CHAPTER IX

BANKING OPERATIONS AND ACCOUNTS

[31]The intermediate employed in actual transactions is, in increasing degree, that form of currency called credit, the lowest order of currency, rather than money itself. Checks and drafts make up a progressively larger share of the circulating medium. The net deposit credits in the national banks in the United States--to say nothing of the other banks--are double the volume of the actual money in the country. And a large share of this actual money is really employed as reserves to support the credit circulation. More than 90 per cent. of the larger sorts of transactions are mediated through the use of deposit credit, and probably more than one-half of the remaining transactions are similarly effected. Thus the study of banking is essential to any understanding of monetary problems....

[32]For a bank, as well as for any other considerable establishment, it is requisite that a capital should be provided at the outset. There can be no constant proportion between the amount of this capital and the extent of the business which may be built up by its means. We can only say that, other things being equal, the larger the business that can be carried on with safety with a given capital, the larger will be the field from which profits can be earned, and the higher the proportion which the profits will bear to the original investment; but the point at which the extension of the business passes the line of safety, must be determined by the circumstances of the particular bank, by the kind of business carried on by those dealing with it, and by the condition of the community in which it is established. The attempt has sometimes been made to limit by law for incorporated banks the proportion of transactions for a given amount of capital, but no such provision has any foundation except a conjectured average, too rough to be of service in any individual case. In this respect, as in so many others, the judgment of the persons most interested, acting under the law of self-preservation, is far more trustworthy than any legislative decision.

The capital thus to be provided at the outset is, of course, in the case of a private bank, the contribution of the partners, as in any other undertaking. In the case of an incorporated bank the capital is divided by law into equal shares or units of fixed amount; as _e. g._, under the law of the United States, a capital of $100,000 is divided into 1,000 shares of $100 each; and these shares are contributed by the individual shareholders, in such proportion as they please. The law may as a matter of public policy limit the proportion of capital stock to be owned by any one individual or firm, and it may also limit the liability of shareholders for debts due by the bank, in case of its failure; but in general, in the absence of special provisions to the contrary, the powers, rights, and liabilities of every shareholder are now usually determined by the number of shares of the stock contributed or owned by him. In the election of directors and of other officers for the immediate management of the business, every share entitles its owner to cast one vote; the dividend of profit is divided in the ratio of shares owned, and contributions to meet losses, if required by law, are called for in the same ratio.

The capital subscribed by the intending shareholders must necessarily be paid in in money or in the legal tender of the country. It is not necessary that the whole should be paid in at the outset, but the payment of the whole usually precedes the full establishment of the business; and, in the case of incorporated banks, the law often requires that some definite proportion, as _e. g._, one-half, shall be paid in before the opening of business, in order to insure good faith and a solid basis for the business undertaken.

If, now, we undertake to represent by a brief statement of account the condition of a bank having a capital of $100,000 paid in, in specie, on the morning when it opens its doors for business, we shall have the following:

_Liabilities_ _Resources_ Capital $100,000 Specie $100,000

It may at first sight appear to be a contradiction in terms, that the capital should be set down as a liability and not as a resource. But we must here distinguish between the financial liability for what has been received from the shareholders and the right of property in the thing received. The bank has become accountable to its shareholders for the amounts paid in by them respectively, but the money actually paid in has become the property of the bank; or, in the language of accountants, the bank has become liable for its capital, and the money in hand is for the present its resource for meeting this liability, or for explaining the disposition made of what has been received.

As the bank requires banking-rooms and a certain supply of furniture and fixtures for the convenient transaction of its business, we may suppose it to expend $5,000 of its cash in providing this "plant." The property thus procured, with the remaining $95,000 in cash, will then be the aggregate resources by means of which the capital is to be accounted for, and the account will stand as follows:

_Liabilities_ _Resources_ Capital $100,000 Real estate, furniture, fixtures, etc. $ 5,000 Specie 95,000 -------- -------- $100,000 $100,000

The bank, however, cannot answer the purposes of its existence, or earn a profit for its shareholders, until its idle cash is converted into some kind of interest-bearing security. Nor is it enough that a permanent investment of the ordinary kind should be made, as by the simple exchange of the cash for government bonds or railway securities. It is the chief business of the bank to afford to purchasers and dealers the means of using, by anticipation, funds which are receivable by them in the future, and this implies both the purchase of private securities or "business paper" to a considerable extent, and also frequent change and renewal of purchases. Moreover, while the private capitalist finds it advantageous to make simple investments of a permanent sort, this would plainly be insufficient for the shareholders of a bank, who have to pay from its profits some serious expenses of management, and need, therefore, a larger field for earnings than the ordinary returns on their capital alone. The bank being obliged then to extend its operations beyond the amount of its capital, is compelled for this purpose to make use of its credit. In fact, it is only by such a use of its credit that the establishment becomes in reality a bank.

Most of the conditions of the case are best answered by the "discount" of commercial paper as above described. The time for which such obligations have to run varies with the custom of the trade which gives rise to them, but is in most cases short enough to imply early repayment to the bank. And even where custom gives the paper longer time, if the paper itself is used only as a collateral security, the note which is the actual object of negotiation with the bank is by preference usually made not to exceed four months. It is easy then to arrange the purchases of paper with reference to the times of maturity, so as to provide for a steady succession of payments to the bank, and thus facilitate the reduction of the business, if necessary, or its direction into new channels, as prudence or good policy may require. The certainty of prompt payment at maturity, needed for this end, is presented in a high degree by the paper created in the ordinary course of business. Independently of the collateral security which the bank may hold, the written promise of a merchant or manufacturer to pay on a fixed day is an engagement which involves the credit of the promisor so far that failure is an act both of legal insolvency and of commercial dishonor. Selected with judgment, then, such paper is not only the investment which most completely answers the purposes of the bank's existence, but is probably as safe as any investment which could be found.

