Lombard Street: A Description of the Money Market

by Walter Bagehot

The old practice of bill-broking, which Mr. Richardson describes, also still exists. There are many brokers to be seen about Lombard Street with bills which they wish to discount but which they do not guarantee. They have sometimes discounted these bills with their own capital, and if they can re-discount them at a slightly lower rate they gain a difference which at first seems but trifling, but with which they are quite content, because this system of lending first and borrowing again immediately enables them to turn their capital very frequently, and on a few thousand pounds of capital to discount hundreds of thousands of bills; as the transactions are so many, they can be content with a smaller profit on each. In other cases, these non-guaranteeing brokers are only agents who are seeking money for bills which they have undertaken to get discounted. But in either case, as far as the banker or other ultimate capitalist is concerned, the transaction is essentially that which Mr. Richardson describes. The loan by such banker is a re-discount of the bill; that banker cannot obtain repayment of that loan, except by the payment of the bill at maturity. He has no claim upon the agent who brought him the bill. Bill-broking, in this which we may call its archaic form, is simply one of the modes in which bankers obtain bills which are acceptable to them and which they re-discount. No reference is made in it to the credit of the bill-broker; the bills being discounted 'without recourse' to him are as good if taken from a pauper as if taken from a millionaire. The lender exercises his own judgment on the goodness of the bill.

But in modern bill-broking the credit of the bill-broker is a vital element. The lender considers that the bill-broker—no matter whether an individual, a company, or a firm—has considerable wealth, and he takes the 'bills,' relying that the broker would not venture that wealth by guaranteeing them unless he thought them good. The lender thinks, too, that the bill-broker being daily conversant with bills and bills only, knows probably all about bills: he lends partly in reliance on the wealth of the broker and partly in reliance on his skill. He does not exercise much judgment of his own on the bills deposited with him: he often does not watch them very closely. Probably not one-thousandth part of the creditors on security of Overend, Gurney and Co., had ever expected to have to rely on that security, or had ever given much real attention to it. Sometimes, indeed, the confidence in the bill-brokers goes farther. A considerable number of persons lend to them, not only without much looking at the security but even without taking any security. This is the exact reverse of the practice which Mr. Richardson described in 1810; then the lender relied wholly on the goodness of the bill, now, in these particular cases, he relies solely on the bill-broker, and does not take a bill in any shape. Nothing can be more natural or more inevitable than this change. It was certain that the bill-broker, being supposed to understand bills well, would be asked by the lenders to evince his reliance on the bills he offered by giving a guarantee for them. It was also most natural that the bill-brokers, having by the constant practice of this lucrative trade obtained high standing and acquired great wealth, should become, more or less, bankers too, and should receive money on deposit without giving any security for it.

But the effects of the change have been very remarkable. In the practice as Mr. Richardson described it, there is no peculiarity very likely to affect the money market. The bill-broker brought bills to the banker, just as others brought them; nothing at all could be said as to it except that the Bank must not discount bad bills, must not discount too many bills, and must keep a good reserve. But the modern practice introduces more complex considerations. In the trade of bill-broking, as it now exists, there is one great difficulty; the bill-broker has to pay interest for all the money which he receives. How this arose we have just seen. The present lender to the bill-broker at first always used to discount a bill, which is as much as saying that he was always a lender at interest. When he came to take the guarantee of the broker, and only to look at the bills as a collateral security, naturally he did not forego his interest: still less did he forego it when he ceased to take security at all. The bill-broker has, in one shape or other, to pay interest on every sixpence left with him, and that constant habit of giving interest has this grave consequence: the bill-broker cannot afford to keep much money unemployed. He has become a banker owing large sums which he may be called on to repay, but he cannot hold as much as an ordinary banker, or nearly as much, of such sums in cash, because the loss of interest would ruin him. Competition reduces the rate which the bill-broker can charge, and raises the rate which the bill-broker must give, so that he has to live on a difference exceedingly narrow. And if he constantly kept a large hoard of barren money he would soon be found in the 'Gazette.'

The difficulty is aggravated by the terms upon which a great part of the money at the bill-brokers is deposited with them. Very much of it is repayable at demand, or at very short notice. The demands on a broker in periods of alarm may consequently be very great, and in practice they often, are so. In times of panic there is always a very heavy call, if not a run upon them; and in consequence of the essential nature of their business, they cannot constantly keep a large unemployed reserve of their own in actual cash, they are obliged to ask help of some one who possesses that cash. By the conditions of his trade, the bill-broker is forced to belong to a class of 'dependent money-dealers,' as we may term them, that is, of dealers who do not keep their own reserve, and must, therefore, at every crisis of great difficulty revert to others.

