Banking Part 2

In times of crisis and other periods of extraordinary demand, bank reserves must be much larger than in ordinary times. h.o.a.rding, unusually large shipments of money to foreign countries and between different sections of the same country, and payments of unusual magnitude, increase the demands for cash made upon banks at such times.

The manner in which clearing and other balances between banks are met also has an influence on the amount of reserves required. If such balances are paid daily and always in cash, the amount needed for this purpose is much larger than if they are paid in checks on some one or a few inst.i.tutions and at longer intervals.

The note issue privileges of a bank also affect its reserve requirements. Since, if not prohibited by law, notes may be issued in all denominations needed for hand-to-hand circulation within a nation, and since for all purposes except small change such notes are as convenient as any other form of currency, a bank with unrestricted issue privileges can supply all the demands of its customers for currency for domestic use, except those for small change, without resort to outside sources of supply. In this case, however, it needs to keep a reserve in order to meet demands for the redemption of notes. Such demands arise on account of the need of coin for small change or for shipment abroad or of means for meeting domestic clearing and other bank balances. The aggregate needed for the supply of such demands, however, is much less than would be required if the privilege of issuing notes did not exist.

In the maintenance of reserves the chief reliance of commercial banks is the circulation of standard coin within a nation and the importation of such coin. The coin within the borders of a nation pa.s.ses regularly into the vaults of banks by the process of deposit, and on account of the credit balances they carry with foreign inst.i.tutions, the loans they are able to secure from them, the commercial paper they hold which is discountable in foreign markets, and the bonds and stocks sometimes in their possession which are salable there, they are able to import large quant.i.ties in case of need. Since the standard coin in existence in the world adjusts itself to the need for it in substantially the same manner that the supply of any other instrument or commodity adjusts itself to the demand, banks ordinarily have no difficulty in supplying their needs, and under extraordinary circ.u.mstances, though difficulties along this line sometimes arise, means of overcoming them are available which will be discussed in the proper place.

If, as is the case in the United States, certain forms of government notes are available as bank reserves, these find their way into the banks' vaults by the process of deposit in the same manner as coin.

The possession of such notes by a bank enables it, to the extent of their amount, to throw the responsibility for the supply of standard coin upon the government, and in the circulation of the country such notes take the place of an equivalent amount of standard coin. Whether or not a government ought to a.s.sume such a responsibility is a question which will be discussed in a subsequent chapter.

For the nation as a whole, the balances in other banks and the discountable commercial paper and bonds which a bank may count as a part of its reserves are not reserves except to the extent that they may be employed as a means of importing gold. They are only means through which real reserves of standard coin are distributed. The payment in cash of a balance with another bank or the discount of commercial paper with another domestic bank or the sale of bonds on domestic stock exchanges do not add to the sum total of the cash resources of the banks of a nation. Their only effect is to increase the cash resources of one bank at the expense of another.

Adequate facilities for the distribution of the reserve funds of a country, however, are second in importance only to the existence of adequate supplies of standard coin. If such facilities are lacking, existing reserves can be only partially and uneconomically used, with the result that much larger aggregate reserves are required than would otherwise be necessary and that the entire credit system is much less stable than it otherwise would be.

_2. The Selection of Loans and Discounts_

The problem of the reserves is vitally connected with that of the selection of loans and discounts. As was shown in the preceding chapter, the chief business of a commercial bank is to conduct exchanges by a process of bookkeeping between individuals, banks, communities, and nations. This process consists primarily in the converting of commercial bills and notes into credit balances and bank notes, in the transfer of such balances and notes between individuals and banks, and in the final extinguishment of such balances and the return of such notes at the maturity of the commercial bills and notes in which the process originated.

In this process there is little need for cash, provided the arrangements between banks for clearing checks and for the interchange of notes are complete and efficiently administered. But when a bank accepts investment in lieu of commercial paper, its need for cash at once increases, because the demand obligations created by the credit balances or the bank notes into which this paper was converted are not extinguished by payments for goods purchased, but must be met by cash.