It may easily happen, however, that the bank may find it desirable to invest a part of its resources in some other form, either because good commercial paper cannot be procured in sufficient amount, or as a matter of policy. In this case it will purchase such other securities as offer not only complete safety of investment, but the possibility of easy conversion into cash in case of need. In this country United States bonds, and many descriptions of State, municipal, and corporation bonds might answer this purpose. Stocks would more rarely answer it, being more liable to the fluctuations in price caused by misfortune or the ordinary vicissitudes of business. Mortgages on real estate, however, would not be admissible, except when held as a security, collateral to some other which is more easily convertible, for even when the mortgaged property is so ample and stable as to insure the goodness of the mortgage, the conversion of the mortgage into cash by sale is not always easy, and is especially difficult at those times when the bank most needs to have all its resources at command. Indeed, the danger to be apprehended from the locking up of resources, in securities which may be solid but are not easily realized, is so great, that it has been said to be the first duty of the banker to learn to distinguish between a note and a mortgage, his business lying with the former. Real estate, of course, cannot be regarded as a banking security, however desirable it may be as an investment for individuals, for it is not only subject to great fluctuations in value, but is at times unsaleable....

The results of the process of investment in commercial paper and in other securities are best understood when we trace the effect in the account of the bank. Taking then the account as it stood after the purchase of fixtures, let us suppose that the bank buys paper or securities from those dealing with it, or, in the common phrase, makes "loans to its customers," to the amount of $90,000, the paper being in many pieces and having various lengths of time to run, but averaging about three months. Supposing the interest to be computed at 6 per cent., we should have the account changed by the operation as follows:

_Liabilities_ _Resources_

Capital $100,000 Loans $90,000 Undivided profits 1,350 Real estate, furniture, fixtures, etc. 5,000 Deposit 88,650 Specie 95,000 -------- -------- $190,000 $190,000

Here we have the securities which certify the right of the bank to demand and receive $90,000 at a future date placed among the resources; the net proceeds of the securities, or the aggregate of the sums which the bank holds itself liable to pay for them on demand, stand among the liabilities as deposits; and the interest deducted in advance, or the profit on the operation, which the bank must at the proper time account for to the stockholders, also stands as a liability. This, however, is the condition of the account at the moment of making the investment, when the bank has made its purchase of securities by merely creating a liability. As this liability is real and must be met, so far as the depositors at any time see fit to press it, let us suppose that depositors call for cash to the amount of $15,000, and we shall have a further change in the account as follows:

_Liabilities_

Capital $100,000 Undivided profits 1,350 Deposits 73,650 ------ $175,000

_Resources_

Loans $90,000 Real estate, etc 5,000 Specie 80,000 ------ $175,000

It is clear that, unless the enforcement of the liability for deposits and consequent withdrawal of specie goes much farther than this, the bank can safely increase its loans or its purchase of securities, although its method of doing so is by the increase of its liabilities. We will suppose it, therefore, to have expanded its affairs until it has reached something like the average condition of those banks in the United States, which, being incorporated under the laws of the several States, are not authorized to issue notes. It will then stand thus:

_Liabilities_

Capital $100,000 Surplus 29,000 Undivided profits 10,000 Deposits 305,000 -------- $444,000

_Resources_

Loans $305,000 Bonds and stocks 23,000 Real estate 15,000 Other assets 20,000 Expenses 1,000 Legal-tender notes } Cash items } 80,000 Specie } -------- $444,000

Postponing for the present the consideration of some terms which here occur for the first time, it appears from the above account that purchases of securities have been made to more than three times the amount of the capital, and that this has been effected chiefly by the creation of liabilities in the form of deposits. What determines the limit to which this process can be carried?

If depositors seldom demanded the payment to which they are entitled, but were contented with the mere transfer of their rights among themselves as a conventional currency, the bank might dispense with holding any large amount of specie or cash in any form and keep most of its resources employed in its productive securities. The expansion of the deposits would then resemble in its effects the expansion of any other currency and might go on until a check should be interposed by the consequent rise of prices and demand for specie for exportation. And it is true, as we shall see, that in communities where banking is largely practised, the use of deposits as currency by transfer from hand to hand is so extensive, that a bank in good credit can rely upon their being withdrawn so slowly, or rather to so small an extent, as to make it unnecessary to have cash in readiness for the payment of more than a small proportion at any given moment. But in a period of financial disorder or alarm, withdrawals may be made earlier or more frequently, and a larger provision of cash may be needed for safety, than at other times; the kind of business carried on by depositors may expose one bank, or the banks in one place, to heavier occasional demands, or may on the other hand make demands steadier, than is the case elsewhere; and a city bank may be more subject to heavy calls from depositors than a country bank. In general, then, for every bank, in its place and under the circumstances of the time, there is some line below which its provision of cash cannot safely fall. This provision of cash, which in the account last given includes the cash items, specie, and legal-tender notes, is called the reserve, and the necessity of maintaining a certain minimum reserve fixes a limit to the ability of the bank to increase its securities. For obviously any increase of securities, that is, of loans or bonds, must ordinarily be effected, either by an increase of deposits, or by an actual expenditure of cash. If, then, the reserve were already as low as prudence would allow, or were threatened by approaching heavy demands from depositors, no increase of securities could be made without serious risk.

What proportion the reserve should bear to the liabilities which it is to protect is a question which the law has sometimes attempted to settle, by requiring a certain minimum, leaving it to every individual bank to determine for itself how much may be required in addition to this minimum. And this is no doubt as far as any general rule can go. As has already been suggested, the requirements for safety of different banks and in different places must vary, and so must the requirements of the same bank at different times. In fact, the question as to the proper amount of reserve never depends simply on the absolute ratio of the reserve to the liabilities, but always involves further questions as to the probable receipts of cash by the bank and probable demands upon it, in the near future. It can only be said that the reserve should be large enough, not only to insure the immediate payment of any probable demand from depositors, but also to secure the bank from being brought down to the "danger line" by any such demand. If 25 per cent. is the minimum consistent with safety, the reserve should be far enough above this to be secure from reduction to a point where any further demand or accident may make the situation hazardous.