In a natural state of banking, that in which all the principal banks kept their own reserve, this demand of the bill-brokers and other dependent dealers would be one of the principal calls on that reserve. At every period of incipient panic the holders of it would perceive that it was of great importance to themselves to support these dependent dealers. If the panic destroyed those dealers it would grow by what it fed upon (as is its nature), and might probably destroy also the bankers, the holders of the reserve. The public terror at such times is indiscriminate. When one house of good credit has perished, other houses of equal credit though of different nature are in danger of perishing. The many holders of the banking reserve would under the natural system of banking be obliged to advance out of that reserve to uphold bill-brokers and similar dealers. It would be essential to their own preservation not to let such dealers fail, and the protection of such dealers would therefore be reckoned among the necessary purposes for which they retained that reserve.

Nor probably would the demands on the bill-brokers in such a system of banking be exceedingly formidable. Considerable sums would no doubt be drawn from them, but there would be no special reason why money should be demanded from them more than from any other money dealers. They would share the panic with the bankers who kept the reserve, but they would not feel it more than the bankers. In each crisis the set of the storm would be determined by the cause which had excited it, but there would not be anything in the nature of bill-broking to attract the advance of the alarm peculiarly to them. They would not be more likely to suffer than other persons; the only difference would be that when they did suffer, having no adequate reserve of their own, they would be obliged to ask the aid of others.

But under a one-reserve system of banking, the position of the bill-brokers is much more singular and much more precarious. In fact, in Lombard Street, the principal depositors of the bill-brokers are the bankers, whether of London, or of provincial England, or of Scotland, or Ireland. Such deposits are, in fact, a portion of the reserve of these bankers; they make an essential part of the sums which they have provided and laid by against a panic. Accordingly, in every panic these sums are sure to be called in from the bill-brokers; they were wanted to be used by their owners in time of panic, and in time of panic they ask for them. 'Perhaps it may be interesting,' said Alderman Salomons, speaking on behalf of the London and Westminster Bank, after the panic of 1857, to the committee, 'to know that, on November 11, we held discounted bills for brokers to the amount of 5,623,000 L. Out of these bills 2,800,000 L. matured between November 1 and December 4; 2,000,000 L. more between December 1 and December 31; consequently we were prepared merely by the maturing of our bills of exchange for any demand that might come upon us.' This is not indeed a direct withdrawal of money on deposit, but its principal effect is identical. At the beginning of the time the London and Westminster Bank had lent 5,000,000 L. more to the bill-brokers than they had at the end of it; and that 5,000,000 L. the bank had added to its reserve against a time of difficulty.

The intensity of the demand on the bill-broker is aggravated therefore by our peculiar system of banking. Just at the moment when, by the nature of their business, they have to resort to the reserves of bankers for necessary support, the bankers remove from them large sums in order to strengthen those reserves. A great additional strain is thrown upon them just at the moment when they are least able to bear it; and it is thrown by those who under a natural system of banking would not aggravate the pressure on the bill-brokers, but relieve it.

And the profits of bill-broking are proportionably raised. The reserves of the bankers so deposited with the bill-broker form a most profitable part of his business; they are on the whole of very large amount, and at all times, except those of panic, may well be depended upon. The bankers are pretty sure to keep them there, just because they must keep a reserve, and they consider it one of the best places in which to keep it. Under a more natural system, no part of the banking reserve would ever be lodged at the brokers. Bankers would deposit with the brokers only their extra money, the money which they considered they could safely lend, and which they would not require during a panic. In the eye of the banker, money at the brokers would then be one of the investments of cash, it would not be a part of such cash. The deposits of bill-brokers and the profits of bill-broking are increased by our present system, just in proportion as the dangers of bill-brokers during a panic are increased by it.

The strain, too, on our banking reserve which is caused by the demands of the bill-brokers, is also more dangerous than it would be under a natural system, because that reserve is in itself less. The system of keeping the entire ultimate reserve at a single bank, undoubtedly diminishes the amount of reserve which is kept. And exactly on that very account the danger of any particular demand on that reserve is augmented, because the magnitude of the fund upon which that demand falls is diminished. So that our one-reserve system of banking combines two evils: first, it makes the demand of the brokers upon the final reserve greater, because under it so many bankers remove so much money from the brokers; and under it also the final reserve is reduced to its minimum point, and the entire system of credit is made more delicate, and more sensitive.