To distinguish between commercial and investment paper is, therefore, one of the chief problems confronting commercial bankers. For its solution an accurate knowledge of the business operations of customers is necessary. An inspection of the paper presented and a general knowledge of their wealth and business capacity are important, but not sufficient. The forms of the paper employed in both commercial and investment operations may be the same, and the possession of wealth does not ensure the payment of the paper at maturity.

The chief means available for the acquisition of this knowledge are the requirement from customers of frequent statements of their operations, on properly prepared forms; the use, wherever possible, of the doc.u.mented commercial bill of exchange; and the maintenance of credit departments equipped with the means of accurately studying commercial, industrial, and agricultural operations, and of diagnosing economic conditions. The study of carefully prepared statements of customers made at frequent intervals reveals to the banker not only the nature of the operations represented by the paper presented for discount, but the trend of the business of his customers and, through them, of the entire country. With such knowledge, he is not only able to protect his inst.i.tution against improper loans and discounts, but to give valuable advice to his customers, advice which no one else is in a position to give so accurately.

By a doc.u.mented bill of exchange is meant a bill drawn by a seller upon the purchaser of goods, accompanied by doc.u.ments evidencing the transaction; such, for example, as bills of lading, warehouse receipts, and insurance policies. The names on such bills guide the banker in his efforts to trace the transaction in which it originated and the doc.u.ments enable him absolutely to identify it, and const.i.tute security for the loan.

Instead of such bills, promissory notes made payable to banks are commonly used in this country, greatly to the disadvantage of the banking business. Such a note reveals nothing to the banker concerning the purpose for which the loan is made, while a commercial bill, even without doc.u.ments, reveals the names of the princ.i.p.als of the transaction in which the banker is asked to partic.i.p.ate. Acquaintance with these men and knowledge of the business in which they are engaged at once suggests the probable origin of the bill and furnishes the clue needed for subsequent investigation.

A properly equipped credit department will keep on file and at all times available for use the data requisite for the information of the officers upon whom the responsibility of selecting the loans and discounts rests. Such data will not only concern the character and business of each customer and the bank's previous dealings with him, but general economic conditions, the operations and experiences of other banks, other business inst.i.tutions, governments, etc.

_3. Rates_

Besides rates of exchange considered in the preceding chapter, commercial banks are concerned with loan and discount rates.

Rates on deposits, though sometimes employed, have no place in commercial banking, since commercial deposits are only the credit balances resulting from loans and discounts or from funds intrusted to the bank for temporary safekeeping or disburs.e.m.e.nt in the interest of the depositor. In every case they represent a service rendered the depositor for which the bank must be paid, and, when interest is allowed, the depositor must repay it in some form with an increment sufficient to remunerate said service.

Commercial banks may and usually do conduct savings accounts also, for which an interest payment is not only defensible but in every sense desirable, but in so doing they are going beyond the sphere of commercial banking, which alone is under consideration at this point.

Rates charged on loans and discounts are the chief means through which commercial banks are remunerated for the services they perform. In the long run these rates are determined by compet.i.tion, and represent the current market value of the services performed by bankers. Custom often affects them temporarily and sometimes for long periods prevents their response to influences tending to produce change, but in the long run they yield to economic force and conform to the laws of value.

Variations in the rate of discount are the most efficient means employed by commercial banks for the regulation of the volume of their loans and discounts and for changing the percentage their reserves bear to deposits and note issues. An increase of these rates tends to check loans and discounts, to decrease deposits and note issues, to increase reserves, and consequently to raise the percentage of reserves to deposits and issues.

It checks loans and discounts by increasing the expense of conducting business operations on a credit basis, thus diminishing profits and sometimes causing losses, checking enterprise and decreasing the volume of commercial transactions. A decrease of loans and discounts correspondingly diminishes deposits or note issues, or both, since these are simply the counterpart or representative of such loans and discounts in the form of credit balances in the checking accounts conducted by the banks or the equivalent of such balances in a hand-to-hand money form. An increase in the rate of discount at a given point tends to attract funds from other points where the rates are lower and thus to increase reserves. A decrease of rates produces opposite effects all along the line.

