Banking Part 4

The a.s.sociated Banks of New York City, as the members of the clearing house a.s.sociation are called, hold the greater part of the reserves of the banks and trust companies not required by law to be kept in the local vaults, as well as the greater part of the surplus investment funds of the entire country. It is through the operation of the New York subtreasury on the reserves of the a.s.sociated Banks that the chief influence of the independent treasury system on the banking business of the country is exerted, the greater part of the government's receipts coming directly out of those reserves, and a large part of the expenditures going into them, and the greater part of the money deposited in national banks by the Secretary of the Treasury going directly or indirectly into New York inst.i.tutions. Most of the exports and imports of coin and bullion pa.s.s through New York, and the major portion of the foreign exchanges of the entire country are there effected. The New York a.s.say Office receives and distributes the greater part of the new supplies of gold and silver bullion which come from our mines and transforms into bullion the major part of these metals that come to us from abroad and do not find employment as foreign coin. The New York Stock Exchange is the medium through which a large part of the surplus savings of the country are invested in our industries or loaned for the use of our national, state, munic.i.p.al, and other local governmental agencies.

_5. Operation of the System_

The most noteworthy features of the working of this machinery may be discussed under the heads: conflict of functions and laws; loan operations; treasury operations; reserve system; absence of elasticity in the currency.

(_a_) _Conflict of Functions and Laws._--The two cla.s.ses of banking inst.i.tutions which have been described (state banks and national banks) and trust companies, described in a subsequent chapter, exist side by side in many communities, and in the performance of certain services compete for the patronage of the public. As has already been pointed out, state and national banks differ little in their functions except in their relation to real estate loans, and in some states trust companies perform all the functions of these inst.i.tutions and many others besides. In the performance of these common services, however, they are rarely regulated by the same laws or subjected to the same kind or degree of public supervision. The compet.i.tion between them, therefore, is not always on a fair basis and the temptation to violate restraining laws and administrative regulations is strong. The supervising officers recognize the situation as a rule and go to the extreme limit of leniency in administering laws and regulations which operate to the manifest disadvantage of the inst.i.tutions over which they have jurisdiction, but even then it is often impossible to render the basis of compet.i.tion fair and equitable.

This condition of affairs has resulted in the devising of ways and means of circ.u.mventing obnoxious laws and in some cases in practices which are pernicious in themselves. As examples may be mentioned the widespread practice of national banks, which are prohibited by law from making loans on real estate security, of making loans to customers who can offer no other collateral, on the security of their personal notes only, or of making loans secured by real estate by a three cornered operation utilizing a director or officer or some other third party as intermediary. All three cla.s.ses of inst.i.tutions compete in soliciting the savings deposits of the community, with the result that the trust companies and savings banks, which often have the advantage here, sometimes force upon their state and national bank compet.i.tors a higher rate of interest on such deposits than they ought to pay. The differing regulations in some places in force regarding the amount that may be loaned to a single individual or firm has also resulted in some cases in devious and uncommendable practices.

For the remedy of these conditions the first desideratum is the careful differentiation of the various functions performed by all these inst.i.tutions, and the devising of appropriate legal and administrative regulations for each one. These regulations should then be incorporated into the legislation and the administrative practices of the federal government and of each state, and any inst.i.tution which performs any of these functions should be obliged to submit to the regulations pertaining thereto. The difficulties in the way of securing such a differentiation of functions and such community of action between the federal government and our states are too obvious to require statement, but they should not prevent the formulation of ideal conditions, and a conscious and persistent effort to attain them.

(_b_) _Loan Operations._--In making loans, a typical method of procedure for a business man is to arrange with a bank for what is technically called a "line," that is, the maximum amount he may expect to be able to borrow under normal conditions. This "line" determined, he borrows from time to time according to his needs, giving as security his personal note, payable in one, two, three, four, or six months. Sometimes an indorser is required, and sometimes the deposit of collateral, mortgages on real estate, bonds, stocks, and warehouse receipts being the most commonly used securities employed in such cases. Ordinarily, when a note falls due, he expects the bank to renew it, if its payment at the time is not convenient, the agreement on a "line of credit" ordinarily carrying with it that implication, though not legally, probably not morally, binding the bank so to do. Indeed, the customer ordinarily counts the amount of his "line" as a part of his working capital and expects to keep it in use a large part, if not all, of the time.

