with the systems of Europe may very certainly be attributed in part to the omission of the bank act to permit bank acceptances. It is a weakness, furthermore, which involves the country in serious economic loss. Without a national discount market, the great majority of our merchants and manufacturers are compelled to confine their borrowings to American capital, either through the discounting of their paper with their local banks or through its sale to note brokers. All but the strongest and largest are practically excluded from the benefits of foreign competition for their paper. Aside from the great concerns with international ramifications, which are able to arrange their own credits abroad, our merchants and manufacturers are not benefited by low foreign discount rates, except in so far as note brokers, who make it a practice to borrow in Europe with commercial paper as collateral, are better able to finance their purchases. What is more, they receive relatively little advantage from an accumulation of funds in New York banks. Low call loan rates have an indirect rather than a direct effect on the rate which the mercantile community has to pay for money. Low call rates, in other words, are an indication more especially of stagnation in the stock market than of a lack of demand for accommodation from merchants and manufacturers. Such rates do not act as a stimulus to trade in general any more than high call rates act as an immediate check to over-expansion.
It is not only in our domestic trade that the country suffers through the want of a discount market. Without bank acceptances we are at a distinct disadvantage in connection with our foreign trade. Our importers, unable to open credits with their banks, as is done abroad, are not in a position to finance their purchases upon as favorable a basis as the importers in other countries, as English cotton spinners, for example. The English spinner about to purchase cotton in America arranges for his bank to accept sixty or ninety days' sight bills drawn on it by the American shipper. The latter draws his bills on the English bank and attaches the documents covering the shipment, such as the bills of lading, insurance certificates, invoices, etc. He then sells them to a New York bank, thereby receiving immediate payment for his cotton. The New York bank forwards the bills to its London correspondent, which presents them for acceptance to the bank upon which they are drawn. Upon the acceptance of the bills the documents are delivered to the accepting bank, which then turns them over to the spinner upon whatever arrangement has previously been made. The accepted bills are discounted by the New York bank in London and the proceeds placed to its credit there. The New York bank can afford to pay a high rate for such bills, as they are drawn on prime bankers, rendering certain their ultimate payment. The purchase of the bills does not, moreover, necessitate any outlay of money, as against the credit to be received through the discount of the bills the New York bank can immediately sell its checks on London.
Without such banking facilities—that is, the ability to arrange with his bank to accept time bills drawn on it by a foreign shipper, the American importer is compelled to finance his purchases in either one of two ways. He may pay for the goods at once by remitting funds direct to the shipper. This, however, ordinarily necessitates the negotiation by the importer of a loan on his promissory note. If he is not in a position to secure such an advance he must shift the burden of providing funds to finance the shipment, from the time it is forwarded until it is to be paid for, upon the foreign shipper, who is then in a position to exact terms more favorable to himself through an adjustment of prices. The practice in connection with this method of making payment for foreign purchases is for the shipper to draw his draft on the American importer and turn it over to his banker to forward for collection. Such drafts, drawn as they are on individual importers and not on banks whose standing is well known abroad, must be sent for collection since there is no general market for them. Practically the only way in which a foreign shipper can realize immediately on bills of this character is to dispose of them to his own banker or get him to make an advance on them.
Either of these two methods of financing our imports is expensive even when the time between the shipment and the receipt of the goods is short. When the time is much longer, as in the case of imports from South America and the Far East, the cost is almost prohibitive—that is, so great that we can not compete on an even basis with foreign buyers. In fact, we might be practically excluded from these markets if a makeshift were not possible. Our importer gets around our lack of banking facilities by having his bank arrange a credit with its London correspondent. He receives an undertaking, called a commercial letter of credit, giving the terms of the credit—that is, the name of the London bank upon which the bills are to be drawn, the amount which may be drawn, the character of the goods which are to be purchased, the tenor of the bills, and the documents which must accompany them. On the strength of such a letter of credit, the shipper in South America, for example, is able to dispose of his bills on London and thus receive immediate payment for his goods. The local bank which buys the bills sends them with the documents to its London correspondent, which presents the bills to the bank on which they are drawn—that is, the bank with which the credit was opened. Upon the acceptance of the bills the documents are delivered. They are then sent by the London accepting bank to the New York bank which opened the credit and the latter delivers them to the importer against his trust receipt. Twelve days prior to the maturity of the bills in London the New York bank presents a statement to the importer indicating the amount of pounds sterling which must be remitted to London to provide for their payment at maturity or rather a bill stated in dollars for the amount of pounds sterling drawn under the credit. In this purchase of exchange the importer makes payment for his goods. This method while workable is obviously cumbersome, yet it is practically the only one which the American importer can follow in connection with such imports. It is expensive for the importer, for not only must he pay his bank a commission for arranging the credit, but there is included in this commission a charge made by the London bank for its acceptance. Further than that the importer must take a material risk in exchange. At the time a credit is opened the cost of remitting, say £10,000 to take up the bills in London, might be only $48,600, or at the rate of $4.86, whereas by the time the bills actually mature exchange may have risen and cost him $4.87, or $48,700.
