The Mechanism of Exchange - Banks and Credit
( Originally Published Early 1900's )
WE suppose the reader to have clearly in mind what has been said in § 4—6 on the relation of wealth to its owner. When we study the operations of business we see that although in most cases the wealth one possesses is a definite existing object, such as a house, a table, or a field of wheat, yet in other cases the wealth is not definite. For example, I agree with a cabinet-maker that he shall make me a table and de-liver it next week. I may then consider myself in a certain sense the owner of that table, although it has no existence and may possibly never come into existence. Again, in the sale of commodities in the market, it rarely happens that payment is made at the time of the sale. In this case what the seller receives for his commodity is not money, but the right to demand money at some future time. But he considers him-self the owner of that much money as completely as if he had it in his safe, and, for economic purposes, we may consider this imaginary money, which lie is to get at some future time, as a part of his wealth. Legally, however, the creditor is considered, not as the owner of wealth, but as the possessor of a right, namely, the right to demand from his debtor the payment of the money, and to enforce this payment by legal measures. This right to require the payment of money from another person is called credit.
To prevent confusion we must carefully distinguish this meaning of the word credit from the analogous and common meaning of good business standing. When we say, "That man's credit is good," we use the word, in a different sense from the economic one. In the latter sense a man's credits are simply the sum total of the moneys which others owe to him, and have nothing to do with his character or standing.
Transfer of Credit. A creditor may transfer his rights to other legal persons on the same principles by which be transfers the ownership of wealth. The transferee then takes his place as the possessor of the right in the way pointed out in II.9. The methods and forms of transfer vary with the nature of the credit. Commonly, any piece of writing clearly indicating the transfer of the right, and duly signed by the party transferring, is sufficient.
How Banks Arise. In a primitive state of society every payment of money is made by the payer actually delivering the money into the hands of the payee. In modern mercantile operations this transaction would involve a heavy tax upon the resources of the community. Large sums in possession of the owner would be in danger of being lost, stolen, or burnt. Serious danger of loss and theft would be incurred in the transportation of money from the office of the payer to that of the payee. Doubts and disputes about the amount actually paid, or the amounts in the possession of individuals, would frequently arise.
A little consideration will show us that in most payments the delivery of the money is not necessary. Since only the ownership of the money is changed by the payment, and since, as a general rule, the payee only wants the ownership in order that he may transfer it to some other person, it follows that all the requirements of exchange will be fulfilled if the money is stored where he can get possession of it in case he-wants it, provided a system of transferring the ownership can be devised. Thus, all the inhabitants in a town may keep their money deposited in some one place, and make payments by transfers of ownership in such form as might be mutually agreed upon. Such is the basis of the banking system now prevalent in all civilized communities.
A bank may be defined as primarily a place in which money is deposited for safe-keeping. It has, indeed, more complicated functions, but they will be best understood by starting from this first and most simple function of all. Let us then begin by considering the case of a town the inhabitants of which deposit all their money for safe-keeping in a single bank, and make all payments among themselves by transferring the ownership of the money. Such an institution is called a bank of deposit, and the moneys in it are called deposits. It is obvious that the total amount of deposits at any time would be the sum total of all the moneys owned by each individual of the community at that time. It would therefore represent the volume of the currency so far as the town was concerned (§ 71).
Bank Deposits and Cheques. From what has been said of the dual character of financial transactions and obligations, it will be seen that the deposits appear to the managers of the bank under two aspects.
I. As liabilities or obligations of the bank. By this is meant the obligation of the bank to pay to each or any depositor the amount of his deposit whenever required. Of course the sum total of liabilities is in this case equal to the sum total of the deposits.
II. As resources of the bank. The resources would in this case be the coin in possession of the bank, and would constitute the fund which enables the bank to satisfy its liabilities. So long as the bank engaged in no other transactions than those which we have described, the resources and liabilities would remain equal. Of course there is no physical necessity for this equality, since the coin might be stolen without lessening the liability of the bank. But the balance can always be produced by suitably accounting for any deficiency, so long as the accounts of the bank are kept in order.
Cheques. The ownership of money in a bank is transferred by an instrument in writing called a cheque. The drawer of the cheque is an owner of money deposited who wishes to transfer that ownership to another person. The drawee is the person to whom the transfer is made. The usual form of a cheque is the following :
New YORK, June 30, 1885. EXCHANGE NATIONAL BANK,
Pay to Samuel Rhett [drawee] or order
($910) Nine hundred and ten dollars.
WILLIAM JONES [drawer].
By this instrument $910 of the right of William Jones to his deposit in the bank is transferred to Samuel Rhett, whose right is increased by the same amount. When Rhett presents the cheque at the bank his credit is increased, and, Jones's is diminished by this amount. Thus the cheque appears in its dual aspect as an increase of one man's credit and a diminution of another's, which cancel each other, leaving the sum total at $25,000 as before.
