THE BANK RATE IN RELATION TO BANKERS’ CHARGES
Very many persons who are out of touch with money-market problems fail
to see why the Bank of England’s rate of discount should be in any way
connected with a banker’s charges; and though, to those who have not
studied the question, the swaying of the pendulum seems due to some
occult influence, the forces that move it are both visible to the naked
eye and capable of explanation. In the first place, the Bank of England
keeps the cash reserves of all the banks in the United Kingdom, and,
as a natural consequence, possesses the only large store of gold in
the land. The other banks, which are dependent upon this accumulation,
become nervous immediately the gold in the Bank’s vaults begins to
leave the country in appreciable quantities, because, should not the
Bank of England be able to meet their demands, they, too, will be
unable to supply the requirements of their own customers.
We need not, in a small book of this description, enter into the
mysteries of the foreign exchanges, or discuss internal and external
drains of gold, but the Bank, in order to arrest a drain of gold
outwards, raises its rate, when the other banking companies, equally
anxious to stop the efflux, raise their rates too, with the result
that borrowers, whether upon bills or securities, have to pay more.
Conversely, when the Bank’s reserve is high and the political horizon
unclouded this nervous feeling no longer exists. The Bank, we will
assume, then lowers its rate, and the other banks follow suit, when the
borrower pays less.
When speaking of the money-market, the London money-market is always
implied, and here we encounter the bill-brokers to whom the banks
advance their surplus funds. The banks, that is to say, finance
their rivals, who make bills a speciality, and whose knowledge of
bills of exchange is doubtless both extensive and peculiar. Seeing
that the banks themselves discount trade-bills for their customers,
the necessity of a middleman or bill-broker between the person who
discounts a bill and the banker who supplies the capital is not very
apparent, but the broker’s “turn,” when he re-discounts with the
banks, is extremely small; so it is quite possible that were the banks
to establish special departments to deal with this business, the
slight increase in their rates would not compensate them sufficiently
for the troubles of management. As, under this system, the brokers’
rate of discount is below that of the banks, it follows that all the
bank-bills and most of the best trade-bills pass through the hands of
the bill-brokers, while bills are also sent to them from all the great
cities. The bankers, consequently, discount inferior paper at higher
rates for their own customers.
But the Bank of England is a great bank of discount. Moreover, it
pays a dividend like any other bank, and, as the bill-brokers are its
rivals, it follows that it cannot afford to allow all the business to
drift into their hands. When, therefore, the brokers’ rate (the market
rate) is below its own, it either takes steps to make its own rate
of discount, as the saying is, “effective,” or else it reduces its
advertised rate of discount (the Bank rate). The Bank makes its rate
representative or effective by selling Consols, and thereby reducing
“bankers’ balances.” The banks in consequence have less to lend to the
brokers, who are then bound to apply to the Bank of England, which
compels them to discount their bills at its own terms, and the rate in
the outside market, of course, advances.
We can see, therefore, that though the Bank rate is sometimes either
above or below the market rate, it is necessarily never out of touch
with it for any very considerable length of time; so now, perhaps, it
will be understood why the banks allow 1½ below Bank rate on deposit;
and their reason for basing their rate for loans and advances upon the
Bank of England’s advertised rate of discount will also be apparent.
Of course, the demand for, and the supply of, loanable capital decides
the rate of interest, and as demand and supply are never equal,
the rate is always fluctuating, but we might just remember that our
artificial banking system “influences” the rate from time to time.
During periods of dull trade, when loanable capital accumulates in the
hands of the banking companies, we should expect to see a low Bank
rate, because, prices of commodities having fallen, people are less
anxious to borrow, while fewer bills are on offer, and, the demand
for those bills having increased proportionately, it follows that
the holders can discount them at a cheap rate. But when business is
brisk and the prices of commodities are rising, more bills are drawn,
and as the fund with which they are discounted is not limitless, it
follows that the increasing demand upon that fund sends up the rate.
Bankers, consequently, who have also to meet the requirements of their
current-account customers, are sometimes obliged to administer a
salutary check to speculation by making the rate almost prohibitive in
order to protect their reserves of cash, as if they then lent to all
and sundry even Lombard Street would collapse.
Now the Bank of England, we have seen, holds the national reserve, as
it were, and is, in consequence, the pillar upon which the money-market
rests. Threadneedle Street (the Bank) is, therefore, the centre of the
money-market (hence the description “central institution”) into which
Lombard Street (the rest of the banks in the United Kingdom) pours its
reserve and surplus cash. We might describe the Bank as the heart of
the money-market, through which a stream of cash and credit-documents
is continually flowing. The brokers (the outside market), who
practically keep no reserves of cash, are largely financed by Lombard
Street, which, however, calls in its advances to them during certain
conditions of the market; and the bill-brokers are then compelled to
fall back upon the Bank of England which holds the bankers’ reserves.
In assisting the brokers the Bank is also supporting the credit of
Lombard Street; so, clearly, the interests of each division are
identical; and the closer and more friendly the relations between them
the smoother will be the surface of the money-market.
But we have to consider the Bank rate in relation to bankers’ charges;
and here another factor must be introduced, to wit, the nature of the
securities deposited by the customer. The business man’s favourite
investments are English railways, Corporation Stocks, Industrial
Companies, and so on, whilst occasionally, endowed with imagination,
and recognizing how erratically the earth dispenses her favours, the
blessed uncertainty of mines appeals to his gambling instinct. As
a rule, a banker’s loans and advances are not covered by Consols,
because it would pay the borrower better to sell out and place the sum
they realized to his credit. Advances against Consols would be made
principally to stockbrokers and to speculators who had bought them
largely in the hope of a rise in price.
Competition for an advance, which is covered by tangible securities,
is keen both in London and the provinces, and competition, we must
remember, tends to reduce the rate. Then, again, assuming that the
Bank rate be 3 per cent., and that a banker suggests 4 per cent. on an
advance covered by railway debentures, the customer may not see the
force of maintaining a margin of 10 per cent. between the market-price
of his stock for the protection of his banker, and paying him, say, ¾
per cent. more than his securities return on his purchase-money. As
the customer’s loan or advance is well secured, and as the banker will
only advance to the extent of 90 per cent. of the market-price on the
condition aforesaid, he is only willing to pay Bank rate upon the sum
he borrows.
We next have to consider the amount of pressure the customer can bring
to bear on his banker, of whom his securities make him practically
independent. He may, in the first place, threaten to remove his account
unless his banker grant him a loan at 3½. Secondly, he may decide that
it will pay him better to sell his debentures at the market-price.
Again he may only require the loan for a few months or even weeks; and
as, in his opinion, the debentures will probably appreciate in value,
he may decide to pay 4 per cent. for a short period to either selling
out or troubling to find a cheaper market. Obviously, the higher the
Bank rate advances the less disposed is this class of customer to
pay ½ per cent. above it; so, when the official minimum is at 5 and
6, he can often arrange for an advance at Bank rate or even at a ½
below it. On the other hand, the banker, when Bank rate is at 2 or 2½,
generally refuses to lend at less than 3 per cent. per annum. The rate,
therefore, upon a secured advance is influenced by the nature of the
cover deposited as well as by the state of the money-market.
This description of the market is, of course, the veriest sketch, but,
perhaps, it may possibly prove somewhat enlightening to those who
have hitherto regarded this very simple subject as an exceptionally
difficult one.