BANKING OPERATIONS AND ACCOUNTS
[31]The intermediate employed in actual transactions is, in increasing
degree, that form of currency called credit, the lowest order of
currency, rather than money itself. Checks and drafts make up a
progressively larger share of the circulating medium. The net deposit
credits in the national banks in the United States--to say nothing of
the other banks--are double the volume of the actual money in the
country. And a large share of this actual money is really employed as
reserves to support the credit circulation. More than 90 per cent. of
the larger sorts of transactions are mediated through the use of deposit
credit, and probably more than one-half of the remaining transactions
are similarly effected. Thus the study of banking is essential to any
understanding of monetary problems....
[32]For a bank, as well as for any other considerable establishment, it
is requisite that a capital should be provided at the outset. There can
be no constant proportion between the amount of this capital and the
extent of the business which may be built up by its means. We can only
say that, other things being equal, the larger the business that can be
carried on with safety with a given capital, the larger will be the
field from which profits can be earned, and the higher the proportion
which the profits will bear to the original investment; but the point at
which the extension of the business passes the line of safety, must be
determined by the circumstances of the particular bank, by the kind of
business carried on by those dealing with it, and by the condition of
the community in which it is established. The attempt has sometimes
been made to limit by law for incorporated banks the proportion of
transactions for a given amount of capital, but no such provision has
any foundation except a conjectured average, too rough to be of service
in any individual case. In this respect, as in so many others, the
judgment of the persons most interested, acting under the law of
self-preservation, is far more trustworthy than any legislative
decision.
The capital thus to be provided at the outset is, of course, in the case
of a private bank, the contribution of the partners, as in any other
undertaking. In the case of an incorporated bank the capital is divided
by law into equal shares or units of fixed amount; as _e. g._, under the
law of the United States, a capital of $100,000 is divided into 1,000
shares of $100 each; and these shares are contributed by the individual
shareholders, in such proportion as they please. The law may as a matter
of public policy limit the proportion of capital stock to be owned by
any one individual or firm, and it may also limit the liability of
shareholders for debts due by the bank, in case of its failure; but in
general, in the absence of special provisions to the contrary, the
powers, rights, and liabilities of every shareholder are now usually
determined by the number of shares of the stock contributed or owned by
him. In the election of directors and of other officers for the
immediate management of the business, every share entitles its owner to
cast one vote; the dividend of profit is divided in the ratio of shares
owned, and contributions to meet losses, if required by law, are called
for in the same ratio.
The capital subscribed by the intending shareholders must necessarily be
paid in in money or in the legal tender of the country. It is not
necessary that the whole should be paid in at the outset, but the
payment of the whole usually precedes the full establishment of the
business; and, in the case of incorporated banks, the law often requires
that some definite proportion, as _e. g._, one-half, shall be paid in
before the opening of business, in order to insure good faith and a
solid basis for the business undertaken.
If, now, we undertake to represent by a brief statement of account the
condition of a bank having a capital of $100,000 paid in, in specie, on
the morning when it opens its doors for business, we shall have the
following:
_Liabilities_ _Resources_
Capital $100,000 Specie $100,000
It may at first sight appear to be a contradiction in terms, that the
capital should be set down as a liability and not as a resource. But we
must here distinguish between the financial liability for what has been
received from the shareholders and the right of property in the thing
received. The bank has become accountable to its shareholders for the
amounts paid in by them respectively, but the money actually paid in has
become the property of the bank; or, in the language of accountants, the
bank has become liable for its capital, and the money in hand is for the
present its resource for meeting this liability, or for explaining the
disposition made of what has been received.
As the bank requires banking-rooms and a certain supply of furniture and
fixtures for the convenient transaction of its business, we may suppose
it to expend $5,000 of its cash in providing this "plant." The property
thus procured, with the remaining $95,000 in cash, will then be the
aggregate resources by means of which the capital is to be accounted
for, and the account will stand as follows:
_Liabilities_ _Resources_
Capital $100,000 Real estate, furniture, fixtures, etc. $ 5,000
Specie 95,000
-------- --------
$100,000 $100,000
The bank, however, cannot answer the purposes of its existence, or earn
a profit for its shareholders, until its idle cash is converted into
some kind of interest-bearing security. Nor is it enough that a
permanent investment of the ordinary kind should be made, as by the
simple exchange of the cash for government bonds or railway securities.
It is the chief business of the bank to afford to purchasers and dealers
the means of using, by anticipation, funds which are receivable by them
in the future, and this implies both the purchase of private securities
or "business paper" to a considerable extent, and also frequent change
and renewal of purchases. Moreover, while the private capitalist finds
it advantageous to make simple investments of a permanent sort, this
would plainly be insufficient for the shareholders of a bank, who have
to pay from its profits some serious expenses of management, and need,
therefore, a larger field for earnings than the ordinary returns on
their capital alone. The bank being obliged then to extend its
operations beyond the amount of its capital, is compelled for this
purpose to make use of its credit. In fact, it is only by such a use of
its credit that the establishment becomes in reality a bank.
Most of the conditions of the case are best answered by the "discount"
of commercial paper as above described. The time for which such
obligations have to run varies with the custom of the trade which gives
rise to them, but is in most cases short enough to imply early repayment
to the bank. And even where custom gives the paper longer time, if the
paper itself is used only as a collateral security, the note which is
the actual object of negotiation with the bank is by preference usually
made not to exceed four months. It is easy then to arrange the purchases
of paper with reference to the times of maturity, so as to provide for a
steady succession of payments to the bank, and thus facilitate the
reduction of the business, if necessary, or its direction into new
channels, as prudence or good policy may require. The certainty of
prompt payment at maturity, needed for this end, is presented in a high
degree by the paper created in the ordinary course of business.
Independently of the collateral security which the bank may hold, the
written promise of a merchant or manufacturer to pay on a fixed day is
an engagement which involves the credit of the promisor so far that
failure is an act both of legal insolvency and of commercial dishonor.
Selected with judgment, then, such paper is not only the investment
which most completely answers the purposes of the bank's existence, but
is probably as safe as any investment which could be found.
