Readings in Money and Banking / Selected and Adapted

by Chester Arthur Phillips

The most important function of the merchant bankers is not that of banking, but of accepting. Banking, in the strict sense of the term, they do not engage in—that is to say, they are not prepared to meet claims upon them by an immediate payment of cash or legal tender over the counter, but by payment of a cheque on one of the banks in the stricter sense of the term. The function of the London accepting houses, though of enormous importance, is still to a certain extent subordinate to the judgment of the English banks. They finally decide whose paper is most readily negotiable, and, in times when the credit machine is felt to be somewhat out of gear, the bankers occasionally discriminate against the paper of firms which they consider to have been giving their acceptance too freely. In this respect, as in so many others, the Bank of England remains the final arbiter, since the paper of an accepting house which is questioned by the other banks can be negotiated at the Bank of England through a discount house, and the Bank of England has before now intervened with effect when it considered that questions raised concerning certain acceptances have been without justification.

This business of acceptance is one into which the other banks have themselves recently intruded with considerable effect, accepting bills for their customers, home and foreign, for a commission; and there is a certain apparent anomaly in the position which makes them guardians of the volume of acceptance created by the private firms and acceptors themselves on a steadily increasing scale. Nevertheless, this anomaly has little or no untoward effect in practice. The bankers are naturally extremely cautious in raising any question as to the security of general credit in London, and they are in many ways closely connected with the private accepting houses, so that the system, which appears to be full of uncomfortable possibilities on paper, works easily enough in practice.

Other functions of the merchant firms and accepting houses are their activity in general finance and in exchange business. Both these functions arise out of their old business as merchants, which gave them close connection both with the governments and the business communities of foreign countries.

The Discount Houses

The great volume and diversity of the bills of exchange which come into the London market to be melted and turned into present cash before their date of maturity has caused the existence of a class of dealers in bills (bill brokers) who specialise in handling them and may be regarded as intermediaries between the holders of the bills—that is to say, originally, the drawers of them, or their representatives, or any one else into whose hands they may have passed them on—and the bankers, who are the ultimate buyers and hold them as investments until maturity. It is the business of the discount houses to buy these bills on a wholesale scale, using for this purpose funds largely lent them by the banks, and to meet the requirements of the bankers with regard to the date named and quality of the bill, providing them out of the store that they keep constantly replenished.

We have also seen that the discount houses fulfill a very important function by borrowing funds from the bankers at call and short notice. These funds are regarded by the bankers, and actually described in their balance sheets, as cash, cash at call, and short notice. It is a somewhat elastic extension of the term "cash" to apply it to money that is being lent to any borrower, even of the highest credit and against the most liquid possible collateral. But it is always assumed by the bankers that these funds placed in the discount market can be called in readily at any moment. That they can be called in is practically a fact; but it arises chiefly from the ability of the discount houses when pressed for repayment of these loans by the bankers to fill the gap in credit by an appeal to the Bank of England and the production of fresh cash, as it is called, by borrowing from it. The discount houses take security to the Bank of England and raise with it the right to draw cheques. These cheques they pay to their bankers, whose cash at the Bank of England, which we have already seen to be regularly used as a part of the basis of credit in England, is thus increased.

Besides the money that they habitually borrow for short periods from bankers, the discount houses also have considerable amounts placed on deposit with them by other lenders, some of which they employ, especially in times when the volume of bills is comparatively small, by loans to the Stock Exchange for financing the speculative commitments of the public, and by holding or carrying securities of a reasonably liquid character. They also take some part in the underwriting of new loans and in the general financial business of the London market.

[154]It is impossible to exaggerate the importance of the functions which the bill brokers discharge in the London money market. They are only about twenty in number, including three joint stock companies. One or two of the brokers work on commission, as your brokers do, but the majority are really dealers in bills. That is, they buy or discount, and sell, or rediscount, bills of exchange.

Let me illustrate their method of working: A bank in New York may buy $1,000,000 worth of sterling bills drawn on England and send them forward to its London agent to be discounted with the bill broker. The bill broker will discount these bills at, say, 4 per cent. If he thinks rates are likely to fall, he will hold the bills; if he thinks them likely to rise, he will try to sell the bills at about 3-3/4 per cent. or 3-7/8 per cent. discount, thus making a profit on the transaction of 1/4 per cent. or 1/8 per cent. per annum. Similarly he may discount large parcels of bills for Eastern and South American banks. Many of these bills will be bills drawn on and accepted by banks and finance houses. These are known as "bank bills." But on the other hand, the bill brokers are free buyers of "trade bills." The trade bill in England arises in the following way: Trader A sells goods to trader B. He will draw a draft on trader B at, say, three months date. Trader B will accept the draft and return it to trader A, who will discount it with his banker or with the bill broker. The rate of discount for trade bills is usually 1/2 per cent. per annum higher than the rate for bank bills.

The essential feature of almost all the bills on the market is that they represent a commercial transaction, such as a sale of goods, where value passes. It is this that lends them their self-liquidating quality; for they are usually liquidated by the acceptor out of the proceeds of the resale of the goods during the currency of the bill.