Readings in Money and Banking / Selected and Adapted

by Chester Arthur Phillips

When its rate is not effective, the Bank of England finds itself obliged to intervene in the outer money market—consisting of the other banks and their customers—and control the rates current in it. This it does by borrowing some of the floating funds in this market, so lessening their supply and forcing up the price of money. By means of this borrowing it diminishes the balances kept with it by the other banks, either directly or indirectly—directly if it borrows from them, indirectly if it borrows from their customers who hand the advance to it in the shape of a cheque on them. The result is that so much of the "cash at the Bank of England," which the English banking community uses as part of its basis of credit, is wiped out, money—which in London generally means the price at which the bankers are prepared to lend for a day or for a short period to the discount houses—becomes dearer, the market rate of discount consequently tends to advance, the foreign exchanges move in favor of London, and the tide of gold sets in the direction of the Bank of England's vaults, and it is enabled to replenish its reserve or check the drain on it. That the Bank of England should have to go through this clumsy ceremony of borrowing money that it does not want, in order to deprive the outer market of a surplus which depresses discount rates in a manner that is dangerous owing to its effect on the foreign exchanges, arises from the want of connection between bank rate and market rate. In former days the London money market never had enough money to work without help from the Bank of England. Bagehot, in his great work on Lombard Street, published in 1873, says that "at all ordinary moments there is not money enough in Lombard Street to discount all the bills in Lombard Street without taking some money from the Bank of England."

As long as this was so, bank rate—the price at which the bank would discount bills—was at all times an important influence on the market rate. Since then, however, the business of credit making has been so quickly and skillfully extended that Lombard Street is frequently able to ignore bank rate, knowing that it will easily be able to supply its needs from the other banks, at rates which are normally below it. Currency in England consists of cheques drawn against deposits which are largely created by the loans and discounts of the other banks. There is no legal limit whatever on the extent to which these loans and discounts can be multiplied, and the only limits imposed are those of publicity, which is applied rarely in all cases and in some not at all, and of the prudence with which the banks conduct their business. Hence it follows that competition between the banks often impels them to continue to make advances or discount bills at low rates when the Bank of England, as custodian of the English gold reserve, thinks it advisable in the interests of the foreign exchanges to impose a higher level. This it does by borrowing some of the credit manufactured by the other banks, in order to create artificial scarcity of money, and make its own official rate effective.

It thus appears that the Bank of England's official rate is often through long periods a mere empty symbol, bearing no actual relation to the real price of money in London; and only becomes effective, and a factor in the monetary position (1) when the trade demand for credit is keen enough to tax the credit-making facilities of the other banks to their full extent, (2) when the payment of taxes transfers large sums from the other banks to the Government's account at the Bank of England, so reducing the "cash at the bank" on which they build credit operations, and (3) when, owing to foreign demands for gold, the Bank of England takes measures, by borrowing, to restrict credits in the open market and to make its rate effective. In other respects its official rate differs materially from the rates quoted by ordinary dealers in credit. It does not fluctuate according to the supply and demand for bills, but is regularly fixed once a week at the meetings of the Bank of England court on Thursday morning. It is extremely rare for any change to be made in the Bank of England rate on any day except Thursday. Instances occur rarely when some sudden change of position makes it essential, as at the end of 1906, when the bank rate was raised to 6 per cent. on a Friday morning. In normal times the rate which is fixed on one Thursday is maintained until the next, though the rate is only a minimum and the Bank of England occasionally takes advantage of this fact and refuses to discount at its minimum, which still remains ostensibly the bank rate, while the bank actually makes a rather higher charge, which is usually made the official rate on the next Thursday.

But it must not be supposed that when bank rate is ineffective the Bank of England is doing no business. It discounts bills and makes advances at market rates at its branches, and also at its head office to its private customers. Bank rate may be described as the price at which the bank is prepared to discount in its official capacity as centre of the London market, and it is because appeal is only made in exceptional circumstances to the bank to provide credit in this capacity that bank rate is often ineffective.

The Joint-Stock Banks

The most obvious function of the joint-stock banks of England is the business of taking care of money for customers and meeting cheques drawn against their balances. Customers place money with them either on current or deposit account. On current account it can be withdrawn at any time and earns, as a rule, no interest. Many banks make it a condition that unless the current account is maintained at a certain figure, generally £100, a charge shall be made for keeping it. A usual charge is £1 5s. 0d. each half year, but arrangements vary according to the terms agreed with different customers, and the keen competition now prevalent enables many to obtain the convenience of a bank account for nothing. Sums left on deposit are generally placed for a week or longer, and if placed for a week the rate paid on them by the banks is generally 1-1/2 per cent. below bank rate.

