Bank Rate And Market Rate
( Originally Published 1909 )
BANK rate is the official minimum rate at which the Bank of England will discount bills. It differs from the market rate of discount in that it is normally higher, and in that it is not a constantly fluctuating rate, shifting with the supply of and demand for bills, but is fixed and announced every Thursday morning at a special meeting of the Bank Court, and except under most unusual circumstances is not changed on any other day.
But the fact that it is only the minimum is occasionally enforced in practice, if the Bank finds that too many bills are being brought to it for discount; on such occasions it sometimes refuses to take bills except at a higher rate, which usually becomes the official rate on the following Thursday. For loans and advances the Bank usually charges half per cent. more than for discounting bills. When the Bank is discounting bills at the official rate, or making advances at or above it, Bank rate is said to be effective, because the Bank is then in a position to regulate, more or less, the price of money in London.
It should be noted that the official rate only rules at its head office, and there only partially.
The Bank of England discounts at the market rate for private customers at its head office and also at its branches ; in fact, according to the frequent complaints of the other banks, it competes with them in the country by undercutting in the matter of rates in a manner which annoys them seriously, and with some reason. Here again the Bank has been elbowed into a very difficult position by the force of circumstances. Its branches were never a spontaneous creation, but were founded by it largely in answer to a demand for them in the country which arose out of special and temporary conditions ; now that the industrial and agricultural centres have been enmeshed in a network of banking facilities, the branches of the Bank of England remain, and necessarily make some exertion to justify their existence. Hence very natural grumbling on the part of the other banks, which say that the Bank of England takes their money and uses it to underbid them in their own territories.
This grievance against the Bank of England brings into view at once an important quality of the official Bank rate, namely, the fact that it is, in normal times, seldom effective. If the Bank then wants discount business, it has to take bills at a lower rate. If it took bills in the country only at its official rate its customers, the other banks, would have no genuine cause of complaint, and the Bank would get few bills, if any ; but when it steps off its pedestal and enters into the chaffering circle of the market, and chaffers against the market with the market's money, the market has reason to feel that it has a grievance.
This want of connection between the official rate and the market rate also has the effect of leaving the market rate wholly without regulation.
The market rate, as has already been shown, is at most times practically arrived at by competition among the other banks and higgling between them, the bill-brokers and the sellers of the bills; and hence it follows that it is ruled by mere haphazard cross-currents of individual conceptions on the subject of any particular business proposition that may come forward, and is not directed by the guidance of any consideration for the welfare of the market and of the monetary world as a whole.
An individual banker or bill-broker who wants to add to his holding of bills or renew his maturities naturally discounts at the best rate he can get, and cannot be expected to stop and wonder whether his purchase at a lower rate of discount will have an adverse effect on the foreign exchanges, or give some foreign financier too close a hold on London's store of gold. Hence it often happens that we read in the money articles of the newspapers remarks expressing regret concerning the rapidity with which rates are being allowed to decline, as if the bankers and bill-brokers were carrying out some questionable and immoral transaction, when all that they are doing is to buy the bills that they want at the only rate at which the conditions allow them to do so : and it must seem strange that City editors should shake their heads so sadly about the behaviour of the discount market, while they accept a rise or fall in Consols as due to the inevitable action and reaction of supply and demand in the stock market.
The justification for this attitude towards the movements of the discount market arises out of the very close connection which we have already seen to exist between the market rate of discount and the foreign exchanges. When the market rate of discount is allowed to fall relatively low in London, bills of exchange are naturally sent here in increasing numbers from foreign countries to be discounted ; that is to say, our imports of securities are stimulated, and so the balance of international indebtedness is affected, we have more payments to make abroad, and the rates of exchange tend to move towards the point at which it pays better to ship gold than to buy drafts. The London rate is normally low when compared with those of other centres ; but the extent of its relative lowness is a question of degree; and when this degree becomes exaggerated in a manner which the general monetary outlook does not seem to justify, a situation arises which occasionally calls for deprecating comment by the Press, which endeavours to reflect the judicious opinion of the City. The individual bankers and brokers, however, whose competition depresses discount rates, are little deterred by these considerations ; in the first place, because each one would think it absurd to suppose that his individual action would have any appreciable effect ; in the second, because even if it had, he would consider that he could not be expected to refuse a fine parcel of bills in order that by holding out for a higher rate he might prevent an adverse movement in the exchanges. Adverse exchanges make them cautious in their purchases of bills in their own interests, because adverse exchanges generally hold out a promise of higher rates, and so encourage buyers to wait. But individual buyers cannot be expected to be deterred by consideration for the interests of the market as a whole.
