THE NATURE AND OPERATIONS OF COMMERCIAL BANKING
In the preceding chapter commercial banking has been defined as the
conduct of exchanges by means of a world-wide process of bookkeeping.
We must now describe this process. Its essential features are the
discount of commercial paper, the conduct of checking accounts, and
the issue of notes.
_1. Commercial Paper_
By commercial paper is meant the credit instruments or documents which
the credit system now in general use throughout the commercial world
regularly brings into existence and liquidates.
The essence of this system is buying and selling _on time_. The farmer
buys seed, implements, fertilizer, labor, etc., and pays for them
after the crops have been harvested and sold. The manufacturer buys
raw materials and pays for them after they have passed through the
transformation process which he conducts and the completed goods have
been marketed. He frequently sells them to jobbers or wholesalers on
time and these in turn sell them on time to retailers and these to
consumers. Farmers, manufacturers, and merchants both buy on time and
sell on time, and are thus both debtors and creditors, and each
expects that his sales will ultimately pay for his purchases.
The obligations involved in these transactions are represented and
recorded in the form of book accounts, promissory notes, or bills of
exchange, the latter being written or printed, or partly written and
partly printed, orders of creditors on debtors to pay to themselves or
to third parties the sums indicated. These documents are being
constantly made and constantly paid as the processes of agriculture,
industry, and commerce proceed. Indeed, their creation and liquidation
is a normal phenomenon of our modern economic life.
The term commercial paper, as we are using it, applies to such
promissory notes and bills of exchange as belong to this credit
system. It does not apply to such notes and bills when they owe their
existence to credit operations of a different kind, such for example
as accommodation loans or investment operations. Indeed, the
essential characteristic of commercial paper is not revealed in the
form of the credit document but in the fact that it is a link in this
chain of exchange operations by which modern commerce is carried on.
This use of the term should also be distinguished from the one common
among bankers and others. In this popular usage these documents are
called commercial paper because they are themselves objects of
commerce. In our use of the term the adjective "commercial" applies to
them only when they play the role of intermediary in a process of
exchange through credit. In this sense it is a matter of indifference
whether they pass through the hands of brokers or not, and the fact of
their being objects of purchase and sale does not confer the quality
of commercial paper upon documents having an origin and character
other than that above described.
_2. The Operation of Discount_
Every person in this chain of credit is confronted with the problem of
paying his debts as they mature by the use of the amounts due him from
other people. Since it is rarely possible to arrange maturities on
both sides in such a way that the amounts due to be paid him at a
given date shall at least equal those he is due to pay on that date,
some means of transforming claims against other people due in the
future into present means of payment must be found. The one
universally employed is the discount of commercial paper. By this is
meant the exchange at a bank of his own promissory notes due at times
when debts of equal or greater amount due him mature, or of bills of
exchange drawn against his debtors, for cash or credits on a checking
account. These latter are available as means of payment at any time.
As a consideration for this accommodation, the bank charges interest
for the period intervening before the maturity of the paper
discounted. Sometimes this charge is paid at the time the paper is
purchased and sometimes at the date of its maturity. The term
"discount" technically means taking interest in advance by making
available as means of present payment in any of the above mentioned
forms a sum less than the amount the bank expects to collect at the
date of the maturity of the discounted paper. If the interest is paid
when the discounted paper matures, the process is technically called
a loan. However, since the time of collecting interest makes no
essential difference in the nature of the transaction, the process is
commonly described as the discount of commercial paper, regardless of
whether the interest is collected in advance or not.
_3. The Conduct of Checking Accounts_
A checking account is an ordinary book account on which are credited
the cash deposited by a customer and the proceeds of collections,
loans, and discounts made on his behalf, and on which are debited
payments made to him in cash or on his behalf to other people or to
the bank itself. These payments are made on orders signed by the
customer and known as checks.
The ordinary customer of a commercial bank every day brings to the
bank the cash he receives as the result of the day's business, and the
checks received, drawn on his own and other banks, and is credited
with the amount on the books of the bank as well as on a passbook
which he himself retains. If he needs cash during the day, he presents
to the bank a check payable to himself for the amount needed, and
receives the kinds and denominations wanted; and if he wants to make
payments to his creditors in other forms than cash, he sends them
checks on his bank payable to their order, or a check drawn by his
bank on some bank in another place, usually called a draft, which he
has obtained by exchanging for it a check drawn to the order of his
bank. To the amount of these payments his account at the bank is
debited, and from time to time his passbook is left at the bank for
the entry therein of the debits made to date and its subsequent return
to him.
