Books: Lombard Street: A Description of the Money Market

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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 m 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.

The peculiarity, indeed, of the effects of the one reserve is indeed
even greater in this respect. Under the natural system, the
billbrokers would be in no respect the rivals of the bankers which
kept the ultimate reserve. They would be rather the agents for these
bankers in lending upon certain securities which they did not
themselves like, or on which they did not feel competent to lend
safely. The bankers who in time of panic had to help them would in
ordinary times derive much advantage from them. But under our
present system all this is reversed. The Bank of England never
deposits any money with the bill-brokers; in ordinary times it never
derives any advantage from them. On the other hand, as the Bank
carries on itself a large discount business, as it considers that it
is itself competent to lend on all kinds of bills, the bill-brokers
are its most formidable rivals. As they constantly give high rates
for money it is necessary that they should undersell the Bank, and
in ordinary times they do undersell it. But as the Bank of England
alone keeps the final banking reserve, the bill-brokers of necessity
have to resort to that final reserve; so that at every panic, and by
the essential constitution of the money market, the Bank of England
has to help, has to maintain in existence, the dealers, who never in
return help the Bank at any time, but who are in ordinary times its
closest competitors and its keenest rivals.

It might be expected that such a state of things would cause much
discontent at the Bank of England, and in matter of fact there has
been much discussion about it, and much objection taken to it. After
the panic of 1857, this was so especially. During that panic, the
Bank of England advanced to the bill-brokers more than 9,000,000 L.,
though their advances to bankers, whether London or country, were
only 8,000,000 L.; and, not unnaturally, the Bank thought it
unreasonable that so large an inroad upon their resources should be
made by their rivals. In consequence, in 1858 they made a rule that
they would only advance to the bill-brokers at certain seasons of
the year, when the public money is particularly large at the bank,
and that at other times any application for an advance should be
considered excep tonal, and dealt with accordingly. And the object
of that regulation was officially stated to be 'to make them keep
their own reserve, and not to be dependent on the Bank of England.'
As might be supposed, this rule was exceedingly unpopular with the
brokers, and the greatest of them, Overend, Gurney and Co., resolved
on a strange policy in the hope of abolishing it. They thought they
could frighten the Bank of England, and could show that if they were
dependent on it, it was also dependent on them. They accordingly
accumulated a large deposit at the Bank to the amount of
3,000,000 L., and then withdrew it all at once. But this policy had
no effect, except that of exciting a distrust of 'Overends': the
credit of the Bank of England was not diminished; Overends had to
return the money in a few days, and had the dissatisfaction of
feeling that they had in vain attempted to assail the solid basis of
everyone's credit, and that everyone disliked them for doing so. But
though this un-conceived attempt failed as it deserved, the rule
itself could not be maintained. The Bank does, in fact, at every
period of pressure, advance to the bin-brokers; the case may be
considered 'exceptional,' but the advance is always made if the
security offered is really good. However much the Bank may dislike
to aid their rivals, yet they must aid them; at a crisis they feel
that they would only be aggravating incipient demand, and be
augmenting the probable pressure on themselves if they refused to do
so.

I shall be asked if this anomaly is inevitable, and I am afraid that
for practical purposes we must consider it to be so. It may be
lessened; the bill-brokers may, and should, discourage as much as
they can the deposit of money with them on demand, and encourage the
deposit of it at distant fixed dates or long notice. This will
diminish the anomaly, but it will not cure it. Practically,
bin-brokers cannot refuse to receive money at call. In every market
a dealer must conduct his business according to the custom of the
market, or he will not be able to conduct it at all. All the
bin-brokers can do is to offer better rates for more permanent
money, and this (though possibly not so much as might be wished)
they do at present. In its essence, this anomaly is, I believe, an
inevitable part of the system of banking which history has given us,
and which we have only to make the best of, since we cannot alter
it.

CHAPTER XII.

The Principles Which Should Regulate the Amount of the Banking
Reserve to Be Kept by the Bank of England.