In the management of its reserve the bank itself necessarily feels a strong conflict of interests. On the one hand, it is impelled to increase its securities as far as possible, for it is from them that it derives its profits, and the retention of a large amount of idle cash is felt as a loss. On the other hand, the maintenance of a reserve sufficient, not only to enable the bank to continue its payments but to inspire the public with confidence in its ability to continue them, is a necessity of its existence, even though a part of its resources do thus appear to be kept permanently idle. As a natural consequence, the actual settlement of the question in favor of a large or of a small reserve in any particular case will depend in good measure on the temperament of the managers. In every banking community may be found "conservative" banks, the caution of whose managers forbids them to take risks by extending their business at the expense of an ample reserve; and by their side may be seen the more "active" banks, whose managers habitually spread all possible sail, and provide for the storm only when it comes.

It is to be observed that the necessity of providing a cash reserve is not met by the excellence of the securities held by the bank. Although their certainty of payment at maturity be absolute, still the demands upon the banks are demands for cash, and cannot be answered by the offer of even the best securities. If the depositor or creditor does not receive cash in full for his demand when it is made, the bank has failed, and any satisfaction of his claim by the delivery of a security is, as it were, only the beginning of a division of the property of the bank among its creditors. Specie, therefore, or the paper which is a substitute for it as a legal tender for debt, forms the real banking reserve. The reserve of the bank may, however, be greatly strengthened by the judicious selection of securities. For example, if, in the account above given, the "bonds and stocks" are, as they should be, of descriptions which are readily saleable, they afford the means of replenishing the reserve in case of need, without foregoing the enjoyment of an income from this amount of resources for the present. In extreme cases of general financial panic, it is true, even the strongest government securities may find but few purchasers; still such a provision is the best support which can be had in the absence of, or as an auxiliary to, a sufficient reserve of actual cash.

The natural method of securing the proper apportionment of resources between securities and reserve, under ordinary circumstances, is by increasing or diminishing the loans, or, in other words, the purchases of securities made from day to day in the regular course of business. That part of the securities which consists of the promises of individuals or firms to pay to the bank at fixed dates, is made up of many such pieces of commercial paper, maturing, if properly marshalled, in tolerably steady succession. The payment of one of these engagements when it becomes due may be made either in money, or by the surrender to the bank of an equal amount of its own liabilities ... [in the form of deposits]. In the former case, the payment of the maturing paper to the bank is in fact the conversion of a security into cash, and increases the reserve without change in the liabilities; in the latter, the reduction of securities is balanced by a reduction of liabilities which raises the proportion of reserve. If, then, the bank stops its "discounts" or the investments in new securities, or if it even slackens its usual activity in making such investments, the regular succession of maturing paper will gradually strengthen its reserve; if it increases its activity in investment, it will weaken or lower its reserve; and if it adjusts the amount of its new investments to the regular stream of payments made by its debtors, it may keep the strength of its reserve unaltered, until some change in the condition of affairs brings cash to it or takes cash away by some other process.

This natural dependence of the reserve upon the more or less rapid re-investment of its resources by the bank is distinctly recognized by the law of the United States, which provides that when the reserve of any national bank falls below the legal minimum, such bank "shall not increase its liabilities by making any new loans or discounts," until its reserve has been restored to its required proportion. By a less harsh application of the same principle, the Bank of England operates upon its reserve by lowering or raising its rate of discount, and thus encouraging or discouraging applications for loans. And it was with a view of facilitating the replenishment of the reserve by the curtailment of loans, that the law of Louisiana formerly provided that the banks of New Orleans should hold what were called "short bills," or paper maturing within ninety days, to the amount of two-thirds of their cash liabilities, so that the constant stream of payments of such paper might always insure to every bank the early command of a large part of its resources.

To return, in conclusion, to the account last given; we have there among the liabilities certain sums classified as "surplus" and as "undivided profits." Taken together these sums represent the profits which have been made, but not divided among the stockholders, and which are therefore to be accounted for by the bank. The surplus is that portion of these profits which as a matter of policy it has been determined not to divide and pay over to the stockholders, but to retain in the business, as in fact, although not in name, an addition to the capital. The remaining portion, the undivided profits, is the fund from which, after payment of current expenses and of any losses which may occur, the next dividend to the stockholders will be made. The current expenses are for the present entered on the other side of the account, as they represent a certain amount of cash which has disappeared; but at the periodical settlement of accounts they must be deducted from the undivided profits, and will thus drop out from the statement. "Other assets," here set down as an investment, may be supposed to cover any form of property held by the bank and not otherwise classified, but especially the doubtful securities, or such property, not properly dealt in by a bank, as it may have been necessary to take and to hold temporarily, for the purpose of securing some debt not otherwise recoverable. For example, although the bank could not properly invest in a mortgage, it might be wise for it to accept a mortgage in settlement with an embarrassed debtor, and in this case the mortgage would stand among the "other assets." And, finally, "cash items" include such demands on individuals or other banks as are collectible in cash and can therefore fairly be deemed the equivalent of cash in hand. In the absence of any legal provision limiting the classification of such demands as reserve, they may be regarded as virtually a part of the reserve, which in the case before us may therefore be treated as made up of cash items, specie, and legal-tender notes.

To illustrate what has been said in this chapter we will now suppose the bank to make the following operations:

a. To add to its securities $20,000, by discount of three-months paper at 6 per cent., three-fourths being purchased by the creation of liabilities, and one-fourth by the expenditure of cash. The account would then stand as follows:

_Liabilities_

Capital $100,000 Surplus 29,000 Undivided profits 10,300 Deposits 319,775 -------- $459,075

_Resources_

Loans $325,000 Bonds and stocks 23,000 Real estate 15,000 Other assets 20,000 Expenses 1,000 Reserve 75,075 -------- $459,075

b. To retrace its steps by diminishing its "discounts" or holding of securities to the extent of $50,000, of which four-fifths are paid to it by the surrender of demands for deposits to a like amount and one-fifth in cash; to pay $1,250 for current expenses; and further to increase its reserve by the sale of bonds and stocks to the amount of $10,000. The following would then be the state of the account:

_Liabilities_

Capital $100,000 Surplus 29,000 Undivided profits 10,300 Deposits 279,775 -------- $419,075

