# Hints About Investments/Chapter 14

A glance at a bank balance-sheet shows at once one of the great advantages that shareholders in these institutions enjoy, namely, the enormous sums handled in relation to the amount of the shareholders' capital employed. The consequent diversification of risk is evident. Here are the figures on December 31, 1924, of the Westminster Bank, which we will take as the oldest of the London Joint Stock Banks, apart from the Bank of England, which stands by itself.
£34,185,041 :
| Reserve | 9,051,718 | Balances with and cheques in course of collection on other banks | 10,309,104 |
| Current, deposit and other accounts | 272,832,400 | Money at call and short notice | 23,399,849 |
| Notes in circulation | 14,616 | Bills discounted | 41,970,486 |
| Acceptances, endorsements, etc. | 16,430,325 | Investments | 53,307,672 |
| Profit and Loss | 1,238,038 | Shares in other banks | 2,991,706 |
| | | Advances to customers | 121,946,012 |
| | | Liability of customers for acceptances, etc. | 16,430,325 |
| | | Banks and other premises | 4,078,620 |
| | £308,618,815 | | £308,618,815 |
Looking more closely at the assets we see that ​in the full balance-sheet as set out by the bank, the investments were subdivided into War Loans and other securities of or guaranteed by the British Government, which account for 51¾ millions of the total, the balance of a million and a half being composed of "Colonial Government securities, British Corporation stocks and other investments." As a matter of interest and guidance for the public it would be kind of the banks to tell us exactly what investments they hold, instead of leaving us wondering what those "other investments" mean.
The items which I summarized as "shares in other banks," amounting to nearly three millions, consist in fact of shares in the Westminster Foreign Bank (£1,080,000), an institution founded to carry the Westminster's prestige and services abroad, and in the Ulster Bank £1,911,706.
It will be noted that by far the largest item £122 millions out of a total of £308½ millions—is made up of Advances to Customers. Those hundred and twenty-two millions are the means by which the bank gives the most direct assistance to the country's industry, and the large total shows how a shareholder in one bank is able to feel that he owns part of a machine which distributes credit to thousands of borrowers in different parts of ​England for the financing of various kinds of industry.
Bills discounted perform the same function to some extent; but in the first place they probably contain a large proportion of Treasury bills and thereby finance the Government rather than industry; and in the second, it is likely that a large part of the commercial bills held are drawn to finance foreign trade, and so, though of enormous importance to a country which could not live without foreign trade, are less directly a home product, though at the same time widening still further the diversification of risks which is provided by investment in bank shares.
Money at call and short notice means loans to discount houses, bill-brokers and—stockbrokers engaged in financing the floating mass of bills of exchange and securities which form the stock-in-trade of Lombard Street and Capel Court.
It is interesting to look back at our investigation of an industrial balance-sheet, and to compare the assets shown by a bank in the light of the difficulty that we found in the case of a well-known brewery of being certain as to the likelihood that the assets if realized would fetch the sums set against them.
The assets of Messrs. Bass came to a total ​of over 84 millions, of which rather more than £585,350 was in cash, and £1,823,926 was in investments in British Funds, Colonial and Foreign stocks and bonds, railway preference stocks and sundry debentures and shares "at or below current quotations or valuations." The other six millions were made up of bills receivable, debtors on trade account, stocks of material, stores and movable plant, freehold and leasehold premises and fixed plant, licensed properties, trade loans, goodwill and trade marks.
We found that the figures set against all these items depend to a great extent on the opinion held by the Board and the managers concerning the value that should be set upon them for balance-sheet purposes, and that this was an inevitable feature in the great majority of industrial balance-sheets. We also saw reason to believe that most Boards and managers would err on the side of undervaluing rather than overstating these necessarily doubtful assets.
In the case of the banks, the proportion of doubtful assets is much smaller. There is no doubt about the cash and practically none about the loans at call and short notice, which are lent to first-class firms on first-class security. The bills of exchange are also for ​definite sums due, from the British Government or from accepting houses, usually of the highest credit. The investments are nearly all obligations of the British Government and the small outside minority are pretty certain to be publicly quoted and easy to deal in at the quoted price. The Advances to customers are also loans for definite amounts made to customers, concerning whose standing and solvency the banks have exceptionally good opportunities of satisfying themselves; and the liability of customers against acceptances is in the same category, though, in this case, the bank has not lent its money, but only its name, thereby incurring a liability to pay a sum if the customer fails to do so, and this liability appears on the debit side of the balance-sheet.