In the determination of the amount of these "lines of credit," the judgment of some one or more bank officers, a.s.sisted by a discount committee and sometimes, though not as a rule, by a specially organized credit department, rules. In forming these judgments, the bankers of the United States as a cla.s.s are not guided by any universally recognized and well established principles. The best ones require from their customers carefully prepared statements showing the nature and volume of the business they transact, and a careful cla.s.sification of their a.s.sets and liabilities. Others, and these are a large majority, rely upon the knowledge they already possess, gained by general observation, and supplemented by verbal inquiries made from time to time and by the voluntary statements of the customers themselves.

The significance of the distinction between commercial and investment operations in the business of banking is not generally understood, and is consequently little regarded. The dominant question in the mind of the average banker, both in determining the amount of a customer's line and in making loans to him after the line is fixed, is how much he is "good for," and on this point the total net worth, rather than the nature of the business operations, of the customer is likely to be decisive. Of course, the banker is also influenced by the customer's reputation for both integrity and business ability.

This method of procedure has the advantage of rendering access of people to the banks easy and of promoting their extensive use, but it has the grave disadvantage of opening the doors wide to inflation of credit. The majority of our bankers do not know whether more or less than their savings deposits and their capital and surplus, the only funds which can safely be invested in fixed forms, is so invested. The promissory notes of their customers, which const.i.tute the major part of their a.s.sets, give no information on this point, and they have not made the investigations necessary to determine with certainty the destination of the funds they have loaned. They are satisfied with the knowledge or the conviction that their loans can be collected, not at maturity--they know very well that many, probably most, of them can not--but ultimately. The result is that unconsciously and gradually the banks create their demand obligations in the form of balances on checking accounts against fixed investments in machinery, buildings, lands, mines, etc., and, when the payment of these obligations is demanded, the reserves fall below the danger point and they are forced to require payment at maturity of paper which the maker had counted upon having renewed indefinitely, and the payment of which is only possible by the forced sale of the property in which the borrowed funds were invested, or of some other property in his possession. If only a single bank or a comparatively few banks find themselves in this condition, relief may be found in the rediscount of paper with other banks, in direct loans, or in the sale of securities on the exchanges; but, if the condition is general, relief by these means is impossible, and widespread forced liquidation becomes necessary. An aggravated situation of this kind causes panic and results in a commercial crisis.

(_c_) _Treasury Operations._--The operation of our independent treasury system produces arbitrary fluctuations in the reserves of the banks and prevents that degree of prevision which is essential to the most economical and the safest practices. The funds needed for current purposes are withdrawn from the banks and kept under lock and key in the treasury vaults, thus diminis.h.i.+ng reserves to the extent of their amount. Surplus funds likewise acc.u.mulate in the vaults with the same result, until the Secretary of the Treasury sees fit to deposit, and the banks find it possible to receive them. Even then the depository banks alone are directly benefited, and no one of these knows long in advance how much it is going to receive or when funds left on deposit will be withdrawn.

Since the volume of the business of the government is very large, the effects produced by the movement of its funds are of such magnitude as to give them national importance, the ability of banks to loan and to meet obligations already incurred being profoundly affected by them.

Among these effects must also be noted the inability of the banks to calculate these movements in advance, as they to a degree can those produced by the operations of their commercial customers, and the relation between them and the Secretary of the Treasury, which results. The relation between the receipts and the disburs.e.m.e.nts of the government vary greatly from month to month and year to year, so that, on the basis of past experience, it is impossible to predict when the banks will gain from or lose to the treasury. The action of the Secretary of the Treasury regarding deposits of surplus funds is equally uncertain and unpredictable. No fixed policy regarding this matter has yet been established by precedent or determined by law.

Each secretary follows his own judgment and is influenced by current events and conditions.