_Resources_ Loans $275,000 Bonds and stocks 13,000 Real estate 15,000 Other assets 20,000 Expenses 2,250 Reserve 93,825 -------- $419,075

c. To sell $2,000 of its other assets for cash with a loss of $500; to make a semi-annual dividend of 4 per cent., of which one-half is credited to stockholders who happen to be depositors also, and one-half is paid in cash; to sell $4,000 of bonds at a profit of 15 per cent., and to carry $1,000 of its undivided profits to surplus. The account would then stand at the beginning of the new half year, as follows:

_Liabilities_

Capital $100,000 Surplus 30,000 Undivided profits 3,150 Deposits 281,775 -------- $414,925

_Resources_

Loans $275,000 Bonds and stocks 9,000 Real estate 15,000 Other assets 18,000 Reserve 97,925 -------- $414,925

STATEMENT OF A REPRESENTATIVE NATIONAL BANK

_Resources_

Loans and discounts $739,743.27 Overdrafts, secured 973.08 U. S. bonds deposited to secure circulation 100,000.00 U. S. bonds pledged to secure U. S. deposits 1,000.00 Bonds other than U. S. bonds pledged to secure postal savings deposits 7,000.00 Other Securities 191,098.05 Stock of Federal Reserve bank 4,800.00 Banking House 30,000.00 Furniture and Fixtures 5,000.00 Due from Federal Reserve Bank 20,000.00 Due from approved reserve agents 89,919.25 Due from other banks 12,074.23 Checks on banks in same city 6,051.46 Outside checks and other cash items 13,171.83 Fractional currency, nickels, and cents 283.14 Notes of other national banks 1,295.00 Coin and certificates 38,604.05 Legal-tender notes 25,000.00 Redemption fund 3,500.00 ------------- $1,289,513.36

_Liabilities_

Capital stock paid in $100,000.00 Surplus fund 60,000.00 Undivided profits 40,877.46 Less current expenses, interest, and taxes paid 17,110.28 23,767.18 Circulating Notes Out-standing 98,500.00 Individual deposits subject to check 404,871.37 Certificates of deposit due in less than 30 days 596,335.82 Certified Checks 125.00 United States deposits 1,000.00 Postal savings deposits 4,913.99 ------------- $1,289,513.36

[33]~The Method and Extent of Credit Issue.--~Assume that a bank with a cash capital of $100,000 is opening for business in an isolated town and is the only bank in that town. How much can it lend? Ordinarily a bank lends by discounting a customer's note and by giving the customer a deposit credit upon its books for the proceeds of the note.... If, now, our bank in question lends $100,000, giving deposit credit for this sum, it has $100,000 of cash on hand against $100,000 of cash liability. Its statement will stand as follows:

_Resources_

Cash $100,000 Notes 100,000 -------- $200,000

_Liabilities_

Capital Stock $100,000 Deposits 100,000 -------- $200,000

Now let it lend another $100,000. With its loans and deposits each standing at $200,000 its reserves are 50 per cent. of its demand liability. Only with $666,666 of loans will its reserves have reached ... [a] 15 per cent. limit:

_Resources_

Cash $100,000 Notes (Loans and Discounts) 666,666 -------- $766,666

_Liabilities_

Capital Stock $100,000 Deposits 666,666 -------- $766,666

Further: Suppose that $100,000 of cash is deposited with the bank from the channels of business; how much more can it lend? Fifteen thousand dollars must be retained as reserve against the new liability; $85,000 is available as reserves against further lending. Based upon these further reserves loans may be granted to the extent of nearly $600,000 more. In fact, only with an expansion of $1,233,333 in loans and in derived deposits--a total deposit of $1,333,333--has its reserve fallen to the ratio of 15 per cent. of its liability.

_Resources_

Cash (original) $100,000 Loans and Discounts 666,666 Cash (new) (85,000 (15,000 L & D (new) 566,666 ---------- $1,433,333

_Liabilities_

Capital Stock $100,000 Deposits 666,666 Deposits (new) (100,000 (566,666 ---------- $1,433,333

The situation summarizes as follows: On its asset side the bank has $200,000 of cash and $1,233,333 of securities (Bills and Notes). Its deposit liabilities amount to $1,333,333.

Its cash is 2/13.3+ of its liability--15 per cent.

~The Function of Reserves.~--If this is what actual banking means, is banking safe? What would happen if all these deposits were immediately called for in cash? True, not all are likely to be called for, but some cash will be demanded. In fact, the borrowers, instead of accepting all of the proceeds of these notes in deposit credit, will in some measure require and receive cash. Precisely so; and so the bank must keep on hand a cash reserve to meet this possibility. For the most part, however, the customers of the bank make payments through checks upon the bank, and these credits are deposited in turn to the credit of other customers. No cash, but only bookkeeping, is required. And if some customers draw out cash, other customers will probably receive it and return it to the bank. A reserve of 15 per cent. is enough for the case. There, would, indeed, be small gain in banking if against every deposit an equal sum in cash must be held in store by the bank.

~Economy of Redemption Money.~--It is thus evident that the employment of $200,000 cash as a banking reserve has made possible the existence of a more than sixfold volume of circulating medium--currency. Against each $1,000 of deposit liability there need be only $150 of actual cash. The bank customer, however, thinks of his deposit claim as money, and it really serves him all the purposes of money. The right to have the money when desired is as good as the actual money, is more convenient, and is as readily and as serviceably transferred.

The economy of money through the use of credit substitutes for money extends really further than the foregoing analysis indicates. Under the [now superseded] law, three-fifths of the reserves of a rural bank may be on deposit with banks in reserve cities. Thus against $100,000 of deposit liability the rural bank needs hold only $6,000 of reserve money. Against the deposit of the remaining $9,000, the reserve city bank is required in turn to hold a reserve of only 25 per cent.--$2,250. And of this required $2,250, one-half may be represented by deposits in central reserve cities, _e. g._, New York, Chicago, and St. Louis. Against the $1,125 deposited with it the central reserve bank is required to hold only 25 per cent. of reserves--$281.25. Thus at the outside limit of credit extension, $100,000 of deposit currency may be supported by only $7,406.25 of reserves in money,

(6000 + 1/2 x (9000/4) + (1125/4)).

one dollar of reserves upholding $13 of currency.[34]

It is, of course, not true that the banks ordinarily allow their reserves to run as low as the legal limit, or make the utmost possible use of the privilege of counting claims against one another as legal reserves. Nor is it accurately true that all forms of money are of equal efficiency in the support of credit. Not all forms of money, but only those of the higher levels in the money scale, are allowed to be counted as legal reserves.... Some forms of money make demands upon other forms for redemption, or are limited in exchange power to the exchange power of the form in which redemption is to be made. The total exchange efficiency of the money of a country is, then, not accurately to be computed on the assumption that all moneys are equally efficient for all purposes--that some are not in varying degree burdens upon the money functions of the others.