There is a very common notion that the amount of the reserve which
the Bank of England ought to keep can be determined at once from the
face of their weekly balance sheet. It is imagined that you have
only to take the liabilities of the Banking department, and that a
third or some other fixed proportion will in all cases be the amount
of reserve which the Bank should keep against those liabilities. But
to this there are several objections, some arising from the general
nature of the banking trade, and others from the special position of
the Bank of England.

That the amount of the liabilities of a bank is a principal element
in determining the proper amount of its reserve is plainly true; but
that it is the only element by which that amount is determined is
plainly false. The intrinsic nature of these liabilities must be
considered, as well as their numerical quantity. For example, no one
would say that the same amount of reserve ought to be kept against
acceptances which cannot be paid except at a certain day, and
against deposits at call, which may be demanded at any moment. If a
bank groups these liabilities together in the balance-sheet, you
cannot tell the amount of reserve it ought to keep. The necessary
information is not given you.

Nor can you certainly determine the amount of reserve necessary to
be kept against deposits unless you know something as to the nature
of these deposits. If out of 3,000,000 L. of money, one depositor
has 1,000,000 L. to his credit, and may draw it out when he pleases,
a much larger reserve will be necessary against that liability of
1,000,000 L. than against the remaining 2,000,000 L. The intensity of
the liability, so to say, is much greater; and therefore the
provision in store must be much greater also. On the other hand,
supposing that this single depositor is one of calculable
habitssuppose that it is a public body, the time of whose demands is
known, and the time of whose receipts is known alsothis single
liability requires a less reserve than that of an equal amount of
ordinary liabilities. The danger that it win be called for is much
less; and therefore the security taken against it may be much less
too. Unless the quality of the liabilities is considered as well as
their quantity, the due provision for their payment cannot be
determined.

These are general truths as to all banks, and they have a very
particular application to the Bank of England. The first application
is favourable to the Bank; for it shows the danger of one of the
principal liabilities to be much smaller than it seems. The largest
account at the Bank of England is that of the English Government;
and probably there has never been any account of which it was so
easy in time of peace to calculate the course. All the material
facts relative to the English revenue, and the English expenditure,
are exceedingly well known; and the amount of the coming payments to
and from this account are always, except in war times, to be
calculated with wonderful accuracy. In war, no doubt, this is all
reversed; the account of a government at war is probably the most
uncertain of all accounts, especially of a government of a scattered
empire, like the English, whose places of outlay in time of war are
so many and so distant, and the amount of whose payments is
therefore so incalculable. Ordinarily, however, there is no account
of which the course can be so easily predicted; and therefore no
account which needs in ordinary times so little reserve. The
principal payments, when they are made, are also of the most
satisfactory kind to a banker; they are, to a great extent, made to
another account at his bank. These largest ordinary payments of the
Government are the dividends on the debt, and these are mostly made
to bankers who act as agents for the creditors of the nation. The
payment of the dividends for the Government is, therefore, in great
part a transfer from the account of the Government to the accounts
of the various bankers. A certain amount no doubt goes almost at
once to the non-banking classes; to those who keep coin and notes in
house, and have no account at any bank. But even this amount is
calculable, for it is always nearly the same. And the entire
operation is, to those who can watch it, singularly invariable time
after time.

But it is important to observe, that the published accounts of the
Bank give no such information to the public as win enable them to
make their own calculations. The account of which we have been
speaking is the yearly account of the English Governmentwhat we may
call the Budget account, that of revenue and expenditure. And the
laws of this are, as we have shown, already known. But under the
head 'Public Deposits' in the accounts of the Bank, are contained
also other accounts, and particularly that of the Secretary for
India in Council, the laws of which must be different and are quite
unknown. The Secretary for India is a large lender on its account.
If any one proposed to give such power to the Chancellor of the
Exchequer, there would be great fear and outcry. But so much depends
on habit and tradition, that the India Office on one side of Downing
Street can do without remark, and with universal assent, what it
would be thought 'unsound' and extravagant to propose that the other
side should do. The present India Office inherits this independence
from the old Board of the Company, which, being mercantile and
business-like, used to lend its own money on the Stock Exchange as
it pleased; the Council of India, its successor, retains the power.
Nothing can be better than that it should be allowed to do as it
likes; but the mixing up the account of a body which has such a
power, and which draws money from India, with that of the Home
government clearly prevents the general public from being able to
draw inferences as to the course of the combined account from its
knowledge of home finance only. The account of 'public deposits' in
the Bank return includes other accounts too, as the Savings' Bank
balance, the Chancery Funds account, and others; and in consequence,
till lately the public had but little knowledge of the real changes
of the account of our Government, properly so called. But Mr. Lowe
has lately given us a weekly account, and from this, and not from
the Bank account, we are able to form a judgment. This account and
the return of the Bank of England, it is true, unhappily appear on
different days; but except for that accident our knowledge would be
perfect; and as it is, for almost all purposes what we know is
reasonably sufficient. We can now calculate the course of the
Government account nearly as well as it is possible to calculate it.