As a result of the inability of our banks to finance imports through the acceptance of time bills, American importers are, then, made dependent to a large extent upon London, and are required to pay London a considerable annual tribute in the way of acceptance commissions. This practice not only adds to the importance of London and militates against the development of New York as a financial center, but it at the same time works serious injury to our export trade. Since time bills can not be drawn on our banks from foreign points against shipments of goods to the United States, there are consequently in such foreign countries very few bills which can be purchased for remittance to the United States in payment for goods which have been bought here. In other words, under our present banking system our imports do not create a supply of exchange on New York, for example, which can be sold in foreign countries to those who have payments to make in New York. This means that our exporters are also, to their great disadvantage, made dependent upon London. It means that when they are shipping goods to South America and to the Orient they can not, when they are subject to competition, advantageously bill them in United States dollars. They naturally do not care to value their goods in local currency—that is, in the money of the country to which the goods are going—so their only alternative is to value them in francs or marks or sterling, preferably the latter, owing to the distribution and extent of British trade, creating throughout the world, as it does under the English banking system, a fairly constant supply of and demand for exchange on London. When we come to bill our goods in sterling, however, it is at once seen that our exporters are obliged to take a risk of exchange, which is a serious handicap when competing with British exporters. Our exporters who are to receive payment for their goods in sterling must previously decide on what rate of exchange will make the transaction profitable. If, in an effort to safeguard themselves against a loss in exchange, they calculate on too low a rate for the ultimate conversion of their sterling into dollars, their prices become unfavorable compared to those made by British exporters and they lose the business. If they do not calculate on a sufficiently low rate they get the business but lose money on the transaction through a loss in exchange.
The prohibition of bank acceptances not only acts as a hamper upon our domestic and foreign trade, but is detrimental to our banks as well. It is the small country bank which is chiefly affected. The business of the country bank, so far as the employment of its funds is concerned, may be divided into two classes—that which relates to advances to local customers and that connected with the investment of its surplus. It is in respect to the latter that the matter of acceptances is important. Under the present limitations of the National Bank Act there are three principal ways in which a country bank may render its surplus funds productive. It may deposit them with its reserve agent. This means a low interest return, too low in fact to permit of only a relatively small amount being thus employed. It may invest in bonds. In this way an increased interest return can be secured, providing a wise selection of securities is made, but it partakes of the nature of speculation. The third way is to buy commercial paper. Such purchases give an ample interest return and there is no savor of speculation. Even this method of employing a bank's funds, however, is far from satisfactory. It means the investment in a security for the strength of which the bank must depend on the word of note brokers, the rating of the mercantile agencies, or the opinion of some correspondent bank. It means, furthermore, the tying up of the bank's funds for a fixed period. If national banks were permitted to accept time bills the country bank could then invest its funds in paper bearing the guaranty of some great bank with whose standing it is perfectly familiar. Risk such as now has to be taken would be eliminated. What is vital, however, is that with a national discount market an investment in a bank-accepted bill is one which could be realized upon immediately. Commercial paper and bank acceptances are both discountable. The prime difference between them, as affecting a country bank, is that they are not both readily rediscountable. Herein probably lies the reason for the strong prejudice against rediscounts which exists among bankers in the United States. In this country when a bank discounts a piece of commercial paper it is discounting something which for its security depends solely on its maker. Should the bank desire to realize on this paper it could do so by rediscounting it, but such a rediscount would be practically equivalent to a loan to the bank on the strength of its own name. In other words, to rediscount its commercial paper would affect a bank's credit. To ask for a rediscount is to ask for accommodation. This would not be the case with bank-accepted bills. If such bills were discounted by a country bank as a means of investing its surplus and it was desired to realize on them such a rediscount would be made not on the name of the country bank, but on the name of the accepting bank. A rediscount in this instance would not constitute a loan to the country bank and would have absolutely no effect on its credit. It would merely indicate that some more profitable business had arisen in which to employ its funds or that it was desirous of increasing its reserve.
