Banking Part 1

Banking.

by William A. Scott.

PREFACE

The purpose of this book is to supply the general reader with a simple statement of the principles and problems of banking. Since it is designed primarily for American readers, special attention has been given to conditions in this country. An effort has been made clearly to draw the line between commercial and investment banking and to indicate the problems peculiar to each. That it may a.s.sist the average person in understanding present-day banking problems and thus contribute towards the formation of a sound public opinion regarding them, is the author's hope and desire.

WM. A. SCOTT.

_University of Wisconsin._

CHAPTER I

THE NATURE, FUNCTIONS, AND CLa.s.sIFICATION OF BANKING INSt.i.tUTIONS

The terms, "bank" and "banking," are applied to inst.i.tutions and to businesses which differ considerably in character, functions, and methods, but which nevertheless have certain common features which justify their being grouped together. We can best prepare the way for a discussion of these differences and common features by a description of the services which these inst.i.tutions perform in modern society.

_1. Services Performed by Banking Inst.i.tutions_

From the point of view of their customers these services may be grouped under the following heads: The safekeeping of money and other valuables; the making of payments; the making of loans; and the making of investments. It is a common practice everywhere, and in some countries, notably the United States, almost a universal practice for people to intrust their money to banks for safekeeping. To a degree, h.o.a.rding, in the sense of locking up money in private vaults and other receptacles and keeping it under the eye and in the personal care of the owner, is still practiced, but it is doubtless on the wane in all civilized countries. The practice of intrusting to banks the safekeeping of other valuables, such as important doc.u.ments, jewelry, plate, etc., is also widespread and growing.

The service of the safekeeping of money naturally leads to the second, the making of payments. When we intrust our means of payment to a bank, it is natural that we should also make it our treasurer and disbursing agent, and so we do. If we have payments to make to people at home, in other cities of our own country, or in other countries, we usually order our bank to perform the service for us.

Loans of almost all kinds are made by banks, and certain kinds, namely, those to business men for the everyday conduct of commerce and industry, are made almost exclusively by them. For the most part these are short-term loans. For long-term loans banks are also one of the chief resorts, but in some countries these are not to so great a degree monopolized by them as the short-term variety.

For the investment of the surplus funds of people banks are the chief agencies. This function takes the form mainly of the sale of stocks, bonds, and mortgages, and sometimes of the promotion of new enterprises.

None of these services are performed by banks exclusively. For the safekeeping of valuables, and sometimes of money, there are in some places safe deposit companies to which the term "banks" is not applied. In the making of payments the post office departments of governments and express companies partic.i.p.ate, and in the making of loans and investments brokers, loan companies, lawyers, etc., partic.i.p.ate. The peculiarity of banking inst.i.tutions consists not in the performance of any one of these services, but in the fact that they specialize in them all, or in a combination of them. Merely to keep money and valuables on deposit, or to act as paymaster, or to make loans, or to sell bonds, stocks, and mortgages would not make an inst.i.tution a bank or an individual a banker; but to make a business of performing most or all of these services for the public involves the use of certain machinery and certain methods of procedure, and the a.s.sumption of a role in the nation's economy which is distinctive and peculiar, and which has set these inst.i.tutions apart in every country as objects of legislation and of scientific treatment, as well as in the thought and regard of the people.

_2. The Economic Functions of Banks_

Viewed from the standpoint of the nation rather than from that of individuals, the functions of banks may be described as those of intermediaries in exchanges and in the investment of capital. In the former capacity they supply the world with the major part of its medium of exchange and serve as distributing agents for that portion of the supply which comes from other sources. They create a medium of exchange through a process of bookkeeping which is world-wide in extent, and through which the mutual indebtedness of individuals, cities, and other subdivisions of countries and nations, brought about by purchases and sales on credit, are offset without the use of money.

The practice of depositing surplus funds with banks for safekeeping and consequently of using them as paymasters has resulted in the reliance of everybody upon banks for currency in any form, and has thus thrown upon them the responsibility of directly utilizing all the sources of money supply. Thus while the mints of the United States and most other countries coin gold bullion, and supply subsidiary silver and copper and nickel coins to private persons on the same terms as to banks, as a matter of fact few private persons take advantage of this privilege, finding it more convenient and profitable to get the coin they want from banks. The same is true of government notes in countries in which such notes const.i.tute a portion of the currency.

