Readings in Money and Banking Part 36

The great value of clearing-house loan certificates lies in the fact that they take the place of money in settlements at the clearing house, and hence save the use of so much actual cash, leaving the amount to be used by the banks in making loans and discounts, and in meeting other obligations. The volume of currency, to all intents and purposes, is expanded by this means to the full amount of the certificates issued.

The loan certificates are taken out by the clearing-house members through loan committees, specially appointed, and are used, as a rule, only in the payment of balances among the a.s.sociated banks. Thus, when the stringency in the money market seems sufficient to demand it, the clearing-house a.s.sociation meets and appoints a committee called the "loan committee," consisting usually of five bank officers, to act in concurrence with the president of the clearing-house a.s.sociation, who serves ex officio as a member. It is the duty of such committee to meet each morning at the clearing house and examine the collateral offered as security by the banks and issue loan certificates thereon, in such denominations and proportions to collaterals deposited as may be agreed upon. In the past the denominations have varied from 25 cents to $100,000 in the different a.s.sociations and in proportions varying from $50 to $100 of certificates to $100 of collateral deposited.

These loan certificates bear interest at rates varying from 5 to 10 per cent. per annum, payable by the banks to which they are issued to the banks receiving such certificates in settlement of daily balances. Hence the interest charged against certain banks must exactly equal and offset that credited to certain other banks. The aim is to fix the rates sufficiently high to insure the retirement of the certificates as soon as the emergency which called them forth has pa.s.sed by. As a rule they are retired by the banks, which take them out as soon as they have obtained sufficient cash to meet their daily obligations. Notice is given by the debtor banks to the committee, calling for such certificates as they wish to retire, and the committee gives notice to the banks holding the same, stating that the interest will cease after a specified date. In due course the holders send the certificates to the clearing house for redemption. Upon the retirement of the certificates the collateral deposited as security is surrendered by the committee in the same proportion to certificates turned in as was required for deposit at the time of issue.

It is by no means the general practice for all the members to take out loan certificates when issues are arranged by the a.s.sociation. Some banks are in such condition as to be able to weather the storm without them, while others are weak and in great need of relief. Some banks regard their use of clearing-house loan certificates as a reflection upon their standing, and hence refuse to apply for them unless driven to it by sheer necessity. Others regard it as in no way prejudicial to their interests, but rather as a patriotic movement in which all the banks should engage, both for the purpose of a.s.sisting their fellow-members and for the welfare of the community as a whole.

CLEARING-HOUSE LOAN CERTIFICATES AND THE EQUALIZATION OF RESERVES[129]

Comparison of the course of events during the crisis of 1873 with that in subsequent crises shows a progressively increasing unwillingness or inability among the New York banks to make use of their cash reserves.

In 1873 the New York banks at the outset of the crisis held an available reserve of $34,300,000. In the course of four weeks this was reduced to $5,800,000, and the ratio to deposit liabilities was then less than 4.5 per cent.[130] Suspension was not escaped in 1873 but it was of shorter duration than in later crises. The banks at that time were unable to increase their cash resources by any of the means which have been available in later crises. The Government had no surplus of greenbacks, aside from about $12,000,000 which was almost entirely secured and retained by the savings banks. Banknotes could not be issued because the total circulation was at that time limited by law. Finally, additional supplies of gold, secured through imports, were useless for ordinary banking purposes because the business of the country was then carried on by means of an inconvertible and depreciated paper currency.

Notwithstanding all these special difficulties, the New York banks, by continuing to use their reserves freely even after payments had been restricted, were able to restore confidence in a comparatively short time, and money began to flow back to them within three weeks after the outbreak of the crisis.

In 1893 the New York banks were in what was for them an unusually strong condition at the beginning of the disturbance, having early in June a cash reserve exceeding 30 per cent. of their net deposits. A succession of banking failures in the West and South led to heavy withdrawals from New York during the latter part of June and the beginning of July. Then followed a lull and money began to be returned to New York. During the third week of July banking failures were renewed in the West and South and the drain was resumed. The positively unfavorable aspects of the situation were altogether similar to those of the previous month with the one further circ.u.mstance of a reduced cash reserve in New York. On the other hand, additional means with which to meet the situation were becoming available. At the end of July gold imports in large amount had been arranged. Foreign purchases of our securities were heavy, reflecting increasing confidence in the repeal of the silver purchase law. Arrangements had also been made which would certainly lead to a considerable increase in the issues of bank-notes during August and September. Notwithstanding all these favorable circ.u.mstances the New York banks suspended, during the first week of August, when they still held a cash reserve of $79,000,000, more than 20 per cent. of their deposit liabilities.