So far, as we have said, an analysis of the return of the Bank of
England is very favourable to the Bank. So great a reserve need not
usually be kept against the Government account as if it were a
common account. We know the laws of its changes peculiarly well: we
can tell when its principal changes will happen with great accuracy;
and we know that at such changes most of what is paid away by the
Government is only paid to other depositors at the Bank, and that it
win really stay at the Bank, though under another name. If we look
to the private deposits of the Bank of England, at first sight we
may think that the result is the same. By far the most important of
these are the 'Bankers' deposits'; and, for the most part, these
deposits as a whole are likely to vary very little. Each banker, we
will suppose, keeps as little as he can, but in all domestic
transactions payment from one is really payment to the other. All
the most important transactions in the country are settled by
cheques; these cheques are paid in to the 'clearing-house,' and the
balances resulting from them are settled by transfers from the
account of one banker to another at the Bank of England. Payments
out of the bankers' balances, therefore, correspond with payments
in. As a whole, the deposit of the bankers' balances at the Bank of
England would at first sight seem to be a deposit singularly stable.

Indeed, they would seem, so to say, to be better than stable. They
augment when everything else tends to diminish. At a panic, when all
other deposits are likely to be taken away, the bankers' deposits,
augment; in fact they did so in 1866, though we do not know the
particulars; and it is natural that they should so increase. At such
moments all bankers are extremely anxious, and they try to
strengthen themselves by every means in their power; they try to
have as much money as it is possible at command; they augment their
reserve as much as they can, and they place that reserve at the Bank
of England. A deposit which is not likely to vary in ordinary times,
and which is likely to augment in times of danger, seems, in some
sort, the model of a deposit. It might seem not only that a large
proportion of it might be lent, but that the whole of it might be
so. But a further analysis will, as I believe, show that this
conclusion is entirely false; that the bankers' deposits are a
singularly treacherous form of liability; that the utmost caution
ought to be used in dealing with them; that, as a rule, a less
proportion of them ought to be lent than of ordinary deposits.

The easiest mode of explaining anything is, usually, to exemplify it
by a single actual case. And in this subject, fortunately, there is
a most conspicuous case near at hand. The German Government has
lately taken large sums in bullion from this country, in part from
the Bank of England, and in part not, according as it chose. It was
in the main well advised, and considerate in its action; and did not
take nearly as much from the Bank as it might, or as would have been
dangerous. Still it took large sums from the Bank; and it might
easily have taken more. How then did the German Government obtain
this vast power over the Bank? The answer is, that it obtained it by
means of the bankers' balances, and that it did so in two ways.