All these items, representing more than 300 millions out of the 3084 millions which is the sum total of the assets, are a matter of a definite sum owned by or owed to the bank, or represented by securities saleable at or above the figure set against them. In the case of the advances to customers and the customers' liability on acceptance there must be, and in those of the short loans and discounts there may be, some question whether all the multifarious borrowers who have had ​credit supplied by the bank will be able to meet their obligations in full, in view of all the widespread industrial and commercial risks that they are facing.
But there are two important differences between the doubtful assets of a bank and those of an ordinary industrial company. The directors and managers of a bank have a better chance of being able to judge of their value; they are experts in credit, that is, in the solvency of the people to whom they lend, or for whom they accept bills, or whose bills they discount. They are thus only doing what is their own regular job when they make estimates of the value of their promises to pay; whereas an industrial director, in putting a figure against land and buildings, plant and machinery and trade debtors, must often be called on to decide the values of articles on which his opinion, as valuer, is not quite that of an expert.
And the second difference is, that whereas we have reason to hope that the Boards of most industrial companies—at least those which have stood the test of time through a reasonably long life—err on the side of prudence and caution in valuing their assets for balance-sheet purposes, with the banks it is a matter of common knowledge; doubtful ​assets are written down ruthlessly, and they hold, in fact, large hidden reserves owing to the lowness of the figure set against their Advances to Customers, their premises and every other item which gives them an opportunity of exercising a damnatory imagination. They have also a habit of putting away profits earned on sales of investments. The Economist Banking Supplement of May 9, 1925, quoted Mr. Beaumont Pease, of Lloyds Bank, as having told his shareholders that such sales had "yielded substantial profits; but these," he added, "we have not brought into our profit and loss figures, preferring the more conservative method of keeping them in our internal reserves. . . . They are safely there, however, employed in the business, ready for any emergency, earning you extra profits."
The liabilities' side has already been explained, sufficiently for our present purpose, in commenting on the assets. Perhaps it is worth while to add that the tiny item of notes in circulation is a rara avis in the balance-sheet of a leading English bank, since those with London offices are not allowed to issue notes in England, this privilege being reserved to the Bank of England. The notes outstanding in this case represent the circulation of an ​Isle of Man bank, which has been absorbed by the Westminster.
The outstanding feature on the debtor side is the huge total of the deposit and current accounts, money placed with the bank by the public, which has the right to demand its repayment at once in the case of current accounts and practically at once in that of deposit accounts, since no bank could refuse a depositor who was in a hurry the power to waive the necessary notice in return for some sacrifice of interest. It is the ever-present possibility of a demand for cash by holders of current and deposit accounts that compels the banks to keep their assets so liquid and so well written down, that their shareholders can read the figures set against them with a different feeling from that with which they regard the values on the right side of the ordinary commercial balance-sheet.
Another item that is what advertisers call a "talking point" is the reserve fund standing at the same figure as the paid-up capital. Some banks have reserve funds which exceed this cent per cent. of capital—the Ulster Bank in which the Westminster holds a considerable share showed in its balance-sheet, dated November 29, 1924, capital paid up £500,000 and reserve fund £900,000. The latter has ​since been increased by £100,000, and now stands at 200 per cent. of capital paid up. The Westminster, as we shall see when we look at the Profit and Loss Account, left the Reserve Fund at the figure shown in the balance-sheet, but put away £625,000, out of a net profit of £2,013,5O2, in allocations to Bank Premises Account, Rebuilding Account, Contingent Fund, and addition to carry forward, besides £100,000 placed to Provident Fund, presumably for the benefit of the employees.
This policy of building up big reserves, the benefits of which to the shareholder have already been dilated on with "damnable iteration," has a disadvantage, also already noted, of giving an appearance of a much higher rate of profit earned than is derived from the capital actually invested. The banks declare dividends on their paid-up capital, but they earn them on capital plus reserve fund plus hidden reserves, all of which have been put in directly or indirectly by the shareholders.
For example, in the report now before us the Westminster directors propose to pay a dividend which will make, with the interim distribution already paid, 20 per cent. for the year on the £20 shares £5 paid, and 12½ per ​cent for the year on the £1 shares. This looks like a very handsome rate and gives a misleading view of the profit to be earned by banks because, as we have seen, the reserve fund is as big as the paid-up capital and there are hidden reserves besides, so that the real rate of dividend has to be found by dividing the apparent rate by something over 2.