In 1907 the New York banks restricted payments when they still held a cash reserve of more than $220,000,000 and when the reserve ratio was also above 20 per cent. Both in 1893 and in 1907 suspension was not a measure of last resort taken after the banks had entirely exhausted their reserves and when there was no means of securing additional cash resources. Moreover, after cash payments were restricted the policy of the banks was unlike that adopted in 1873, in that the banks did not make further use of their reserves; they h.o.a.rded them and added to their amount, thus unduly prolonging the period of suspension.

Explanation of the failure of the banks in 1893 and 1907 to use their cash resources as completely as in 1873 is simple; but it is of the very greatest significance because it will bring to light the most serious element of weakness in our credit structure. [Written before our banking reform of 1913.]

In 1893 and in 1907 the clearing-house loan certificate was the only device resorted to in order to secure the adoption of a common policy by the banks. In 1873, as on earlier occasions when its use was authorized, provision was also made for the equalization of the reserves of the banks. Thus in 1873 the Clearing House a.s.sociation in addition to the customary arrangements for the issue of loan certificates adopted the following resolution:

That in order to accomplish the purposes set forth in this agreement the legal tenders belonging to the a.s.sociated banks shall be considered and treated as a common fund, held for mutual aid and protection, and the committee appointed shall have power to equalize the same by a.s.sessment or otherwise at their discretion. For this purpose a statement shall be made to the committee of the condition of such bank on the morning of every day, before the opening of business, which shall be sent with the exchanges to the manager of the Clearing House, specifying the following items:

(1) Loans and discounts. (2) Amount of loan certificates.

(3) Amount of United States certificates of deposit and legal tender notes. (4) Amount of deposits deducting therefrom the amount of special gold deposits.

Two fairly distinct powers were given the clearing-house committee: the right to issue clearing-house certificates, and control over the currency portion of the reserves of the banks. This machinery was devised (according to tradition) after the crisis of 1857 by George S.

Coe, who for more than thirty years was president of the American Exchange National Bank. The purpose of the certificate was to remove certain serious difficulties which had become generally recognized during that crisis. The banks had pursued a policy of loan contraction which ultimately led to general suspension, because it had proved impossible to secure any agreement among them.[131] The banks which were prepared to a.s.sist the business community with loans could not do so because they would be certain to be found with unfavorable clearing-house balances in favor of the banks which followed a more selfish course. The loan certificate provided a means of payment other than cash. What was more important, it took away the temptation from any single bank to seek to strengthen itself at the expense of its fellows, and rendered each bank more willing to a.s.sist the community with loans to the extent of its power.

But in addition to the arrangement for the use of loan certificates provision was also made for what was called the equalization of reserves. The individual banks were not, of course, equally strong in reserves at the times when loan certificates were authorized. From that moment they would be unable to strengthen themselves, aside from the receipt of money from depositors, except in so far as the other banks should choose to meet unfavorable balances in cash. Moreover, withdrawals of cash by depositors would not fall evenly upon the banks.

Some would find their reserves falling away rapidly with no adequate means of replenishing them. The enforced suspension of individual banks would pretty certainly involve the other banks in its train. Finally, it would not be impossible for a bank to induce friendly depositors to present checks on other banks directly for cash payment, instead of depositing them for collection and probable payment in loan certificates, through the clearing house. The arrangement for equalizing reserves therefore diminished the likelihood of the banks working at cross purposes--a danger which the use of clearing-house certificates alone cannot entirely remove.

These arrangements had enabled the banks to pa.s.s through periods of severe strain in 1860 and in 1861 without suspension. In both instances the use of the loan certificate was followed immediately by an increase in the loans of the banks, and in no short time by an increase in their reserves. The situation in 1873 was more serious, and as events proved, the reserve strength of the banks, while sufficient to carry them through the worst of the storm, was not enough to enable them to avoid the resort to suspension.

