Finance, Credit And Commercial Exchange

( Originally Published 1918 )

Money and Credit are so closely interwoven with the commercial life of a nation that it is essential for every person engaged in business to have some knowledge of the part which they play in it.

The Part Played by Banks. As generally understood, bankers are merely middle men who borrow from one set of persons at a rate in order to lend to another set at a greater rate, the difference between the two rates being their margin of profit. But in reality they are much more than this. They are conservors of a nation's capital and promoters of its trade and industry.

The most common function of banks is the discount of commercial paper running for short periods of time and representing actual transfers of property in the business world for the less known credit of merchants and manufacturers.

How Banks Increase the Potency of Capital. By means of banking, a given amount of wealth acquires nearly the same potency when diffused among millions as when concentrated in the hands of a few. Banks take the place of large capitalists; they gather into one fund the small savings or reserve-wealth of the masses, and thus render these as available for the employment of labor as if they belonged to a single possessor. And also they supply the knowledge and enter-prise requisite for the employment of that wealth which is in great part wanting on the part of the actual owners of it. Hence the banking system accomplishes the same results as if the wealth of a country were concentrated in the hands of a few large capitalists, and yet allows of that wealth being actually diffused among tens of thousands of owners. The banking system, in short, immensely increases the potency of capital, which has quite as much to do with national progress as the actual amount of the national wealth.

Banks, as before stated, take the place of large capitalists; so that the money expended by the wealthy and enterprising portion of the community in trade or industrial works, such as railways, etc., although dispersed in wage payments among workers who do not themselves employ the money thus acquired in reproductive industry, is not thereby withdrawn from production, seeing that it immediately finds its way back into the banks, who employ it just as large capitalists would.

If there were no banks, a large portion of the money employed in the construction of a railway would stagnate as small hoards in the hands of thousands of owners, and a very long time would elapse before it became again available for production by returning into the hands of large capitalists; whereas, through the agency of banks, the small sums are quickly reunited, and become disposable anew for industrial investment. In this way capital is recollected as soon as dispersed, and hence, by means of Banking, the reserve-wealth of a country, although ceaselessly dispersed in industrial expenditure, practically remains massed or concentrated, and therefore in the most effective condition for augmenting production. In this way a very large amount of capital which would otherwise become "fixed," in consequence of its being employed in industrial enterprise, immediately reappears as "floating" capital, available for similar investments by other parties.

Financial panics in America were chiefly due to the want of a centrally controlled banking system. That there was a movement among American bankers to remedy this deficiency prior to the enactment of the Federal Reserve Law is strikingly shown by the following extract from an article by the Hon. A. Piatt Andrew, published in "the American Academy of Political and Social Science" for November, 1910:

"No phase of recent American banking is more striking than the groping of over 25,000 independent banks toward some coherent organization and leadership. This is shown not merely in the consolidation of great city banks and the affiliation of banks and trust companies, but in the development of association and joint control through the clearing houses, and the absorption on the part of these institutions of new and far-reaching functions. The adoption of methods of mutual supervision through clearing-house bank examinations which has been so much in evidence in western and middle cities during recent years is one step in this direction. The more careful regulations governing the conduct of firms which are admitted to membership in the clearing-house, and with regard to the non-member institutions which clear through members, about which so much controversy has centered during recent years in New York, is another instance of the same tendency. Above all, the resort to clearing-house loan certificates in time of unsettlement which became so surprisingly general throughout the country in 1907 is the best illustration of the way in which our banks are forced at times to act together under common leadership. It shows, too, how an ingenious people can improvise a needed institution if it does not already exist.

"The operations of the clearing-house associations during the panic of 1907 were essentially akin to the ordinary functions of the Bank of England and the Bank of France. With the banks as customers, these clearing-house associations made loans on collateral, rediscounted notes, and made the reserves of all of the banks available for each other in practically the same way as do the great national banks of Europe. The operations were of an identical nature, but there were two essential differences in form and in measure of effectiveness. First, the arrangements had to be devised in the stress of an emergency, and only began to operate after the panic had become acute, and it was no longer possible to forestall the general collapse. Second, there was no general clearing-house association for the country as a whole, and even though the banks of each locality were able by a belated expedient to pool their reserves and transform their commercial paper into available, liquid assets, there was no arrangement for a similar settlement of accounts as between different cities. Hence the struggle which was witnessed of each locality endeavoring to fortify itself at the ex pense of every other locality a spectacle which could not have occurred in any :European country and which we ought to make impossible of recurrence here."

Origin and Nature of Credit. There can be no system of credit until there has been a considerable accumulation of capital; for, when capital first begins to be accumulated, those who possess it apply it directly in aid of their own labor. As a country increases in wealth, many persons acquire capital which they cannot employ in their own business, or can only employ by offering inducements to purchase in the shape of deferred payments. As soon as a sufficient capital exists, a system of credit has a natural tendency to arise and will continue to grow with the increase of capital, unless it be checked by a general in-security of property, by imperfect legal securities for the payment of debts, or by .a want of confidence in the integrity of the parties who desire to barrow. When the society and laws of a country are in a sound state, and capital is abundant, credit comes fully into operation.