_4. Protection against Unsound Practices_

Commercial banks are an essential part of the machinery by which the agriculture, industry, and commerce of a country are carried on, and their proper conduct is, therefore, a matter of public concern. On this account they have long been subjects of legislation and of public supervision and control. The methods evolved for safeguarding the public against abuses and unsound practices differ considerably among different nations and to some extent among the different states of the United States, and could only be adequately explained by a history of banking in each nation. Only the more important and most widely used of them will be described here.

(_a_) _Capital and Surplus Requirements and Double Liability of Stockholders._--A very common, indeed, almost universal, legal requirement is that before beginning business the proprietors of a commercial bank shall contribute a fund to be known as the _capital stock_, and that an additional fund, usually called the _surplus_, shall afterwards be set aside from profits. These funds are required to be maintained intact, so long as the bank continues in business, and to be used for the payment of losses in case of failure or liquidation for any reason. In this country it is also customary to hold the proprietors legally liable in case of failure for an a.s.sessment equal to the amount of their capital stock. In foreign countries it is a common practice to have the subscribed considerably in excess of the paid-in capital, the balance being subject to call by the directors at any time, and being available for the payment of losses in case of failure.

These funds serve not only as a protection against loss to the customers of a bank in case of failure, but also as a restraining influence on the managers in the everyday conduct of the bank's affairs. They const.i.tute the proprietors' stake in the business, what they are likely to lose if the management is imprudent, dishonest, or inefficient. The absence of such funds would put a premium on rashness and speculation and tempt into the business the unscrupulous and the unfit.

In the determination of the size of capital and surplus funds and of the amount of the liability of stockholders for subscriptions in case of failure, no well-founded principles have been developed for the guidance of legislators. They should be great enough to cover prospective losses and to induce conservatism, honesty, and efficiency in management, and not so great as to prevent the free flow of an adequate amount of capital into the business. Unfortunately, the statistics of losses in cases of failure are not a sufficient guide.

In some cases they bear a large proportion to the volume of business transacted and in others a very small one, and the number of cases available are too small to give much value to averages. The amount necessary to secure the best possible management is also purely problematical.

In lieu of well-founded principles, the practice has developed in this country of making the minimum capitalization permitted depend upon the population of the town in which the bank is located. This seems to be a very crude and indirect method of proportioning capital to the volume of business transacted. The fixing of such a proportion, or of a proportion which no bank should be permitted to exceed, is probably the best method of solving this problem, but it should be done directly and not by the roundabout method which has been mentioned above.

A proportion of ten to one between capital and aggregate demand obligations would probably be justified by American experience. The present practice of fixing the surplus fund at twenty per cent of the capital would be justifiable if the capital fund were properly regulated in amount.

(_b_) _Inflation and Means of Protecting the Public against It._--The greatest abuse to which the business of commercial banking is subject, and against which the public most needs protection, is inflation. This is a condition difficult to diagnose, and not well understood by the general public and even by bankers. The most easily recognized symptom of its existence is the forced liquidation of credits; that is, forced sales of property in order to meet maturing obligations to banks.

When, for example, the people whose notes or bills have been discounted by banks default in large numbers, and the collateral deposited as security has to be sold, or, in the absence of collateral, the courts must order the sale of their property, the presence of inflation may be suspected.

The chief cause of inflation is the issue by commercial banks of demand obligations against investment securities. The means of liquidating such securities are the profits of the enterprises in which the investments were made and in the nature of the case several years are required for the accomplishment of this end. Meantime the demand obligations of the banks issued against them in the form of balances on checking accounts or notes must be met and, the funds regularly deposited with them as a result of the operation of such enterprises being inadequate, other means must be found. The only one available is the sacrifice, at forced sales, of the property in which the investment was made or of some other property in the possession of the persons responsible to the bank.

