Organization of Banks in Detail
( Originally Published Early 1900's )
THE system of banking, as described in the preceding chapter, is subject to a weakness dealing with which is the most intricate problem connected with the subject. The source of weakness is this: the bank, in order to make any profit, must always have upon its books credits payable on demand (that is, deposits and circulating notes) to an amount greater than it has the cash on hand to pay with. The result is that if everybody having money in the bank should demand immediate payment, the bank could not fulfil its obligations, and would he obliged to postpone payment and suspend business. But this suspension would not imply any lack of ability to make good its obligations in the course of time. Excluding such abnormal cases as those arising from defalcation, robbery, bad debts, etc., every bank has on hand not only cash, but the promissory notes of its customers; and these two items, as already shown, must, in the normal case, equal or exceed the deposits and capital combined. A well-conducted bank has generally a large reserve fund in addition to what would make good its capital and deposits.
Let us see the consequences of a continued demand upon a bank for the payment of its debts, called in common language a " run." Suppose the run to be upon the bank whose condition is described in 1881. It has on deposit or in circulation the sum of $155,000; that is to say, it has credit to this amount circulating as money through the medium of cheques and notes, and forming this amount of the currency of the community. Suppose now that the owners of this whole $155,000 come day after day to demand payment, while no others deposit money in their places. The bank having cash to the amount of $40,000 can redeem this amount of its indebtedness. But there will still be $115,000 outstanding. In order to meet this indebtedness it must refuse to discount any more notes, and must require the payment of all those which it holds, as fast as they become due. As the payments come in they can be applied to the redemption of the indebtedness until the whole $115,000 remaining is paid. This will still leave $15,000 out of the $130,000 of notes discounted, and this money will be-long to the stockholders as capital. The final result of the run will be as follows :
I. A diminution of $115,000 in the volume of the currency circulating in the community. Instead of $145,000 in bank credits and $10,000 in banknotes, there is now circulating $40,000 in coin, just as if the bank had never been organized.
II. The bank will during a period of several months have been obliged to refuse to loan any money to its customers, and thus many of the latter, failing of their expected loans, will be unable to pay their debts.
These two evils will tend to aggravate each other, since, owing to the diminution in the volume of the currency, not only the ability of the merchants to borrow from the banks, but to borrow from other people, will be diminished. So long as a man has a considerable deposit in the bank he is in a much better position to loan money than when he has only a small quantity of coin on hand. The general result will be what is called a "commercial panic," or a general inability on the part of large numbers of the community to pay their debts.
But this, be it remembered, results, not from any inherent necessity of the case, but because the customers of the bank, either from loss of confidence or from any other reason whatever, have determined to withdraw their balances. So long as general confidence is felt in the bank there is no danger of a run upon it. The state of mind of the ordinary depositor has been facetiously expressed in the form : " If you can pay me my money, I do not want it; but if you cannot pay me, then :I must have it." The reason why a general run upon banks is never to be feared under ordinary conditions is that there can be no occasion for it. The depositor can generally make his ordinary payments in his own community by cheque as easily as by money ; and even if he must withdraw his money to make the payment, the chances are that the payee will re deposit it in the same bank or in some other bank. The exceptional cases arise when he is to make a payment in some other place, or when he wants the gold or silver coin to use for some other purpose than paying it out.
The reader must, however, be on his guard against the popular illusion that these exceptional cases can never arise except from distrust of the bank. Such would indeed be the case if no one ever wanted money except to pay out within the sphere of operations of the bank. But experience shows that if banks act on this supposition by increasing their credits, their depositors will come demanding coin for foreign export, or to melt down for manufacturing purposes. We shall hereafter see that the facility with which coin can be exported operates like a safety-valve to stop an undue expansion of bank credit. The banks themselves keep each other in check by requiring the prompt payment of all cheques which they hold against each other.
