The discount houses

Text B

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.

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.

I. Key terms:

Discount	- скидка, знижка - reduction in the face value of a financial claim, such as a Bill of Echange or Treasury Bill, by the amount of money represented by the interest due on the claim during the remainder of its maturity. The reduction involved is the discount. It also denotes the action of selling a claim at a discount, i.e. to discount;
Lenser of last resort	- кредитор останньої інстанції - an institution, normally a central bank, that stands ready to lend to the commercial banking system, when the latter is in overall shortage of funds. (The latter position will arise when extra large payments out of the banking system, such as seasonal tax payments (e.g. periodic corporation tax payments by companies), reduce the banking system’s holdings below the reserves. The central bank will, in such cases, lend at short term to the banking system until such time as funds return through normal depositors.)
Commercial bill	- комерційний акредитив - any bill other than a Treasury bill. Commercial bills are bank bills or trade bills – Bills of Exchange are devided into these categories.
Eligible bill	- першокласний комерційний вексель, акцептований першокласним банком - a bank bill issued by a bank on the eligible list which may be rediscounted at the Bank of England.
Big Bang	- “Біг-бенг” - the term used to encapsulate the changes culminating on 27 October with abandonment of the commission agreementbetween members of the London Stock Exchange and of strict segregation of jobbers and brokers.
Gilts, gilt-edged securities	- золотообрізні цінні папери - fixed interest UK government securities traded on the London Stock Exchange. They are called gilt-edged because it is certain that interest will be paid and that they will be redeemed (where appropriate) on the due date.
Standby credit	- резервний (гарантійний кредит) - credit guaranteed in a note issurance facility or European facility.
Short-dated securities	- которкострокові цінні папери - gilts, bonds, bills of Echange or other securities that have a stated date for redemption (repayment) of their nominal value.

II. Answer the following questions:

1. State the broad functions of the discount houses.

2. What types of deposits dominate discount houses' liabilities portfolios?

3. What is the major risk faced by discount houses in their intermediation activities?

4. What special facility is available to the discount houses which helps them to be able to meet substantial demands for withdrawals of funds at very short notice?

5. What are the most important assets held by the discount houses?

6. In what way do the discount houses provide short-term funds for the commercial sector?

7. Examine the main events which have put pressure on discount houses' opera­tions in recent years.

8. How have discount houses tended to react to the pressures which they have faced in recent years?

III. Find in the text the following words and word combinations and translate the sentences in which they are used:

Monetary policy operations; flow of funds; payment-clearing operations; maturity value; assets maturity; short-term wholesale deposits; short-dated assets; earned on the assets purchased; overwhelming majority; “at call”; on an overnight basis; short of cash; liquidity position; deposit bases; cash shortages or surpluses; solvency; rediscounting; a lender of last resort; borrowed funds; the aggregate balance sheet; sterling certificates of deposits; short-term borrowings; commercial bills; a liquid secondary market; eligibility status; bills eligible; “Big Bang” reforms; gilt-edged market; repurchase agreement; gross; establish dealings relationships.

IV. For each of the following words you should provide a word with the same or similar meaning and a word, which is opposite in meaning:

Word	Synonym	Opposite
shortage (noun)
purchase (verb)
value (verb)
profit (noun)
earn (verb)
deposit (verb)
straightforward (adjective)
short-date (adjective)
lend (verb)
assets (noun)
extend (verb)
demand (noun)
reduce (verb)
loan (noun)
competition (noun)
long-term interest rates (adjective)

V. Join the halves.

1) The sterling money market or discount market involves … 2) The market plays a central role … 3) Discount houses borrow money, mainly from banks but also from other sources, and… 4) The funds they borrow are almost wholly short term, either overnight or at call (i.e. can be recalled without notice) and … 5) The discount houses provide the banks with a convenient form of liquidity … 6) Banks finding themselves with tempor­arily surplus funds … 7) Banks with a shortage of funds … 8) Deposits with discount houses earn a competitive rate of interest and, … 9) The discount market's role in providing liquidity does not end here, for … 10)The role of market-maker is an important one: for financial assets to be negotiable (i.e. readily tradeable), … 11)Assets that are not negotiable are not liquid: and efficient financial markets need liquid assets in order … 12)The discount houses' willingness to buy and sell bills and CDs ensures their negotiability and …

a) as they are fully secured, any risk is slight. b) so makes them that much more useful as liquid assets, both for banks and for other market participants. c) the discount houses also act as market-makers in Treasury bills, local authority bills, commercial bills and CDs. d) can add to their deposits with the discount market. e) there have to be dealers who stand ready to buy and sell on a regular basis. f) that market participants can quickly respond to changes in cash flow by buying or selling assets. g) are secured against the financial assets they hold. h) a number of dis­count houses, other traders in bills, a large number of banks and the Bank of England. i) which can be added to, or sub­tracted from, on a day-to-day basis. j) can call back monies already lent to the marker. k) within the monetary system. l) invest in short-term financial assets, notably bills and certifi­cates of deposit.

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