~Banking Viewed in Detail and in the Aggregate.~--And one further modification is called for. The analysis so far made, while valid for any isolated bank, or for the banking system regarded as an aggregate, is not precisely accurate for the affairs of any one competing bank among other banks. When the check drawn by the borrowing depositor may be deposited in other banks and collected by them against the lending bank, its granting of credits rapidly draws down its reserves to swell the reserves of its competitors. One hundred thousand dollars of new reserves may not mean to it an increase of lending power of more than, say, $125,000. For banks in the aggregate, however, this increase of reserves brings its full several-fold increase of lending power, provided that all the reserve efficiency is utilized in whatever bank it rests. As the lending by each bank is depleting its reserves, the lending which other banks are doing is reinforcing these reserves. The aggregate possible extension of credit is not changed.

~What Banks Actually Do and Lend.~--It follows from the foregoing analysis that, in the main, banks do not lend their deposits, but rather, by their own extensions of credit, create the deposits; that these deposits are funds which the deposit-creditors of the bank can lend if they will, and that many men into whose hands these deposits fall through transfer are certain to use them as funds to be lent. In fact, also, even when the deposits in the bank are not derived from the lending activity of the bank, but are really funds deposited from outside sources, these funds are commonly used by the bank as a reserve basis on which loans are extended rather than as funds which are themselves loaned out by the bank. Banks are, in truth, mostly intermediaries between debtors and creditors--but not in the sense of borrowing funds from one class of customers in order to lend them to another class, but rather in the sense of creating for their borrowing customers funds which may be used by these borrowers as present purchasing power. The borrower becomes indebted to the bank in order that for his own purposes he may use the promise of the bank as the equivalent of cash to himself. In the form of a deposit liability the bank becomes a debtor to whomever the borrower shall nominate. The fact that the borrower pays interest while the bank undertakes a noninterest-bearing obligation, or pays relatively low interest, explains in the main the gains attending the business of commercial banking.

~Deposits and Solvency.~--It is, therefore, a sheer blunder to infer that a bank is rich or strong because of its great total of deposits, or to regard deposits in banking institutions as making part of the aggregate wealth of the community. Instead, the deposits indicate for a bank the extent of its operations, and indicate for a community the extent to which the banks, under the guise of noninterest-bearing obligations, have assumed the debts of business men, on terms of these business men becoming debtors--and interest-paying debtors--to the banks. The solvency of the bank is in its portfolio of securities. Its deposits are not its assets, but its liabilities. These liabilities it has mostly created for the use of its borrowers. The further it may safely go in assuming liabilities, the larger its holdings of borrowers' notes may be, and the more interest or discount charges it may collect. Essentially, therefore, the business of a bank is a form of suretyship--the guaranteeing of its borrowers' solvency--an underwriting of the credit of its customers. The bank transfers its customers' prospective future paying power into present funds. It is for this reason that the contract takes the form of a money loan and the premium the guise of an interest payment.

~Bank Loans Related to Currency and Loan Funds.~--And note now that it is precisely because the business of a bank is to furnish to its borrower a present purchasing power for his own use that the business of banking becomes the source of the larger part of the circulating medium of society. In their service to their customers the banks create currency; and in creating currency they create loan funds which, in the hands of the holders of them, are available like other currency for any purpose, either lending or other.

~The Sources of Currency Supply.~--It is, then, clear that the larger part of the circulating medium of society is not money; that not all of the money that there is is bullion money; and that not even all of the bullion money need be ultimate money--redemption money of the highest rank. The sources of currency in society are various--some of it bullion, with a cost of production limit upon its supply, some of it government paper, substantially free of cost, some of it banking credit with certain peculiar and appropriate costs attending its issue.

~Currency and Its Cost of Production.~--It is obvious that the actual limitations upon the supply of exchange media must be made clear if we are to understand the influences which are fundamental to the exchange values of the currency unit. Only, indeed, by this investigation of the sources of the supply, and of the terms on which each different factor of the supply is available, are we in position to understand the influences which impose upon bidders for money a certain level of sacrifice in obtaining it.

What, then, are the limitations upon the supply of credit currency supplied by the banks? In other words, what are the banking costs in the granting of demand deposit rights to customers? Evidently limitations there must be, and limitations in the nature of costs, else the competitive activity of the banks would indefinitely increase the supply of currency, and any would-be purchaser of goods or payor of debts or projector of an enterprise could have the time use of purchasing power gratis; no limit would exist to the rise in prices which must attend this increase in the circulating medium.

What are these limitations? (1) Each bank must conform the volume of its lending, and therewith its issue of circulating credit, to the fundamental requirement that it be always able to make good its agreement to discharge its deposit liabilities on demand. To maintain reserves involves expense. Especially may it be expensive if they have been allowed to get low; securities may have to be marketed at a sacrifice, or good customers pressed for payment at inconvenient times. In periods of general pressure or panic, other banks are not likely to be in a position to lend their own reserve funds or to consent to create deposit credit in aid of still other suffering banks. Not rarely the Bank of England, in the attempt to attract reserve funds, advances bank notes or deposit credit to importers of gold, without imposing the customary interest charge for the covering of the delays of the mint. In at least one case, in 1890, it borrowed reserves from the Bank of France. In 1907 the United States Treasury made especially large money deposits with the national banks of New York to help eke out the needed reserves. Meantime the interior banks were compelled to pay to exporting merchants generous premiums for exchange bills upon Europe, through which, despite the high interest rates ruling in European markets, these banks were able to import 107 millions of gold for their own reserve requirements. In fact, the banking business involves the hazard not merely that some of the debtors of the bank may become insolvent, but also the general and overhead hazard attaching to its underwriting service that it may itself in time of stress become unable to meet its obligations. Its liabilities must not be allowed to get seriously out of ratio to its cash resources.