In 1884, the next occasion when clearing-house loan certificates were issued, the opposition to the provision for the equalization of reserves was so widespread that it does not appear that it was even formally considered. The ground for this opposition can be readily understood. In 1873 the practice of paying interest upon bankers' deposits was generally regarded with disfavor. Only twelve of the clearing-house banks offered this inducement to attract deposits; but by this means they had secured the bulk of the balances of outside banks. It was in meeting the requirements of these banks that the reserves of all the banks were exhausted at that time. The noninterest paying banks entered into the arrangement for the equalization of reserves in expectation of securing a clearing-house rule against the practice of paying interest on deposits. But their efforts had resulted in failure. Some of them had employed their reserves for the common good most reluctantly in 1873, and the feeling against a similar arrangement in 1884 was naturally far stronger and more general. Moreover, the working of the pooling agreement in 1873 had occasioned heart-burnings which had not entirely disappeared with the lapse of time. It was believed, and doubtless with reason, that some of the banks had evaded the obligations of the pooling agreement. It was said that some of the banks had encouraged special currency deposits so as not to be obliged to turn money into the common fund. Further, as the arrangement had not included bank-notes, banks exchanged greenbacks for notes in order either to increase their holdings of cash or to secure money for payment over the counter. Here we come upon an objection to the pooling arrangement which doubtless had much weight with the specially strong banks, although it is more apparent than real. In order to supply the pressing requirements of some banks, others who believed that they would have been able to meet all demands of their depositors were obliged to restrict payments. That such an expectation would have proved illusory later experience affords ample proof. When a large number of the banks in any locality suspend, the others cannot escape adopting the same course. But in 1884 the erroneousness of the belief had not been made clear by recent experience.

The New York banks weathered the moderate storms of 1884 and 1890 without suspension, by means of the clearing-house loan certificate alone, and in the course of time all recollection of the arrangement for the equalization of reserves seems to have faded from the memory of the banking community. There was, however, in those years another potent influence which tended to lessen the likelihood of suspension following the issue of loan certificates. Many banks were unwilling to take them out, fearing that such action would be regarded as a confession of weakness. The prejudice against them was indeed so strong that needed loan expansion did not follow the authorization of their issue. In 1890 the directors of the Bank of Commerce, then, as now, one of the most important banks of the city, pa.s.sed a resolution urging other banks to relieve the situation by increasing loans and by taking out loan certificates.

In 1893 only a small part of the balances between the banks was settled in certificates at first; but by the end of July practically all balances were settled in that way and suspension followed at once. In 1907 all the banks having unfavorable balances, with but one important exception, took out certificates on the first day that their issue was authorized, and suspension was then for the first time simultaneous with their issue.

The connection between suspension and the use of clearing-house loan certificates as the sole medium of payment between the banks is simple and direct. The bank which receives a relatively large amount of drafts and checks on other banks from its customers cannot pay out cash indefinitely if it is unable to secure any money from the banks on which they are drawn. So long as only a few banks are taking out certificates and the bulk of payments are made in money, no difficulty is experienced; but as soon as all the banks make use of that medium, the suspension of the banks which have large numbers of correspondents soon becomes inevitable. The contention of bankers both in 1893 and in 1907 that they had not suspended since they had only refused to honor drafts on other banks was untenable. The clearing-house loan certificate was a device which the banks themselves had adopted and they had failed to provide any means for preventing partial suspension as the result of its use. The further contention of some bankers that they had suspended because they had no money to pay out was doubtless true of a few banks, but for that very reason other banks must have been all the stronger, probably well above their required reserve.

That the arrangement for equalizing the reserves, adopted in 1873, would have availed to prevent suspension on subsequent occasions, is highly probable, indeed a practical certainty. In 1893 events proved that the banks had maintained payments up to the very last of the succession of disasters with the results of which they had been contending. During August the number of bank failures was not large and none of them was of great importance. We cannot, of course, know how soon money would have begun to flow back to New York, but certainly the suspension of payments could hardly have hastened the movement. From the beginning of September the reported movements of currency showed a gain for the New York banks, and for the week ending September 16 the gain was no less than $8,000,000. One month more of drain, therefore, was the most that the banks would have been obliged to endure, and for the needs of that month the banks would not, as in 1873, have been confined to the single resource of the $79,000,000 of the cash in their vaults.[132]

Similarly, the enormous increase in the money supply of the country in November and December, 1907, would have offset much of the loss of reserve which the banks would have incurred, if they had continued to meet all the demands of their customers for cash. And, finally, it may be observed that in the unlikely event that alarm had not been allayed and suspension in the end had become unavoidable, it would not have made any practical difference to depositors whether the reserves of the banks had been but 10 per cent. rather than 20 per cent. of their demand liabilities.