The customer must take care that his account is not overdrawn, that
is, that the debits on his account do not exceed the credits, since
overdrafts, except by accident or for very short periods and small
amounts, are not allowed in this country, and in other countries,
where they are allowed, they must be provided for in advance by a
special agreement between the bank and the customer, which usually
involves the deposit with the bank of ample security. In order to
avoid overdrafts, the customer in this country agrees with his banker
on what is known as a "line," that is, a maximum amount of loans or
discounts to be allowed. Whenever his credit balance falls to a
certain minimum, also established by agreement with the bank, the
latter discounts for him the paper of his customers, that is, bills of
exchange drawn on them or their promissory notes in his favor, or his
own promissory notes. The proceeds of these discounts are credited on
his account like deposits of cash or of checks for collection.
So long as the discounts are confined to commercial paper the bank's
part in these transactions consists almost exclusively of bookkeeping
between its customers and between itself and other banks. Ordinarily,
what is debited on one man's account is credited on another's, the
cash received nearly balancing that paid out. To the extent that the
cash receipts and payments do not balance, the bank either has a
surplus or is obliged to provide for the meeting of a deficit. The
means available for this latter purpose will be explained in
subsequent sections, as well as some of the details of this
bookkeeping process. For the present it is important to note precisely
how the discount of commercial paper is related to this bookkeeping
process.
As explained in Section 1, commercial paper is an essential part of
the process of exchanging goods through credit. A person buys on time
and sells on time and expects to pay for his purchases by the
proceeds of his sales. So long, therefore, as the processes of
commerce and industry proceed in a normal fashion, the paper
discounted by a bank will be paid at maturity and the credit balance
created by means of such discounts offset by corresponding debits.
Ordinarily the credits created through discounts during a given
period, say a day or a week, in favor of one set of customers will be
balanced during this same period by the payment of notes previously
discounted for other customers. Within a complete trading area this is
certain to happen, since purchases and sales of goods are equal and
what is credited to one man is debited to another.
The result is very different if a bank discounts investment paper,
that is, credit documents which represent the unproductive consumption
of individuals or of public and private corporations, or which
represent the purchase on time of the instruments of production rather
than the production of goods through the use of such instruments and
their transfer from the producer to the consumer. The means of payment
of such documents can only be created gradually by the application of
the profits of the enterprises in which the investments were made, or
by taxes spread over a series of years, or by a slow process of
saving. If a bank issues its own demand obligations in exchange for
such documents, it cannot make its books balance and it will be
constantly exposed to the danger of forced liquidation. If it attempts
to protect itself by requiring that the discounted paper shall mature
in a short period, the necessity of liquidation will be forced upon
customers who are responsible for the payment of the discounted paper;
that is, such customers will be obliged to sell at such prices as they
can command the property in which the investments were made, or some
other property. Such liquidation always results in forced
readjustments of prices and business depression, and sometimes in
commercial crises.
_4. The Issue of Notes_
As an alternative for or a supplement to the conduct of checking
accounts a commercial bank may issue its promissory notes payable to
bearer on demand. By the issue of notes is meant their transfer to
customers in exchange for cash, for checks left for collection or
drawn against a credit balance in a checking account, or for
discounted notes and bills.
By the use of these notes commercial banking can be carried on
without checking accounts. In that case the notes are issued in
exchange for cash and discounted bills, and notes are returned to the
bank in exchange for cash or when discounted bills or notes mature and
are paid. In the bookkeeping process which has been described bank
notes thus issued and returned perform precisely the same function as
checking accounts, and are related to the discount of commercial paper
and the credit system of the country in precisely the same manner as
such accounts.
Most banks of issue at the present time conduct checking accounts
also, using the one instrumentality or the other as their customers
desire. In this case notes are issued in exchange for checks drawn
against credit balances on checking accounts or deposited for
collection as well as in exchange for discounted notes and bills and
cash.