It may easily happen, however, that the bank may find it desirable to
invest a part of its resources in some other form, either because good
commercial paper cannot be procured in sufficient amount, or as a matter
of policy. In this case it will purchase such other securities as offer
not only complete safety of investment, but the possibility of easy
conversion into cash in case of need. In this country United States
bonds, and many descriptions of State, municipal, and corporation bonds
might answer this purpose. Stocks would more rarely answer it, being
more liable to the fluctuations in price caused by misfortune or the
ordinary vicissitudes of business. Mortgages on real estate, however,
would not be admissible, except when held as a security, collateral to
some other which is more easily convertible, for even when the mortgaged
property is so ample and stable as to insure the goodness of the
mortgage, the conversion of the mortgage into cash by sale is not always
easy, and is especially difficult at those times when the bank most
needs to have all its resources at command. Indeed, the danger to be
apprehended from the locking up of resources, in securities which may be
solid but are not easily realized, is so great, that it has been said to
be the first duty of the banker to learn to distinguish between a note
and a mortgage, his business lying with the former. Real estate, of
course, cannot be regarded as a banking security, however desirable it
may be as an investment for individuals, for it is not only subject to
great fluctuations in value, but is at times unsaleable....
The results of the process of investment in commercial paper and in
other securities are best understood when we trace the effect in the
account of the bank. Taking then the account as it stood after the
purchase of fixtures, let us suppose that the bank buys paper or
securities from those dealing with it, or, in the common phrase, makes
"loans to its customers," to the amount of $90,000, the paper being in
many pieces and having various lengths of time to run, but averaging
about three months. Supposing the interest to be computed at 6 per
cent., we should have the account changed by the operation as follows:
_Liabilities_ _Resources_
Capital $100,000 Loans $90,000
Undivided profits 1,350 Real estate, furniture, fixtures, etc. 5,000
Deposit 88,650 Specie 95,000
-------- --------
$190,000 $190,000
Here we have the securities which certify the right of the bank to
demand and receive $90,000 at a future date placed among the resources;
the net proceeds of the securities, or the aggregate of the sums which
the bank holds itself liable to pay for them on demand, stand among the
liabilities as deposits; and the interest deducted in advance, or the
profit on the operation, which the bank must at the proper time account
for to the stockholders, also stands as a liability. This, however, is
the condition of the account at the moment of making the investment,
when the bank has made its purchase of securities by merely creating a
liability. As this liability is real and must be met, so far as the
depositors at any time see fit to press it, let us suppose that
depositors call for cash to the amount of $15,000, and we shall have a
further change in the account as follows:
_Liabilities_
Capital $100,000
Undivided profits 1,350
Deposits 73,650
------
$175,000
_Resources_
Loans $90,000
Real estate, etc 5,000
Specie 80,000
------
$175,000
It is clear that, unless the enforcement of the liability for deposits
and consequent withdrawal of specie goes much farther than this, the
bank can safely increase its loans or its purchase of securities,
although its method of doing so is by the increase of its liabilities.
We will suppose it, therefore, to have expanded its affairs until it has
reached something like the average condition of those banks in the
United States, which, being incorporated under the laws of the several
States, are not authorized to issue notes. It will then stand thus:
_Liabilities_
Capital $100,000
Surplus 29,000
Undivided profits 10,000
Deposits 305,000
--------
$444,000
_Resources_
Loans $305,000
Bonds and stocks 23,000
Real estate 15,000
Other assets 20,000
Expenses 1,000
Legal-tender notes }
Cash items } 80,000
Specie }
--------
$444,000
Postponing for the present the consideration of some terms which here
occur for the first time, it appears from the above account that
purchases of securities have been made to more than three times the
amount of the capital, and that this has been effected chiefly by the
creation of liabilities in the form of deposits. What determines the
limit to which this process can be carried?
If depositors seldom demanded the payment to which they are entitled,
but were contented with the mere transfer of their rights among
themselves as a conventional currency, the bank might dispense with
holding any large amount of specie or cash in any form and keep most of
its resources employed in its productive securities. The expansion of
the deposits would then resemble in its effects the expansion of any
other currency and might go on until a check should be interposed by the
consequent rise of prices and demand for specie for exportation. And it
is true, as we shall see, that in communities where banking is largely
practised, the use of deposits as currency by transfer from hand to hand
is so extensive, that a bank in good credit can rely upon their being
withdrawn so slowly, or rather to so small an extent, as to make it
unnecessary to have cash in readiness for the payment of more than a
small proportion at any given moment. But in a period of financial
disorder or alarm, withdrawals may be made earlier or more frequently,
and a larger provision of cash may be needed for safety, than at other
times; the kind of business carried on by depositors may expose one
bank, or the banks in one place, to heavier occasional demands, or may
on the other hand make demands steadier, than is the case elsewhere; and
a city bank may be more subject to heavy calls from depositors than a
country bank. In general, then, for every bank, in its place and under
the circumstances of the time, there is some line below which its
provision of cash cannot safely fall. This provision of cash, which in
the account last given includes the cash items, specie, and legal-tender
notes, is called the reserve, and the necessity of maintaining a certain
minimum reserve fixes a limit to the ability of the bank to increase its
securities. For obviously any increase of securities, that is, of loans
or bonds, must ordinarily be effected, either by an increase of
deposits, or by an actual expenditure of cash. If, then, the reserve
were already as low as prudence would allow, or were threatened by
approaching heavy demands from depositors, no increase of securities
could be made without serious risk.
What proportion the reserve should bear to the liabilities which it is
to protect is a question which the law has sometimes attempted to
settle, by requiring a certain minimum, leaving it to every individual
bank to determine for itself how much may be required in addition to
this minimum. And this is no doubt as far as any general rule can go. As
has already been suggested, the requirements for safety of different
banks and in different places must vary, and so must the requirements of
the same bank at different times. In fact, the question as to the proper
amount of reserve never depends simply on the absolute ratio of the
reserve to the liabilities, but always involves further questions as to
the probable receipts of cash by the bank and probable demands upon it,
in the near future. It can only be said that the reserve should be large
enough, not only to insure the immediate payment of any probable demand
from depositors, but also to secure the bank from being brought down to
the "danger line" by any such demand. If 25 per cent. is the minimum
consistent with safety, the reserve should be far enough above this to
be secure from reduction to a point where any further demand or accident
may make the situation hazardous.