CLEARING-HOUSE BANK EXAMINATIONS[133]

Most bank failures are due to the gradual acquirement of undesirable a.s.sets over a period of years, and if some authority exists with power to make recommendations of a remedial character, with the further power to enforce such recommendations, if necessary, there is little doubt that many bank failures would be averted.

The panic of 1907 presented many striking examples of just what is intended to be here emphasized, viz., that under the careful supervision of a competent and reliable examiner many of the a.s.sets of the failed banks, upon which it was impossible for them to realize at a time when they needed their funds, would probably have been liquidated upon his recommendation and advice long before the necessity for such liquidation had arisen.

Mr. J. B. Forgan of Chicago, has recently said on this subject:

A competent examiner--and there are many such now in the government employ--while he can not pa.s.s judgment on all the loans in a bank, can, after a careful examination, or a series of examinations, form a wonderfully correct judgment as to the general character of its a.s.sets and as to whether its management is good or bad, conservative or reckless, honest or dishonest. Examinations, as they are now conducted, have a most beneficial influence on bank management, especially by way of restraint. The correspondence carried on by the Comptroller, based on the examiners' reports, does an inestimable lot of good in the way of forcing bank officers to comply with the law and in compelling them to face and provide for known losses as they occur. Supervision by examination does not, however, carry with it control of management and can not, therefore, be held responsible for either errors of judgment or lapses of integrity. Examination is always an event after the act, having no control over a bank's initiative, which rests exclusively with the executive officers and directors, and depends entirely on their business ability, judgment, and honesty of purpose.

The clearing-house a.s.sociation of Chicago was the pioneer in the establishment of an independent system of clearing-house bank examinations in this country, its system having been inaugurated on June 1, 1906, with results that have, to the present time, more than fulfilled the expectations of the bankers of that community[134]....

In substantially his own words the Chicago examiner operates under the following conditions: The examinations extend to all the a.s.sociated banks of Chicago and to all non-member inst.i.tutions. The work is conducted with the aid of five regular a.s.sistants, each fitted by experience to thoroughly do that part of the work a.s.signed to him. The examinations include, besides a verification of the a.s.sets and liabilities of each bank, so far as is possible, an investigation into the workings of every department and are made as thorough as is practicable. After each examination the examiner prepares a detailed report in duplicate, describing the bank's loans, bonds, investments, and other a.s.sets, mentioning specially all loans, either direct or indirect, to officers, directors, or employees, or to corporations in which they may be interested. The report also contains a description of conditions found in every department. One of these reports is filed in the vaults of the clearing house, in the custody of the examiner, and the other is handed to the examined bank's president for the use of its directors. The individual directors are then notified that the examination has been made and that a copy of the examiner's report has been handed to the president for their use. In this way every director is given an opportunity to see the report, and the examiner, in every instance, insists upon receiving acknowledgment of the receipt of these notices.

The detailed report retained by the examiner is not submitted to the clearing-house committee, under whose direct supervision he operates, unless the discovery of unusual conditions makes it necessary. A special report in brief form is prepared in every case and read to the clearing-house committee at meetings called for that purpose. The report is made in letter form, and describes in general terms the character of the examined bank's a.s.sets, points out all loans, direct or indirect, to officers, directors, or employees, or to corporations in which they may have an interest. It further describes all excessive and important loans, calls attention to any unwarranted conditions, gross irregularities, or dangerous tendencies, should any such exist, and expresses, in a general way, the examiner's opinion of each bank as he finds it.