The uncertainty which results creates a speculative atmosphere about the money market and renders the banks dependent upon the secretary and the secretary influential on the money market in a manner which is unfortunate for both. Since they cannot be indifferent to the operations of the treasury, and cannot predict them, banks are obliged to speculate regarding them, and, if they err, they are likely either to over-extend their credit operations or unduly to contract them. The former will result when they expect an increase in their reserves from treasury sources and do not get it, and the latter when contemplated withdrawals of funds do not occur.

The Secretary of the Treasury is not in a position properly to exercise the power conferred upon him. He is outside the channels of commerce and industry, and must, therefore, secure at second hand the information necessary for intelligent action. Such sources of information are frequently unreliable and inaccurate and their use subjects him to the charge of favoritism and to the danger of acting in the interest of special groups or special localities.

(_d_) _Operation of the Reserve System._--Each national bank now keeps locked up in its vaults money to the amount of at least six to twenty-five per cent of its deposits and a balance with banks in reserve and central reserve cities sufficient to bring the total to at least fifteen per cent of deposits in the case of country banks, and twenty-five per cent of deposits in the case of reserve city banks. In addition, it is customary for most banks to carry as a secondary reserve high-grade bonds which can be readily sold in case of need.

The practice of state banks is practically the same as that of national, and that of trust companies differs only in the amount of reserves carried and in the proportion between the different items.

This system has many disadvantages. Among them the most obvious, perhaps, is the withdrawal of enormous sums from the current use of the agriculture, industry, and commerce of the country. That portion of these reserve funds which is required to be kept under lock and key in the vaults, amounting in the aggregate to a billion and a half of dollars or more, is not available for use in ordinary times, and is practically useless even in times of stringency, since according to present law, when the reserves fall to the minimum prescribed by law, banks must stop discounting, under penalty of being put in the hands of a receiver. The other portions of these funds, namely, those deposited with banks in reserve cities and those invested in bonds, are likewise withdrawn from the uses of current commerce, since a large part of the former is only available for use on the New York Stock Exchange, and the latter are invested in railroads, mines, factories, land, etc.

The explanation of the devotion of the redeposited portion of the reserves to the operations of the New York Stock Exchange is to be found in the fact that that exchange furnishes a regular market for call loans on a large scale. Since these funds are held subject to the call of the banks which deposited them, and interest at the rate of at least two per cent is paid upon them, the depository banks are bound to seek investment for them, and call loans on collateral listed on the exchange under ordinary circ.u.mstances are best suited to their purposes.

Another disadvantage of this reserve system is the dangerous situation in which it places banks from time to time, and the tendency to panic which it fosters. The demands made upon banks for both cash and credit vary with the seasons. In the fall and spring they are much greater than in the winter and summer. They also vary regularly through periods of years, increasing during the up-grade of a credit cycle and decreasing for a longer or shorter period after a crisis. Irregular and unexpected events also cause variations. On account of the rigidity of this reserve system and the lack of elasticity in our currency, the means available to banks for meeting increased demands, especially those of an irregular and unexpected character, are inadequate, and their employment is often dangerous. These means are: keeping in the vaults in slack times a large amount of unused cash, a practice too expensive to be employed; keeping surplus balances with correspondents at two or three per cent interest, not a sufficiently remunerative practice to be employed on a sufficiently extensive scale; rediscount with correspondents of some of their customers'

paper, or loans from them on the security of their own signatures or on such security supplemented by collateral; and sale of bonds at such prices as they will bring.

None of these expedients is certain at all times and under all conditions, and some of them are precarious at all times. Surplus balances with correspondents are most reliable, but they occasionally fail on account of the inability of correspondents to realize upon their call loans. When calls for the payment of balances are large and general, it is impossible for brokers whose loans are called by one bank to transfer them to another. The collateral deposited as security must, therefore, be offered for sale on the stock exchange, and the very stringency which resulted in their being so offered renders their sale, even at slaughter prices, difficult and sometimes impossible.

The result at the best is a heavy fall in the prices of stock-market securities, and at the worst a stock-market panic and a suspension of payments by the banks.

Rediscounts and loans from correspondent banks cannot be depended on.

Correspondents are under no obligation to make them. They will usually do so as a favor, if their condition warrants, otherwise not. Sales of bonds on the stock exchange are difficult and sometimes impossible in times of emergency, and are usually attended with loss.