So once again we arrive at the fact that the store of gold which the Bank of England is expected to keep is constantly threatened by a mass of credit created by the other banks, which work without any immediate reference to the Bank of England's position, but to suit the requirements of their own business,. And thus the beautiful elasticity of our monetary system leads to a certain lack of cohesion, which requires, occasionally, drastic measures by the Bank of England to correct it.
This lack of cohesion is a comparatively modern development, and has arisen out of the great growth of the credit-making machinery which is outside of the Bank of England, but is loosely founded on its reserve, and renders its reserve liable to attack by every credit given to a foreigner, by means of a discount or an advance. In Bagehot's time the power of the Bank of England was evidently much more easily exercised, and we find him stating, in the passage quoted on page 211, that in normal times Lombard Street could not discount its bills without the help of money provided by the Bank.
In other words, when he wrote, Bank rate was always effective, save on exceptional occasions. So far is this now from being so, that in order to make its rate effective, the Bank of England often has to borrow money that it does not want, because, the market supply of money being abundant, it knows that the bankers and brokers will continue to discount bills at rates which will keep the foreign exchanges against us, unless a curtailment of the supply of money is carried out.
In other words, the credit-making machinery has worked so efficiently in the output of its product that the Bank of England, which has to be ready to meet the liabilities so created, has to take some of the output away from its holders, and pay them a rate for restricting their temptations to take bills at too low rates.
This it does by going into the money market and borrowing. Any money that it borrows can only be got back from it by being borrowed again, and it, of course, only lends, at- its head office, at the official rate, or 1/2 per cent. above it.
It has already been observed that when the Bank of England lends money the result of the operation is generally expressed in a book entry, by which it shows more securities (which it has received as collateral) among its assets, and more deposits among its liabilities. When it borrows, the book entry of course works similarly, but contrariwise; its holding of securities is reduced by the fact that part of them is pledged to the lenders, and the amount that it borrows cancels so much of its liability under deposits, in other words, reduces the balances of the other banks, and so narrows the basis of credit, makes money dear, brings the market rate of discount into some connection with the official rate, influences the foreign exchanges, and increases the probability that gold will be sent to London, or that gold which arrives will not be taken for export. By this roundabout process the Bank finally arrives at its object of protecting or increasing its reserve.
It has been said that by borrowing money the Bank of England reduces the balances of the other banks; this it does either directly by borrowing part of their balances from them, or indirectly, by borrowing from the bill-brokers and finance houses, who pay it what they lend with cheques on the banks, which to that extent cancel the balance of the banks in question at the Bank of England. The banks in question, having their balances at the Bank thus reduced, either reduce the credits that they have based on them, or more probably restore their balances by calling in money from the bill-brokers, their loans to whom have already been described as their second line of defence, after their holding of cash in hand and at the Bank of England.
The bill-brokers, from whom these loans are called in, first have recourse to the other bankers and money-lenders, trying to fill the gap that has been made in the funds on which they work their business, but are finally, as it generally happens, driven to the Bank of England, whence they have to borrow part of the money that it has borrowed from the market, and will have to pay for it at or over the official rate, which is thus made effective, and becomes a controlling factor in market rates.
The system is thus clumsy and artificial, and, as has been observed, is comparatively novel, having been brought into existence by the great development of the activities of the other banks, which have manufactured credit so successfully that part of the output has sometimes to be absorbed by the Bank of England, which does not want it, but has to prevent the evil consequences that might result from its over abundance.
The bill-brokers, whom we have seen to be the first sufferers when the Bank of England thinks it necessary to reduce the overgrown mass of credit, generally wax eloquent concerning the absurdities of the system, the hardship involved to all legitimate users of credit when it is thus artificially controlled, and the monstrous interference with the natural laws of supply and demand, which ought, they contend, to be left to regulate the value of money like that of every other commodity.
Their position is certainly one with which a disinterested observer can readily sympathize, for they are constantly tempted, not to say forced, by the free credit facilities given by the other banks, into taking bills at rates which have an adverse effect on the foreign exchanges ; and then the Bank of England, in order to rectify the position, has to reduce the mass of credit, and the bill-brokers find themselves, with their portfolios full of bills taken at low rates, artificially deprived of the wherewithal to carry them, and obliged to pay an unexpectedly high price for money to finance their bills, or rediscount them with the Bank of England at a loss.
Nevertheless their appeal to economic first principles, and the natural , laws of supply and demand, does not seem to bear examination. Even in the production of agricultural and industrial commodities the law of supply and demand, if left unfettered, brings many evils in its train, the most obvious among which are the periodical spells of exuberance and depression to which the producing industries are habitually exposed, to their own loss and that of the community as a whole. For some time past the civilized world has submitted to these evils as inevitable or as small in comparison with the great benefit arising from the increase in production that has taken place under the system of unrestricted competition ; but there are very plain indications that this acquiescent attitude is being modified. The modern trend of production is certainly in the direction of co-ordination, co-operation, combination, and regulation, and unrestricted com- petition seems to be gradually retiring into the obscurity of obsolescence.