Less than a year after the Chicago Clearing House a.s.sociation appointed its special examiner the a.s.sociated banks of Minneapolis took similar action. The conditions under which the Minneapolis examiner operates are substantially the same as those governing the examiner at Chicago, the princ.i.p.al difference being that instead of the examiner sending a copy of his report to the president of the examined bank and notifying each of the directors of such bank that he has made such examination and that the report is in the hands of the president of the inst.i.tution, as is the rule of procedure at Chicago, and which, in a measure, leaves it to the discretion of the directors whether they examine the report carefully and in detail, the original report is delivered by the examiner at Minneapolis in person to the board of directors of each bank which he examines, at a meeting convened for that purpose. The report is read and the criticisms, if any, are fully discussed, and the recommendations considered. In this way no director can complain that he had not sufficient opportunity to become fully conversant with all the details of his bank.

II. CLEARING HOUSES IN ENGLAND

THE LONDON BANKERS' CLEARING HOUSE AS THE FOREMOST EXAMPLE

[135]The exact origin of the London Bankers' Clearing House will probably never be determined, for, like other inst.i.tutions whose purpose has been to save time and trouble, its system appears to have been gradually evolved.[136]

With the growth of the check system, each banker would daily find himself in possession of a number of drafts for the credit of his customers that needed collection at the offices of other bankers. This would necessitate each bank sending out one or more clerks on what became known as "walks" to obtain cash or notes for these drafts from the houses on which they were drawn.

As in London alone there were some fifty or more private firms carrying on a banking business this necessitated a considerable amount of work and was attended with grave risk of robbery.

It is probable, therefore, that arrangements were made by some of the bankers, as it is still done in some country towns, to meet at one bank one week and at another the next for the purpose of exchanging checks.

But in consequence of the number of the London bankers this method would prove awkward, and about the year 1770 we find that the walk clerks from the city and West End banks had made a practice of meeting at lunch time at a public house called the Five Bells in Dove Court, Lombard Street, close to St. Mary Woolnoth Church, and not so very far from the site of the Bankers' Clearing House of to-day. Here in the public room, or according to tradition on the posts in the court outside, each day after lunch a rough system of exchange of checks was carried on between the clerks from each bank, the balances being settled in notes and cash.

From this rough system has developed the efficient organization of to-day.

In May, 1854, the clearing house was closed for alterations and enlargement, and the business was temporarily carried on at the Hall of Commerce. Here, on June 6, 1854, applications for admission to the clearing house were received from the following joint-stock banks: The London and Westminster, the London Joint Stock, the Union Bank of London, the Commercial Bank of London, and the London and County Bank; and it was resolved "that the secretary be authorized to comply with such applications, subject to the payment of an annual sum to be fixed by the committee to reimburse them for the outlay that has been found necessary to afford accommodation for their admission." There were at this time 25 private banks in the clearing house.

Following on the admission of the five premier joint-stock banks in 1854 there were frequent applications from other joint-stock banks--many from the moment of their foundation. But the wise reply of the committee was invariably that they did not "deem it expedient to take into consideration such applications from any banking establishment that has not been in operation at least for a period of twelve months."

Though the joint-stock banks had been admitted to the clearing house yet they were only allowed to rent seats there and had no share in the management, so for the support of their mutual interests they had a committee of their own which settled the rate to be given by the joint-stock banks in the London district for deposit money at seven days' notice.

In 1858 the country bankers submitted a plan for establishing a country bankers' clearing house in London and proposed that the clearing house committee should appoint two or three of their number to unite with them as a working committee.

The establishment of a separate country bankers' clearing house would have led to many inconveniences, and Mr. John Lubbock, now Lord Avebury, submitted a plan for carrying out a separate country clearing at the clearing house. The committee approved the plan and submitted it to the country bankers' committee, who also gave their approval.

Thus was inst.i.tuted at the Bankers' Clearing House the country clearing, which more than all else has brought about the almost universal use of checks in England, to the exclusion of notes and coin.

Mr. Lubbock's scheme was so well thought out that from its initiation to the present time the rules have had to be only very slightly modified.

In 1864 the Bank of England entered the clearing house to clear on one side only, the outside, for though the bank presents to the clearing bankers at the clearing house all checks payable by them, all checks and bills drawn on the bank are presented by the clearing bankers at the bank itself, and the proceeds placed to the credit of each bank's account. At the same time the governor of the Bank of England was made ex officio a member of the committee of clearing bankers. After 1864 few changes were made in the working of the clearing house, the volume of the country and town clearings increased greatly, but the house proved capable of meeting any increase.