~The Protection of Reserves.~--In point of fact also the efforts of the various different banks to maintain each its own reserve place a limit on the extent to which any one bank can extend its activity in the expansion of loans and of the derivative liabilities. Just as a relatively liberal granting of credit by one bank must tend to transfer its reserves to other banks, so a relatively great extension of credit in one center or in one country must tend to transfer the reserves, _e. g._, gold, to other centers or countries. Even were it true that a local credit expansion has no effect upon local prices and thereby upon the currents of trade, some transfers of reserves would still take place, and would impose a policy of restriction in credit accommodations.... The influence is actually exerted by both methods.

~(2) Another Cost in Bank-Made Currency.~--The loan rates of the bank must also provide a fund to cover its costs of administration--salaries, clerk hire, rents, and the like. Where transactions run in large units the ratio of expense to the volume of business may be low. This is in part the explanation for the low rates of discount in the great financial centers compared with the rates outside. Credit currency has its cost of production rate as truly as any other service upon the market....

THE RELATION BETWEEN LOANS AND DEPOSITS

[35]The money of modern English commerce and finance is the cheque, and the credit dealt in in the London money market is the right to draw a cheque....

Now that we have come to the point at which the manufacture of the right to draw cheques has to be made as clear as may be, it will be well to come into close touch with the facts of the case and look at a bank balance-sheet of to-day. In order to get a fair average specimen I have taken the latest available balance-sheets of half a dozen of the biggest London banks, and put their figures together.... Let us examine the aggregated specimen that I have drawn up.

_Millions of L_ Capital paid up 16 Reserve Fund 11 Current and deposit accounts 249 Acceptance on behalf of customers 16-1/2 Profit and Loss account 1-1/2 ------- 294

_Millions of L_ Cash in hand and at the Bank of England 43 Loans at call and short notice 27-1/2 Bills discounted and advances 153 Investments 48 Liability of customers on acceptances 16-1/2 Premises 6 ------- 294

The above statement does not include the figures of the Bank of England, but is an agglomeration of the balance-sheets of six of the biggest of the ordinary joint-stock banks.

The first feature that strikes the casual observer is the smallness of the paid-up capital of the banks when compared with the vastness of the figures that they handle. We see that only 16 millions out of the 294 that they have to account for have been actually paid up by shareholders, though 11 millions have been retained out of past profits and accumulated in reserve funds ["surplus," in United States], and 1-1/2 millions are due to shareholders, for distribution as dividend or addition to reserve, in the shape of the profit and loss account balance for the period covered by the balance-sheet. A profit of 1-1/2 millions on 16 is handsome enough, especially when it is considered that most of these balance-sheets covered a half-year's work, but 1-1/2 millions out of 294 is a trifle, and it thus appears that a narrow margin of profit on their total turnover enables the banks to pay good dividends, and that the business of credit manufacture earns its reward, as might be expected, out of the credit that it makes.

Proceeding in our examination, we see that the item of acceptances on behalf of customers on one side is balanced by the liability of customers on the other. This means that the banks have accepted bills for their customers (so making them first-class paper and easily negotiable), and are so technically liable to meet them on maturity; but since the customers are expected to meet them, and have presumably given due security, this liability of the customer to the bank is an offsetting asset against the acceptance. And since the acceptance business is a comparatively small item, and a bank's liability under its acceptances is not a liability in quite the same sense as its deposits, and does not immediately affect the present question of the manufacture of currency, it may be omitted for the present. We can thus simplify the balance-sheet by taking out this contra entry on both sides.

Further analysis of the liabilities shows that the capital, reserves, or surplus, and profit and loss balance may be regarded as due from the banks to their shareholders, and that the remaining big item, current and deposit accounts, is due to their customers. This is the item which is usually spoken of as the deposits, according to the tiresome habit of monetary nomenclature which seems to delight in applying the same name to a genus and one of the species into which it is divided. Just as the bill of exchange is divided into cheques and bills of exchange, so the English banks' deposit accounts are divided into current and deposit accounts. But most people who have a banking account know the meaning of this distinction. Your current account is the amount at your credit which you can draw out, or against which you can draw cheques, at any moment; your deposit account is the amount that you have placed on deposit with the bank and can only withdraw on a week's or longer notice, and it earns a rate of interest, usually 1-1/2 per cent. below the Bank of England's official rate. The essential point to be grasped is the fact that the banks' deposits, as usually spoken of, include both the current and deposit accounts, and are due by the banks to their customers.

Now let us see how this huge debt from the banks to the public has been created. An examination of the assets side of the balance-sheet proves that most of it has been created by money lent to their customers by the banks, and that the cheque currency of to-day is, like the note currency of a former day, based on mutual indebtedness between the banks and their customers. For the assets side shows that the banks hold 43 millions in cash and at the Bank of England, 48 millions in investments, and 6 millions invested in their premises--the buildings in which they conduct their business--and that 180-1/2 millions have been lent by them to their customers, either by the discounting of bills or by advances to borrowers, or by loans at call or short notice. We can now reconstruct our balance-sheet, leaving out the acceptances on both sides, as follows:

_Millions of L._ _Millions of L._ Due to shareholders 28-1/2 Cash in hand and at Bank Due to customers 249 of England 43 -------- Investments 48 277-1/2 Premises 6 Due from customers 180-1/2 -------- 277-1/2

And it thus appears that nearly three-quarters of the amount due from the banks to their customers are due from their customers to the banks, having been borrowed from them in one form or another. And this proportion would perhaps be exceeded if we could take the figures of English banking as a whole. But that cannot be done at present, because some of the smaller banks do not separate their cash from their loans at call in their published statements. The greater part of the banks' deposits is thus seen to consist, not of cash paid in, but of credits borrowed. For every loan makes a deposit, and since our balance-sheet shows 180-1/2 millions of loans, 180-1/2 out of the 249 millions of deposits have been created by loans.