Out of this function of meeting checks drawn by customers against the sums deposited has grown the banker's chief duty, which is now the provision of cheque currency for the mercantile and financial community. Currency in England consists of coins, notes, and cheques. The note issues are almost obsolete as currency, the Bank of England's being used chiefly as reserve by the other banks, while the issues of the country banks are so small as to be negligible. Most of the commercial and financial transactions of England to-day are settled by cheques drawn on the banks by their customers. These cheques are not legal tender, since it would obviously be impossible that a cheque drawn by an individual on a bank could be legally made acceptable by a creditor whether he wished to take it or not.

There is no legal obligation of any sort on them to maintain any regular proportion between cash and liabilities, and as their position in this respect is only subjected to occasional publicity they are not obliged to consider even the effect upon their customers of any considerable variation in the proportion between cash and liabilities which they keep. The system thus works with extreme elasticity and banking facilities can be provided in England with extraordinary ease. It has of late years been frequently contended that the ease and elasticity with which it works have carried the English banking machinery to a somewhat extreme length in the matter of the economy of gold and legal tenders and the extent of the credit pyramid which it builds up on them. After the crisis of 1890, Lord Goschen seems to have been strongly imbued with the conviction that the system had been carried too far. He therefore urged upon the London banks that they should make a monthly statement of their position, and this suggestion was adopted by the majority of them. The result was that they published a monthly statement showing how they stood on one day at the end of each month, and it thus followed that on one day at the end of each month the banks showed a proportion of cash to liabilities which they considered sufficiently adequate to stand the light of publicity. But the system has long been seen to be faulty, and a certain amount of abuse has grown up round it. It is strongly suspected, for example, that some of the banks which publish these statements make preparations for them by calling in loans or reducing their discounts for the day on which the statements are drawn up. As far as this is done the statement is to a certain extent misleading, and this practice of "window dressing," as it is called in Lombard Street, has been subject to frequent criticism, so much so that one of the leading London banks—the London and County—adopted early in 1908 the practice of showing its daily average cash holding, thus demonstrating that it was not in the habit of preparing a statement which did not represent its position fairly throughout the month. It has been stated by a president of the English Bankers' Institute that the proportion of cash to liabilities shown by country banks ranges down to a point as low as 2.2 per cent. No one can contend that this is an adequate cash basis for banking to work on, and as long as certain members of the banking community conduct their business on these lines an obvious hardship is involved on those which keep a more prudent and strong reserve of cash. It is contended by the big strong banks that their smaller brethren compete with them by providing more credit than they have any right to create, relying on their assistance in times of difficulty.

Apart from this danger of the over-multiplication of credit on an inadequate cash basis, the complete absence of any legal or other restrictions on the operations of English banking enables it to work with extraordinary ease and readiness. As long as good unpledged security, whether in the form of bills of exchange, commodities, or Stock Exchange securities, are available in the hands of customers the banks can advance against them to any extent that they consider prudent. Prudence dictates in the case of a great majority of them that a certain proportion of cash to liabilities shall be maintained, but, as was shown above in dealing with the Bank of England, the cash of English banking consists partly of credits with the Bank of England. These credits with the Bank of England, and consequently the cash credits of English banking, can be multiplied as rapidly as the Bank of England is prepared to make advances or discount bills, and so give credit in its books. The Bank of England must publish its account weekly, and it watches over its proportion of cash to liabilities with a vigilance which is greater than that of the rest of the banking community as a whole. Nevertheless, its prudence in this respect is the only restriction on it, and we thus arrive at the conclusion that the chief function of the English joint stock banks, that of providing the mercantile community with currency and credit, can be carried out to any extent as long as their customers have security to offer and their proportion of cash remains adequate to their sense of prudence. And further, their proportion of cash can be increased as rapidly as the Bank of England is prepared to make advances, which it can and does to an extent which again is only limited by its own prudence.

Besides this absence of outside regulation, the English monetary system is also distinguished by a remarkable lack of cohesion and co-operation among the members of its own body. Except to a certain extent in the country districts, where the rates allowed to depositors and charged to customers are to a certain extent a matter of convention, English banking works almost entirely at the mercy of very keen internal competition. This extreme development of competition leaves the market liable to pronounced depression in rates at times when slackness of trade or other causes decrease the demand for credits. At these times the adroit bill brokers and discount houses, which are in some respects the most important borrowing customers of the banks in London, are enabled by the use of this weapon of competition to obtain loans from the banks at rates which are often below the price that the bankers are paying to their depositors. Hence, it follows that in these times of monetary ease the credit machine goes on turning out its product at rates which are quite unremunerative and have a detrimental effect on the market rate of discount, and so on the foreign exchanges, thus increasing the difficulties of the Bank of England, which at these times of extreme ease is without any control of the position. Against this weakness of the system, however, must be set the advantage which the unrestricted and fiercely competitive manufacture of credit confers on the mercantile and trading community.