Other possibilities

Loans and discounts

The value of the note at the time of execution is not, of course, the same as its value at maturity. Three things tend to create a difference, namely, rate of discount, the time that must elapse before maturity, and the uncertainty concerning A's ability and willingness to pay. Time, rate and risk are elements that must be taken into account in the evaluation of all kinds of credit instruments.

The longer the time that a given credit instrument has to run the less does its present value tend to be. In the case of the promissory-note exchange assumed above, had A paid B cash instead of asking him to accept a note, B could have put the money out at interest in some form, so that at the expiration of the three months he would presumably have had the principal plus the interest. The same opportunity to add to the principal would be open to anyone having the given sum. Hence, apart from risk, nobody would give B the face value of the note until the date of maturity. The most that B could expect to get would be such a sum, which when put at interest at the current rate, would, at the date of maturity of the note, yield the amount promised on its face. This sum, which is spoken of as the present value of the note, tends to increase as the period of maturity shortens, and as the interest rate declines.

But risk, too, must be taken into account. Apart from having to wait for the promised sum there is the inevitable possibility that the promise itself may not be kept. The degree of this possibility naturally varies from promisor to promisor, but it exists to some extent in practically every credit instrument. Government bonds are perhaps least affected by it. But in general it may be said that the greater this risk of nonpayment at maturity, the less is the present value of the credit instrument.

Allowance for both time and risk in the valuation of credit instruments is ordinarily made only in connection with the "rate" at which such instruments are said to be "discounted." When the banker "discounts" a credit instrument of any kind he is simply buying it, paying as a price approximately its "present value," determined, as was described above, by the prevailing interest rate, the time involved and the risk assumed. Thus he may discount A1 paper or "prime bills" - namely, commercial credit instruments in satisfactory sums and maturities, issued or indorsed by tried and trusted business firms, at a comparatively low rate. Other borrowers, offering paper of the same denomination and maturity, but enjoying less exalted credit, will have to "pay a higher rate" - that is, will receive a smaller sum in exchange for their paper. The banker who is the normal purchaser of such paper, in making allowance for risk, simply adds something to the interest that he demands. Thus A, whose credit is good, may discount at 5% paper bearing his indorsement, while B pays 6% and others 7%, or even 8%. The margin beyond current interest is a charge for the risk.

The importance of the time element and of the rate

The importance of risk

Both time and risk are reflected in the rate

The "loan" differs somewhat from the "discount." In discounting any form of commercial paper the banker really buys an independently existing and embodied right to demand a certain sum of money. The process involves the deduction of the interest in advance and this may be said to be its characteristic feature. Moreover, the field of discounting is narrowly restricted. It covers only rights to demand of comparatively short maturities growing presumably out of previous transfers of actual wealth. Discounts are not adapted to long-time, fixed investments. They are normally serviceable only where capital circulates rapidly. Loans, on the other hand, may be used for any purpose and may run for any period of time. They normally involve, not the purchase of a future claim at a lower present price, but simply the repayment at a specified time by the borrower of a sum equivalent to that received from the lender, with the payment of interest at the agreed rate at specified intervals in the meantime. Ordinarily also the loan is specially secured with valuable property of some kind turned over to the lender as collateral. While security may be required for discounts none is ordinarily demanded beyond the claim that the indorsements on the credit instrument themselves give against all the legally attachable property of the indorsers. Security is usually more necessary in the loan than in the discount, because the loan is extended to a given individual, group, or firm to whom alone the obligation to repay is confined; but in the case of notes, bills of exchange, etc., offered for discount, through the addition of one or more "'names" or indorsements the obligation to pay is more broadly extended and the risk assumed by the purchaser is correspondingly lessened. In like manner the foundation of a discount is more secure than that of a loan because the discount normally grows out of a transfer of wealth representing a completed transaction on an established basis of value, whereas a loan is less definitely connected with given transactions and tends to be, therefore, somewhat more speculative. Lastly, it may be mentioned that largely as a result of the differences already referred to the discount is much more liquid than the loan. The discounted instrument can be rapidly passed from hand to hand. Loans can ordinarily be transferred from one lender to another lender only with considerable difficulty, and usually only as a result of the intervention of the borrower himself.

The nature of loans

Deposits then may be obtained through discounts and loans as well as through the payment of cash or of immediate rights to demand cash from others. But in the discount and loan we are dealing simply with rights to demand cash in the future. The deposit, which, as was shown, is simply a present right to demand cash from the bank, is exchanged for a future right to demand cash from the borrower, whoever he be. The transaction, in other words, is purely a credit transaction, namely, one of an exchange of rights. The essential difference of time, however, gives rise also to a difference in the present value of the two kinds of rights, and it is in the purchase, at the present valuation, of future rights to demand from others in exchange for present rights to demand from itself that, in the main, the bank finds its source of profit.