Since the reserves of interior banks are so largely concentrated with them and it is essential that they keep their assets in an especially liquid condition, the prohibition of bank acceptances works injury to the banks at the country's financial center, New York, in a different way. It deprives them of what London banks, for example, have—that is, a mass of the soundest securities against which to loan their money on call or in which they may invest their funds for very brief periods—bills of exchange, covering genuine commercial transactions, bearing the acceptance of prime bankers. Unquestionably such securities as a basis for loans are preferable to stock and bonds, but without them New York banks must have recourse to day-to-day loans on the Stock Exchange. Moreover, when the demand for such loans is limited. New York banks are forced into the keenest kind of competition, a competition which, as has been pointed out, is not only of little benefit to trade but which, through the lowering of the money rate, actually stimulates speculation. Furthermore, without a steady money rate such as exists in countries possessing discount markets, New York banks are left with no reasonable or satisfactory basis upon which to fix a rate of interest to pay for the deposits of country banks. In London interest on bank deposits is fixed at a certain percentage below the Bank of England discount rate, usually 1-1/2 per cent.—that is, a rate which fluctuates with the value of money and normally leaves a certain margin of profit to the London bank. The same practice is followed in all the great financial centers of Europe. With us, country banks receive a fixed rate of interest for their deposits, usually 2 per cent., the year around, regardless of fluctuations in the value of money. The unscientific nature of such a rate is obvious. When the call loan rate is high country banks do not receive interest in proportion to the value of their deposits. When it is low the New York banks pay more interest than the deposits are worth. In the latter instance the New York banks are forced into injurious competition with one another. They are in much the same position as competing railroads were earlier in our history, with results similarly baneful. With the railroads it was worth while to secure traffic even at a losing rate, as no matter what the return it helped, if only a little, toward meeting fixed charges. Oftentimes with the New York banks to-day any rate which they can secure for their money whether losing or not is acceptable as helping to meet this fixed interest charge on bank deposits. To pay 2 per cent. for deposits and to keep a 25 per cent. reserve a bank must loan its money at 2-3/4 per cent., to come out even, taking into consideration the actual expense of making and recording the transaction. It is better to loan at 1-3/4 per cent., however, than to let the money lie idle. It is better to lose 1 per cent. than to lose the entire 2-3/4 per cent., as would be done in case no loans at all were made, clerk-hire being just as much a fixed charge as interest. With the amendment of the National Bank Act, to permit the acceptance of time bills, such ruinous competition would cease. The funds of the banks would come to be principally invested in trade paper and stock-exchange loans would be relegated to a position of secondary importance, as in London and on the Continent. The field for the investment of their deposits would be greatly broadened, to the benefit both of the banks and trade in general.
To remedy this primary defect in our banking system, to make possible the financing of our domestic and foreign trade along the lines which have proved so advantageous in other countries, to provide negotiable paper of a character suitable to the investment of foreign funds, paper which can not only be discounted but rediscounted, to give trade the advantage of bank surpluses accumulated both in the country at large and in New York, to lessen the evils of speculation, to afford a reasonable basis for the calculation of interest rates on bank deposits in central reserve cities, to bring New York into the circle of those financial centers between which funds move naturally as discount rates rise or decline, to secure the advantage of the competition of foreign capital for our trade paper, can be put in the way of accomplishment by the insertion of a paragraph or two in the National Bank Act.