To show how a loan makes a deposit, let us suppose that you want to buy a thousand-guinea motor-car and raise the wherewithal from your banker, pledging with him marketable securities, and receiving from him an advance, which is added to your current account. Being a prudent person you make this arrangement several days before you have to pay for the car, and so for this period the bank's deposits are swollen by your L1,050, and on the other side of its balance-sheet the entry "advances to customers" is also increased by this amount, and the loan has clearly created a deposit.

But you raised your loan for a definite purpose, and not to leave with your bank, and it might be thought that when you use it to pay for your car the deposit would be cancelled. But not so. If the seller of your car banks at your bank, which we will suppose to be Parr's, he will pay your cheque into his own account, and Parr's bank's position with regard to its deposits will be unchanged, still showing the increase due to your loan. But if, as is obviously more probable, he banks elsewhere--perhaps at Lloyd's--he will pay your cheque into his account at Lloyd's bank, and it will be the creditor of Parr's for the amount of L1,050. In actual fact, of course, so small a transaction would be swallowed up in the vast mass of the cross-entries which each of the banks every day makes against all the others, and would be a mere needle in a bottle of hay. But for the sake of clearness we will suppose that this little cheque is the only transaction between Parr's and Lloyd's on the day on which it is presented; the result would be that Parr's would transfer to Lloyd's L1,050 of its balance at the Bank of England, where all the banks keep an account for clearing purposes. And the final outcome of the operation would be that Parr's would have L1,050 more "advances to customers" and L1,050 less cash at the Bank of England among its assets, while Lloyd's would have L1,050 more deposits and L1,050 more cash at the Bank of England. And the L1,050 increase in Lloyd's deposits would have been created by your loan, and though it will be drawn against by the man who sold you the car, it will only be transferred perhaps in smaller fragments to the deposits of other banks; and as long as your loan is outstanding there will be a deposit against it in the books of one bank or another, unless, as is most unlikely, it is used for the withdrawal of coin or notes; and even then the coin and notes are probably paid into some other bank, and become a deposit again; and so we come back to our original conclusion that your borrowing of L1,050 has increased the sum of banking deposits, as a whole, by that amount.

The same reasoning applies whenever a bank makes a loan, whatever be the collateral, or pledge deposited by the borrower, whether Stock Exchange securities, as in the case cited, or bales of cotton or tons of copper; or, again, whenever it discounts a bill. In each case it gives the borrower or the seller of the bill a credit in its books--in other words, a deposit; and though this deposit is probably--almost certainly--transferred to another bank, the sum of banking deposits is thereby increased, and remains so, as long as the loans are in existence. And so it appears that the loans of one bank make the deposits of others, and its deposits consist largely of other banks' loans....

RELATION BETWEEN RESERVES AND DEMAND LIABILITIES AGAIN

[36]... a bank must so regulate its loans and note issues as to keep on hand a sufficient cash reserve, and thus prevent insufficiency of cash from ... threatening. It can regulate the reserve by alternately selling securities for cash and loaning cash on securities. The more the loans in proportion to the cash on hand, the greater the profits, but the greater the danger also. In the long run a bank maintains its necessary reserve by means of adjusting the interest rate charged for loans. If it has few loans and a reserve large enough to support loans of much greater volume, it will endeavor to extend its loans by lowering the rate of interest. If its loans are large and it fears too great demands on the reserve, it will restrict the loans by a high interest charge. Thus, by alternately raising and lowering interest, a bank keeps its loans within the sum which the reserve can support, but endeavors to keep them (for the sake of profit) as high as the reserve will support.

If the sums owed to individual depositors are large, relatively to the total liabilities, the reserve should be proportionately large, since the action of a small number of depositors can deplete it rapidly. Similarly, the reserves should be larger against fluctuating deposits (as of stock brokers) or those known to be temporary. The reserve in a large city of great bank activity needs to be greater in proportion to its demand liabilities than in a small town with infrequent banking transactions.

Experience dictates differently the average size of deposit accounts for different banks according to the general character and amount of their business. For every bank there is a normal ratio and hence for a whole community there is also a normal ratio--an average of the ratios for the different banks. No absolute numerical rule can be given. Arbitrary rules are often imposed by law. National banks in the United States, for instance, are required to keep a reserve for their deposits, varying according as they are or are not situated in certain cities designated by law as "reserve" cities, _i. e._, cities where national banks hold deposits of banks elsewhere. These reserves are all in defense of deposits. In defense of notes, on the other hand, no cash reserve is required--that is, of national banks. True, the same economic principles apply to both bank notes and deposits, but the law treats them differently. The Government itself chooses to undertake to redeem the national bank notes on demand.

The state banks are subject to varying restrictions. Thus the requirement as to the ratio of reserve to deposits varies from 12-1/2 per cent. to 22-1/2 per cent., being usually between 15 per cent. and 20 per cent. Of the reserve, the part which must be cash varies from 10 per cent. (of the reserve) to 50 per cent., usually 40 per cent.

Such legal regulation of banking reserves, however, is not a necessary development of banking....

THE ROLE OF A SPECIE RESERVE ILLUSTRATED BY THE INCONVERTIBLE NOTES OF THE BANK OF ENGLAND ISSUED DURING THE OPERATION OF THE RESTRICTION ACT[37]

[38]... Your Committee proceeded, in the first instance, to ascertain what the price of gold bullion [in terms of Bank of England notes] had been, as well as the rates of the foreign exchanges, for some time past; particularly during the last year.

Your Committee have found that the price of gold bullion, which, by the regulations of his Majesty's Mint, is L3 17_s._ 10-1/2_d._ per ounce of standard fineness, was, during the years 1806, 1807, and 1808, as high as L4 in the market. Towards the end of 1808 it began to advance very rapidly, and continued very high during the whole year 1809; the market price of standard gold in bars fluctuating from L4 9_s._ to L4 12_s._ per ounce. The market price at L4 10_s._ is about 15-1/2 per cent. above the Mint price....