In a recently published article, the Hon. George E. Roberts, Director of the United States Mint, thus lucidly discusses the nature and value of credit as a substitute for money :

"There is a very common misunderstanding of the meaning of the word 'credit' when used as a banking term. Some people associate it wholly' with advances of money or goods upon time, but credit is also a substitute for money in cash trans-actions. When a customer gives a merchant a check for a bill of goods and the merchant de-posits the check for his own bank account and simultaneously draws against it, credit is being used, and a great convenience and economy are effected over payments of money from hand to hand. When payments are between distant localities the advantages are obviously greater. The great bulk of the payments between the East and West are accomplished by offsetting the purchases they make of each other. The great bulk of the bank deposits of the country are created in this way, and not by passing money over the counter. All of this involves the use of credit. This method of doing business will not be changed. The public will not go back to a greater use of money from hand to hand; on the contrary, it is certain that the various forms of bank credit will more and more become the means by which payments are made."

Deposits, Discounts and Loans. It is very important for merchants requiring credit accommodations of banks, that they place their deposits in the kind of banking institution that can most certainly and conveniently accommodate them in the matter of discounts and loans. Depositors are given preference over outsiders on the loan-able funds of the bank in which their money is deposited.

The State Banks, that is to say, banks organized under the laws of a state instead of under the National banking act, are not, in most of the states, required to hold a reserve against savings and time deposits, and therefore are usually in better position than the National banks to accommodate their depositors by advances to them on notes, drafts, bills of exchange, and collateral of various descriptions.

The National Banks are required to maintain a certain portion of cash reserves to their liabilities, and when their reserves fall to a certain point they must stop loaning.

The National Banks, moreover, in the central reserve cities, are prohibited from advancing loans on real estate, while the State Banks have this power. This makes patronage of the State Banks very desirable in such cities. The Federal Reserve Board may name additional cities where National Banks shall not be permitted to make such loans.

Where, however, business is to be transacted with persons in other states, the National Banks have an advantage over the State Banks, since the residents of one state are ordinarily not acquainted with the provisions of the banking laws of another state, while they know the general character of the provisions of the National Bank Act.

Trust Companies, in nearly all the states, have most of the characteristics of the State Banks. Besides having authority to execute trusts, they receive deposits, lend money on real estate and any other security, and their reserve requirements are lower than for National Banks. In fact they are not a distinct class of banking institutions, but only State Banks with additional powers.

"The Money Market," explains Horace White, in a recent issue of The Annals of the American Academy, "consists of the loanable funds in the country. The money which people are using in their daily business, which passes from hand to hand in retail trade, is no part of the money market. Such money is not marketable,' because it cannot be recalled from the immediate service which it is rendering to society. The bulk of loanable funds of the country consists of bank credits which are bottomed on gold, and the magnitudes of such credits is limited by the amount of 'lawful money' held by the banks as reserves. Bank notes are not available as reserves of National Banks, although they are such for State Banks and Trust Companies.

"The Stock Exchange is a meeting place of the buyers and sellers of invested capital; that is, of incomes present or prospective. This is a comparitively modern institution because invested capital transferable by negotiable instruments is of modern origin. There were exchanges in the ancient world where traders met to deal in various kinds of movable goods. The Agora of Greece and the Forum of Rome, and the Fairs of the Middle Ages were such exchanges, but negotiable incomes (stocks and bonds) did not then exist. At the present time no person of intelligence keeps surplus money uninvested. He buys some interest-bearing security, or puts it in a savings bank, in which case the savings bank buys an interest-bearing security, or employs it in such manner as to yield an income.

"Capital is the result of saving. If not the parent of civilization, it is the indispensable promoter and handmaid of it, since capital gives mankind the leisure and the means to take new steps forward in solving the problems of human existence. It is desirable that there should be facilities for investing the savings of the people without serious delay. Such facilities promote saving. It is desirable also that investments should be convertible into cash without delay. The raison d'etre of a stock exchange is to supply a place where money can be invested quickly and recovered quickly, or investments made upon which the investor can borrow money if he so de-sires. It is an incidental advantage that the stock exchange informs all investors, and intending investors, daily and without cost to themselves of the prices at which they can buy or sell securities on the active list of the exchange. These prices are made by the competition of buyers and sellers in the market, who are acting under the spur of self-interest. There is no other way in which true prices can be made. If the quotations so made are not precisely the truth in every case, they are the nearest approach to it that mankind has yet discovered.