In the management of its reserve the bank itself necessarily feels a
strong conflict of interests. On the one hand, it is impelled to
increase its securities as far as possible, for it is from them that it
derives its profits, and the retention of a large amount of idle cash is
felt as a loss. On the other hand, the maintenance of a reserve
sufficient, not only to enable the bank to continue its payments but to
inspire the public with confidence in its ability to continue them, is a
necessity of its existence, even though a part of its resources do thus
appear to be kept permanently idle. As a natural consequence, the actual
settlement of the question in favor of a large or of a small reserve in
any particular case will depend in good measure on the temperament of
the managers. In every banking community may be found "conservative"
banks, the caution of whose managers forbids them to take risks by
extending their business at the expense of an ample reserve; and by
their side may be seen the more "active" banks, whose managers
habitually spread all possible sail, and provide for the storm only when
it comes.
It is to be observed that the necessity of providing a cash reserve is
not met by the excellence of the securities held by the bank. Although
their certainty of payment at maturity be absolute, still the demands
upon the banks are demands for cash, and cannot be answered by the offer
of even the best securities. If the depositor or creditor does not
receive cash in full for his demand when it is made, the bank has
failed, and any satisfaction of his claim by the delivery of a security
is, as it were, only the beginning of a division of the property of the
bank among its creditors. Specie, therefore, or the paper which is a
substitute for it as a legal tender for debt, forms the real banking
reserve. The reserve of the bank may, however, be greatly strengthened
by the judicious selection of securities. For example, if, in the
account above given, the "bonds and stocks" are, as they should be, of
descriptions which are readily saleable, they afford the means of
replenishing the reserve in case of need, without foregoing the
enjoyment of an income from this amount of resources for the present. In
extreme cases of general financial panic, it is true, even the strongest
government securities may find but few purchasers; still such a
provision is the best support which can be had in the absence of, or as
an auxiliary to, a sufficient reserve of actual cash.
The natural method of securing the proper apportionment of resources
between securities and reserve, under ordinary circumstances, is by
increasing or diminishing the loans, or, in other words, the purchases
of securities made from day to day in the regular course of business.
That part of the securities which consists of the promises of
individuals or firms to pay to the bank at fixed dates, is made up of
many such pieces of commercial paper, maturing, if properly marshalled,
in tolerably steady succession. The payment of one of these engagements
when it becomes due may be made either in money, or by the surrender to
the bank of an equal amount of its own liabilities ... [in the form of
deposits]. In the former case, the payment of the maturing paper to the
bank is in fact the conversion of a security into cash, and increases
the reserve without change in the liabilities; in the latter, the
reduction of securities is balanced by a reduction of liabilities which
raises the proportion of reserve. If, then, the bank stops its
"discounts" or the investments in new securities, or if it even slackens
its usual activity in making such investments, the regular succession of
maturing paper will gradually strengthen its reserve; if it increases
its activity in investment, it will weaken or lower its reserve; and if
it adjusts the amount of its new investments to the regular stream of
payments made by its debtors, it may keep the strength of its reserve
unaltered, until some change in the condition of affairs brings cash to
it or takes cash away by some other process.
This natural dependence of the reserve upon the more or less rapid
re-investment of its resources by the bank is distinctly recognized by
the law of the United States, which provides that when the reserve of
any national bank falls below the legal minimum, such bank "shall not
increase its liabilities by making any new loans or discounts," until
its reserve has been restored to its required proportion. By a less
harsh application of the same principle, the Bank of England operates
upon its reserve by lowering or raising its rate of discount, and thus
encouraging or discouraging applications for loans. And it was with a
view of facilitating the replenishment of the reserve by the curtailment
of loans, that the law of Louisiana formerly provided that the banks of
New Orleans should hold what were called "short bills," or paper
maturing within ninety days, to the amount of two-thirds of their cash
liabilities, so that the constant stream of payments of such paper might
always insure to every bank the early command of a large part of its
resources.
To return, in conclusion, to the account last given; we have there among
the liabilities certain sums classified as "surplus" and as "undivided
profits." Taken together these sums represent the profits which have
been made, but not divided among the stockholders, and which are
therefore to be accounted for by the bank. The surplus is that portion
of these profits which as a matter of policy it has been determined not
to divide and pay over to the stockholders, but to retain in the
business, as in fact, although not in name, an addition to the capital.
The remaining portion, the undivided profits, is the fund from which,
after payment of current expenses and of any losses which may occur, the
next dividend to the stockholders will be made. The current expenses are
for the present entered on the other side of the account, as they
represent a certain amount of cash which has disappeared; but at the
periodical settlement of accounts they must be deducted from the
undivided profits, and will thus drop out from the statement. "Other
assets," here set down as an investment, may be supposed to cover any
form of property held by the bank and not otherwise classified, but
especially the doubtful securities, or such property, not properly dealt
in by a bank, as it may have been necessary to take and to hold
temporarily, for the purpose of securing some debt not otherwise
recoverable. For example, although the bank could not properly invest in
a mortgage, it might be wise for it to accept a mortgage in settlement
with an embarrassed debtor, and in this case the mortgage would stand
among the "other assets." And, finally, "cash items" include such
demands on individuals or other banks as are collectible in cash and can
therefore fairly be deemed the equivalent of cash in hand. In the
absence of any legal provision limiting the classification of such
demands as reserve, they may be regarded as virtually a part of the
reserve, which in the case before us may therefore be treated as made up
of cash items, specie, and legal-tender notes.
To illustrate what has been said in this chapter we will now suppose the
bank to make the following operations:
a. To add to its securities $20,000, by discount of three-months paper
at 6 per cent., three-fourths being purchased by the creation of
liabilities, and one-fourth by the expenditure of cash. The account
would then stand as follows:
_Liabilities_
Capital $100,000
Surplus 29,000
Undivided profits 10,300
Deposits 319,775
--------
$459,075
_Resources_
Loans $325,000
Bonds and stocks 23,000
Real estate 15,000
Other assets 20,000
Expenses 1,000
Reserve 75,075
--------
$459,075
b. To retrace its steps by diminishing its "discounts" or holding of
securities to the extent of $50,000, of which four-fifths are paid to it
by the surrender of demands for deposits to a like amount and one-fifth
in cash; to pay $1,250 for current expenses; and further to increase its
reserve by the sale of bonds and stocks to the amount of $10,000. The
following would then be the state of the account:
_Liabilities_
Capital $100,000
Surplus 29,000
Undivided profits 10,300
Deposits 279,775
--------
$419,075
_Resources_
Loans $275,000
Bonds and stocks 13,000
Real estate 15,000
Other assets 20,000
Expenses 2,250
Reserve 93,825
--------
$419,075
c. To sell $2,000 of its other assets for cash with a loss of $500; to
make a semi-annual dividend of 4 per cent., of which one-half is
credited to stockholders who happen to be depositors also, and one-half
is paid in cash; to sell $4,000 of bonds at a profit of 15 per cent.,
and to carry $1,000 of its undivided profits to surplus. The account
would then stand at the beginning of the new half year, as follows:
_Liabilities_
Capital $100,000
Surplus 30,000
Undivided profits 3,150
Deposits 281,775
--------
$414,925
_Resources_
Loans $275,000
Bonds and stocks 9,000
Real estate 15,000
Other assets 18,000
Reserve 97,925
--------
$414,925
STATEMENT OF A REPRESENTATIVE NATIONAL BANK
_Resources_
Loans and discounts $739,743.27
Overdrafts, secured 973.08
U. S. bonds deposited to
secure circulation 100,000.00
U. S. bonds pledged to
secure U. S. deposits 1,000.00
Bonds other than U. S.