[275]The European financial system is constructed upon discounts as its foundation; the American system is constructed upon bonds and stocks as its foundation. Bank notes in Europe are issued mainly against bullion and discounts; in the United States mainly against bullion and bonds.
The quick assets held by European banks against their deposits consist of discounts or call loans, largely secured by discounts. The quick assets of American banks ... are primarily call loans on stock and bond collateral.
In Europe the daily plus and minus of money requirements are adjusted by the use of the discount market—that is to say, in a final analysis, by purchase or sale of bills. (Calling in or putting out money on call where the loans are secured by bills amounts, in effect, to a sale or a purchase of bills.) In a last analysis this means that in Europe attempts to liquidate are primarily appeals to the whole nation to liquidate its temporary commercial investments, the brunt of such liquidation being borne by the entire community, and the pressure being constantly subdivided, every member of the community thus contributing his share.
As a majority of discounts represent goods in process of production or on the way to consumption, liquidation with them primarily expresses itself by a falling off in new production, while the consumer, on the other hand, can not stop consuming and must therefore continue to pay. The brunt is thus borne by the whole nation and adjustment follows without violent convulsions.
In sharp contrast with such a system the attempts to liquidate in the United States are directed primarily at the contractors of stock exchange loans. This means that a comparatively limited number of debtors are called upon to sell their securities. This they can do only by finding new investors, who, as a rule, are at such times comparatively rare, because when acute pressure arises it generally originates in the inability of the investor to purchase because of lack of funds or in his unwillingness by reason of his distrust of the financial situation. The concomitant of this is that those forced to sell securities at such times must offer them at sufficiently reduced prices to bring about an entire change in the attitude of the investor. The difficulty here is that violent reductions of prices in themselves cause distrust, and low prices caused by distrust not only frighten away purchasers but, in addition, unsettle the owners of securities and thus cause them to join the ranks of the sellers. An acute convulsion, therefore, must inevitably follow before the tide can be turned....
Of course, general liquidation in Europe includes a liquidation of securities, just as liquidation in the United States also includes liquidation of commercial paper as it matures. But the difference is that in Europe bills will be the main factor and securities will play a much more subordinate part, while with us just the reverse is true.
THE ESSENTIAL CONDITIONS FOR THE ESTABLISHMENT OF AN INTERNATIONAL DISCOUNT MARKET
[276]The essential conditions for the establishment of an international discount market are:
1. Every bill offered for discount should be based on a commercial transaction where value passes. Finance or accommodation bills should be extremely rare and capable of satisfactory explanation.
2. It follows that almost invariably the bill will arise out of a sale of goods and will be in the form of a draft by the seller upon the buyer, and accepted by the buyer.
3. It will thus be a two-name bill, and not an individual promissory note. How far you can change your system in this respect and how far the powers of your new Federal banks can be used to induce such a change, is a question which I cannot pretend to answer, but which you will no doubt be able to answer.
4. The bill should be drawn for a period neither too long nor too short. The period should be sufficient to allow of a resale of the goods on which the bill is based, thus making the bill in a sense self-liquidating. The usual period is three months.
5. While there should be a large proportion of trade bills, there should be a still larger proportion of acceptances by banks and finance houses, based, of course, on collateral, which usually takes the form of imported produce. In Germany, however, I understand that banks accept a good many drafts arising out of internal transactions.
6. If the market is not to be merely a home market, but international: that is, attractive to foreign bill buyers, an important and desirable step would be the opening of American banks or branches of American banks in foreign exchange centres, such as London, Paris, Berlin, Amsterdam, Buenos Aires, Shanghai, and so on, and these banks should always be prepared to encourage American bills by buying, at reasonable rates of exchange, bills on New York, Chicago, and other American centres, payable in dollars.
7. Your usury laws would have to be modified so as to allow discount rates to move freely upwards if required.
8. Your Federal reserve banks which are intended to be the equivalent of the Central banks of other countries, such as the Bank of England, Bank of France, and the Reichsbank, should be prepared to rediscount approved bills at all times and to any extent.
The advantages to you of such a market would be the same advantages that we possess, namely, liquid employment for short money; power to meet demands for money without disorganizing stock exchange prices; power to check overtrading at home, and finally, power to check a foreign drain of gold.