It is due,... in justice to the present Directors of the Bank of England, to remind the House that the suspension of their cash payments, though it appears in some degree to have originated in a mistaken view taken by the Bank of the peculiar difficulties of that time, was not a measure sought for by the Bank, but imposed upon it by the Legislature for what were held to be urgent reasons of state policy and public expediency. And it ought not to be urged as matter of charge against the Directors, if in this novel situation in which their commercial company was placed by the law, and entrusted with the regulation and control of the whole circulating medium of the country, they were not fully aware of the principles by which so delicate a trust should be executed, but continued to conduct their business of discounts and advances according to their former routine.

It is important at the same time to observe that under the former system, when the Bank was bound to answer its notes in specie upon demand, the state of the foreign exchanges and the price of gold did most materially influence its conduct in the issue of those notes, though it was not the practice of the Directors systematically to watch either the one or the other. So long as gold was demandable for their paper, they were speedily apprised of a depression of the exchange, and a rise in the price of gold, by a run upon them for that article. If at any time they incautiously exceeded the proper limit of their advances and issues, the paper was quickly brought back to them, by those who were tempted to profit by the market price of gold or by the rate of exchange. In this manner the evil soon cured itself. The Directors of the Bank having their apprehensions excited by the reduction of their stock of gold, and being able to replace their loss only by reiterated purchases of bullion at a very losing price, naturally contracted their issues of paper, and thus gave to the remaining paper, as well as to the coin for which it was interchangeable, an increased value, while the clandestine exportation either of the coin, or the gold produced from it, combined in improving the state of the exchange and in producing a corresponding diminution of the difference between the market price and Mint price of gold, or of paper convertible into gold.

Your Committee do not mean to represent that the manner in which this effect resulted from the conduct which they have described, was distinctly perceived by the Bank Directors. The fact of limiting their paper as often as they experienced any great drain of gold, is, however, unquestionable....

It was a necessary consequence of the suspension of cash payments, to exempt the Bank from that drain of gold, which, in former times, was sure to result from an unfavourable exchange and a high price of bullion. And the Directors, released from all fears of such a drain, and no longer feeling any inconvenience from such a state of things, have not been prompted to restore the exchanges and the price of gold to their proper level by a reduction of their advances and issues. The Directors, in former times, did not perhaps perceive and acknowledge the principle more distinctly than those of the present day, but they felt the inconvenience, and obeyed its impulse; which practically established a check and limitation to the issue of paper. In the present times the inconvenience is not felt; and the check, accordingly, is no longer in force....

By far the most important ... consequence ... [of the Restriction Act] is, that while the convertibility into specie no longer exists as a check to an over-issue of paper, the Bank Directors have not perceived that the removal of that check rendered it possible that such an excess might be issued by the discount of perfectly good bills. So far from perceiving this ... they maintain the contrary doctrine with the utmost confidence.... That this doctrine is a very fallacious one, your Committee cannot entertain a doubt. The fallacy, upon which it is founded, lies in not distinguishing between an advance of capital to merchants, and an addition of supply of currency to the general mass of circulating medium. If the advance of capital only is considered, as made to those who are ready to employ it in judicious and productive undertakings, it is evident there need be no other limit to the total amount of advances than what the means of the lender, and his prudence in the selection of borrowers, may impose. But in the present situation of the Bank, intrusted as it is with the function of supplying the public with that paper currency which forms the basis of our circulation, and at the same time not subjected to the liability of converting the paper into specie, every advance which it makes of capital to the merchants in the shape of discount, becomes an addition also to the mass of circulating medium. In the first instance, when the advance is made by notes paid in discount of a bill, it is undoubtedly so much capital, so much power of making purchases, placed in the hands of the merchant who receives the notes; and if those hands are safe, the operation is so far, and in this its first step, useful and productive to the public. But as soon as the portion of circulating medium in which the advance was thus made performs in the hands of him to whom it was advanced this its first operation as capital, as soon as the notes are exchanged by him for some other article which is capital, they fall into the channel of circulation as so much circulating medium, and form an addition to the mass of currency. The necessary effect of every such addition to the mass is to diminish the relative value of any given portion of that mass in exchange for commodities. If the addition were made by notes convertible into specie, this diminution of the relative value of any given portion of the whole mass would speedily bring back upon the Bank which issued the notes as much as was excessive. But if by law they are not so convertible, of course this excess will not be brought back, but will remain in the channel of circulation, until paid in again to the Bank itself in discharge of the bills which were originally discounted. During the whole time they remain out, they perform all the functions of circulating medium; and before they come to be paid in discharge of those bills, they have already been followed by a new issue of notes in a similar operation of discounting. Each successive advance repeats the same process. If the whole sum of discounts continues outstanding at a given amount, there will remain permanently out in circulation a corresponding amount of paper; and if the amount of discounts is progressively increasing, the amount of paper, which remains out in circulation over and above what is otherwise wanted for the occasions of the public, will progressively increase also, and the money prices of commodities will progressively rise. This progress may be as indefinite as the range of speculation and adventure in a great commercial country....

FOOTNOTES:

[31] Herbert Joseph Davenport, _The Economics of Enterprise_, pp. 259, 60. The Macmillan Company, New York. 1913.

[32] Charles F. Dunbar, _Chapters on the Theory and History of Banking_, pp. 20-38, G. P. Putnam's Sons, New York and London. 1902.

[33] Herbert Joseph Davenport, _The Economics of Enterprise_, pp. 260-6. The Macmillan Company. New York. 1913.

[34] It should not be overlooked, furthermore, that the velocity of the circulation of deposits is approximately two and one-half times that of money.--EDITOR.

[35] Hartley Withers, _The Meaning of Money_, pp. 57-73. E. P. Dutton and Company. New York. 1914.

[36] Irving Fisher, _The Purchasing Power of Money_, pp. 45-47. The Macmillan Company. New York. 1911.

[37] This act, passed in 1797 in order to prevent a drain of gold to the continent during the Napoleonic War, forbade the Bank of England to redeem its notes. It remained in force until 1821, when specie payment was resumed.--EDITOR.

[38] Report from the Select Committee on the High Price of Gold Bullion. Ordered by the House of Commons, to be printed, 8 June, 1810.