On the other hand, there always exists a greater or less tendency towards an increase of the discounts and deposits of a bank. Men of business continually want to borrow money, provided the rate of interest is not too high ; they therefore go to the banks for loans. But instead of taking the loans out as cash, they commonly leave them on deposit, and make their payment by cheques. In such cases there is a simple exchange of indebtedness, the bank acknowledging the indebtedness to the customer on demand, while the latter gives his note for the same sum payable with interest at a future time. When business is brisk and merchants see good opportunities for profit by enlarging their operations, they naturally go to their banks for discounts, thus creating a demand for money, or, to speak more accurately, for bank credits. In order to avoid too great an extension of this credit, the bank raises its rate of interest, thus discouraging the applications of those borrowers who do not expect to make a profit to justify the increased rate. When business is dull the opposite effects take place: the merchants pay off their notes instead of letting them continue at interest, and the bank must lower its rate of interest in order to. attract borrowers.
Since all the profits which banks can pay their stock-holders are derived from the interest on the moneys loaned, and since all the coin in the vaults is so much dead capital drawing no interest, there is a certain tendency on the part of banks to make the largest loans on the smallest available cash reserve. How far this temptation will be yielded to depends upon the good management and soundness of the bank, the general financial state of the community, and the laws which govern banks. In new countries, where the rate of interest is high and the demand for loans great, the temptation is much stronger than elsewhere. Thus arose the " wild-cat banking" which was so prevalent in our new States during their early history. When a "wild-cat" bank was established, its practice was to loan its own notes on interest. The banker knew that there was little immediate danger of these notes coming back in great numbers, because the community was too much in want of them as money. He was therefore tempted to loan them on insufficient security, especially as good security was difficult to obtain under the circumstances. If he could in-duce his customer to carry the notes to a great distance, the danger of their being returned for payment became still less. So long as people would take his notes, he was thus enabled to draw a high rate of interest on a very small capital. When his notes finally returned for payment, he was frequently obliged to refuse them. To make him pay would. cause embarrassment to the business community, and thus his creditors were disposed to deal very gently with him. The result was throughout our whole western country a great mass of depreciated paper money, issued by banks which those who handled the money really knew nothing about—money which frequently proved worthless, thus causing great loss to the last holders.
Suspension of Specie Payments. We have described the distress resulting to a community in the case of a general run upon banks, causing a shrinkage of the circulation and an inability of the bank to make loans to those requiring them. To avoid this evil it used to be very common in America for banks to suspend specie payment under such circumstances. Then, when the depositor came for his money, they refused to pay him in cash, but tendered him only a circulating note of their own or some other bank. If he asked the payment of this note, he was told that lie must wait. By thus dishonoring its own obligations, the bank was enabled to continue making loans to its customers. In order to do so, it only had to write the appropriate credits on the books of the bank in exchange for the customer's promissory notes. What it loaned him, how ever, was not money, but rather the hope of money. There was little danger, within moderate limits, of the bank having to pay out large amounts of these notes, because no one had an object in demanding notes which would serve him no better purpose than the credits in his bank-book. The bank in its relation to its depositors was in the position of a debtor who was not obliged to pay out anything but promises to pay, and who conld therefore afford to accumulate debts while awaiting the return of better times.
To these defects of the old bank currency we may add the evils arising from counterfeiting. Counterfeit bank-notes were so numerous that the "Bank-note Detector" was almost a necessity in every place where considerable sums of money were paid and received. This Detector was a periodical publication, giving the names of all the incorporated banks in the different States, with descriptions of the genuine notes of each denomination, and of the counterfeits which had got into circulation.
National Banking System of the United States. The evil thus arising led during the Civil War to the establishment by Congress of the national banking system of the United States. Our account of this system will be confined to its leading economic features. Every such system requires for its operation many legal enactments which do not concern the economist. The latter is principally concerned with the provisions which regulate the credits of the bank, and the funds which it holds to make good such credits. We call to mind that an important part of the circulating medium does not consist of coined money, but of debts payable on demand by the bank, the right to receive which is transferred from hand to hand as if it were money. In order that these debts may be of equal value with coin, the bank is obliged to pay them on demand. They are of two kinds, bank-notes and bank credits.