The banks usually protect themselves against such forced liquidation by the requirement that the paper they discount shall mature at short intervals, usually not to exceed four to six months, and accept the long-time securities, such as bonds, stocks, and mortgages, only as collateral. By this means they are able to force the liquidation on their customers. Otherwise they would be obliged themselves to endure it, with the result that their capital and surplus funds would be impaired and perhaps exhausted; and, if they should prove inadequate, failure would be inevitable.

The evil involved in the forced sales of property caused by inflation is the readjustment of prices through which it is accomplished, and the depression and, sometimes, panic which follow. When the prices of many kinds of property must be greatly depressed in order to induce their transfer to other hands, the machinery of commerce and industry is thrown out of adjustment and is sometimes rendered temporarily useless. This result is due to the fact that the relations between costs of production and the returns from the sale of finished products are so changed that profits are reduced or annihilated, and many persons are financially ruined. Readjustments of the prices of raw products, labor, and finished goods, and the transfer of plants to new hands, are, therefore, necessary before industry, commerce, and agriculture can again operate in a normal way, and during the period of readjustment some enterprises must entirely stop operations, and all must slow down. At such times many laborers are thrown out of employment, many more work part time only, the wages of nearly all are lowered, and most other cla.s.ses of income are cut down. Depression and, in extreme cases, panic are the result, and these have serious consequences other than financial.

The means employed for the protection of the public against inflation are crude and inadequate. They may be grouped under the heads: regulations regarding investments, reserves, and note issues. Under the first head belong in the banking legislation of this country limitations on real estate investments and on the amount that may be loaned to a single firm or individual. Our national banking act and most of our state banking acts prohibit banks from holding real estate except for their own accommodation, and as a means of reimbursing themselves for defaulted loans, and our national banking act prohibits the taking of real estate security for loans, and many of our state banking acts limit the amount of such security that may be held. Our national banking act limits the amount that may be loaned to a single firm or individual to one-tenth of the bank's capital and surplus, and similar regulations are common in state banking legislation.

The purpose of these regulations is to confine the investments of banks to what are called liquid securities, but they fail to evince a proper conception on the part of their authors of what really makes a security liquid. Apparently legislators and their advisers have felt that if the securities held by the banks mature in short periods, or are listed on a stock exchange, they are liquid; but such is not necessarily the case.

Commercial paper only is really liquid, since it represents a current commercial process which will soon be completed and the completion of which automatically provides the means for its payment. Such paper usually matures in short periods, but the characteristic of liquidity results not from the date at which it is made to mature, but from the commercial process which called it into existence and will ultimately retire it. In this country very often paper of short maturity is so in form only, its makers expecting to renew it, instead of pay it, at maturity.

Bonds and stocks, even though they may be listed on a stock exchange and daily bought and sold, are not liquid securities in the proper sense of that term. An individual bank may be able to sell them in case of need, but such sale is simply the transfer of the investment to another bank or person, and not its liquidation. The security still exists and must be paid, while its liquidation would take it out of existence.

Foreign legislators have approximated more closely than ours what is needed in the regulation of bank investments. In the case of their central banks, many of them, notably those of France and Germany, have recognized the fundamental distinction between commercial and investment paper, and have required them to hold the former against their demand obligations, especially their notes.

The regulation of reserves has become a subject of legislation in this country only. Our national banking act cla.s.sifies national banks into three groups, called country, reserve city, and central reserve city banks, and requires those in the first mentioned group to keep cash in their vaults to the amount of at least six per cent of their deposits, and balances in approved reserve city banks sufficient to bring the total amount up to fifteen per cent of their deposits.

Banks in reserve cities are required to keep in their vaults cash to the amount of at least twelve and one-half per cent of their deposits, and balances in central reserve cities sufficient to bring the total up to twenty-five per cent of their deposits. Banks in central reserve cities are required to keep at least twenty-five per cent of their deposits in cash in their vaults. When the reserves of a bank fall to the prescribed minimum, all discounting must cease. Regulations essentially similar are found in the banking laws of most of our states.