The Profit and Loss Account may be summarized thus:—
£568,480 :
| Premises Account | 100,000 | 2,013,502 |
| Rebuilding Account | 300,000 | |
| Contingent Fund | 200,000 | |
| Provident Fund | 100,000 | |
| Carried forward | 594,095 | |
| | £2,581,982 | £2,581,982 |
It will be noted that the banks are far from lavish in the information that they supply in their profit and loss accounts. They tell their shareholders the amount of the net profit and what has been done with it and "the rest is silence." As to the amount of the gross profit and of the expenses—how much went in taxes, directors' fees, salaries, etc., and how much was appropriated to provision for bad and doubtful debts—on all these matters the Profit and Loss Account that is now before us ​lies low and says nothing, following the prevalent practice of its peers. "Very few of the British banks," says the Economist Banking Supplement of May 9, 1925, "published the figures of their gross profits. Barclays still sets a good example in this respect."
Perhaps this dignified reticence on the part of the banks is necessitated by their peculiar position; living and trading, as they must, on a reputation which is beyond a breath or whisper of suspicion, they have to be not only above reproach but above the possibility of misunderstanding by some irresponsible person with a pen in his hand who might make misleading and damaging comments if he saw that a bank, or several banks, had been obliged, for example, to make a considerable amount of provision for bad debts. And in pursuing a policy of reticence the banks can plead the example of the Bank of England, which never publishes a Profit and Loss Account at all, or anything else besides a weekly account which is largely incomprehensible. An official of the Bank, who had a keen eye for the absurdities of life, once told me that he had two weekly treats, one on Wednesday when he enjoyed his Punch, the other on Friday when he read the attempts of ​an intelligent Press to expound to its readers the meaning of the Bank return.
Whether justified or no, this reticence of the banks concerning the details of their business is not helpful to those who are considering investment in their shares. Combined with the mystery which the possession of large hidden reserves enables them to throw over the process of meeting losses, it gives the whole business an appearance of easily earned and regularly accruing profits and so whets the appetite of those reformers who want to nationalize the banks, and think that their job is so simple that even a Government office could do it. It is true that Mr. Sidney Webb, when he put forward a scheme for their nationalization in the Contemporary Review of July, 1918, proposed that the most difficult part of banking, the lending of money to industry, should be left to "a series of financial concerns, whose business it should be to discount the bills and satisfy the requests for loans of those profit-makers who now appeal to the bankers." But younger enthusiasts have been more daring.
The possibility of nationalization is thus one which a doubting purchaser of bank shares ​has to consider. It is, I believe, a plank in the programme of the Labour Party, but recent experience has shown that Socialist Governments that have taken office on the Continent have been not at all in a hurry to nationalize anything, and the separation of central banks—and still more of the outer banking machinery—from political influence is now recognized as essential, if the monetary world is to be saved from the wild-cat achievements of Governments in currency debasement, that marked the war and after-war period. I think it would be pretty safe to bet against the nationalizaion of our banks during the next twenty years, but one cannot be certain about the jump of the political cat.
A more immediately practical fact, for the possible investor, is the notion that one finds current among bankers, arising partly out of the talk about nationalization, that it is a questionable policy for them to increase their dividends and that they should rather regard their business as an enterprise to be carried on purely in the public interest.
Over a long period of years increases in dividends by the English bank have been scarce; for some time before the war the banks were writing down their investments, having made the mistake (as we all see now) of ​thinking that Consols and other undated or long-dated securities were nice securities for them to hold; and during and since the war—a period which covered the commercial cataclysm of 1920 and 1921, when the prices of commodities were halved—they must have had a good deal of provision to make for the consequences of mishaps to their customers in and after that appalling time.
Now, their position must be greatly strengthened by the writing down of the last twenty years, but if they propose to adopt a self-denying ordinance in the matter of future increases of dividends, shareholders who are buying fully paid shares in English banks which pay them less than 5 per cent. will perhaps feel aggrieved. They will certainly have a strong ground for arguing that part of any increased profit that may be earned during less trying times ahead should fall into the pockets of shareholders.
This view about dividends, however, does not yet seem to have crossed the border, for the Royal Bank of Scotland makes the timely announcement, as I end this chapter, of an increased dividend, following four successive increases.
Moreover, since the above was written the Westminster has announced, with its report for ​1925, a bonus to shareholders in the form of new shares.