"The making of bank loans to stock brokers is bottomed primarily on the confidence which the banker has in the broker as a person, and secondarily on the goodness of the securities offered. The modus operandi is substantially this: The broker, knowing from the clearing sheet of yesterday what payments he has to meet today, obtains from his bank in the morning authority to draw from this aggregate amount at an agreed rate of interest. As his checks come in during the day the bank certifies them and the banker sends to the broker the bank securities whose market value is greater by a certain margin than the amount borrowed.

"The loans are usually payable on call. As National Banks are forbidden by law to certify checks for a sum greater than the drawer of the checks has on deposit, the practice in such cases is for the broker to execute a promissory note, which note the banker discounts, putting the proceeds to the credit of the broker, and attaching the security to it as it comes in during the day. While this method exposes the banker to some danger of loss in the interval between the certification of checks and the receipts of the securities, such losses seldom occur. There is an unwritten rule of the stock exchange that the bank must be protected at all hazards, both as a matter of personal honor and because the stock brokerage business cannot be carried on otherwise."

Abuses of the Stock Exchange.--The distinction between legitimate speculation in "futures" and gambling on prices is not generally under-stood and, therefore, to many people both are equally objectionable.

The difference between gambling and selling "short" the limit of legitimate speculation in futures-is thus clearly pointed out by Mr. T.

Henry Dewey, of the New York bar, in a booklet recently published.

"Selling Produce 'Short' " is selling it for future delivery when the seller does not own the property at the time of the sale, but hopes to be able to buy it at a less price when or before the time for delivery arrives, thus making a profit from a fall in price. The short seller is therefore a speculator.

"Ina `short sale' of stock the contract for future delivery employed is a contract of borrowing. The seller does not, at the time of the sale, own any of the stock sold, but he borrows the same amount of stock from one who does own it and delivers the borrowed stock to the purchaser. The seller must return the stock to the lender and for this purpose he must buy it at some future time. He hopes to be able to buy it at a less price than he sold it at and thus make a profit of the difference between the two prices.

"Gambling on prices is betting on the rise and fall in market prices by means of pretended purchases and sales or pretended employment as a broker or commission merchant to make pre-tended purchases and sales. In other words, it is using the forms of buying or selling, or the forms of employment to buy and sell, where no real buying or selling or real employment is contemplated, the parties agreeing to settle with each other by the mere payment of differences of the prices of pretended purchases and pre-tended sales.

"Thus it appears that in speculation and in gambling on prices the result depends upon an uncertain future event. The difference is that, in one the parties are engaged in legitimate business beneficial to both of them, while in the other they are engaged in an idle and useless occupation beneficial only to the party winning, and, when carried to excess, injurious to society."

The Practice of Short Selling Sometimes Abused That the practice of "short-selling," though ordinarily legitimate, is sometimes perverted so as to work an injury to the public is shown by the following extract from a message of Governor Sulzer of New York, sent to the Legislature of that State in January, 1913:

"The subject of so called 'short sales' is one requiring your serious consideration. A contract to sell property which a man does not own at the time, but with which he can provide himself in time for the performance of his contract, is a general transaction in various branches of business.

"The best views seem to be that short selling in and of itself is not wrongful, but the abuse of this practice works injury to the public.

"Your efforts should therefore be to draw a distinction, so that what will be condemned is the perversion of a legitimate form of business to improper ends."

Exchange is that system of transactions by which debts and credits of persons residing in different places are settled without the actual transference of the money. This is effected by what are known as Bills of Exchange (see form) : Thus A in London is creditor to B in New York to the amount of $5,000; C in London is debtor to D in New York in a like sum. By the operation of the Bill of Exchange the London creditor is paid by the London debtor, and the New York creditor is paid by the New York debtor. This is the principle of Bills of Exchange, and its great convenience is the foundation of exchange itself.

The Course or Rate of Exchange.-That variation above and below par, which is called the course of exchange, results from the same causes that act upon the prices of commodities of every other kind. If bills upon New York be scarce, that is, if New York is but little indebted to London, the London creditor, who wants bills on New York to remit to that city, is obliged to purchase them at a premium; then the course of exchange is above par. If, on the other hand, London owes less to New York than New York owes to London, New York bills will be proportionably plenty, and the exchange with that city necessarily below par. Hence, it is a maxim that, when the course or rate of exchange rises above par, the balance of trade runs against the country where it rises. When two countries trade together, and each buys of the other exactly to the amount that it sells, their claims will balance each other, if the exchange be at par. This, however, is of rare occurrence, inasmuch as there must always be a balance owing to the one side or the other. The course of exchange, or the rate at which bills of exchange may be obtained, is affected by variations which may be either real or nominal. They are real when they grow out of circumstances affecting trade; nominal when they arise from any discrepancy in the actual weight or fineness of the coin, from the use of paper currency, etc.

Transactions in foreign exchange are usually conducted by persons known as exchange brokers, who are acquainted with different merchants in various cities at home and abroad. Ex-change transactions between different parts of the same country are generally conducted by bankers.

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