11: The Bill Brokers
In any financial services market, there will emerge a "class of persons" who invest considerable time in becoming well acquainted with specific kinds of securities, devoting greater time and attention to them than others. By giving close scrutiny they have given to those enterprises that wish to borrow money, the bill brokers identify creditworthy borrowers whose debts can be securitized In effect, these are themselves investors: they loan large sums of money to commercial enterprises, borrowing from bankers, and generally provide the banker with a guarantee of repayment based on their own ability to profit from their investments.
The bill broker is such an investor, specializing in mercantile bills, which are "an exceedingly difficult kind of security to understand." On the level of a single transaction, commercial credit is a fairly simple matter - a manufacturer borrows money to purchase materials and repays it after he has made and sold his wares, or a retailer borrows money to purchase inventory and repays it after his own customers purchase his goods. On the level of a market, however, here is such an immense number of such transactions among a complex web of buyers and sellers of goods that a great deal of knowledge is required to identify bills that are worth backing.
The author goes into quite some detail about the complexity of assessing the value of a bill. The knowledge to do so requires a high level of involvement in commerce. There is no body of theory that can easily be learned and applied to all circumstances, and the landscape is constantly changing. Essentially, knowing the value of any bill entails assessing the ability of the borrower to repay, which considers both the character of the borrower and the nature of the industry in which his business operates.
Bill brokers perform exactly this function - they are immersed in a given industry, know the business and the individuals involved in it, and can make such assessments. These brokers borrow money from banks to purchase bills, making their profit on the difference between the loan interest they pay and the discount on the bills they purchase, and guarantee the repayment of their bank loans, thereby assuming the risk that the bills may not be paid on time or at all.
A number of loose facts are communicated about the business of bill-broking, by way of excerpts from the examination of bill brokers (EN: by the tone, it seems that the inquisitor is implying the bill broker is exploitive and creates no value, and the respondent is refuting these points):
- The bill broker provides immediate capital to a firm in exchange for purchasing the right to collect bills - in effect, enabling a business to spend today money that it was due to collect in future
- The profit of the bill broker comes from discounting the bills - that is, buying them at less than their face value. The business that needs cash is willing to accept less than he is owed to have the funds immediately.
- Bill brokers facilitate the flow of capital: they may broker bills from any industry or location to banks and investors in any other location. This enables cash to go where it is needed, and those who have cash to obtain a return on it regardless of the location of the borrowers.
- Bill broking is a business built on reputation and trust. In instances where a business feels the broker's discount is unfair, they are not compelled to do business with him; and in instances in which the broker does not trust the business to make repayment, he refuses their future business. It is only because the arrangement is acceptable to both parties that the business of bill broking perpetuates.
The author notes that this inquisition had taken place sixty years prior to the writing of this book, but the business of bill brokers remains exactly the same. If anything, it has greatly expanded, as manufacturing and mercantile businesses are generally in greater need of credit than agricultural ones.
The business of bill brokering also expedites the business of banking: the banker can extend credit to a broker whose own creditworthiness gives the banker confidence in repayment. While he is aware the broker's ability to repay is based on his ability to collect the bills he is owed, the lender assumes that the broker exercises his own judgment of those who owe him and stakes his own reputation upon it. In that way, the banker need not assess the creditworthiness of hundreds of unknown parties who wish to discount their bills, but on a smaller number of brokers who serve as middlemen to such transactions.
However, the modern practice of bill broking introduces more complex considerations. Since the broker borrows the money he uses to purchase bills, rather than purchasing them from his own funds, he pays interest while the bill remains outstanding. Not only must he consider his own expense in determining the discount he will offer, but he must also make productive use of borrowed money. As such, he cannot afford to keep vast reserves of "barren cash" to make payment on bills that are not repaid, but must keep his capital employed to avoid the erosion of his own capital by bank interest.
The short-term nature of his business also aggravates his condition. Because commercial credit is extended for brief periods of time (less than a year, and sometimes less than a month), he must repay his own debts in just as timely a manner. Where any debtor is late in repayment, the broker is also late in repaying his own creditors - and as such, any instance of crisis in the financial system, even a mild crisis that will not impact many parties, is first visited upon the bill brokers, as businesses will be late in paying their bills when they are uncertain of their own financial stability.
In any "natural state of banking," in which banks kept their own reserve, the demand of the bill-brokers for cash, or their inability to repay their own debts in a timely manner, would be the principal strain on the bank's reserve. But where banks reserves are held by other banks, they are next in line after the brokers - if a panic destroyed the brokers' ability to discount bills, it would then also destroy the bankers' ability to generate interest from loans to the brokers.
The inability of brokers to receive money for their bills thus depletes the reserves of the bank to provide cash to depositors who demand it, which him turn makes their depositors unable to pay their bills, which then cycles back to the bill brokers' ability to receive money for their bills, in a circular reaction that compounds itself with each iteration.
The same sort of cycle also arises when banks feel the need to increase their reserves: they decrease the amount they loan to bill-brokers, which decreases the amount of cash that the brokers can offer to commercial enterprises, which decreases their ability to profit by their own operations, which decreases the income to shareholder and employee, which causes an increased demand for deposits to be withdrawn to cover living expenses - ultimately, spinning down the market at large.
At the same time, the bill broker depends on some scarcity of money for his own profit. Where money is plentiful, demand of money is low, and there is less need for commercial enterprises to seek to obtain credit by discounting bills, or ample sources competing to profit by purchasing bills that the rate a broker can demand is scarcely more than he must pay to obtain funds.
Also, bill-brokers place something of a strain on the cash reserve of banks: just as with any other form of credit, money lent to the brokers is not available for depositors to withdraw. As such the bank can only provide to bill brokers short-term loans of capital to the degree to which the bank itself is able to conservatively predict its own needs for cash. And in a system that relies upon a central bank for a single reserve of cash, the demand of bill brokers for funds from all banks ultimately aggregate in the demand of money from this single reserve.
This is the cause of some concern at the central bank, but their attempts to curtail the amount of funds made available to bill-brokers turned out to be self-defeating. Specifically, to protect its own reserves, the BE established a rule by which it would only release its own reserves to banks that funded bill-brokers at certain times of year, when cash reserves are traditionally high. The result of this, naturally, was that smaller banks withheld funds from the BE at other times of year so they could continue to profit from their business with bill brokers. In the end, the policy completely failed to achieve its intended goals: it exacerbated the depletion of the central bank/s reserve and diminished its profits from lending activities.
For practical purposes, the author considers this "anomaly" to be inevitable: the demand for money is not generated or even influenced to any significant degree by the bill brokers themselves, but by their clientele whose need of money leads them to seek to discount their receivables for ready cash. If their need is sufficient enough, they will be resourceful in finding a way to obtain it, and pay any cost that is economically feasible. Unless the banks are willing to get directly involved in the risky business of short-term mercantile credit, which has historically been too treacherous a venue for them to venture into, they must surrender this business to the bill brokers to respond to the demand.