By the use of both notes and checking accounts, a bank can supply most
of the needs of its customers for a circulating medium, the notes
serving as hand-to-hand money, and the checking accounts, practically
all other purposes. Being the direct obligations of banks attested by
the signatures of their responsible officers, and being payable to
bearer on demand and capable of being issued in all necessary
denominations, such notes can be transferred without indorsement, can
be used for making change and payments of small and moderate size for
which checks are not convenient, and they do not need to be presented
at a bank for the test of their validity. If the bank or banks which
issue them are properly conducted and supervised and properly
safeguarded by law, such notes will circulate freely through the
length and breadth of a country.
Checking accounts meet in the most satisfactory manner all currency
needs for which hand-to-hand money is not well adapted, such as large
payments and payments at a distance. With a few strokes of a pen
payments of the greatest magnitude can be made through their agency.
Checks can be sent through the mails at slight expense and without
danger of loss of the amount involved. By the devices known as
travelers' and commercial letters of credit, checking accounts supply
the most convenient form of currency for travelers and for merchants
engaged in foreign trade.
Besides bank notes and checking accounts the only forms of currency
needed in any community are standard and subsidiary coins, the former
for use as ultimate redemption material for all other forms of
currency and for the payment of international and other balances, and
the latter for small change. Even these forms of currency are supplied
by commercial banks, but since they do not create them, ways and means
of procuring them in the quantities needed constitute one of their
peculiar problems.
_5. Collections_
One of the most important functions of commercial banks is the
collection for their customers of checks and drafts drawn on other
institutions. When these documents are received, the accounts of
customers who deposited them are credited with the amounts, less a
small fee for collection, unless by agreement this service of
collection is performed free of charge. The checks are then assorted
according to the banks upon which they are drawn and the cities in
which those banks are located.
Checks drawn upon home banks are collected either through messengers
who present the checks at the counters of the banks upon which they
are drawn and secure payment therefor, or through the local clearing
house. This is a place where representatives of the banks meet for the
exchange of checks. After the representative of each bank has
distributed all the checks held by his institution against the others
participating in the clearing, and received from them those drawn
against his bank, a balance sheet is prepared showing the balance due
by or to his bank after the total of the checks distributed has been
balanced against the total received. If said balance is adverse, it is
paid to the master of the clearing house, and if it is favorable, it
is received from him.
The checks received through the clearing house or presented by
messengers from other banks and paid, are debited to the accounts of
the persons who drew them and returned to such persons as vouchers,
the net result of the entire transaction being the same as if all the
parties involved had been customers of a single bank, with the
exception that some means of paying balances had to be found. Since
balances are sometimes paid by checks on some central institution in
which credit balances may be obtained by rediscounts of commercial
paper, this necessity can be met without the use of any form of
currency other than that furnished by banks themselves.
Checks drawn upon out-of-town banks are, in this country, collected
through so-called correspondents. Each bank enters into an
arrangement with a few other banks, distributed throughout the country
and conveniently located for the purpose, by which the correspondent
bank agrees to conduct with it a checking account on which it will
credit at par or at a stipulated discount the checks sent it for
collection and debit checks drawn against such an account. A
comparatively small number of such correspondents suffices, since
certain banks in the larger cities, by making a business of such
collections, conduct checking accounts with a large number of banks,
and can thus make collections by mere transfers of credits on their
own books or by the use of the local clearing house. The so-called
reserve cities in this country constitute clearing centers for the
territories contiguous to them, and New York, Chicago, and St. Louis,
for the entire country.
Checks received from correspondents and drawn against themselves are
debited to the accounts of the customers who drew them and returned as
vouchers in the same manner as checks received through the clearing
house or paid over their own counters.
Through this interchange of checks between banks and the conduct of
checking accounts with each other, intermunicipal and international
exchanges are conducted through the bookkeeping processes of
commercial banks with the same ease and economy as are exchanges
between people living in the same town.
_6. Domestic Exchange_
The accounts of a bank with its correspondents are a record of the
transactions of its customers with the outside world, the checks they
receive as a result of sales to outsiders of merchandise, real estate
or other property, or as a result of gifts by outsiders to them being
credited on such accounts, while the checks they draw or the drafts
they purchase in payment for merchandise, real estate or other
property purchased of outsiders, or of gifts made to them are debited.