On account of this uncertainty and the danger attending it, when new and unusual conditions likely to result in increased demands upon them arise, banks are likely to act "panicky"; to call in their balances from correspondents; to sell bonds; to call loans; and greatly to curtail or absolutely to cut off new discounts. This action spreads the panicky feeling among their customers, and creates such pressure at the reserve centers as to cause curtailment of accommodations and panic there.

At the very best, this reserve system is accompanied by high discount and loan rates and by speculation on the stock market. High rates result inevitably from the h.o.a.rding of currency which it involves, the supply of loan funds being abnormally diminished, and speculation follows from the concentration in slack times of funds in New York City, which can only be employed in call loans on stock-exchange collateral. Stock brokers regularly take advantage of this situation, speculate themselves and inspire speculation among their customers.

The mutual dependence of the stock and money markets thus produced by this reserve system is disadvantageous to both, fluctuations in values, uncertainty, and irregularity on both being the result.

(_e_) _Lack of Elasticity in the Currency._--The money of the United States consists of four main elements, gold and silver coin, United States notes, and national bank notes, and none of these fluctuate in volume in accord with the needs of commerce.

The gold element depends primarily upon the output of our gold mines and upon the international movement of gold, increasing when that output increases and when our imports of gold exceed our exports, and decreasing under opposite conditions. These fluctuations, however, are quite independent of our commercial needs. Silver dollars, which const.i.tute the major part of our silver currency, for several years have been unchanged in quant.i.ty, and the volume of United States notes has remained at $346,681,016 since the resumption of specie payments, January 1, 1879.

National bank notes fluctuate in volume as a result of changes in the number of national banks and in the prices of government bonds.

Whenever a new national bank is organized, a specified portion of its capital must be invested in government bonds, which bonds are usually deposited with the Comptroller of the Currency in exchange for notes; and, when the price of government bonds rises, banks holding more than the minimum required by law frequently retire a portion of their circulation in order to recover their bonds for sale at the enhanced price. When the price of government bonds falls, many banks purchase additional quant.i.ties and increase their circulation.

Changes in the price of government bonds and in the number of national banks, however, have no connection whatever with changes in our currency needs, and no more do the fluctuations in the volume of the currency as a whole, made up of these various elements combined. As a result of this condition, rates on loans and discounts fluctuate greatly on account of wide variations between the demand and the supply of loan funds, and commerce is hampered at certain seasons and overstimulated at others. As was indicated above, this lack of elasticity in our currency aggravates the defects of our reserve system and also aids in the production of financial panics.

_6. Plans for Reform_

On account of the defects in our system of banking, there has been long-continued agitation for reform, increasing in scope and intensity in recent years. After the crisis of 1907, which revealed these defects to many persons who had not observed them before, Congress appointed a commission to make investigations and to prepare a reform measure. In January, 1912, this committee submitted a report which embodied a bill for the incorporation of a National Reserve a.s.sociation, to be made up of a federation of local a.s.sociations of banks and trust companies. The purpose of this a.s.sociation was to supply a market for commercial paper, an elastic element in the currency, a place for the deposit of the bank reserves of the country and of the funds of the government, as well as proper machinery for the administration of this market and these funds.

For various reasons, the plan of the monetary commission did not meet with universal favor. It was condemned in particular by the Democratic party, which was victorious at the polls in the fall elections, and installed a new administration in Was.h.i.+ngton, March 4, 1913. A special session of the new Congress was called to consider the tariff question, and to it was submitted another plan for the reform of our banking system, which was enacted into law December 23, 1913.

This law provides for the incorporation of so-called "Federal Reserve Banks," the number to be not less than eight or more than twelve. The country is to be divided into as many districts as there are Federal Reserve Banks, and the national banks in each district must subscribe six per cent and pay in three per cent of their capital and surplus to the capital stock of the Federal Reserve Bank located in that district. State banks and trust companies may contribute on compliance with the same conditions as national inst.i.tutions. If, in the judgment of the organization committee, the amount of stock thus subscribed is inadequate, the public may be asked to subscribe, and as a last resort stock sufficient to raise the total to an adequate figure may be sold to the Federal Government. Cooperation between these Federal Reserve Banks and a degree of unity in their administration are provided for through a Federal Reserve Board of seven members, two ex officio and five to be especially appointed by the President of the United States.