The latter are transferred by simple delivery, as in the case of money. The r are transferred by written cheques as already described. To pay this indebtedness on demand, the bank has two kinds of resources. The one consists of promissory notes of business men, payable with interest at future times, and of other forms of property and of credit. The other resource is coined money. Since, as already shown, the volume of coined money is less than the amount of credit pay-able on demand, and since the greater the volume of the latter the higher the profit of the bank, it follows that there must be some restrictions upon the power of the bank to increase its credit money and pay out its stock of coin. These restrictions we shall now proceed to consider.
Private banks—that is, men or firms who become bankers simply as a matter of private business—are not ordinarily subject to any legal limitations. It may be assumed that no one does business with such a banker unless he is satisfied of his good financial standing and of his business ability and prudence. The interest which the banker feels in his own reputation is a strong incentive to caution, and, in the view of some, offers better security than any law directing him how to regulate his business can offer.
Private bankers may establish book credits in favor of their customers to any extent, thus performing all the functions of banks of deposit, but they are not allowed to issue circulating notes. Now, although a book credit transferable by cheque is economically of the same nature as the indebtedness expressed by a bank-note, yet the two stand on a very different footing in their relations to the community. Cheques are generally drawn for considerable sums, and are employed for payments only between well-kuown and responsible men of business. Since every person who draws or indorses a check thereby guarantees its validity, any person receiving it can not only re-quire payment of the bank, but in case the bank does not pay he has the right to require payment of the drawer or of any previous indorser. Hence lie has a greater security than that afforded by the solvency of any one individual taken singly.
But in the case of bank-notes this additional security is wanting. When they once get into circulation they will be offered in the course of trade to persons who know nothing about the bank and have no means of assuring themselves that the note is genuine. It therefore seems more necessary that the law shall protect the individual against the danger of being compelled to take a worthless bank-note than that it shall protect him against the danger of a worthless cheque. In the one case he can protect himself, and in the other he cannot.
The principle of protection adopted in the national banking system is taken from one previously in force in the State of New York. To see what the principle is, let us once more recur to the relation between the amount of notes which a bank has in circulation and the funds it retains in its vaults to pay those notes whenever required. The bank could be required to keep in its vaults a supply of coin equal to the whole volume of its notes, and to use this coin for no other purpose than the payment of the notes as presented. But it has already been shown that, were this policy adopted, the bank would have nothing to compensate it for the expense and labor of issuing the notes. Its only source of compensation is the inter-est gained by loaning the money held in reserve. The problem then is to allow this reserve to be invested in such a way as to yield interest, and at the same time to be available for no other purpose than the payment of the notes in case of necessity.
Our national banking system requires that before issuing notes a bank shall have deposited with the Treasurer of the United States interest-bearing bonds of the United States to an amount not less than $30,000 and not less than one third of its capital stock. Thereupon the bank is authorized to issue circulating notes to an amount not exceeding 90 per cent of the par value or the market value of the bonds so deposited. To guard against an excess of notes above the legal limit, the bank is not allowed to issue any except such as it receives in blank from the Comptroller of the Currency in Washington. The bonds held by the Treasurer can be applied to no purpose except the redemption of the notes in case the bank fails to redeem them itself. The bank, however, regularly receives the interest on its bonds. The result of this arrangement is that although a bank may fail to paya note on demand, the holder of the note is secured against ultimate loss. Consequently no person in taking a national-bank note has any occasion to concern himself with the standing of the bank which has issued it. Probably in not one case out of a hundred does the person who receives a note look to see what bank issued it. Counterfeits are of course possible. But the public bas to trust the vigilance of the government to guard it against them.
It is of course always necessary that a well-ordered bank shall keep on hand a reserve in coin or legal-tender money available to pay its notes and credits as they are from time to time presented. The question how large this reserve must be is one of the most difficult in banking. In the case of private banks it is, as already said, left to the discretion of the bankers themselves. In the case of national banks in any of the principal cities of the Union the reserve is required to be at least 25 per cent of the outstanding circulating notes and deposits of the bank. In the case of banks situated in the smaller towns the required reserve is 15 per cent.