When in a given period, say a day or a week, the receipts of the
customers of a bank from outsiders, as a result of current or past
sales and gifts, exceed the payments made by them as a result of
purchases and gifts, its credit balances with its correspondents will
increase, and under opposite conditions they will decrease. If the
payments should continue in excess for a considerable period, the
credit balances of a bank with its correspondents would be exhausted
and some means of replenishing them would have to be found, and under
the opposite conditions too large a portion of the bank's resources
would accumulate with its correspondents and some means of withdrawing
funds would have to be found.
When a bank needs to replenish its credit balances with its
correspondents, it may ship cash or purchase drafts from other home
banks, which it can send to its correspondents for collection like
checks deposited in the ordinary course of business. The latter
resource will of course be available only when these other banks'
balances with their correspondents are not exhausted. Should the
balances of all the banks of a town with their out-of-town
correspondents be nearly or quite exhausted, shipments of cash to
correspondents could not be avoided. If a bank wishes to withdraw
funds from its correspondents for home use, it may order cash shipped
or it may, perhaps, be able to sell drafts for cash to other home
banks.
The expenses involved in shipments of cash, loans, or purchases or
sales of drafts for the purpose of replenishing balances with or
withdrawing them from out-of-town correspondents, give rise to what is
called the _rate of exchange_. If, in order to make out-of-town
payments for its customers, a bank is obliged to pay the expense of
shipping cash to its correspondents or to pay a premium on drafts
purchased from other banks, the natural method of reimbursement will
be a premium charge on drafts sold equal to the amount of the expense
incurred. If it wishes to withdraw a balance with its correspondent,
since to order cash shipped will involve expense, it will be glad to
sell drafts for cash at a discount not to exceed such expense.
The rate of exchange, or the price of drafts on a given point, may,
therefore, fluctuate between a premium equal to the cost of shipping
cash to that point and a discount of the same amount. Beyond these
extremes, these fluctuations cannot ordinarily go, because customers
may demand cash of their banks in payment of checks against their own
credit balances and ship it to their out-of-town creditors at their
own expense, and would do so if the rates charged on drafts should
make such procedure profitable. The actual rate of exchange will not
ordinarily reach either of these extremes, on account of competition
either between the banks which are desirous of selling drafts on their
correspondents or between those which are forced to buy as an
alternative to cash shipments. If the aggregate balances of the banks
of a town with their out-of-town correspondents are large and
increasing, the pressure to sell drafts will be greater than that to
buy and the rate of exchange will go to a discount, the amount of
which, however, will be fixed by competition between the selling
banks. In the opposite case, the rate will go to a premium and be
fixed by competition between the buying banks.
In most towns in the United States there is little or no competition
between banks in the business of buying and selling drafts and
consequently no open market for exchange and no quotations of exchange
rates. In such cases each bank acts more or less independently;
shipments of cash to or from correspondents are the ordinary means of
regulating balances; and the cost of such shipments are charged to the
general expense account of the bank and taken out of customers either
by a fixed and more or less invariable charge on drafts sold, or in
other ways.
Since the balances of the banks of a town with their out-of-town
correspondents depend primarily upon the commercial and gift relations
of their customers with the outside world, it is pertinent to inquire
whether as a result of a long continued excess of purchases from
outsiders over sales to them and of gifts to over gifts from them, the
cash resources of a community might not be completely exhausted, and
if not, how such an outcome is prevented.
Bankers have no direct control over the purchases and sales of their
customers, but through the rate of interest they charge on loans and
discounts and their ability absolutely to discontinue such
accommodations they exert a very potent indirect influence. The rates
of interest and discount charged are an important element in the cost
of doing business and, if loaning and discounting is discontinued,
sales of property to meet maturing obligations are forced, with the
result of price readjustments between the town in question and the
outside world which speedily change the relations between purchases
and sales.
When the cash resources of the banks of a town approach the limit of
safety and their balances with their correspondents fall to an
ominously low point, the normal method of procedure is to raise the
rates on loans and discounts, and if conditions grow worse, to raise
them higher still and as a last resort to cease temporarily to make
them at any price. By increasing the cost of doing business this rise
in the rates will check purchases by diminishing or annihilating the
profits resulting, and will stimulate sales by rendering it more
profitable for some customers to secure funds by sales to outsiders at
lower prices than were formerly asked rather than by borrowing from
banks. Under ordinary circumstances this procedure will be sufficient
to change an unfavorable into a favorable balance of indebtedness with
the outside world, with the result that more checks on outside
institutions will be deposited with the banks and a smaller amount of
drafts purchased. Bankers' balances with their correspondents will,
therefore, increase, and with them their ability to command cash in
case of need. The demands made upon them for cash will also decrease,
since the volume of loans and of business transacted will fall.