bonds pledged to secure
postal savings deposits 7,000.00
Other Securities 191,098.05
Stock of Federal Reserve
bank 4,800.00
Banking House 30,000.00
Furniture and Fixtures 5,000.00
Due from Federal Reserve
Bank 20,000.00
Due from approved reserve
agents 89,919.25
Due from other banks 12,074.23
Checks on banks in same
city 6,051.46
Outside checks and other
cash items 13,171.83
Fractional currency, nickels,
and cents 283.14
Notes of other national
banks 1,295.00
Coin and certificates 38,604.05
Legal-tender notes 25,000.00
Redemption fund 3,500.00
-------------
$1,289,513.36
_Liabilities_
Capital stock
paid in $100,000.00
Surplus fund 60,000.00
Undivided
profits 40,877.46
Less current
expenses, interest,
and
taxes paid 17,110.28 23,767.18
Circulating
Notes Out-standing 98,500.00
Individual deposits
subject
to check 404,871.37
Certificates of
deposit due
in less than
30 days 596,335.82
Certified
Checks 125.00
United States
deposits 1,000.00
Postal savings
deposits 4,913.99
-------------
$1,289,513.36
[33]~The Method and Extent of Credit Issue.--~Assume that a bank with a
cash capital of $100,000 is opening for business in an isolated town and
is the only bank in that town. How much can it lend? Ordinarily a bank
lends by discounting a customer's note and by giving the customer a
deposit credit upon its books for the proceeds of the note.... If, now,
our bank in question lends $100,000, giving deposit credit for this sum,
it has $100,000 of cash on hand against $100,000 of cash liability. Its
statement will stand as follows:
_Resources_
Cash $100,000
Notes 100,000
--------
$200,000
_Liabilities_
Capital Stock $100,000
Deposits 100,000
--------
$200,000
Now let it lend another $100,000. With its loans and deposits each
standing at $200,000 its reserves are 50 per cent. of its demand
liability. Only with $666,666 of loans will its reserves have reached
... [a] 15 per cent. limit:
_Resources_
Cash $100,000
Notes (Loans and Discounts)
666,666
--------
$766,666
_Liabilities_
Capital Stock $100,000
Deposits 666,666
--------
$766,666
Further: Suppose that $100,000 of cash is deposited with the bank from
the channels of business; how much more can it lend? Fifteen thousand
dollars must be retained as reserve against the new liability; $85,000
is available as reserves against further lending. Based upon these
further reserves loans may be granted to the extent of nearly $600,000
more. In fact, only with an expansion of $1,233,333 in loans and in
derived deposits--a total deposit of $1,333,333--has its reserve fallen
to the ratio of 15 per cent. of its liability.
_Resources_
Cash (original) $100,000
Loans and Discounts 666,666
Cash (new) (85,000
(15,000
L & D (new) 566,666
----------
$1,433,333
_Liabilities_
Capital Stock $100,000
Deposits 666,666
Deposits (new) (100,000
(566,666
----------
$1,433,333
The situation summarizes as follows: On its asset side the bank has
$200,000 of cash and $1,233,333 of securities (Bills and Notes). Its
deposit liabilities amount to $1,333,333.
Its cash is 2/13.3+ of its liability--15 per cent.
~The Function of Reserves.~--If this is what actual banking means, is
banking safe? What would happen if all these deposits were immediately
called for in cash? True, not all are likely to be called for, but some
cash will be demanded. In fact, the borrowers, instead of accepting all
of the proceeds of these notes in deposit credit, will in some measure
require and receive cash. Precisely so; and so the bank must keep on
hand a cash reserve to meet this possibility. For the most part,
however, the customers of the bank make payments through checks upon the
bank, and these credits are deposited in turn to the credit of other
customers. No cash, but only bookkeeping, is required. And if some
customers draw out cash, other customers will probably receive it and
return it to the bank. A reserve of 15 per cent. is enough for the case.
There, would, indeed, be small gain in banking if against every deposit
an equal sum in cash must be held in store by the bank.
~Economy of Redemption Money.~--It is thus evident that the employment of
$200,000 cash as a banking reserve has made possible the existence of a
more than sixfold volume of circulating medium--currency. Against each
$1,000 of deposit liability there need be only $150 of actual cash. The
bank customer, however, thinks of his deposit claim as money, and it
really serves him all the purposes of money. The right to have the money
when desired is as good as the actual money, is more convenient, and is
as readily and as serviceably transferred.
The economy of money through the use of credit substitutes for money
extends really further than the foregoing analysis indicates. Under the
[now superseded] law, three-fifths of the reserves of a rural bank may
be on deposit with banks in reserve cities. Thus against $100,000 of
deposit liability the rural bank needs hold only $6,000 of reserve
money. Against the deposit of the remaining $9,000, the reserve city
bank is required in turn to hold a reserve of only 25 per cent.--$2,250.
And of this required $2,250, one-half may be represented by deposits in
central reserve cities, _e. g._, New York, Chicago, and St. Louis.
