Money - Other Reserves
( Originally Published 1909 )
IT has been necessary to lay a good deal of stress on the necessity for an adequate proportion of gold among the assets held by bankers against the credits that they create for their customers, because in times of crisis gold is the only commodity that is of universal acceptance, because it is the essence of the English banking system that all demands are payable immediately in gold, and because a large holding of gold is thus the strongest evidence that a bank can show of its readiness to meet its engagements.
Nevertheless, it must not be inferred that a high proportion of gold is the only necessity, or is by itself sufficient for safety in banking. The national banks in certain cities of the United States are bound by law to keep a proportion of 25 per cent. of their deposits in gold or legal tenders, a higher proportion than any of our banks, except the Bank of England, think it necessary to show.
And the United States has recently suffered from a panic in which its banks made no attempt to meet their liabilities, and their high proportion of cash did not save them from demands which they were quite unable to meet. It is no part of the task now attempted to trace the causes of this remarkable panic, but it was certainly not accounted for by lack of cash in the banks, though Mr. Mead's article in the Atlantic Monthly of February, 1908, already referred to, has shown how the legal limit on the cash proportion of the national banks had been stultified by the growth of state banks which deposited part of their reserves with the national banks, so that a pyramid of banking credit had been built up on a cash reserve which had shown a steadily diminishing proportion to it Lack of cash, though it did not cause the panic, thus appears to have been an important reason for the helplessness with which American banking succumbed before it. The more immediate influence which produced it, however, would seem to have been a conviction in the mind of the American public that the other assets held against the deposits of the United States banks had not been judiciously selected.
A dreary procession of scandals, disclosures, and revelations had shown that the methods of American finance had been in many ways questionable, and the suspicion had gone abroad that the banks had been too closely connected with these undesirable performances, and also that their investments and loans had been arranged to suit the convenience of groups of operators interested in Stock Exchange speculations. In the case of most of them the suspicion was probably ground- less, but in banking matters the public does not easily discriminate, and the good banks and the bad fell under the same ban.
In England such a development as the control of a chain of banks by a gambling group, and the use of the banks' credit to further the group's gambling, is impossible. And the chief reason why we can bank with a comparatively small cash proportion, and with no legal obligation, is because English banking in the expressive phrase of an American who recently discussed the matter with me- "works with a psychological reserve," that is to say, has won and keeps public confidence by means of the character of our bankers. It is because they are so sound, so straight, so sensible from an American point of view, so unenterprising --that they are able to build a bigger credit fabric on a smaller gold basis, and even to carry this building to a height which they themselves have decided to be questionable. This psychological reserve is the priceless possession that has been handed down through generations of good bankers, and every individual of every generation that receives it can do something to maintain and improve it.
A high cash proportion is of little avail if the rest of the assets consist of securities which cannot readily be realized, of advances to insolvent customers against insufficient collateral, of bills of exchange drawn against anticipations of produce that may some day have a market, or of loans on real estate of great promise, but of problematical value if offered for immediate sale. The securities that a bank can hold among its assets are comparatively few ; and the best of them, as has been frequently pointed out, are genuine bills of exchange representing real produce of universal demand moving into consumption.
Such bills pay themselves on maturity. The stocks dealt in on the Stock Exchange, which have to find a purchaser before they can be turned into cash, are thus in quite a different category, and it is only the best and most readily negotiable of them that can really be considered by a banker either as an investment or as collateral security for a loan. I t need hardly be said that the fuller the extent to which securities meet the requirements of the austere banking ideal, the less the yield upon them will be, so that prudence and profits seem at first sight to point out different paths.
And the possibility looks so extremely remote of any sudden application of the test of ready negotiability to banking assets, that the temptation to earn better profits by neglecting the dictates of the strictest prudence must often be almost irresistible. Whether they work for themselves or for shareholders, bankers are naturally impelled to try to earn good profits ; a big dividend is so satisfactory an end to a half-year's work, and makes the shareholders' meeting so complacently complimentary and contented, that it must be difficult for bankers to remember that the strength of the bank is the first and last consideration, and the manner in which, on the whole, our bankers do so, is a remarkable exercise of patience.
They are doubtless fortified by the reflection that the extremely remote possibility of the application of the test of ready negotiability to banking assets is one of those occurrences which appear when least expected, and that the connection which international finance establishes between all the countries of the world makes an outbreak of mistrust anywhere else a cause of possible trouble everywhere, so that the area of possible disturbance has been enormously widened. It is all to the good that the American crisis of 1907 passed by without the smallest appearance of an inclination on the part of the English public to take money from the banks and hoard it, and it is pleasant to record that the Governor of the Bank of England, in a speech at an annual bankers' dinner delivered in July, 1908, paid a handsome compliment to the manner in which English bankers had met the crisis, and had carefully avoided the mistake that is sometimes committed by bankers in troublous times of 'calling in credits, and so creating an atmosphere of mistrust.