If the banks stop discounting, a more or less violent readjustment
with the outside world results. Business men who have obligations to
meet, and most of them will belong to this class, are obliged to sell
their goods and property at whatever prices are necessary and to stop
purchasing entirely. The outcome, so far as the banks are concerned,
is as above indicated. If conditions are such that sales at any price
cannot be forced, a crisis ensues; that is, business operations are
temporarily suspended and transfers of property in settlement of
obligations are made through bankruptcy and other court proceedings.
_7. Foreign Exchange_
The business relations between banks located in different countries do
not differ in any essential respect from those between banks located
in the same country. Interchange of checks, the conduct of checking
accounts, shipments of cash, and borrowing and lending proceed in the
same manner as between domestic institutions. The chief peculiarities
of the foreign exchanges are due to the fact that different units of
value and sometimes different standards must here be reckoned with,
and that the precious metals, chiefly gold, are used in the settlement
of balances. Drafts drawn in the United States on English points, for
example, call for the payment of pounds sterling, those on French
points for francs, and those on German points for marks, while all
must be paid for in dollars.
The translation of the language of values of one country into that of
others thus involved requires the calculation of a so-called _par of
exchange_. By this is meant the relation between the weights of pure
metal contained in their respective units of value, if the countries
in question have the same standard, and the relation between the
market values of the metallic content of their units, if their
standards are different. Thus the par of exchange between this country
and England is $4.8665, since our dollar contains 23.22 grains of pure
gold and the English pound sterling 4.8665 times as many grains, or
113.0016. Our par of exchange with France is 19.294 cents, the
quotient of 4.4802, the number of grains of pure gold in the French
franc, divided by 23.22. Between China and the United States the par
of exchange is the market value in our dollars of the amount of silver
contained in the tael, the Chinese unit.
Another technical term employed in connection with the foreign
exchanges is _the gold points_. These are the points above and below
the par of exchange fixed by the addition in the one case, and the
subtraction in the other, of the cost of shipping gold between the two
places in question. They are the points between which the rates of
exchange fluctuate, or the points at which, when the rate of exchange
reaches them, gold moves between gold standard countries. Assuming
for example, that the cost of shipping gold between New York and
London is two cents per pound sterling, the gold points are 4.8865 and
4.8465, it being profitable to ship gold from New York to London when
sterling exchange reaches the former figure and to import gold from
London when it reaches the latter figure.
In the conduct of the foreign exchanges several classes of bills are
employed upon which the quotations differ, in part on account of
differences in their quality and in part on account of the interest
element entering into the value of time bills. For example, New York
regularly quotes on London _cables_, _demand_, and _sixty-day_ bills.
The rates on a certain date were: Cables, 4.8860; demand, 4.8790; and
sixty days, 4.8370. Inasmuch as these are all bankers' bills and
consequently of the same quality, the differences in their quotations
are due to the interest element and to the fact that in the case of
the cables the cost of the cablegram is included.
When a New York banker sells a cable on London, his balance with his
correspondent is reduced by the amount in a few hours, and the
interest he receives on such balances is proportionately diminished at
once, and he is also out the cost of the necessary cablegram. When he
sells a demand bill, his account with his London correspondent remains
undiminished during the time required for sending the bill by mail
across the Atlantic and for its presentation for payment. He draws
interest on his entire balance during this period. When he sells a
sixty-day bill, his balance does not suffer diminution on its account
for sixty days. In order to place these bills on a footing of equality
so far as he is concerned, therefore, he must quote demand and
sixty-day bills lower than cables; the former by the cost of the
cablegram plus interest on the amount of the bill, say for ten days,
at the rate he receives on his London balance, and the latter by the
amount of the cablegram plus interest on the amount for sixty days at
the same rate.
Trade, or mercantile, as well as bankers' bills are also frequently
and, in some markets, regularly quoted. Being of a quality ranked as
inferior to bankers' bills, they must be negotiated at a lower rate
and are quoted accordingly.