Against the $1,125 deposited with it the central reserve bank is
required to hold only 25 per cent. of reserves--$281.25. Thus at the
outside limit of credit extension, $100,000 of deposit currency may be
supported by only $7,406.25 of reserves in money,
(6000 + 1/2 x (9000/4) + (1125/4)).
one dollar of reserves upholding $13 of currency.[34]
It is, of course, not true that the banks ordinarily allow their
reserves to run as low as the legal limit, or make the utmost possible
use of the privilege of counting claims against one another as legal
reserves. Nor is it accurately true that all forms of money are of equal
efficiency in the support of credit. Not all forms of money, but only
those of the higher levels in the money scale, are allowed to be counted
as legal reserves.... Some forms of money make demands upon other forms
for redemption, or are limited in exchange power to the exchange power
of the form in which redemption is to be made. The total exchange
efficiency of the money of a country is, then, not accurately to be
computed on the assumption that all moneys are equally efficient for all
purposes--that some are not in varying degree burdens upon the money
functions of the others.
~Banking Viewed in Detail and in the Aggregate.~--And one further
modification is called for. The analysis so far made, while valid for
any isolated bank, or for the banking system regarded as an aggregate,
is not precisely accurate for the affairs of any one competing bank
among other banks. When the check drawn by the borrowing depositor may
be deposited in other banks and collected by them against the lending
bank, its granting of credits rapidly draws down its reserves to swell
the reserves of its competitors. One hundred thousand dollars of new
reserves may not mean to it an increase of lending power of more than,
say, $125,000. For banks in the aggregate, however, this increase of
reserves brings its full several-fold increase of lending power,
provided that all the reserve efficiency is utilized in whatever bank it
rests. As the lending by each bank is depleting its reserves, the
lending which other banks are doing is reinforcing these reserves. The
aggregate possible extension of credit is not changed.
~What Banks Actually Do and Lend.~--It follows from the foregoing analysis
that, in the main, banks do not lend their deposits, but rather, by
their own extensions of credit, create the deposits; that these deposits
are funds which the deposit-creditors of the bank can lend if they will,
and that many men into whose hands these deposits fall through transfer
are certain to use them as funds to be lent. In fact, also, even when
the deposits in the bank are not derived from the lending activity of
the bank, but are really funds deposited from outside sources, these
funds are commonly used by the bank as a reserve basis on which loans
are extended rather than as funds which are themselves loaned out by the
bank. Banks are, in truth, mostly intermediaries between debtors and
creditors--but not in the sense of borrowing funds from one class of
customers in order to lend them to another class, but rather in the
sense of creating for their borrowing customers funds which may be used
by these borrowers as present purchasing power. The borrower becomes
indebted to the bank in order that for his own purposes he may use the
promise of the bank as the equivalent of cash to himself. In the form of
a deposit liability the bank becomes a debtor to whomever the borrower
shall nominate. The fact that the borrower pays interest while the bank
undertakes a noninterest-bearing obligation, or pays relatively low
interest, explains in the main the gains attending the business of
commercial banking.
~Deposits and Solvency.~--It is, therefore, a sheer blunder to infer that
a bank is rich or strong because of its great total of deposits, or to
regard deposits in banking institutions as making part of the aggregate
wealth of the community. Instead, the deposits indicate for a bank the
extent of its operations, and indicate for a community the extent to
which the banks, under the guise of noninterest-bearing obligations,
have assumed the debts of business men, on terms of these business men
becoming debtors--and interest-paying debtors--to the banks. The
solvency of the bank is in its portfolio of securities. Its deposits are
not its assets, but its liabilities. These liabilities it has mostly
created for the use of its borrowers. The further it may safely go in
assuming liabilities, the larger its holdings of borrowers' notes may
be, and the more interest or discount charges it may collect.
Essentially, therefore, the business of a bank is a form of
suretyship--the guaranteeing of its borrowers' solvency--an underwriting
of the credit of its customers. The bank transfers its customers'
prospective future paying power into present funds. It is for this
reason that the contract takes the form of a money loan and the premium
the guise of an interest payment.
~Bank Loans Related to Currency and Loan Funds.~--And note now that it is
precisely because the business of a bank is to furnish to its borrower
a present purchasing power for his own use that the business of banking
becomes the source of the larger part of the circulating medium of
society. In their service to their customers the banks create currency;
and in creating currency they create loan funds which, in the hands of
the holders of them, are available like other currency for any purpose,
either lending or other.
~The Sources of Currency Supply.~--It is, then, clear that the larger part
of the circulating medium of society is not money; that not all of the
money that there is is bullion money; and that not even all of the
bullion money need be ultimate money--redemption money of the highest
rank. The sources of currency in society are various--some of it
bullion, with a cost of production limit upon its supply, some of it
government paper, substantially free of cost, some of it banking credit
with certain peculiar and appropriate costs attending its issue.
~Currency and Its Cost of Production.~--It is obvious that the actual
limitations upon the supply of exchange media must be made clear if we
are to understand the influences which are fundamental to the exchange
values of the currency unit. Only, indeed, by this investigation of the
sources of the supply, and of the terms on which each different factor
of the supply is available, are we in position to understand the
influences which impose upon bidders for money a certain level of
sacrifice in obtaining it.
What, then, are the limitations upon the supply of credit currency
supplied by the banks? In other words, what are the banking costs in the
granting of demand deposit rights to customers? Evidently limitations
there must be, and limitations in the nature of costs, else the
competitive activity of the banks would indefinitely increase the supply
of currency, and any would-be purchaser of goods or payor of debts or
projector of an enterprise could have the time use of purchasing power
gratis; no limit would exist to the rise in prices which must attend
this increase in the circulating medium.
What are these limitations? (1) Each bank must conform the volume of its
lending, and therewith its issue of circulating credit, to the
fundamental requirement that it be always able to make good its
agreement to discharge its deposit liabilities on demand. To maintain
reserves involves expense. Especially may it be expensive if they have
been allowed to get low; securities may have to be marketed at a
sacrifice, or good customers pressed for payment at inconvenient times.
In periods of general pressure or panic, other banks are not likely to
be in a position to lend their own reserve funds or to consent to create
deposit credit in aid of still other suffering banks. Not rarely the
Bank of England, in the attempt to attract reserve funds, advances bank
notes or deposit credit to importers of gold, without imposing the
customary interest charge for the covering of the delays of the mint. In
at least one case, in 1890, it borrowed reserves from the Bank of
France. In 1907 the United States Treasury made especially large money
deposits with the national banks of New York to help eke out the needed
reserves. Meantime the interior banks were compelled to pay to exporting
merchants generous premiums for exchange bills upon Europe, through
which, despite the high interest rates ruling in European markets, these
banks were able to import 107 millions of gold for their own reserve
requirements. In fact, the banking business involves the hazard not
merely that some of the debtors of the bank may become insolvent, but
also the general and overhead hazard attaching to its underwriting
service that it may itself in time of stress become unable to meet its
obligations. Its liabilities must not be allowed to get seriously out of
ratio to its cash resources.