Nevertheless, now that that difficult corner has been successfully turned, and the business of credit-making goes on as if it had never existed, there can be no harm in pointing out that the danger was nearer and more real than was pleasant. An injudicious word in a newspaper might have sufficed to start the mischief, and it was within measurable distance of starting by itself. At least, a friend of mine a solicitor of seasoned experience, and of a most unexcitable and unhysterical temperament told me one Sunday morning in the course of the crisis that he did not at all like the look of things, and that he was thinking of withdrawing from his bank a large amount of clients' funds for which he was responsible. The chief influence which restrained him was the difficulty of knowing what to do with the money, and in what form to take it. The alternatives that suggested themselves to him were opening an account with the Bank of England, putting Bank of England notes away with a safe deposit company, or in his strong room at the Law Society, or burying gold in his back garden. While he doubted between these courses the financial sky cleared, and he finally did nothing.
But if one man of strong common-sense and most conservative habit of mind was pondering these possibilities, it is more than probable that many others were doing likewise ; and if the lessons of the American crisis are taken as meaning that English banking is so secure in the confidence of its home customers, that no infection of external trouble need be feared, bankers are laying a flattering unction to their souls. In fact, it demonstrated once more the perennial need for all the safeguards with which good banking can surround itself, adequate cash reserves, and careful selection of the rest of the assets held against deposits with a view to readiness of realization.
Another reserve possessed by English banking, which enables it to work with a smaller cash reserve than is considered necessary in other countries, is the fact that its gold is not locked up and protected by artificial means, but is immediately at the service of the first comer who presents a valid demand on it. It seems paradoxical that this unprotected state of the English gold store should enable us to do business safely with less of it, but it is literally true, because the practical result is that gold flows readily to London, when London signals for it with a high discount rate, since every one knows that gold which goes to London can be got back again. And the benefit that London confers on international banking, by providing this most useful facility of always obtaining gold, makes it most important for international banking to take care that London is not overstrained by performing this function. Because if these facilities that are given by London alone did not exist, the whole machinery of international banking would be thrown out of gear. Consequently, if a crisis became so severe that London had to restrict its facilities in this respect, other centres which habitually keep balances in London which they regard as equivalent to so much gold because a draft on London is as good as gold would find themselves very seriously inconvenienced. And it thus follows that it is to the interest of the other centres, which trade on these facilities which London alone gives, to take care that London's task is not made too difficult. This interest is especially strong in the case of the foreigners who keep a balance in London which is borrowed. London is continually lending its name on a bill, and giving credits, which make the cash of international transactions. In times of crisis it can cut down these credits, and call in loans from all the world. This power is in itself a reserve, but its exercise would take time, and the length of time would depend on the ability of our foreign debtors to get gold from their central banks. But the fact that foreigners habitually owe us large sums which we should call in if we were pressed makes them desire to save us from being pressed.
Hence comes the result that when a crisis arrives, as it did in the autumn of 1907, and an abnormal demand for gold in one country threatens to paralyze the international money market, the task of providing the required gold falls on London in the first place, but all other centres see that it is to their interest to give what help they can, and to relax some of the restraints and restrictions with which they protect their gold stores. In fact London drew in the gold required for New York from seventeen other countries. It must not be supposed that it did so entirely owing to the good-will and enlightened self-interest of those responsible for the currency arrangements of other centres. To a great extent the suction was compulsory, and arose from the determined use of the Bank rate pump by the Bank of England, and also from the fact that the United States were selling all that they could sell, and reducing their purchases to a minimum, and so compelling a stream of gold, through London, to themselves. But at the same time there can be no doubt that the readiness with which all the other countries produced coins and bars to send to London was greatly assisted by the knowledge that when all was over London would certainly send back their contributions as soon as they were in a position to ask for them.
Nevertheless, satisfactory as were the results of the latest crisis in showing that London's power of drawing in gold is at least as strong as ever, it is not safe to base on them the inference that London can altogether neglect the question of its gold reserve and rely entirely on always being able to get gold in from other centres by raising its Bank rate.
In the first place, as has already been intimated, it is hard to be certain how much of the gold obtained in 1907 was brought by our Bank rate, and how much by the action of American finance, which called in its balances through London all over the world, and created new ones as fast as possible by selling everything that it could turn into cash.
In the second, it must be remembered that the crisis of 1907 was an American affair, and English banking was not affected by the smallest breath of suspicion. But if England had been the centre of disturbance, instead of the ministering angel, it is exceedingly doubtful whether gold would have come in as freely as it did. None of the other countries were willing to send gold to New York, which was the storm centre. London had to take the whole responsibility for doing that. And if London were itself the storm centre, who would there be to take its place and responsibilities ?
Imagination is struck dumb by the contemplation of what would happen if such a proposition were presented to the leaders of finance in other centres, and of the well-meant suggestions for international conferences and international clearinghouse certificates which would be produced and ventilated as palliatives for a situation which would require prompt action, and the placing of a certain amount of gold in the place in which it is wanted.
Ultimately, and after delays that would be fatal, London could probably compel gold imports by sales of securities and commodities, and by calling in loans from foreign customers, but in the meantime the mischief that might be wrought is incalculable, and the mere suggestion of the possibilities of the position shows very clearly that London is a monetary physician who cannot afford, under any circumstances, to be sick. The confidence of its customers, both home and foreign, is an asset which enables the English banking system to provide an astonishing amount of credit on a very economical cash basis, but this confidence can only be maintained and secured by the strictest attention to the austerest rules of banking caution, expressed in a continuous strengthening of cash reserves, and increasing vigilance with regard to the soundness and negotiability of the other assets held against liabilities.