For the administration of each Federal Reserve Bank, a board of directors of nine members is provided for, six to be appointed by the member banks and three by the Federal Reserve Board, one of those three to be designated as Federal Reserve Agent and to be the intermediary between the Federal Reserve Board and the bank of whose directorate he is a member.

The proposed Federal Reserve Banks are to hold a part of the reserves of member banks and to rediscount commercial paper, administer exchange accounts, and conduct clearings for them. They are also to serve as depositories for the United States government, and to issue treasury notes obtained from the Federal Reserve Board in exchange for rediscounted commercial bills, these notes to be redeemable on demand by them and to be a first lien on all their a.s.sets. Their retirement, when the need for them has pa.s.sed, is provided for by the requirement that no Federal Reserve Bank shall pay out any notes except its own, all others being sent in to the issuing bank or to the treasury for redemption. Against outstanding note issues a reserve of at least 40 per cent in gold must be maintained, and against deposits one of at least 35 per cent in gold or lawful money.

This law provides remedies for the chief defects of our system; namely, a market for commercial paper which will enable a properly conducted bank at any time, through rediscounts, to secure notes, legal-tender money, or checking accounts in the amounts needed; a system of note issues which will fluctuate automatically with the needs of commerce for hand-to-hand money; a more economical administration of the reserve funds of the country, unattended by the dangers of the present system, and an administration of the funds of the federal government which is free from the evils of the independent treasury system.

CHAPTER V

COMMERCIAL BANKING IN OTHER COUNTRIES

In contrast with that of the United States, the characteristic features of the commercial banking systems of Europe are the central bank performing important functions for all other financial inst.i.tutions and for the government; a relatively small number of large inst.i.tutions with many branches mediating between the central bank and the people; and the use of commercial and bank bills instead of promissory notes as the chief instruments of loans and discounts.

_1. Common Features_

The central banks differ considerably in organization and business methods, but perform essentially the same functions; that is, they act as financial agents for their respective governments; discount high-grade commercial and bankers' bills for other banks and usually for private persons; administer the cash reserves of the entire country; and furnish the greater part and, in some cases, the entire supply of bank notes.

The other large banks do most of the business with the public, the central bank's relations being chiefly with them and with the government. They conduct checking accounts with merchants, manufacturers, farmers, and others; receive and invest savings deposits, and deal in certain cla.s.ses of investment securities; conduct the domestic and foreign exchanges; discount various kinds of commercial and banking bills, frequently those not available for discount at the central bank; and make advances on personal and other kinds of security. Their main offices are located either in the central money market of the country or in important financial centers, and their branches are extended to all places in which banking facilities are supposed to be needed. As a rule, they are less restricted by legislative provisions than are the national and state banks and trust companies of the United States, and are less carefully supervised and inspected by public officers.

Commercial and bankers' bills are widely used as credit instruments between buyers and sellers and between bankers and their customers. A common method of procedure, when a sale is made on time, is the drawing of a bill for the amount due, by the seller upon the buyer, payable at the end of the credit period agreed upon, and accepted by the buyer, and the discount of the bill by the seller's bank. In foreign and in some branches of domestic trade, the banker's bill is used on account of its more general acceptability as an object of discount, such bills usually being discountable by the central bank and by banks far distant from the place in which the bill originated.

In case a buyer desires to furnish his creditors with bills of this kind, he arranges with his banker for a line of "acceptance" credit, which permits people who sell goods to him to draw bills upon his banker instead of himself, the banker agreeing to accept the bill and guaranteeing its payment at maturity. The seller will usually have no difficulty in discounting such a bill at his own bank, no matter how far removed it may be from the home of the buyer, the character of the accepting bank being known throughout the financial world. "Acceptance lines" are usually granted only on condition that the customer agrees to supply the bank with the funds necessary for meeting the accepted bills as they fall due, and to pay a fee for the accommodation. Ample security that these obligations will be met is usually demanded.

_2. The English System_