Readings in Money and Banking Part 11

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 antic.i.p.ation, 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, munic.i.p.al, 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 a.s.sets 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 ent.i.tled, 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 circ.u.mstances 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 subst.i.tute 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 circ.u.mstances, 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 cla.s.sified 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 a.s.sets," here set down as an investment, may be supposed to cover any form of property held by the bank and not otherwise cla.s.sified, 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 embarra.s.sed debtor, and in this case the mortgage would stand among the "other a.s.sets." 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 cla.s.sification 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 ill.u.s.trate 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 a.s.sets 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 a.s.sets 20,000 Expenses 2,250 Reserve 93,825 -------- $419,075

c. To sell $2,000 of its other a.s.sets 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 a.s.sets 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