But in this matter of the supply of credit and of credit instruments it has long been recognized that regulation is essential, and that the free play of supply and demand cannot be left to itself, because of the vast and wide-spreading disasters that result to the whole of a community from any dislocation in the machinery of credit. Moreover, it must be remembered that supply and demand cannot possibly work as effectively in the case of money as in that of an ordinary commodity, because of an important and essential difference which sets a great gulf between money, in the modern English sense, and concrete and tangible commodities.
This difference lies in the fact that the cost of production of money is a negligible factor in its price.
If the farmer is bid £1000 for his crop, his answer will be strongly influenced by the amount of workand capital that have been spent on producing it, and will be required for producing another; when a banker is bid 4 per cent. for a loan of £1000 for six months, in other words, is offered £1020 six months hence for £1000 today, the sum that it will have cost him or somebody else to produce that £1000 will hardly enter into his calculation ; for it will be merely a matter of cheque drawing and book entries involving a certain amount of penmanship, and whether the loan is for ,£1000 or £1,000,000 will make little difference very likely none at all to the cost involved to the producer of it. It was quite otherwise when money consisted of metal that had to be dug out and treated ; but now that money is a matter of book entries and pieces of paper, which pass current because they are convertible into gold and so have to have a certain amount of gold behind them but are brought into being according to the varying views of bankers, as to how much may safely be based on a given quantity of gold the supply of money can obviously be multiplied without any question of cost, so long as borrowers have security to offer, and bankers are prepared to make book entries.
Regulation is in fact already an accepted part of our monetary system, and we have seen that the Bank Charter Act carefully and precisely regulated the number of bank-notes that might be created. If the bank-note had retained its position as the most important of our credit instruments, Bank rate would have retained its control of the money market, that is to say, the rate at which the Bank of England was prepared to provide borrowers with notes would have remained the dominant factor in the price of money. But we have seen that the regulation arranged by the Bank Act has been set aside by the development of the use of cheques, and the dominant factor in the price of money is now the rate at which the other banks are prepared to provide borrowers with the right to draw cheques.
Hence it is that the Bank of England, which is expected to keep a gold reserve for the whole economic body, English and foreign, whence any one who has a cheque on England can help himself at a moment's notice, is only in exceptional circumstances able to regulate the supply of credit which is based on its reserve.
These exceptional circumstances arise (1) when trade is so active that the lending power of the other banks has reached its limit, and so any more credit required has to be provided by the Bank of England, at its price, and so Bank rate is effective ; (2) when the payment of the direct taxes in the January to March quarter sweeps millions into the Treasury's account at the Bank of England, which thus obtains control of the position ; (3) at the end of the quarters, when the demand for credit and currency generally exceeds the outside supply, and the Bank of England has to fill the gap on its own terms ; and (4.) when the Bank of England decides that the conditions of the international money market make regulation imperative, and so borrows money that it does not want in order to curtail the mass of credit created by the other banks, and force discount rates up to a point at which they will have the desired effect on the foreign exchanges.
In times of crisis or of strong external demand for gold it need not be said that the Bank of England holds control either because it has taken measures to get it, or because the demand for credit has reached the limit of the outside supply, or the exports of gold have narrowed the basis of the outside supply. The weak point in the system is that in ordinary times, and especially when the I price of money is declining, the Bank has no control of the position ; the credit factory of the other banks works away merrily and unregulated, probably rather too fast, and perhaps laying up trouble for the next spell of depression ; and in the meantime the Bank's task of increasing its reserve with a view to this next spell of depression is rendered difficult or impossible, because it has no voice in the value of money, which regulates the discount rate, which rules the exchanges.
An interesting example of the working of this weakness in our system was afforded in this summer of 1908. Every one who has followed the recent events of monetary history, knows that for some years the abnormal activity of trade and other influences had caused chronic monetary stringency, which culminated in the American crisis of 1907.
This eruption effectively checked the abnormal activity of trade, and monetary stringency gave place to abundance. The Bank of England, which had stood in the breach in defence of the economic world during the crisis, and by raising its rate had drawn in gold from seventeen different countries to supply America's needs, led the way in recognizing the change in the position, and reduced its rate rapidly from 7 to 2 1/2 per cent. during the spring of 1908, thus allowing other centres, whose reserves had been depleted during the crisis, to replenish them out of the gold which arrives regularly in London from South Africa and elsewhere. This was the obviously wise and sensible policy, but after it had been carried out it might have been thought that the next step was to set about securing that increase in the Bank's gold store which had long been urged as desirable, and was then rendered possible by the great change that had come over the money market's position.
