Looking At The Issue Of The Bills Of Exchange
The discount houses got their name because they discount bills of exchange: they buy them at a discount to their face value. To see how this market works we need to examine the mechanism more closely.
Bills of exchange are a form of short-term IOU widely used to finance trade and provide credit, the work like this Company A sells Lim worth of goods to Company B. It ‘draws’ a bill of exchange for Lim which it sends to Company B. This bill is an acknowledgement by Company B that it owes the Lim, and Company B signs it to show that it accepts the debt. The bill may state that the money is not payable until some date in the future: perhaps in three months. The bill returns to Company A.
Company A then has a choice. It can hold on to the bill, in which case Company B will pay it the Lim in three months. Or, if it needs the cash sooner, it can sell the bill to somebody else. Whoever holds the bill when the three months are up gets the £lm from Company.
Bills of exchange do not pay interest. But if Company A sells the bill before it is due for payment, it will receive less than face value. In other words, it sells at a discount. So if the bill is due for payment in, say, three months, the buyer might pay only £97.50 for every £100 of face value. The buyer is thus getting a profit of £2.50 per £100 when the bill is repaid at face value, which is equivalent to receiving interest: the discount is usually expressed as an annual rate of interest. When the Bank of England is said to have bought bills at 10/4 per cent, it means that the Bank bought them at a discount to their face value. Thus if interest rates generally come down, the prices of bills will rise. This is why discount houses may be reluctant to sell them when they think interest rates should come down.
The bill described above is a trade bill, issued by one company to another. But a bill may be accepted by a bank, in which case it becomes a bank bill. By putting its name on the bill, the bank agrees it will pay the amount of the bill on maturity, even if the company which acknowledged the debt should default: it is therefore a form of guarantee. Accepting bills in this way was an important part of the business of the merchant banks in the past, hence the term accepting houses which used to be used for the top-tier merchant banks. A bill accepted by a bank, because of the security it offers, sells at the very lowest interest rates. Any monetary sector institution can accept bills, but the Bank of England only buys or lends against bills accepted by eligible banks, hence the term eligible bills. The Bank maintains a published list of eligible banks; in general these are banks which have a substantial and broadly-based sterling acceptance business.
Bank bills also provide a substitute for overdrafts in big company financing. A company arranges an acceptance credit with a bank, which allows it to issue bills up to an agreed limit. Each bill is accepted by the bank in return for a fee and can be sold at a discount to raise cash for the company. The effective rate of interest may be lower than on other forms of borrowing.
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