Transfer of Cheques. By long-established mercantile usage the drawee may transfer the right given him by the cheque to any other person, this person to another, and so on indefinitely, by suitable indorsements on the back of the cheque. This right is expressed by the words "or order," which mean his order or that of any party whom, he may designate. Thus the ownership may pass from hand to hand like that of money.
Individual Accounts. If to the total deposits of any customer last night be added all the cheques in his favor which he has deposited to-day, and from the sum be subtracted the cheques he has drawn today, the remainder will be his deposit tonight ; that is, it will express his share of the money held by the bank. In mercantile usage the subtractive quantity is transferred to the other side of the equation, which thus becomes credit yesterday plus cheques since deposited equals cheques drawn plus credit tonight. Thus the amount may be balanced every day.
Variations of Sum Total of Deposits. In the case so far supposed, so long as no party in town made payments to parties outside, or received payments from parties outside, the total amount of the deposits would remain unchanged. The only varying quantities would be the individual amounts owned by each depositor; and the additions would in all cases balance the diminutions. But when a depositor had to make a payment abroad, he would have to withdraw his money for that purpose. Thus the sum total would be diminished by all payments made by the townspeople to persons outside. When a depositor receives money from parties outside he deposits it in the bank, and the sum total is then increased by the amount so received. Thus the sum total would fluctuate according as the payments in one direction or the other were in excess, and the state of the bank from day to day would be the index of the balance of trade of the town with the world outside.
Capital of the Bank. That perfect solvency which has just been described would depend on the bank's meeting with no losses. Since all mercantile transactions are now and then liable to loss, it is necessary that the bank, in order perfectly to secure the depositors whose money is loaned, should have a guarantee capital. This capital is a fund sub-scribed or paid in by the stockholders of the bank, who thus become the owners of its rights. The capital thus paid in appears again on both sides of the statements of the bank.
Discount Functions of the Bank. The cost of man-ging such a bank as we have described would have to be paid by its customers, since we have assigned it no business by which it could make a profit. Having in its possession all the coin owned by the town, the bank would find a certain sum lying idle in its vaults from year to year and from generation to generation. For althongh, as we have just shown, the sum of the deposits would fluctuate according to the state of trade with the outside community, yet in practice these fluctuations would be slight. Although the individual may and often does pay out all the money he has got, the community at large never does. If the average amounts of deposits were, as we have supposed, $25,000, it might be found that they occasionally went as high as $30,000, and might perhaps from time to time fall as low as $20,000. Of course no numerical rule for the limits can be set in practice. But the actual fluctuations are found to be of this order of magnitude. Thus the sum idle forever in the vaults of the bank might be fixed at $20,000 plus the capital, making $35,000 in all. Now the bank could loan this money out at interest without any danger of its being unable to fulfil its engagements; and this for two reasons: in the first place, as business goes, it would not be called upon by the depositors of the money loaned to pay it; and in the second place, if it ever should be called upon, it could get the money by demanding payment from the borrowers. Hence so long as the loans were well secured the solvency of the bank would be unimpaired.
The result of this policy would be, that instead of the institution being a custodian of money, it would become a borrower, bound to repay the money on demand, but at liberty to loan it out as long as the depositor does not demand it. The deposit then becomes a credit simply, and the depositor, instead of being the owner of money, is the possessor of a right, namely, the right to require money from the bank and enforce its payment.
Now, by the hypothesis just made, suppose that there is in the vaults of the bank a cash sum of $20,000, which lies there unused year after year and generation after generation, and an additional sum of $15,000 paid in by the stockholders. This makes a sum of $35,000 which the bank can loan out at inter-est without any danger of being unable to meet its obligations on demand. Then all residents of the town who want to borrow money can go to the bank and secure loans until the whole $35,000 is thus borrowed. For each sum borrowed the borrower gives his promissory note, which in banking practice is usually payable in one, two, or three months.
The very same reason which originally prompted the depositors to place their money in the bank will now prompt the borrowers to deposit their loans, and to make such transfers as they desire by cheques upon the bank. When these loans are all effected, and the deposits made, the state of the bank is as follows :
The amount of cash in the vaults remains the same as before, $40,000, since all borrowed has been redeposited.
The amount due depositors is increased by $40,000 which they have borrowed and immediately deposited.
This amount is balanced by $ ___ in promissory notes from the borrowers, payable in one, two, or three months.