~The Protection of Reserves.~--In point of fact also the efforts of the
various different banks to maintain each its own reserve place a limit
on the extent to which any one bank can extend its activity in the
expansion of loans and of the derivative liabilities. Just as a
relatively liberal granting of credit by one bank must tend to transfer
its reserves to other banks, so a relatively great extension of credit
in one center or in one country must tend to transfer the reserves, _e.
g._, gold, to other centers or countries. Even were it true that a local
credit expansion has no effect upon local prices and thereby upon the
currents of trade, some transfers of reserves would still take place,
and would impose a policy of restriction in credit accommodations....
The influence is actually exerted by both methods.
~(2) Another Cost in Bank-Made Currency.~--The loan rates of the bank must
also provide a fund to cover its costs of administration--salaries,
clerk hire, rents, and the like. Where transactions run in large units
the ratio of expense to the volume of business may be low. This is in
part the explanation for the low rates of discount in the great
financial centers compared with the rates outside. Credit currency has
its cost of production rate as truly as any other service upon the
market....
THE RELATION BETWEEN LOANS AND DEPOSITS
[35]The money of modern English commerce and finance is the cheque, and
the credit dealt in in the London money market is the right to draw a
cheque....
Now that we have come to the point at which the manufacture of the right
to draw cheques has to be made as clear as may be, it will be well to
come into close touch with the facts of the case and look at a bank
balance-sheet of to-day. In order to get a fair average specimen I have
taken the latest available balance-sheets of half a dozen of the biggest
London banks, and put their figures together.... Let us examine the
aggregated specimen that I have drawn up.
_Millions of L_
Capital paid up 16
Reserve Fund 11
Current and deposit accounts 249
Acceptance on behalf of customers 16-1/2
Profit and Loss account 1-1/2
-------
294
_Millions of L_
Cash in hand and at the Bank of England 43
Loans at call and short notice 27-1/2
Bills discounted and advances 153
Investments 48
Liability of customers on acceptances 16-1/2
Premises 6
-------
294
The above statement does not include the figures of the Bank of England,
but is an agglomeration of the balance-sheets of six of the biggest of
the ordinary joint-stock banks.
The first feature that strikes the casual observer is the smallness of
the paid-up capital of the banks when compared with the vastness of the
figures that they handle. We see that only 16 millions out of the 294
that they have to account for have been actually paid up by
shareholders, though 11 millions have been retained out of past profits
and accumulated in reserve funds ["surplus," in United States], and
1-1/2 millions are due to shareholders, for distribution as dividend or
addition to reserve, in the shape of the profit and loss account balance
for the period covered by the balance-sheet. A profit of 1-1/2 millions
on 16 is handsome enough, especially when it is considered that most of
these balance-sheets covered a half-year's work, but 1-1/2 millions out
of 294 is a trifle, and it thus appears that a narrow margin of profit
on their total turnover enables the banks to pay good dividends, and
that the business of credit manufacture earns its reward, as might be
expected, out of the credit that it makes.
Proceeding in our examination, we see that the item of acceptances on
behalf of customers on one side is balanced by the liability of
customers on the other. This means that the banks have accepted bills
for their customers (so making them first-class paper and easily
negotiable), and are so technically liable to meet them on maturity; but
since the customers are expected to meet them, and have presumably given
due security, this liability of the customer to the bank is an
offsetting asset against the acceptance. And since the acceptance
business is a comparatively small item, and a bank's liability under its
acceptances is not a liability in quite the same sense as its deposits,
and does not immediately affect the present question of the manufacture
of currency, it may be omitted for the present. We can thus simplify the
balance-sheet by taking out this contra entry on both sides.
Further analysis of the liabilities shows that the capital, reserves, or
surplus, and profit and loss balance may be regarded as due from the
banks to their shareholders, and that the remaining big item, current
and deposit accounts, is due to their customers. This is the item which
is usually spoken of as the deposits, according to the tiresome habit of
monetary nomenclature which seems to delight in applying the same name
to a genus and one of the species into which it is divided. Just as the
bill of exchange is divided into cheques and bills of exchange, so the
English banks' deposit accounts are divided into current and deposit
accounts. But most people who have a banking account know the meaning of
this distinction. Your current account is the amount at your credit
which you can draw out, or against which you can draw cheques, at any
moment; your deposit account is the amount that you have placed on
deposit with the bank and can only withdraw on a week's or longer
notice, and it earns a rate of interest, usually 1-1/2 per cent. below
the Bank of England's official rate. The essential point to be grasped
is the fact that the banks' deposits, as usually spoken of, include both
the current and deposit accounts, and are due by the banks to their
customers.
Now let us see how this huge debt from the banks to the public has been
created. An examination of the assets side of the balance-sheet proves
that most of it has been created by money lent to their customers by the
banks, and that the cheque currency of to-day is, like the note currency
of a former day, based on mutual indebtedness between the banks and
their customers. For the assets side shows that the banks hold 43
millions in cash and at the Bank of England, 48 millions in investments,
and 6 millions invested in their premises--the buildings in which they
conduct their business--and that 180-1/2 millions have been lent by them
to their customers, either by the discounting of bills or by advances to
borrowers, or by loans at call or short notice. We can now reconstruct
our balance-sheet, leaving out the acceptances on both sides, as
follows:
_Millions of L._ _Millions of L._
Due to shareholders 28-1/2 Cash in hand and at Bank
Due to customers 249 of England 43
-------- Investments 48
277-1/2 Premises 6
Due from customers 180-1/2
--------
277-1/2
And it thus appears that nearly three-quarters of the amount due from
the banks to their customers are due from their customers to the banks,
having been borrowed from them in one form or another. And this
proportion would perhaps be exceeded if we could take the figures of
English banking as a whole. But that cannot be done at present, because
some of the smaller banks do not separate their cash from their loans at
call in their published statements. The greater part of the banks'
deposits is thus seen to consist, not of cash paid in, but of credits
borrowed. For every loan makes a deposit, and since our balance-sheet
shows 180-1/2 millions of loans, 180-1/2 out of the 249 millions of
deposits have been created by loans.