The purpose of these regulations is to set a limit to the extent to which banks may expand the volume of their loans and discounts, in the belief, apparently, that, if at least the prescribed proportion of cash is all the time kept on hand, the banks will be able to meet their obligations. As in the case of the regulations concerning investments, the authors of these failed to recognize the significance, from the point of view of the cash demands likely to be made upon banks, of the kind of paper admitted to discount. If discounts be confined to commercial paper, the demand obligations they create will be met for the most part by transfers of credits on the banks' books or by the return of the notes issued, and, as foreign experience has demonstrated, the adjustment of cash resources to needs can safely be left to the judgment of the bankers themselves, who, through variations in the discount rate, rediscounts, and other means, can regulate it with ease. If investment paper is admitted to discount, reserves less than one hundred per cent of the demand obligations thereby created are unsafe, since a less amount is likely to force liquidation on the banks' customers, with the results above indicated.

The most elaborate regulations for the prevention of inflation have been developed in connection with legislation concerning note issues.

The reason for this is the fact that commercial banking was at its origin and for a long time thereafter carried on almost exclusively through note issues, the conduct of checking accounts being a comparatively recent development. The phenomenon of inflation was, therefore, first observed in connection with note issues and a.s.sociated with them. Even now the essential similarity of note issues and checking accounts as banking instrumentalities is not universally recognized.

The means of safeguarding note issues which have been incorporated into legislative enactments are the prior lien on a.s.sets, the safety fund, the requirement and sometimes the mortgaging of special a.s.sets, and the limitation of the total issues. By the prior lien is meant the provision that in case of failure the note holders shall be paid in full before any of the a.s.sets are distributed among other creditors.

By the safety fund is meant a required contribution from each bank, usually a percentage of the amount of notes issued, placed in the hands of some public official and kept for the redemption, in case of failure, of such of the notes of failed banks as cannot be redeemed out of the a.s.sets of the banks themselves. Additional contributions from the solvent banks are required for the replenishment of the fund when it has been depleted.

The practice of different countries regarding the requirement of special a.s.sets to be held against note issues, as well as regarding the mortgaging of such a.s.sets, is not the same. Germany and France, for example, require their banks to cover their note issues by designated proportions of commercial paper and coin, while the United States requires its banks of issue to cover their notes by government bonds and to contribute a five per cent redemption fund in addition, and England requires the Bank of England to cover a designated amount of its issues by government and other securities and the remainder by coin. Unlike the others, the United States mortgages to the note holders the securities, that is, the government bonds, required to be held against the notes, by providing that in case of failure these securities shall be sold and the proceeds used for the settlement of their claims.

In all of these provisions, the protection of note holders against loss in case of failure has been an influential consideration, and in the cases of the prior lien and the safety fund, the only one. The prevention of inflation may have entered into consideration in the other cases, but among the states mentioned the regulations of France and Germany alone are efficient in this direction, since they alone prohibit note issues against investment securities. The above mentioned regulations of England and the United States tend rather to promote, than to prevent, inflation, since they require the holding of investment securities against note issues.

The limitation of the aggregate amount of notes that may be issued is a common legislative regulation. In the United States the limit set is the amount of the capital stock, and in France it is an arbitrary figure from time to time changed as the needs of the bank seem to require. As a safeguard against inflation, the value of such limitation depends upon the basis of the issues. If it is investment securities, as in the case of the United States, limitation to a low figure, not in any case to exceed the capital stock, is desirable, since such limitation keeps the inflation within such bounds that the banks themselves may be able to withstand the effects of it by selling upon foreign markets, without great and perhaps without any loss, the securities in which their capital and surplus funds are invested. If the basis of issues be commercial paper, such limitation is unnecessary, since inflation in such a case is improbable, and pernicious, unless it be placed above the point which the volume of issues is likely in ordinary cases to reach.