XX. Role-play

Three different groups of inexperienced young business people in a small town require capital for their businesses. They all apply to the local branch of Megabank.

The three groups of would-be borrowers must develop financial arguments that they think will convince the bankers. The group preparing the role of the bankers has to think of questions about the viability of the future businesses: will they be successful, and why? Or why might they not be successful?

The roles are:

1. A junior manager (and assistants) at the bank, responsible for new local small businesses. To lend or not to lend, that is the question.

2. A group of young people who want to open a small specialist shop selling CDs of black music — jazz, soul, funk, reggae, rap, house, and any new trends.

3. A group of young people who want to buy an existing take-away pizza business (the lease on the premises, the kitchens, the delivery scooters, and so on). The business is profitable, and well-known in the town, with loyal customers. The new owners can keep the same telephone number, and either keep or change the name.

4. A group of students who already operate a part-time computing consultancy service, advising small businesses on what hardware and software to buy, and how to set up an Internet home page. They want to borrow money to buy more computers for themselves, on which to try out elaborate new software programs.

Text b The discount houses

Discount houses are a very special group of banks. They comprise seven institutions which are unique to the UK financial system, and they fulfill three significant functions.

• Their activities are crucial to the Bank of England's monetary policy op­erations.

• They have an important function in permitting the retail banks, in par­ticular, to adjust their liquidity positions and to smooth flows of funds between banks as a consequence of their payments-clearing operations.

• They are instrumental in providing a mechanism for short-term financ­ing of companies.

Their title of 'discount houses' stems from the fact that they were originally established to purchase bills of exchange at a discount to their maturity value, thereby providing the vendor with immediate funds whilst earning for the house an effective capital gain (yield) upon the asset's maturity.

The essence of the operations of the discount houses is that they attract short-term wholesale deposits and then use these to make short-term loans and to buy assets with short periods to maturity. The funds used to purchase the short-dated assets are borrowed, mainly, from the UK retail banks. Profits are earned by borrowing money at a lower interest rat' than that earned on the assets purchased. This activity would appear to be very straightforward and of low risk, except that the funds they borrow are extremely short-term: the overwhelming majority of these funds are either 'at call' (meaning that the lender can demand them back without notice) or are on an overnight basis. If the lenders find themselves short of cash for whatever reason, they will call in. or not renew, loans to the discount houses, and in so doing are able to adjust their liquidity position quickly and easily. The discount houses then find themselves short of funds and have to pay higher rates in order to maintain their deposit bases - perhaps rates higher than they are earning on their purchases of short-dated assets, so that losses are being incurred. As a consequence, the ability to forecast accurately cash shortages or surpluses within the banking system, and future levels of short-term interest rates, is crucial to the profitability of these institutions.

It could conceivably be the case that funds are unavailable to the discount houses at almost any interest rate and under these circumstances their sol­vency is threatened. This possibility is, however, covered by a unique characteristic of the discount houses: the right to borrow funds directly from the Bank of England (in practice, it is the sale - 'rediscounting' - of suitable assets to the Bank of England). The rate at which the Bank of England acts as a lender of last resort to the discount houses is. however, a rate of the Bank of England’s choos­ing and it is this characteristic of the relationship between the discount houses and the Bank that is the basis of the Bank's ability to influence short-term interest rates throughout the whole of the financial system.

The primary activity of the discount houses remains essentially straightforward, however: it is the purchase of short-dated assets by means of borrowed funds. The aggregate balance sheet of the discount houses is correspondingly straightforward: the asset side is dominated by holdings of commercial bills arid. in particular, sterling certificates of deposit (CDs). The liability side of the balance sheet is dominated by very short-term borrowing in sterling from UK banks and, to a much lesser extent, other financial institutions.

The discount houses are collectively responsible for holding very large quan­tities of commercial bills and sterling CDs, and are responsible for the maintenance of a liquid secondary market in them. Through the purchase of commercial bills, they allow holders of these bills to realise their funds prior to maturity. As a consequence, the discount houses are important providers of short-term finance to the commercial sector.

Like all groups of financial institutions, the environment within which the discount houses operate has been changing. Although the Bank of England acknowledges the importance of the discount houses to the financial system in general and the operation of government monetary policy in particular, it has been prepared to allow, and indeed has encouraged, a higher level of competition within the discount market. In 1981 the Bank sought to main­tain the privileged position of tile discount houses by requiring banks with eligibility status (that is, those banks who were responsible for underwriting – accepting - bills eligible for rediscounting at the Bank of England) to maintain amounts of funds with the discount houses that constituted a certain proportion of their short-term sterling deposit liabilities. This arrangement was phased out during the late 1980s, so that the discount houses no longer had a secure supply of funds and had to compete more openly for them. At the same time, the 'Big Bang' reforms of the Stock Exchange in 1986 allowed more participants into the gilt-edged market, causing a higher level of com­petition for the discount houses in the area of short-dated gilts. Since the mid-1980s the Bank of England has additionally been prepared to deal di­rectly with institutions other than the discount houses. This has been in the form of sale and repurchase agreements (termed Repo agreements) with in­dividual banks and building societies, which has enabled these institutions to manage their liquidity positions by means of direct dealing with the Bank of England rather than at one remove via the discount houses. Since January 1996 these Repo transactions have been shown gross, i.e. both assets and liabilities, in UK banking statistics.

In 1988 the Bank of England published its intention to extend its dealing relationships beyond what at the time constituted the eight discount houses and made clear that it would be prepared to establish dealing relationships with any suitable institution. This move resulted in two additional institu­tions establishing dealing relationships with the Bank, although only one of these took on full discount house status. However, subsequently two discount houses withdrew from the market.

Taken together, these developments represent a substantial shift away from the houses' protected position of the past and hence raise questions regarding their future development. While the majority of the institutions have hitherto been prepared to remain involved with the discount market, a number of them have been busy diversifying their activities to reduce their dependence on the discount market. They have, for example, become involved in leasing, in futures business and in the insurance market.