To show how a loan makes a deposit, let us suppose that you want to buy
a thousand-guinea motor-car and raise the wherewithal from your banker,
pledging with him marketable securities, and receiving from him an
advance, which is added to your current account. Being a prudent person
you make this arrangement several days before you have to pay for the
car, and so for this period the bank's deposits are swollen by your
L1,050, and on the other side of its balance-sheet the entry "advances
to customers" is also increased by this amount, and the loan has clearly
created a deposit.
But you raised your loan for a definite purpose, and not to leave with
your bank, and it might be thought that when you use it to pay for your
car the deposit would be cancelled. But not so. If the seller of your
car banks at your bank, which we will suppose to be Parr's, he will pay
your cheque into his own account, and Parr's bank's position with regard
to its deposits will be unchanged, still showing the increase due to
your loan. But if, as is obviously more probable, he banks
elsewhere--perhaps at Lloyd's--he will pay your cheque into his account
at Lloyd's bank, and it will be the creditor of Parr's for the amount of
L1,050. In actual fact, of course, so small a transaction would be
swallowed up in the vast mass of the cross-entries which each of the
banks every day makes against all the others, and would be a mere needle
in a bottle of hay. But for the sake of clearness we will suppose that
this little cheque is the only transaction between Parr's and Lloyd's on
the day on which it is presented; the result would be that Parr's would
transfer to Lloyd's L1,050 of its balance at the Bank of England, where
all the banks keep an account for clearing purposes. And the final
outcome of the operation would be that Parr's would have L1,050 more
"advances to customers" and L1,050 less cash at the Bank of England
among its assets, while Lloyd's would have L1,050 more deposits and
L1,050 more cash at the Bank of England. And the L1,050 increase in
Lloyd's deposits would have been created by your loan, and though it
will be drawn against by the man who sold you the car, it will only be
transferred perhaps in smaller fragments to the deposits of other banks;
and as long as your loan is outstanding there will be a deposit against
it in the books of one bank or another, unless, as is most unlikely, it
is used for the withdrawal of coin or notes; and even then the coin and
notes are probably paid into some other bank, and become a deposit
again; and so we come back to our original conclusion that your
borrowing of L1,050 has increased the sum of banking deposits, as a
whole, by that amount.
The same reasoning applies whenever a bank makes a loan, whatever be the
collateral, or pledge deposited by the borrower, whether Stock Exchange
securities, as in the case cited, or bales of cotton or tons of copper;
or, again, whenever it discounts a bill. In each case it gives the
borrower or the seller of the bill a credit in its books--in other
words, a deposit; and though this deposit is probably--almost
certainly--transferred to another bank, the sum of banking deposits is
thereby increased, and remains so, as long as the loans are in
existence. And so it appears that the loans of one bank make the
deposits of others, and its deposits consist largely of other banks'
loans....
RELATION BETWEEN RESERVES AND DEMAND LIABILITIES AGAIN
[36]... a bank must so regulate its loans and note issues as to keep on
hand a sufficient cash reserve, and thus prevent insufficiency of cash
from ... threatening. It can regulate the reserve by alternately selling
securities for cash and loaning cash on securities. The more the loans
in proportion to the cash on hand, the greater the profits, but the
greater the danger also. In the long run a bank maintains its necessary
reserve by means of adjusting the interest rate charged for loans. If it
has few loans and a reserve large enough to support loans of much
greater volume, it will endeavor to extend its loans by lowering the
rate of interest. If its loans are large and it fears too great demands
on the reserve, it will restrict the loans by a high interest charge.
Thus, by alternately raising and lowering interest, a bank keeps its
loans within the sum which the reserve can support, but endeavors to
keep them (for the sake of profit) as high as the reserve will support.
If the sums owed to individual depositors are large, relatively to the
total liabilities, the reserve should be proportionately large, since
the action of a small number of depositors can deplete it rapidly.
Similarly, the reserves should be larger against fluctuating deposits
(as of stock brokers) or those known to be temporary. The reserve in a
large city of great bank activity needs to be greater in proportion to
its demand liabilities than in a small town with infrequent banking
transactions.
Experience dictates differently the average size of deposit accounts for
different banks according to the general character and amount of their
business. For every bank there is a normal ratio and hence for a whole
community there is also a normal ratio--an average of the ratios for the
different banks. No absolute numerical rule can be given. Arbitrary
rules are often imposed by law. National banks in the United States, for
instance, are required to keep a reserve for their deposits, varying
according as they are or are not situated in certain cities designated
by law as "reserve" cities, _i. e._, cities where national banks hold
deposits of banks elsewhere. These reserves are all in defense of
deposits. In defense of notes, on the other hand, no cash reserve is
required--that is, of national banks. True, the same economic principles
apply to both bank notes and deposits, but the law treats them
differently. The Government itself chooses to undertake to redeem the
national bank notes on demand.
The state banks are subject to varying restrictions. Thus the
requirement as to the ratio of reserve to deposits varies from 12-1/2
per cent. to 22-1/2 per cent., being usually between 15 per cent. and
20 per cent. Of the reserve, the part which must be cash varies from 10
per cent. (of the reserve) to 50 per cent., usually 40 per cent.
Such legal regulation of banking reserves, however, is not a necessary
development of banking....
THE ROLE OF A SPECIE RESERVE ILLUSTRATED BY THE INCONVERTIBLE NOTES OF
THE BANK OF ENGLAND ISSUED DURING THE OPERATION OF THE RESTRICTION
ACT[37]
[38]... Your Committee proceeded, in the first instance, to ascertain
what the price of gold bullion [in terms of Bank of England notes] had
been, as well as the rates of the foreign exchanges, for some time past;
particularly during the last year.
Your Committee have found that the price of gold bullion, which, by the
regulations of his Majesty's Mint, is L3 17_s._ 10-1/2_d._ per ounce of
standard fineness, was, during the years 1806, 1807, and 1808, as high
as L4 in the market. Towards the end of 1808 it began to advance very
rapidly, and continued very high during the whole year 1809; the market
price of standard gold in bars fluctuating from L4 9_s._ to L4 12_s._
per ounce. The market price at L4 10_s._ is about 15-1/2 per cent. above
the Mint price....