Whether the Bank Court did or did not desire to do so, is known only to itself; it may have had information which led it to believe that monetary prospects promised continued ease, and that there was no need to regret the course of events. But the point to be noted is that even if the Bank had wished to increase its gold store, it would have been impossible for it to do so, unless it had intervened and borrowed a very large amount from the market; and this is a weapon of which it naturally only makes use when the outlook makes its employment imperative. Bank rate was still 2 per cent., but it was wholly ineffective and an empty symbol. The market rate was of course the rate at which the business was done, and its low level had the inevitable effect of sending a mass of bills to be discounted here, and of preventing foreign holders of English bills from renewing them as they fell due, much less increasing their purchases of them. And so England's imports of securities were stimulated to a point at which it had to send gold continually to the Continent, instead of using it to build up the reserve.
And this happened largely owing to the want of connection, in times of monetary ease, between the official rate and the market rate. The only connection that exists between them arises because the rate which bankers allow to depositors is more or less regulated by Bank rate, and is usually 11 per cent. below it. It might be supposed that this connection would suffice to establish some relation between the Bank rate and the market rate of discount, because it would be natural to infer that the bankers would expect to make some profit between their depositors and their borrowers ; if that were so it would follow that the rate at which they would lend to the bill-brokers could not fall much lower than 1 per cent. below Bank rate, and that the market discount rate would thus be kept more or less approximately in touch with the official rate.
But this expectation is not borne out in practice, because the large amounts of credit that the banks handle, besides those which are represented by sums definitely placed on deposit, make the deposit rate: a factor in part only of their business. The principle on which they seem to work is the theory that it is better to get some sort of rate than none, and each one considers that if it refuses to lend to the bill-brokers at the rates which are supposed to be current, its neighbours will only get all the more business ;and so in times of monetary ease, competition and rivalry deliver the bankers into the hands of the bill-brokers, who get money out of them on merely nominal terms, and then proceed to discount bills at rates which are unwholesome for the foreign exchanges, So, to return to our example, the system worked in July, 1908, when Bank rate was 2 1/2 per cent., the rate allowed by bankers to depositors was 1 per cent., the rate at which bankers were lending to bill-brokers was 1 per cent., the market rate of discount was 1 3/16 per cent., the foreign exchanges were adverse, and all the gold that came into London from the mines of Johannesburg, went on to Paris or Berlin. It went to Paris because the low level of discount rate here made it unprofitable for French banks to renew the English bills that they held, and so gold went to pay for them as they were presented, and it went to Berlin because the low level of discount rates here enabled Berlin to pour bills much of them mere finance paper into this market to be discounted, and gold went to pay for these imported securities.
We thus see in this example the direct chain of causation between the competition and rivalry among the banks, which incite them to lend money to bill-brokers at, or sometimes below, the rate at which they borrow it from depositors, and the consequent inability of the Bank of England to increase its reserve, because the operations of the other banks drive gold abroad. This result of their competition and rivalry, besides being injurious to the wider interests of the money market, is unprofitable to the banks. If we could for a moment imagine that they could lay aside their rivalries and make a mutual arrangement by which they agreed not to lend money to bill-brokers or anybody else at a lower rate than per cent. above that which they are giving to their depositors, it is probable that the amount that they would lend would be reduced; but, on the other hand, the rate that they would receive on the sums lent would be very materially increased.
The result would be that they would make less credit in times of ease, and in times of ease the superfluity of manufactured credit is a dangerous temptation to speculators and kite-flyers so much so that it has been observed by a seasoned and exceptionally well-placed watcher of the money market that "bad debts are made when money is cheap"; the banks' proportion of cash to liabilities would be higher, and their position would be stronger; their profits would be greater or no less, and the connecting link between Bank rate and the market rate would be established to an extent which would still permit of all desirable elasticity, but would provide a minimum beyond which the divorce between the two would probably not be stretched. For the market rate of discount, as has been shown, depends to a considerable extent on the current rate for loans from the banks to the bill-brokers.
Whether such an agreement is possible is another question. But the fact that a considerable number of the banks already work by mutual agreement in deciding on the rate at which they will lend money to their Stock Exchange clients is in favour of the possibility. And since the bankers already to some extent regulate the rate that they allow to depositors by Bank rate, such an arrangement as is here suggested would introduce no new principle and effect no revolution, but merely carry the application of an established principle a step further.
It would bring the Bank rate and the market rate into touch, yet quite distantly and elastically, and without establishing any cast-iron link between them. And it would enable Bank rate to work, not as now, with the assistance of artificial and expensive measures that have suddenly to be decided on and executed by the Bank of England, and upset calculations, and cause inconvenience and irritation, but by a continuous and normal relation between it and the lowest price at which credit is available in the market.
Under such circumstances the other banks might fairly claim to have a more definite influence on the movements in Bank rate ; and any process which would lead to closer co-operation between them and the Bank of England would be a gain.