What each of the bankers concerned makes out of the transaction is plain enough. As to what Smith & Jones' ninety-day loan cost them, in addition to the flat 3/8 per cent. they had to pay, that depends upon what they realize from the sale of the ninety days' sight bills in the first place and secondly on what rate they had to pay for the demand bill for £100,000. Exchange may have gone up during the life of the loan, making the loan expensive, or it may have gone down, making the cost very little. Plainly stated, unless they secured themselves by buying a "future" for the delivery of a £100,000 demand bill in ninety days at a fixed rate, Messrs. Smith & Jones have been making a mild speculation in foreign exchange.
If the same loan had been made on the other basis, the New York Bank would have turned over to Smith & Jones not a sterling bill for £100,000, but the dollar proceeds of such a bill, say a check for $484,000. At the end of ninety days Smith & Jones would have had to pay back $484,000, plus ninety days' interest at 6 per cent., $7,260, all of which cash, less commission, the New York Bank would have invested in a demand bill of exchange and sent over to the London Bank, Ltd. Whatever more than the £100,000 needed to pay off the maturing nineties such a demand draft amounted to, would be the London Bank, Ltd.'s profit.
From all of which it is plainly to be seen that when the London bankers are willing to lend money here and figure that the exchange market is on the down track, they will insist upon doing their lending on the "currency loan" basis—taking the risk of exchange themselves. Conversely, when loaning operations seem profitable but rates seem to be on the upturn, lenders will do their best to put their money out in the form of "sterling loans." Bankers are not always right in their views, by any means, but as a general principle it can be said that when big amounts of foreign money offered in this market are all offered on the "sterling loan" basis, a rising exchange market is to be expected.
From what has been said about the mechanism of making these foreign loans, it is evident that no transfer of cash actually takes place, and that what really happens is that the foreign banking institution lends out its credit instead of its cash. For in no case is the lender required to put up any money. The foreign lender is at no stage out of any actual capital, although it is true, of course, that he has obligated himself to pay the drafts on maturity, by "accepting" them.
Where, then, is the limit of what the foreign bankers can lend in the New York market? On one consideration only does that depend—the amount of accepted long bills which the London discount market will stand. For all the ninety days' sight bills drawn in the course of these transfers of credit must eventually be discounted in the London discount market, and when the London discount market refuses to absorb bills of this kind a material check is naturally administered to their creation.
V. THE DRAWING OF FINANCE-BILLS
Approaching the subject of finance-bills, the author is well aware that concerning this phase of the foreign exchange business there is a wide difference of opinion. Finance-bills make money, but they make trouble, too. Their existence is one of the chief points of contact between the foreign exchange and the other markets, and one of the principal reasons why a knowledge of foreign exchange is necessary to any well-rounded understanding of banking conditions.
Strictly speaking, a finance-bill is a long draft drawn by a banker of one country on a banker in another, sometimes secured by collateral, but more often not, and issued by the drawing banker for the purpose of raising money. Such bills are not always distinguishable from the bills a banker in New York may draw on a banker in London in the operation of lending money for him, but in nature they are essentially different. Whether or not any collateral is put up, the whole purpose of the drawing of finance-bills is to provide an easy way of raising money without the banker here having to go to some other bank to do it.
The origin of the ordinary finance-bill is about as follows: A bank here in New York carries a good balance in London and works a substantial foreign exchange business in connection with the London bank where this balance is carried. A time comes when the New York banking house could advantageously use more money. Arrangements are therefore made with the London bank whereby the London bank agrees to "accept" a certain amount of the American banker's long bills, for a commission. In the course of his regular business, then, the American banker simply draws that many more pounds sterling in long bills, sells them, and for the time being has the use of the money. In the great majority of cases no extra collateral is put up, nor is the London bank especially secured in any way. The American banker's credit is good enough to make the English banker willing, for a commission, to "accept" his drafts and obligate himself that the drafts will be paid at maturity. Naturally, a house has to be in good standing and enjoy high credit not only here but on the other side before any reputable London bank can be induced to "accept" its finance paper.
The ability to draw finance-bills of this kind often puts a house disposed to take chances with the movement of the exchange market into line for very considerable profit possibilities. Suppose, for instance, that the manager of a house here figures that there is going to be a sharp break in foreign exchange. He, therefore, sells a line of ninety-day bills, putting himself technically short of the exchange market and banking on the chance of being able to buy in his "cover" cheaply when it comes time for him to cover. In the meantime he has the use of the money he derived from the sale of the "nineties" to do with as he pleases, and if he has figured the market aright, it may not cost him any more per pound to buy his "cover" than he realized from the sale of the long bills. In which case he would have had the use of the money for the whole three months practically free of interest.