The Discount Houses in London

There are certain features inherent in the business of present day discount houses that have characterised their operations throughout their history. In the first place, although some of them operate as brokers through subsidiaries, acting to bring together buyers and sellers, discount houses carry on their main business as principals, by the purchase and sale of financial claims on account of their own portfolios, deriving a profit from the difference between the price at which they buy and the price at which they sell. Secondly, to finance their portfolios, which will contain a variety of short and longer-term assets — for example, certificates of deposit, bills and bonds — discount houses borrow funds at very short term from a wide range of banks, non-bank financial intermediaries and other institutions. All but a very small fraction of funds are borrowed on a secured basis which means, in effect, that the institutions which have provided the funds hold as collateral the assets in which the houses have invested the borrowed money. For the lenders the discount houses provide a very important adjustment mechanism through which banks and other institutions can regulate their liquidity position on a daily basis.

In the second half of the nineteenth century the financial sector of the British economy became subject to forces of change which were to alter it almost beyond recognition. The growth of international trade, in which Britain took full part, meant that banking and other financial institutions had to become responsive to and be involved in the conduct and finance of foreign trade and in the international movement of capital.

The four years of war from 1914 to 1918 provided a further important phase of development for the discount houses, because of the very marked and lasting effect that the circumstances of war had on their business and therefore on the functions they performed. International trade and finance, which had come to dominate the life of the market by 1913, were so disrupted and reduced in volume during the period of hostilities that they ceased to provide a sufficient livelihood for bill dealers and brokers. Through pure necessity the houses substituted on an increasing scale in their portfolios the public sector debt that was an indispensable product of war finance.

For the discount houses the approach of the Second World War appeared to offer no comfort at all. The only distinctive contribution that the houses could offer to justify their existence in the later 1930s was their provision of the call-loan market, based upon bill dealing. Because bill business yielded no profit the houses subsidised it through their bond dealing, which itself was hardly tolerated by the authorities. The ‘rescue’ operation of 1934–5 had been mounted in the hope that because the existence of a separate call-money market suited both the Bank of England and the clearing banks, it might again, one day, become a profitable activity for the houses as the business in commercial bills revived or as the return on Treasury bills was increased by the ending of the cheap money policy. Now the houses faced the possibility that a major war would not only dash all hopes of a revival of commercial paper but would demand finance on such a scale that the authorities would be forced to modify the financial process — to the possible exclusion of the discount market.

Because of the very nature of their operations and of the peculiar position they have occupied at the centre of the British monetary system, the way in which the discount houses have at any time been able to conduct their business has been profoundly and immediately influenced by the goals of official monetary policy and the techniques employed to achieve them. This would be sufficient reason for an examination of the theoretical framework of official action in the monetary field between 1951 and 1970 but, in addition, interesting questions arise in connection with the part played by the houses in the process of monetary control itself. In the present chapter there is a general assessment of the aims and theoretical bases of British monetary policy during the period with indications of the discount houses’ strategic role. In Chapters 7–11 this role is analysed in the context of the houses’ operations in individual markets. Chapter 12 presents a close analysis of the discount houses’ role in the mechanisms whereby the Bank might have sought to regulate the level of bank deposits, via leverage on reserve ratios.

Individual chapters below are devoted to the sources of discount houses’ borrowed funds and to their major assets, both traditional and new. The business of the present chapter is to outline concisely the principles which governed discount house operations and to provide a framework into which the detailed analysis of the later chapters can be fitted. The framework utilised is the houses’ daily routine of buying and selling bills, bonds and certificates of deposit and of borrowing and repaying the funds necessary to finance them, culminating in the all-important ‘daily balance’ or squaring of books at 3 p.m.

During the course of each day, discount houses borrowed money under a variety of heads, the various categories of loans being distinguished as to: the source from which the funds came; the term for which the funds were taken; the rate that was paid on the funds relative to other rates in the structure. Within this rough framework of analysis the present chapter examines the factors which shaped the houses’ daily money position and the operations by means of which the daily balance was achieved. Indication is given of the main changes that took place in the relative importance of various lenders to the discount houses, the varieties of loans taken by the houses and the interest rate structures they encountered.