The acc.u.mulation of a nation's capital and its investment require the cooperation of numerous agencies of which banks are the chief. They collect the savings of the people, combine them into amounts of sufficient size for investment purposes, and invest them temporarily and sometimes permanently. Cooperating agencies in this work are insurance companies, societies of various kinds for the promotion of saving, stock exchanges, promoters, etc. Some of these take the place of banks in the performance of these services, while others supplement and aid them.

_3. Cla.s.sification of Banking Inst.i.tutions_

Banks differ from one another chiefly in the nature and degree of their specialization, in legal status, and in the place they occupy in the system to which they belong. Some banks devote the major portion of their effort to the conduct of exchanges and are called _commercial_ banks, others to investment banking and are called _investment_ banks. The most common subcla.s.ses under the latter head are savings banks, land or mortgage banks, and bond houses. Savings banks specialize in the collection and investment of small savings; land banks are primarily intermediaries between capitalists and people who wish to invest capital in land, building operations, and agriculture; and bond houses are intermediaries between capitalists and those who wish to invest capital in industrial, commercial, and transportation enterprises, or loan it to states, cities, or other public corporations.

Commercial banks rarely confine themselves exclusively to the conduct of exchanges. Most of them also conduct savings departments and invest the funds intrusted to them through such departments in agricultural, industrial, or commercial enterprises or loan them to public corporations. Commercial banking, however, is their main concern, their other departments being side issues of greater or less importance according to circ.u.mstances. Investment banks also frequently carry on commercial banking as a side issue. These two lines of business are sometimes mixed in such proportions as to render cla.s.sification difficult.

From a legal point of view the banks of nearly all countries may be cla.s.sified as _private_ or unincorporated, and _incorporated_, sometimes also called joint-stock banks. Private banks are started by individuals or firms, like any other private enterprise, without the formality of application for permission to some public officer, and without compliance with a set of legally prescribed regulations. They are subject to the laws of the country governing all kinds of private business enterprises and sometimes to special laws applying specifically to them. In some of the states of the United States such banks are prohibited by law.

Incorporated banks are usually started by private initiative but owe their actual legal existence and status to a special law, to the requirements of which they must conform before they are permitted to do business. Their right to do business is usually evidenced by a doc.u.ment known as a charter, executed and delivered by a public officer legally endowed with the requisite authority, or pa.s.sed in the form of a law by the legislative organs of the state. Charters of the latter kind are known as special charters and are rarely used nowadays, except in the case of inst.i.tutions of a peculiar character, endowed with special functions. The central banks of Europe owe their existence to such charters, as did also the first and second United States banks. In the early history of the United States special charters were uniformly employed by the states, but for many years general incorporation laws have been the rule, on compliance with the requirements of which persons who desire to incorporate banks can secure charters.

In federal states, both the federal government and the governments of the const.i.tuent states frequently have and exercise the right to incorporate banks. In the United States, banks incorporated by the federal government under the terms of a general law, originally pa.s.sed in 1863 and many times amended since that date, are known as _national_ banks, and those incorporated by the states under the terms of general banking acts or of general incorporation laws are known as _state_ banks. These latter are endowed with privileges which enable them to exercise commercial and some investment banking functions. Other banks also are incorporated by our states under the terms of general laws, which are known as savings banks and trust companies. The former, as the name implies, are inst.i.tutions primarily designed for the encouragement, collection, and investment of savings.

The latter are called trust companies because the earliest inst.i.tutions of this type made the execution of trusts of various kinds their exclusive business. Banking functions were later added and in many cases have now a.s.sumed chief importance.

The nature of the banking business requires some kind of organization of the individual inst.i.tutions in which certain ones will a.s.sume to a degree at least the role of bankers' banks. In most European countries this position is occupied by single inst.i.tutions specially chartered and endowed with special privileges and usually described as central banks. Examples are the Bank of England in England, the Bank of France in France, and the Imperial Bank of Germany in Germany. Around these are grouped the other inst.i.tutions in a kind of hierarchy, certain large banks in the larger cities forming centers about which smaller inst.i.tutions group themselves. In the United States there is no single central inst.i.tution, but a small group of banks in New York City are the real centers of the system. Around these are grouped the banks in the other large cities of the country and these in turn perform important services for banks in the surrounding smaller towns and country districts.

CHAPTER II

THE NATURE AND OPERATIONS OF COMMERCIAL BANKING

In the preceding chapter commercial banking has been defined as the conduct of exchanges by means of a world-wide process of bookkeeping.