It is due,... in justice to the present Directors of the Bank of
England, to remind the House that the suspension of their cash payments,
though it appears in some degree to have originated in a mistaken view
taken by the Bank of the peculiar difficulties of that time, was not a
measure sought for by the Bank, but imposed upon it by the Legislature
for what were held to be urgent reasons of state policy and public
expediency. And it ought not to be urged as matter of charge against the
Directors, if in this novel situation in which their commercial company
was placed by the law, and entrusted with the regulation and control of
the whole circulating medium of the country, they were not fully aware
of the principles by which so delicate a trust should be executed, but
continued to conduct their business of discounts and advances according
to their former routine.
It is important at the same time to observe that under the former
system, when the Bank was bound to answer its notes in specie upon
demand, the state of the foreign exchanges and the price of gold did
most materially influence its conduct in the issue of those notes,
though it was not the practice of the Directors systematically to watch
either the one or the other. So long as gold was demandable for their
paper, they were speedily apprised of a depression of the exchange, and
a rise in the price of gold, by a run upon them for that article. If at
any time they incautiously exceeded the proper limit of their advances
and issues, the paper was quickly brought back to them, by those who
were tempted to profit by the market price of gold or by the rate of
exchange. In this manner the evil soon cured itself. The Directors of
the Bank having their apprehensions excited by the reduction of their
stock of gold, and being able to replace their loss only by reiterated
purchases of bullion at a very losing price, naturally contracted their
issues of paper, and thus gave to the remaining paper, as well as to the
coin for which it was interchangeable, an increased value, while the
clandestine exportation either of the coin, or the gold produced from
it, combined in improving the state of the exchange and in producing a
corresponding diminution of the difference between the market price and
Mint price of gold, or of paper convertible into gold.
Your Committee do not mean to represent that the manner in which this
effect resulted from the conduct which they have described, was
distinctly perceived by the Bank Directors. The fact of limiting their
paper as often as they experienced any great drain of gold, is, however,
unquestionable....
It was a necessary consequence of the suspension of cash payments, to
exempt the Bank from that drain of gold, which, in former times, was
sure to result from an unfavourable exchange and a high price of
bullion. And the Directors, released from all fears of such a drain, and
no longer feeling any inconvenience from such a state of things, have
not been prompted to restore the exchanges and the price of gold to
their proper level by a reduction of their advances and issues. The
Directors, in former times, did not perhaps perceive and acknowledge the
principle more distinctly than those of the present day, but they felt
the inconvenience, and obeyed its impulse; which practically established
a check and limitation to the issue of paper. In the present times the
inconvenience is not felt; and the check, accordingly, is no longer in
force....
By far the most important ... consequence ... [of the Restriction Act]
is, that while the convertibility into specie no longer exists as a
check to an over-issue of paper, the Bank Directors have not perceived
that the removal of that check rendered it possible that such an excess
might be issued by the discount of perfectly good bills. So far from
perceiving this ... they maintain the contrary doctrine with the utmost
confidence.... That this doctrine is a very fallacious one, your
Committee cannot entertain a doubt. The fallacy, upon which it is
founded, lies in not distinguishing between an advance of capital to
merchants, and an addition of supply of currency to the general mass of
circulating medium. If the advance of capital only is considered, as
made to those who are ready to employ it in judicious and productive
undertakings, it is evident there need be no other limit to the total
amount of advances than what the means of the lender, and his prudence
in the selection of borrowers, may impose. But in the present situation
of the Bank, intrusted as it is with the function of supplying the
public with that paper currency which forms the basis of our
circulation, and at the same time not subjected to the liability of
converting the paper into specie, every advance which it makes of
capital to the merchants in the shape of discount, becomes an addition
also to the mass of circulating medium. In the first instance, when the
advance is made by notes paid in discount of a bill, it is undoubtedly
so much capital, so much power of making purchases, placed in the hands
of the merchant who receives the notes; and if those hands are safe, the
operation is so far, and in this its first step, useful and productive
to the public. But as soon as the portion of circulating medium in which
the advance was thus made performs in the hands of him to whom it was
advanced this its first operation as capital, as soon as the notes are
exchanged by him for some other article which is capital, they fall into
the channel of circulation as so much circulating medium, and form an
addition to the mass of currency. The necessary effect of every such
addition to the mass is to diminish the relative value of any given
portion of that mass in exchange for commodities. If the addition were
made by notes convertible into specie, this diminution of the relative
value of any given portion of the whole mass would speedily bring back
upon the Bank which issued the notes as much as was excessive. But if by
law they are not so convertible, of course this excess will not be
brought back, but will remain in the channel of circulation, until paid
in again to the Bank itself in discharge of the bills which were
originally discounted. During the whole time they remain out, they
perform all the functions of circulating medium; and before they come to
be paid in discharge of those bills, they have already been followed by
a new issue of notes in a similar operation of discounting. Each
successive advance repeats the same process. If the whole sum of
discounts continues outstanding at a given amount, there will remain
permanently out in circulation a corresponding amount of paper; and if
the amount of discounts is progressively increasing, the amount of
paper, which remains out in circulation over and above what is otherwise
wanted for the occasions of the public, will progressively increase
also, and the money prices of commodities will progressively rise. This
progress may be as indefinite as the range of speculation and adventure
in a great commercial country....
FOOTNOTES:
[31] Herbert Joseph Davenport, _The Economics of Enterprise_, pp. 259,
60. The Macmillan Company, New York. 1913.
[32] Charles F. Dunbar, _Chapters on the Theory and History of Banking_,
pp. 20-38, G. P. Putnam's Sons, New York and London. 1902.
[33] Herbert Joseph Davenport, _The Economics of Enterprise_, pp. 260-6.
The Macmillan Company. New York. 1913.
[34] It should not be overlooked, furthermore, that the velocity of the
circulation of deposits is approximately two and one-half times that of
money.--EDITOR.
[35] Hartley Withers, _The Meaning of Money_, pp. 57-73. E. P. Dutton
and Company. New York. 1914.
[36] Irving Fisher, _The Purchasing Power of Money_, pp. 45-47. The
Macmillan Company. New York. 1911.
[37] This act, passed in 1797 in order to prevent a drain of gold to the
continent during the Napoleonic War, forbade the Bank of England to
redeem its notes. It remained in force until 1821, when specie payment
was resumed.--EDITOR.
[38] Report from the Select Committee on the High Price of Gold Bullion.
Ordered by the House of Commons, to be printed, 8 June, 1810.