We now have a state of things which may almost seem paradoxical, and which is a frequent source of confusion to those not familiar with business. The inhabitants of the town consider that they have altogether $60,000 in money in bank, and yet there exists only $40,000 in money all told. They are therefore, in a certain sense, the possessors of money which has no real existence. There is, however, nothing more confusing in this than that a man should be the owner of a table which is not yet made, but which the maker has agreed to finish and deliver next week, or that he should be the owner of a house which a contractor has agreed to build. In fact he is not the owner of money, but the possessor of credit, which, as already explained, is merely a debt from the bank. But this credit serves all the purposes of money, and may be used in making exchanges, exactly as if it were gold and silver.
Since each depositor counts himself the possessor of so much money in the bank, it follows that the total volume of the currency is now $60,000. We therefore reach the conclusion that the volume of currency in circulation may include not only material money, but credit, expressed by nothing more than figures written in the books of a bank. In other words, when a customer goes to a bank, gives his promissory note for $1000, and has the figures $1000 written on the credit side of his ac-count, thereby giving him the right to draw cheques for that amount, an addition of $1000 is made to the total volume of the effective currency. By effective currency we mean that which can be used in payment.
Since all the money borrowed has been deposited, there still remains the same amount in cash in the vaults of the bank. But this amount will fluctuate yet more than before, owing to the number of persons who may make or receive payments to or from the rest of the world. Still it would probably be found that the amount would never fall below $30,000. This sum could again be loaned out to customers, and if they de-posited it, it could be loaned again, and so on indefinitely. Thus we cannot set any mathematical limit to the volume of the credit currency which the bank may have in circulation through the cash in its vaults. But with every increase in this volume there would be an increase in the fluctuations arising from trade, so that a limit of safety would be soon reached. The national banking law of the United States sets the limit at 25 per cent of the current liabilities, but of course the bank must seek to keep its cash a little above that limit.
Bank Circulation. It often happens that the depositor or borrower desires to make payment without the formality of drawing and signing a cheque. The bank may then, in making him a loan, issue its own promissory note, payable on demand. Thus arises the familiar bank-note. This transaction will consist in the simple exchange of credit between the individual and the bank. The individual gives the bank his promissory note, payable with interest at some future time, and in return receives from the bank its own promissory note, payable on demand without interest. If now we suppose our bank to issue notes in this way to the sum of $10,000.
At this point we may notice one of those singular mistakes which frequently influence the views and actions of masses of men, although in direct conflict with facts which would be well known would men only attend to them. This error is the belief that the main function of a bank is to issue circulating notes. It may be questioned whether this function should be considered a legitimate one of any bank, and as a matter of fact the large majority of the banking firms of the world do not issue such notes. Public or incorporated banks generally, but not universally, issue them. We shall hereafter see reason to believe that if no such thing as a bank-note for general circulation had ever been thought of, the world would not have been any worse off.
Ulterior Development of the Bank. The transactions which we have described complete those which necessarily pertain to the business of conducting the bank. In practice, how-ever, there is yet further development in various ways. In the first place, instead of all the business men of the town keeping their money in one bank, there are frequently a great number of banks. The result is that when a payment is made by cheque it will happen in a large majority of cases that the payee does not himself keep an account in the bank on which the cheque is-drawn, but in some other bank. Then, instead of sending himself to the bank to get his cheque cashed, he hands it to his own bank, authorizing the latter to collect it by indorsing his name on the back. The result is that in the course of the day the various banks of the city will have a collection of cheques drawn against each other.
Now if we take tile sum total of all the cash in the banks of the city, it will remain true (leaving out the exceptional cases where parties withdraw cash to make payments) that the sum total will vary only in consequence of payments to par-ties outside the city. But when the cheques drawn upon each other are presented, each bank is obliged to pay in cash all drawn upon itself, and has the right to collect in cash all held for payment by other banks. The cash in the vaults of anyone bank will then increase or diminish according as the cheques deposited with it are in excess of or below those drawn upon it. Still, as business ordinarily goes, it will frequently happen that these amounts closely balance each other.
As business goes on, the accounts of the resources and liabilities of the bank become more complex. The statement can be balanced at any time by calculating the conditions if the bank should at that moment wind up all its business and dissolve. Its resources would then consist of all the property which it possessed and all the debts due to it, in whatever shapes they might be. Ideally we conceive that this whole sum is put into cash. The liabilities would then consist essentially of the statement what would be done with this cash. In the first place, the depositors and holders of notes would all have to be paid off. Then other creditors would have to be paid, the capital stock would have to be made good, and the balance would be divisible pro rata among the stockholders as accrued profits. It must also be remembered that, in the statements published by the banks, the cash on hand and debts due are divided up under a number of separate heads, instead of being combined into one sum total. These little details are, however, of slight economic importance, and all that is essential for the student is to understand the nature of the large amounts which pertain to the conduct of the business.