On a smaller scale the discount companies enjoy the same advantages as the banks, of handling a mass of money many times the size of their capital We saw that the Westminster Bank, with a paid-up capital of nine millions, held nearly 273 millions deposited with it by the public. When we look at the balance-sheet of the Union Discount Company, the largest of the joint stock companies that engage in this kind of business, we find that, with a paid-up capital of £1,125,000, it held forty millions "in loans and deposits, including provision for contingencies." Let us summarize its balance sheet of December 31, 1924:—
£1,320,683 :
| Reserve Fund | 1,475,000 | British Govt. and other securities | 5,724,642 |
| Provident Fund | 198,732 | Loans at call and short dates | 474,524 |
| Loans and deposits, etc. | 40,100,868 | Bills discounted | 47,023,680 |
| Bills re-discounted | 11,053,918 | Debtors | 9,322 |
| Rebate on bills discounted | 423,485 | Premises | 140,000 |
| Profit and loss (less appropriations) | 315,848 |
| | £54,692,851 | | £54,692,851 |
The position of the company is clear and pleasant; it has borrowed forty millions, put a net sum of thirty-six millions into bills ​of exchange (this being the total of bills discounted less bills rediscounted) and six millions into investments and loans, and it holds more than its paid-up capital in cash at bankers.
We thus see at a glance the function that is performed by these companies and the private firms which engage in the same business. They act as merchants in the market for bills of exchange, which are the currency of international trade, keeping a large stock of them in hand so that they may be able to provide, for the banks and other purchasers, bills of the date and class that are required by the buyer.
In order to finance this mass of credit-merchandize, they borrow from the banks and finance houses and from the India Council and anyone else who wants to place funds for a time. Their utility is obvious—they provide a reservoir into which the floating cash of Lombard Street may be poured to earn the current rate of interest for short loans, and another reservoir which holds the floating supply of bills of exchange which finance the home and foreign trade of Great Britain, and of many other countries, and (at present in the form of Treasury bills) form the greater part of this country's floating debt.
​They thus have two considerable advantages over their big brothers, the banks, whom they serve both as borrowers of surplus cash and providers of bills of exchange.
In the first place they have nothing to do with the queer old public and have not always to provide against its whims about the custody of its money. Their liability is not to thousands of depositors all over the country, but to a few banks and first-rate firms in the city or in the world of finance, from whom they borrow and from whom they can, more or less, rely on reasonable treatment in times of difficulty. Their chief asset is not, like that of the banks, a mass of advances to industrial, commercial and other customers, with exacting ideas about the extent and price of the credit that they ought to be granted, but a portfolio of bills of exchange, most of them accepted or endorsed by the British Government or by banks and accepting houses so eminent and respected that the "bank bills" which they create, for financing the trade of the world, are often quoted at a higher price than British Treasury bills, now that the latter are so enormously plentiful. Moreover, their assets, in bills and securities, being constantly used as pledges for advances, are subjected to continued scrutiny by lenders.
​Their second advantage is that most of their business is done within a square mile of their offices, and that they have none of the difficulty involved by scores of branches but are in close and constant personal touch with their most important connections.
Although it would be interesting to know how much of the Union Discount's investments consists of British Government and how much of other securities and of what kind these latter may be, it will be noted that owing to the high standing of those responsible for meeting the bills which make up the greater part of the company's assets, the question of doubtful assets hardly arises in the balance-sheet of a discount house. Acting as they do as intermediaries for the banks, it is an essential of their business to be above reproach in its conduct, and to add continually to the strength of their position by an active reserve fund policy and by caution in the question of rebating—that is estimating the present value of—their bills of exchange.
From the Profit and Loss Account of the Union Discount it appears that it made a gross profit for the year 1924, after making provision for contingencies, of £753,000. Deducting expenses, £76,000, and rebate £423,000, we find a net profit of £254,000. The company ​pays £172,000 in dividend and bonus, puts £60,000 to reserve and premises and £10,000 to provident fund, and adds £11,000 to carry forward.
The disadvantages of these companies from the investor's point of view are:—
(1) There is a liability on the shares, most unlikely to be enforced, but still there.
(2) There are only three of them to be invested in, and
(3) The market in the shares is far from free.
But in the matter of stability of the business their advantage over any ordinary industrial investment is evident since, whatever may happen to this trade or that, there is always a mass of trade to be financed. The distribution of risk is world-wide in extent, and the elimination of risk is the constant aim of the experts, trained to tell a good bill almost by the feel of it, who manage these companies.