We must now describe this process. Its essential features are the discount of commercial paper, the conduct of checking accounts, and the issue of notes.

_1. Commercial Paper_

By commercial paper is meant the credit instruments or doc.u.ments which the credit system now in general use throughout the commercial world regularly brings into existence and liquidates.

The essence of this system is buying and selling _on time_. The farmer buys seed, implements, fertilizer, labor, etc., and pays for them after the crops have been harvested and sold. The manufacturer buys raw materials and pays for them after they have pa.s.sed through the transformation process which he conducts and the completed goods have been marketed. He frequently sells them to jobbers or wholesalers on time and these in turn sell them on time to retailers and these to consumers. Farmers, manufacturers, and merchants both buy on time and sell on time, and are thus both debtors and creditors, and each expects that his sales will ultimately pay for his purchases.

The obligations involved in these transactions are represented and recorded in the form of book accounts, promissory notes, or bills of exchange, the latter being written or printed, or partly written and partly printed, orders of creditors on debtors to pay to themselves or to third parties the sums indicated. These doc.u.ments are being constantly made and constantly paid as the processes of agriculture, industry, and commerce proceed. Indeed, their creation and liquidation is a normal phenomenon of our modern economic life.

The term commercial paper, as we are using it, applies to such promissory notes and bills of exchange as belong to this credit system. It does not apply to such notes and bills when they owe their existence to credit operations of a different kind, such for example as accommodation loans or investment operations. Indeed, the essential characteristic of commercial paper is not revealed in the form of the credit doc.u.ment but in the fact that it is a link in this chain of exchange operations by which modern commerce is carried on.

This use of the term should also be distinguished from the one common among bankers and others. In this popular usage these doc.u.ments are called commercial paper because they are themselves objects of commerce. In our use of the term the adjective "commercial" applies to them only when they play the role of intermediary in a process of exchange through credit. In this sense it is a matter of indifference whether they pa.s.s through the hands of brokers or not, and the fact of their being objects of purchase and sale does not confer the quality of commercial paper upon doc.u.ments having an origin and character other than that above described.

_2. The Operation of Discount_

Every person in this chain of credit is confronted with the problem of paying his debts as they mature by the use of the amounts due him from other people. Since it is rarely possible to arrange maturities on both sides in such a way that the amounts due to be paid him at a given date shall at least equal those he is due to pay on that date, some means of transforming claims against other people due in the future into present means of payment must be found. The one universally employed is the discount of commercial paper. By this is meant the exchange at a bank of his own promissory notes due at times when debts of equal or greater amount due him mature, or of bills of exchange drawn against his debtors, for cash or credits on a checking account. These latter are available as means of payment at any time.

As a consideration for this accommodation, the bank charges interest for the period intervening before the maturity of the paper discounted. Sometimes this charge is paid at the time the paper is purchased and sometimes at the date of its maturity. The term "discount" technically means taking interest in advance by making available as means of present payment in any of the above mentioned forms a sum less than the amount the bank expects to collect at the date of the maturity of the discounted paper. If the interest is paid when the discounted paper matures, the process is technically called a loan. However, since the time of collecting interest makes no essential difference in the nature of the transaction, the process is commonly described as the discount of commercial paper, regardless of whether the interest is collected in advance or not.

_3. The Conduct of Checking Accounts_

A checking account is an ordinary book account on which are credited the cash deposited by a customer and the proceeds of collections, loans, and discounts made on his behalf, and on which are debited payments made to him in cash or on his behalf to other people or to the bank itself. These payments are made on orders signed by the customer and known as checks.

The ordinary customer of a commercial bank every day brings to the bank the cash he receives as the result of the day's business, and the checks received, drawn on his own and other banks, and is credited with the amount on the books of the bank as well as on a pa.s.sbook which he himself retains. If he needs cash during the day, he presents to the bank a check payable to himself for the amount needed, and receives the kinds and denominations wanted; and if he wants to make payments to his creditors in other forms than cash, he sends them checks on his bank payable to their order, or a check drawn by his bank on some bank in another place, usually called a draft, which he has obtained by exchanging for it a check drawn to the order of his bank. To the amount of these payments his account at the bank is debited, and from time to time his pa.s.sbook is left at the bank for the entry therein of the debits made to date and its subsequent return to him.