First, the German Government had a large balance of its own lying at
a particular Joint Stock Bank. That bank lent this balance at its
own discretion, to bill-brokers or others, and it formed a single
item in the general funds of the London market. There was nothing
special about it, except that it belonged to a foreign government,
and that its owner was always likely to call it in, and sometimes
did so. As long as it stayed unlent in the London Joint Stock Bank,
it increased the balances of that bank at the Bank of England; but
so soon as it was lent, say, to a bill-broker, it increased the
bill-broker's balance; and as soon as it was employed by the
bill-broker in the discount of bills, the owners of those bills paid
it to their credit at their separate banks, and it augmented the
balances of those bankers at the Bank of England. Of course if it
were employed in the discount of bills belonging to foreigners, the
money might be taken abroad, and by similar operations it might also
be transferred to the English provinces or to Scotland. But, as a
rule, such money when deposited in London, for a considerable time
remains in London; and so long as it does so, it swells the
aggregate balances of the body of bankers at the Bank of England. It
is now in the balance of one bank, now of another, but it is always
dispersed about those balances somewhere. The evident consequence is
that this part of the bankers' balances is at the mercy of the
German Government when it chooses to apply for it. Supposing, then,
the sum to be three or four millions and I believe that on more than
one occasion in the last year or two it has been quite as much, if
not more--that sum might at once be withdrawn from the Bank of
England. In this case the Bank of England is in the position of a
banker who is liable for a large amount to a single customer, but
with this addition, that it is liable for an unknown amount. The
German Government, as is well known, keeps its account (and a very
valuable one it must be) at the London Joint Stock Bank; but the
Bank of England has no access to the account of the German
Government at that bank; they cannot tell how much German money is
lying to the credit there. Nor can the Bank of England infer much
from the balance of the London Joint Stock Bank in their Bank, for
the German money was probably paid in various sums to that bank, and
lent out again in other various sums. It might to some extent
augment that bank's balance at the Bank of England, or it might not,
but it certainly would not be so much added to that balance; and
inspection of that bank's balance would not enable the Bank of
England to determine even in the vaguest manner what the entire sum
was for which it might be asked at any moment. Nor would the
inspection of the bankers' balances as a whole lead to any certain
and sure conclusions. Something might be inferred from them, but not
anything certain. Those balances are no doubt in a state of constant
fluctuation; and very possibly during the time that the German money
was coming in some other might be going out. Any sudden increase in
the bankers' balances would be a probable indication of new foreign
money, but new foreign money might come in without causing an
increase, since some other and contemporaneous cause might effect a
counteracting decrease.

This is the first, and the plainest way in which the German
Government could take, and did take, money from this country; and in
which it might have broken the Bank of England if it had liked. The
German Government had money here and took it away, which is very
easy to understand. But the Government also possessed a far greater
power, of a somewhat more complex kind. It was the owner of many
debts from England. A large part of the 'indemnity' was paid by
France to Germany in bills on England, and the German Government, as
those bills became due, acquired an unprecedented command over the
market. As each bill arrived at maturity, the German Government
could, if it chose, take the proceeds abroad; and it could do so in
bullion, as for coinage purposes it wanted bullion. This would at
first naturally cause a reduction in the bankers' balances; at least
that would be its tendency. Supposing the German Government to hold
bill A, a good bill, the banker at whose bank bill A was payable
would have to pay it; and that would reduce his balance; and as the
sum so paid would go to Germany, it would not appear to the credit
of any other banker: the aggregate of the bankers' balances would
thus be reduced. But this reduction would not be permanent. A banker
who has to pay 100,000 L. cannot afford to reduce his balance at the
Bank of England 100,000 L.; suppose that his liabilities are
2,000,000 L., and that as a rule he finds it necessary to keep at
the Bank one-tenth of these liabilities, or 200,000 L., the payment
of 100,000 L. would reduce his reserve to 100,000 L.; but his
liabilities would be still 1,900,000 L. and therefore to keep up his
tenth he would have 90,000 L. to find. His process for finding it is
this: he calls in, say, a loan to the bill-brokers; and if no equal
additional money is contemporaneously carried to these brokers
(which in the case of a large withdrawal of foreign money is not
probable), they must reduce their business and discount less. But
the effect of this is to throw additional business on the Bank of
England. They hold the ultimate reserve of the country, and they
must discount out of it if no one else will: if they declined to do
so there would be panic and collapse. As soon, therefore, as the
withdrawal of the German money reduces the bankers' balances, there
is a new demand on the Bank for fresh discounts to make up those
balances. The drain on the Bank is twofold: first, the banking
reserve is reduced by exportation of the German money, which reduces
the means of the Bank of England; and then out of those reduced
means the Bank of England has to make greater advances.

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