Banks and the Creation of Credit.

We have seen how the Bank of England came to occupy so commanding a position in the money market, and we now have to consider why its rate of discount is still a fairly reliable index to the value of loanable capital. Its advent was extremely distasteful to the private bankers, who then reigned supreme in London, and who were not slow to recognise in the new corporation a formidable competitor, for a company which financed the Government was obviously to be feared. Before 1826 the Bank of England was the only joint stock bank in the country. Its notes gradually drove those of the London bankers out of circulation, and until its joint stock rivals firmly established themselves in the Metropolis, the Bank was in every sense the most powerful institution of its kind in the land.

Being by far the largest lender of capital in the country, it was only natural that its rate should accurately interpret those forces which make loanable capital dear or cheap, as the case may be. But the Bank could not arbitrarily fix the value of money for a very considerable period, even when it was able to issue notes without let or hindrance, any more than it can now. Supply and demand must settle that ultimately; and whenever the Bank inflated prices by the over-issue of paper, we have seen that the reaction produced thereby invariably threatened its existence. This is easily explained.

Persons borrow money in order that they may trade with it; and sudden loans of large amounts of capital in the shape of notes immediately stimulate the markets, and the increased demand engendered thereby causes the prices of commodities to rise. Rising prices, whether of securities or goods, give a marked impetus to speculation—so hopeful are traders directly markets begin to improve; and increased speculation causes further rises in the prices of both commodities and loanable capital. Everybody wants to borrow, and to share, in the coming period of great prosperity.

With prices rising here, imports naturally increase, as foreigners are anxious to sell their goods in the best market. On the other hand, the English markets have become less profitable to buyers, and, consequently, exports fall off, the result being that the balance of our indebtedness to other nations is largely increased. The foreign exchanges soon begin to move against England, and the Bank of England (we will assume) which had created the speculation by large issues of notes, suddenly finds that it is threatened with a foreign drain of gold, and is compelled to raise its rate in order to protect its reserve.

Since 1844 this power has, of course, been taken out of the hands of the Bank; but it is evident that, even before that date, the Bank of England could not fix the rate of discount, for whenever it made the attempt it failed signally. The above illustration fully explains the reason why. Both before and after the Act the Bank of England would have suspended payment upon more than one occasion, when it neglected to keep an adequate reserve, but for Government intervention; and it will be in the same plight again if it trade with too large a proportion of its resources.

The Bank was then by far the largest dealer in credit, and from time to time it stated the minimum rate at which it would lend or discount. But the private bankers were at liberty to underbid it; and although it could, by making sudden advances, cause money to fall in value, its power was not of a lasting character, and the rise which followed was quite beyond its control. Its rivals are now much more powerful, and the Bank is only one large dealer among many—therefore it has to either raise or lower its rate according to the demands made upon its resources; but from its position in the centre of the money market it still possesses a latent power for possible evil, which appears to have escaped the attention it deserves.

This brings us to the vexed question of the creation of credit by a bank, and though it is stoutly maintained that an ordinary banking company cannot create credit, I venture to think that, given certain conditions, it does. But perhaps, before proceeding further, it will be better to briefly discuss the Clearing House system.

Cheques and bills, we all know, pour up to London in a constant stream to the numerous banks, and are presented by them either to the firms upon whom they are drawn or to their agents at the Lombard Street Clearing House. As every bank which is a member of the Clearing House keeps an account with the Bank of England, the debit and credit balances (the result of this exchange) are adjusted in the books of the Bank at the end of each day, and so, though the balances standing to the credit of the various banks are diminished or increased, the total sum to the credit of all the clearing bankers remains unaltered. In other words, the balances, which are the outcome of the exchange of credit documents at the Clearing House, are finally arranged by transfer entries in the books of the Bank of England.

Every cheque presented in the House is debited to one bank and credited by another, therefore the totals of the debit and credit entries must agree; and if the totals are the same, then the debit and credit balances must agree also. In the smaller towns the banks exchange the local cheques between themselves, and settle the balances in cash or by payments through London. But Birmingham, Bristol, Leeds, Leicester, Liverpool, Manchester, and Newcastle-on-Tyne have Clearing Houses of their own at which local cheques and bills are presented.

We can now approach the question of the creation of credit by a bank. Suppose a bank suddenly increases its advances to its customers by £1,000,000, and that the customers pay away the whole sum by cheques. The said cheques are, say, paid by the recipients to the credit of their accounts with other banks, which present them at the London Clearing House. The balance of the bank which made the advance is thereby reduced £1,000,000 at the Bank, and the accounts of other banks are credited to the same extent; so the deposits at the Bank of England are not reduced one penny by the transfer. But £1,000,000 has been added to the working resources of the other banks; and as the liabilities of the bank that made the advance have not been reduced, surely this is a creation of credit? Of course, the bank which made the loan has lost £1,000,000 in "cash" at the Bank of England, and that asset would then be merged in "advances," which are up £1,000,000; and though the bank has not created credit in its own books, it has in those of its rivals. Surely, then, every bank which makes a new advance to a customer, who employs the sum placed to his credit to cancel certain debts of his own, creates credit in the books of other institutions. But the Bank of England can also create credit in its own.

On the other hand, say, Bank A calls in £1,000,000 from the bill brokers, who obtain credit to the extent of £1,000,000 from, say, Bank C, and draw cheques thereupon, and hand them to Bank A, which takes them to the Clearing House. C's balance at the Bank is reduced by £1,000,000, and A's is increased by a like sum; but in neither case is the "liabilities" side of the balance sheet affected. It is a mere transfer of credit from one account on the "assets" side to another on the same side, while the bankers' balances at the Bank of England remain the same. However, should Bank A advance £1,000,000 to a customer, who draws cheques against it, then the creation of credit in the books of other banks begins, as illustrated by our first example.