In 1951 the ‘bills’ in a discount house’s portfolio meant, overwhelmingly, British government Treasury bills, which accounted for over 60 per cent of total assets (see Table 4). The item ‘other sterling bills’, which was mainly made up of commercial bills drawn on banks and firms resident in the United Kingdom and on the London offices of overseas banks — but which also included Treasury bills of the Northern Ireland government and bills issued by local authorities — accounted for only one tenth of that figure, i.e. a mere 6 per cent of total assets. By 1969, however, the proportion of British government Treasury bills had fallen by two-thirds, to 22 per cent, while ‘other sterling bills’ had increased nearly sixfold, to 34.6 per cent. By the latter date, of course, there had been other important changes in the composition of discount house portfolios, but for the moment attention is concentrated on the nature and significance of discount house operations in the Treasury bill market and, in the next chapter, on the phenomenon of the gradual reinstatement of the commercial bill as an important means of finance and medium for discount house investment.

The item ‘other sterling bills’ in Table 4 is composed mainly of commercial bills drawn on banks and firms resident in the United Kingdom and on the London offices of overseas banks and having a maximum maturity not ordinarily longer than six months. Also included are the Treasury bills of the Northern Ireland government and bills issued by local authorities, but the preponderance of commercial paper is sufficient to allow use of the figures as an indicator of changes in the discount houses’ holdings of their traditional asset.

By 1951 discount houses had been carrying on business in short-dated government stocks for more than thirty years. Table 4 shows that in that year houses’ holdings of British Government Stocks (end-year figures) stood at £314m (30·5 per cent of total portfolio). In 1952 they fell to £291m (27·3 per cent) but rose steeply in 1953 to stand at £383m (35·3 per cent). Holdings then fell during the following four years to the low figure of £223m (23·3 per cent) but thereafter grew year by year to stand at £488m (39·0 per cent) in 1962. After dipping slightly over the next two years, holdings rose to £500m (34·4 per cent) in 1965 and then climbed to their highest level since 1951, at £544m (31·1 per cent). Holdings fell sharply in 1968, recovered well in 1969 to £364m (20·0 per cent), and then dropped very sharply to stand at £160m (6·8 per cent), their lowest since 1951. In 1971 holdings recovered strongly to reach £391m (12·8 per cent).

What could be said to constitute the ‘traditional’ business of the discount houses would depend to a large extent upon the particular stage of the houses’ development at which the enquiry was directed. The bill brokers and later the discount houses first came into being in order to perform the ‘equalising function’ of the transfer of credit between areas of surplus and deficit funds. At the end of the nineteenth century it was the international ‘bill on London’ which had come to characterise the business of the discount houses. After the First World War the ‘traditional’ commercial bill business declined in favour of large-scale dealings in Treasury bills and later in short-term bonds. By the end of the 1950s Treasury bills and short-term bonds had become the staple diet with commercial bills making up only 10 per cent of the whole portfolio. On the eve of the Competition and Credit Control reforms in 1971, although British government Treasury bills were again the biggest single item, such changes had taken place in the composition of the assets portfolio that the Treasury bills, bonds and commercial bills of the 1950s could well be looked back upon as the ‘traditional’ business.

Ever since the London bill dealers were granted discount accounts at the Bank of England, in the aftermath of the crisis of 1825, the discount houses have occupied a peculiar and key position in the mechanism through which the Bank might seek to control the private-sector banking system.¹ In the present chapter this role of the discount houses is examined in the context of the controversy, which was ‘important for the development of British monetary economics’² for a period of a decade and a half from the mid-1950s, over the question of central bank control of the level of bank deposits.³ It has already been shown (see Chapter 7, above) that the reserve ratios originally adopted voluntarily by bankers, as a matter of professional prudence, were later imposed by the monetary authorities as possible means of regulating bankers’ operations in order that they might help to implement, or at least that they might not frustrate, official policy.

In 1971 the authorities brought about reforms in the British banking system and techniques of monetary control which were of a magnitude and importance unparalleled in all the years since 1945. The substance of the reforms was set out in a series of official documents, statements and speeches and the reforms themselves and the changed conditions they initiated can be referred to collectively as Competition and Credit Control, after the title of the consultative document in which the Bank first published its proposals.¹

The rules of Competition and Credit Control which were applied to the discount houses in 1971 remained in operation unchanged until July 1973, at which time they were radically revised. It was in the authorities’ attempts to work the new policy in the solution of economic problems during this two-year period, that the discount houses and others were to find answers to some of their most disturbing questions.

The authorities operated Competition and Credit Control unchanged for barely two years before the introduction, in 1973–4, of significant modifications to the mechanism of control. For the discount houses the changes involved abandonment of their 50 per cent public-sector ratio, while for the banks a supplementary credit-control scheme was devised whereby pressure would be exerted on the liabilities, rather than the assets, side of their balance sheets.