Of course it cannot be required absolutely that the reserve shall never fall below this limit, because the very object of the reserve is to pay the indebtedness on demand, and if payment is demanded faster than money is received the reserve may fall to zero. The law therefore simply requires that when the re-serve falls below the required limit the bank shall not increase its liabilities payable on demand ; in other words, it shall stop loaning money.
Thus the law does the best it can to insure that the business of the national banks shall be conducted on sound principles. But experience shows that no legal provisions can afford security against bad management. Examinations are made from time to time to see that every bank has on hand the securities and other property which the state of its business requires. But when a bank is authorized to loan money to individuals, no examination can make it certain that the borrowers are all solvent. Bad debts are incurred from time to time, and stocks and bonds may depreciate or become worthless. The holders of circulating notes have still a security which is almost certain, in the bonds deposited with the Treasurer of the United States, but creditors of all other kinds are liable to suffer loss. Yet, if we should compare the loss actually suffered with the business transacted, the amount of risk would be found surprisingly small. The daily transfers made by bank notes and credits amount in the city of New York alone to many millions of dollars. The total loss in the whole country to depositors probably never amounted to a million of dollars in any one year, except in cases of some great swindle. The danger of loss incurred by money in one's pocket or drawer is many times that which it incurs when deposited in any bank managed with common honesty and prudence.
The Bank of England Plan. The problem of establishing a proper relation between the credit currency issued by a bank and its reserve fund is met differently in different countries. In this respect the Bank of England is governed by the celebrated Charter Act of 1844, a measure due to Sir Robert Peel. The business of the bank is divided into two separate departments, the one the "banking department," the other the "issue department." The banking department receives deposits transferable by cheque in the way described in the preceding chapter, but it does not issue notes. The issue department emits bank-notes for circulation, and keeps its separate reserve fund to insure payment of the notes.
The basis of the regulations governing the issue department is this : it was found that the volume of notes in actual circulation generally ranged between sixteen and twenty millions of pounds, seldom or never falling below the former limit. It was therefore assumed that a certain minimum volume of bank-notes would perpetually remain in circulation, and so never be presented for actual payment at the counter of the bank. This assumed minimum was originally fixed at fourteen mil-lions, but has since been increased to fifteen millions. This amount may be issued by the bank without keeping any coin for their payment, though of course, as already shown, an equal amount of promissory notes from individuals, or of govern-ment securities, must always be held by the bank. But for every note issued above this minimum an equal amount in coin or bullion must be held by the issue department of the bank.
The result of this arrangement is that if the volume of the coin-reserve diminishes, so as to be but little above the excess of notes in circulation over fifteen millions, no more notes can be issued. Now, for reasons the statement of which belongs to a more advanced part of our subject, this state of things is likely to occur at the very time when the public are most in need of notes, credit, or other forms of currency. The power of the bank to perform one of its functions is thus paralyzed at the very moment when this function is most essential to the business interests of the community. This difficulty has been met by an expedient known as a " suspension of the Charter Act" by an "order in council" of the government.
Three such suspensions have been authorized, in the years 1847, 1857, and 1866 respectively. The suspension authorizes the bank directors to count the reserve of the issue department as a part of the reserve fund of the banking department, so that the latter could still discount the notes of merchants, although its reserve fell below the proper limit.
The necessity of this suspension has subjected the act in question to criticism, on the ground that a law which has to be suspended from time to time proves itself to be defective by its own operation. If the object of human laws is to establish regulations which shall forever govern the relations of men, without any modifications whatever, then this criticism is undoubtedly sound. But taking a different point of view, we may regard the arrangement as one of the finest examples of the practical adaptation of laws to the varying circumstances of mankind that ever was invented. A law is devised which works with entire success except in rare emergencies. The provision that it shall cease its operations temporarily under these emergencies may be regarded from a practical point of view as an excellent one, the law being enforced so long as it is beneficial, and no longer.