Again, take the case of a bank which sells securities, say Consols, to the amount of £1,000,000. It receives cheques upon other banks for a like sum; and these it takes to the Clearing House, where it presents them to those banks upon which they are drawn. The result is that the selling bank's balance at the Bank is up £1,000,000, and that the accounts of the other banks are down £1,000,000; but their liabilities also are down £1,000,000, whereas the liabilities of the selling bank are precisely the same. It has simply transferred £1,000,000 from Consols to "cash" at the Bank of England on the "assets" side of its balance sheet. Such a sale has reduced the floating capital of the banks by £1,000,000. Further, could not a little "window dressing" be done in this manner were a bank to find itself short of "cash" at the end of the half-year? By lending the sum so obtained the selling bank could create an amount of credit in the books of its rivals similar to that which it had previously destroyed. By buying stock back, too, it would produce exactly the same effect as if it made a loan.

Now we come to the creation of credit by the Bank of England in its own books. Were the Bank to suddenly lend £3,000,000, the "Other Deposits" would be up to that extent, and "Other Securities" would also be up to a like amount, because the Bank would credit its customers and debit the loans. Both sides of its return are increased, but, so far, credit has not been created by these mere book entries, though the way for its creation has been prepared. The customers or persons to whom the advances have been made begin to draw upon their accounts by cheques, and as these cheques are returned by the other bankers to the credit of their accounts (bankers' balances) it follows that "Other Deposits" are not reduced at the Bank. The Bank, then, has created £3,000,000 of credit in its books, and though it can no longer make sudden loans by a huge issue of notes as was possible prior to 1844, yet, because it holds the bankers' balances, we can see that it is able to produce precisely the same effect by means of another instrument.

If the Bank lends £3,000,000 to the Government, "Public Deposits" and "Government Securities" advance proportionately. When the Government begins to pay out, then a large part of this sum returns to "Bankers' Balances," and credit is created at the Bank of England to the extent of the sum so returned. But the banks (Lombard Street) have more to lend; therefore money is made artificially cheap.

On the other hand, the Government sometimes borrows in the open market on Treasury bills. Credit is then transferred at the Bank through the medium of the Clearing House from "Bankers' Balances" to "Public Deposits." The resources of Lombard Street are reduced, and until Government disbursements are made, and credit thereby transferred to Lombard Street, money becomes tight, and borrowers are often driven to the Bank.

We have seen that in the end an over-issue of notes is certain to reduce the Bank's reserve to a dangerously low level, and that, therefore, directors who know their business would hesitate to make so risky an experiment. The same argument is equally applicable to the creation of credit by sudden large loans on the part of the Bank in its own books. Such loans, we have seen, increase both sides of the return; but the Bank's reserve of notes and coin in the Banking Department remains at the same figures, consequently, its ratio per cent. to liabilities shows an ominous decline, which is, of itself, a warning that something is wrong.

Let us assume that the Bank suddenly lends £5,000,000. Money is thereby made artificially cheap, and the market rate for bills must fall in consequence. But the bankers' balances have been increased in the books of the Bank of England, and Lombard Street is not going to quietly look on while Threadneedle Street does all the business. Consequently, the bankers lend a portion of their balances at lower rates still, in order to attract business to themselves, and the market rate falls again. Here we have a situation analogous to that described in the earlier part of this chapter.

Now suppose this movement took place in October, and that a drain of gold occurred outwards. The Bank, in order to arrest the said drain, would have to raise its rate, and to bring the market rate in touch with its own it would be compelled to sell Consols, thereby reducing the bankers' balances in its books, and, of course, lessening the power of the banks to lend. But such a process is an expensive one, for the Bank is in reality borrowing back at panic prices the capital it created during a time of temporary ease.

Although the Bank undoubtedly possesses this power, the directors are not likely to abuse it, because the risk incurred is out of all proportion to the possible gain if the deal is carried through successfully; so we may say that their power to create credit in their books is limited or regulated by the ratio per cent. of the Bank's reserve to its liabilities.

Of course, it may be asked: Is it safe to entrust such power to a board of directors who have to earn dividends for a body of stockholders?

That is a difficult question to answer, and one, moreover, to which there is no occasion to reply in this work. It may safely be said that no director who understands his business would take the risk upon any consideration; but there is the remote chance that an incompetent Governor might be placed at the helm, and in that event, however improbable, should he lose sight of everything but the dividends, he might create a terrible panic throughout the land. On the other hand, all who see the Bank return from week to week may read the signs, and should the ratio fall abnormally low the critics would flagellate the Governor unmercifully, and the business man, who is unaccustomed to the pleasantries of criticism, unless he be a most hardened member of his species, squirms under such a lash, fearful that his friends may read just what the Press thinks of him; so he takes heed.

Though the Bank's rate is not always the same as the market rate, it is seldom very much out of touch therewith. When the directors find that their rate of discount is too high to attract custom, then, if the reserve be also high, they lower their minimum in order to get a fair share of the business that is doing. Their other alternative, of course, is to borrow on stock, and in that manner to compel the bill brokers to pay them a reluctant visit.

The policy of the Bank has never been one of "grab," though the bill brokers often grumble; but its position, in relation to the market, is an extremely difficult one, so difficult at times as to be fraught with great anxiety; and remembering the power that devolves upon it by reason of its holding the bankers' balances, its policy seems one of enviable restraint and moderation. But that is only what everybody expects of the Bank of England.