Readings in Money and Banking Part 12

_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.--~a.s.sume 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 a.s.set 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 subst.i.tutes for money extends really further than the foregoing a.n.a.lysis 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 (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 a.s.sumption 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 a.n.a.lysis 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 compet.i.tors. 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 a.n.a.lysis 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 cla.s.s of customers in order to lend them to another cla.s.s, 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 inst.i.tutions 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 a.s.sumed 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 a.s.sets, but its liabilities. These liabilities it has mostly created for the use of its borrowers. The further it may safely go in a.s.suming 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 compet.i.tive 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 _ 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 _ 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 acc.u.mulated 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-cla.s.s 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 a.s.set 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 a.n.a.lysis 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 a.s.sets 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 a.s.sets 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: