?tate (^allege of Agriculture At Cornell Iniueroitg Mlium, KL $• ffiihratg Cornell University Library HG 1586.D89 1922 The theory and history of banking 3 1924 013 984 020 || Cornell University B Library The original of this book is in the Cornell University Library. There are no known copyright restrictions in the United States on the use of the text. http://www.archive.org/details/cu31924013984020 THE THEORY AND HISTORY OF BANKING BY CHARLES F. DUNBAR FORMERLY PROFESSOR OF POLITICAL ECONOMY, HARVARD UNIVERSITY WITH CHAPTERS ON FOREIGN EXCHANGE AND CENTRAL BANKS BY OLIVER M. W. SPRAGUE PROFESSOR OF BANKING AND FINANCE, HARVARD UNIVERSITY WITH SUPPLEMENTARY CHAPTER PRESENTING THE RECORD OF THE FEDERAL RESERVE SYSTEM BY HENRY PARKER WILLIS PROFESSOR OF BANKING, COLUMBIA UNIVERSITY FORMERLY SECRETARY FEDERAL RESERVE BOARD FOURTH EDITION G. P. PUTNAM'S SONS NEW YORK AND LONDON ube IKnfcfcerbocfter press Copyright, 1891 by Charles F. Dunbar Copyright, 1901, 1917, by G. P. Putnam's Sons Copyright, 1922, by G. P. Putnam's Sons First Published iSgi Second Revised Edition igoi Third Revised Edition 1917 Fourth Revised Edition October, 1922 Reprinted December, 1922 ., ASS Made in the United States of America PREFACE TO THE FIRST EDITION The preparation of the following -chapters is the result of the need of some convenient statement of ordinary banking operations, felt by the writer when lecturing upon banking to a large class of students in the elements of political economy. To the chapters devoted to such operations it was found useful to add a series of historical chapters on certain of the great banks and banking sys- tems, partly for the easy illustration of theory and partly to supply the want of any good manual of banking history. Eight of the chapters were printed in 1885 for the use of classes in Harvard University, but were not then given to the public. To these have now been added an introductory chapter, a chapter on com- bined reserves or the system of Clearing House loan certificates, and one on the Bank of Amster- dam. The whole has been revised and the notices of current history brought down to the present date, arid the book is now laid before students and readers with the hope that it may aid in the sys- tematic study of a subject, the treatment of which by writers upon economics is generally either too summary or too diffuse for ordinary purposes. The writer has annotated his text with a freedom iv Preface to the First Edition which perhaps demands some apology, desiring to make his notes answer the double purpose of in- forming the reader as to the sources from which statements are drawn, and of inviting him to ex- plore the sources more deeply than was possible within the limits of the present publication. C. F. Dunbar. January, 1891. CONTENTS CHAPTER I PAGE Introductory ...... i CHAPTER II Discount, Deposit, and Issue ... 9 CHAPTER III Banking Operations and Accounts . . 22 CHAPTER IV The Check System 43 CHAPTER V Bank-Notes 59 CHAPTER VI Central Banks 81 By Oliver M. W. Sprague CHAPTER VII Foreign Exchange 103 By Oliver M. W. Sprague CHAPTER VIII The English Banking System . . .132 vi Contents CHAPTER IX PAGE The French Banking System . . .167 CHAPTER X The German Banking System . . . 199 CHAPTER XI The National Banks of the United States . 220 CHAPTER XII Federal Reserve Banks .... 249 By Henry Parker Willis Index 3i7 THE THEORY AND HISTORY OF BANKING THE THEORY AND HISTORY OF BANKING CHAPTER I INTRODUCTORY The operations of banking, as the system has been developed in the last three centuries, appear at first sight to be singularly complex and difficult of comprehension. This is not due, however, to any mystery in the operations themselves, but is the result of their multiplicity and of the varied conditions under which they take place. The wants which banks satisfy are of a simple kind, sure to arise early in the history of any commercial or industrial community in which there is mutual confidence among men; and the satisfaction of these wants is a business easily established, in what might well be regarded as an almost primitive condition of trade. The transactions by which these wants are satisfied are, moreover, as simple as the wants themselves, and are speedily reduced to such routine as to lead Adam Smith, in a well- i 2 Introductory known passage, to rate "the banking trade" as one of the few which, in his judgment, could be brought to such uniformity of method as to be safely con- ducted by a joint-stock company. The leading wants to be provided for by banks are, first, loans upon a considerable scale, required by individuals embarking in enterprises beyond their own means; and, second, the temporary employment of money which is not required by the owner for immediate use, or at least the means of safely keeping it. Some agency for lending and some place of deposit are called for as soon as commerce begins to move in a regular course. In some countries the task of simplifying the currency of the community, and of giving it an ascertained value, was formerly entrusted to bank- ing institutions, but this is a service which can manifestly be more satisfactorily performed by government and has now everywhere become one of its regular functions. Transfers of funds and arrangements for making settlements between persons in different places in the same or in dif- ferent countries, i. e., domestic and foreign ex- change, have always been and will remain an important field of banking activities. The primary and indispensable functions to be provided for, however, are those of lending and of receiving on deposit, and it is these which have given rise to modern banking. These functions, it is clear, imply no very com- plex operations. They require prudence, integ- Introductory 3 rity, and patience, but they have no mystery. The banker who lends, or who engages to sup- ply cash to his customer as it may be called for, needs to be sure of the solvency of his borrower and of the goodness of the security received, and must have the evidence of the trans- action made indubitable, its terms clearly fixed, and the record of it complete and exact. When he receives cash on deposit, or collects for others cash which is due and holds it until it is wanted by the owners, he must in like manner be sure that the evidence of every transaction is regular and placed beyond doubt, and that its record is precise and systematic. And when, as an extension of his system of holding deposits, he recognizes the right of a depositor to transfer his deposit or any part of it to another person, in order to make a payment to the latter, the operation of transfer must be closely followed and the resulting changes in the banker's accounts must be made with fidelity and minute accuracy. But in no one of these cases does the actual transaction present any more diffi- culty of comprehension than the simple payment or receipt of money. The questions of prudence — how much and to whom it is advisable to lend, and upon what terms, how far it is safe to assume that deposits will be left undisturbed, and to what extent it is needful to be prepared for demands by depositors — require all the light that trained sa- gacity and experience can throw upon them, as do the questions relating to the conduct of business 4 Introductory in other departments; but the essence of the transactions themselves, to which the judgment of the banker is applied, is simple. As a natural consequence of the simplicity of the operations involved in lending and in receiving deposits, it is probable that they have been under- taken and carried on in every old country by individuals long in advance of any public establish- ments, and long before the chroniclers of history thought it worth while to notice phenomena of such a humble order. Private lenders established banking in Venice two centuries before the Senate opened its first public bank of deposit in 1587. Banking was in like manner practised by indi- viduals in Amsterdam long before a special class of evils led the city to establish the famous Bank of Amsterdam. And banking of a well-defined mod- ern type was introduced by the London goldsmiths at least a generation before the opening of the Bank of England. Instances of the same sort could easily be multiplied, tending to show that in other countries also banking has had its origin in the effort of individuals to supply certain rather primi- tive wants of an advancing community, and that the process of satisfaction was by means of a few thoroughly simple operations. Such as these leading operations were two or three centuries ago, they have continued to be in the midst of the changes and the enormous development of modern times. Wherever banking has reached an even moder- Introductory 5 ate measure of development, the individual wants which it undertakes to supply have ceased to be the exclusive object of attention. The general influence and ulterior effects of banking operations, not originally foreseen and long a matter of dispute, have become potent factors in the diffusion of banking and in the determination of the char- acter of the legislation to which it has been, sub- jected. The first bankers probably had little thought of affording encouragement or applying a stimulus to the industry of the community as a whole. When they began, however, to lend their money systematically to merchants or the pro- ducers of goods, they began to give the command of capital in the enterprises where, for the time being it was most called for and presumably most needed. When they increased their loans of this sort, by means of the funds left temporarily in their care by persons depositing with them, they began to give to industry the benefit of capital which would otherwise have remained idle, or to secure the more speedy application of capital slowly seeking employment. The use of their own notes as the medium for making their loans, in a manner strictly analogous, gave to their borrowers the command of resources which the fluctuating body of noteholders might forbear to demand. Again the practice of discounting the bills received by dealers from their customers tended to a rapid organization of credit, and, by giving the dealer the immediate use of that which was due to him 6 Introductory at some time in the future, shortened the period required for "turning his money" and undertak- ing some fresh enterprise. It is obvious that the bankers created no new wealth by their lending and deposit-holding, but it is equally plain that they directed the existing capital to the enterprises and industries most in need of support, and that they . quickened the succession of commercial and industrial operations. A given amount of capital was thus made more effective, so that the result of the introduction of banking in any com- munity was the equivalent of a considerable in- crease of capital, although not implying any real increase in the first instance. The stimulus thus applied by banking to the general commercial and industrial movement of any community, whether young or old, has long been clearly seen ; and it is this effect of operations, at first undertaken simply with reference to the demands of individual convenience, that, now chiefly claims attention and excites interest. This stimulus is not unattended by risk. Deposit- holding and the issue of notes are alike opera- tions of credit. They imply, as conditions of their existence, a certain growth of mutual confidence in any community, and a certain degree of domestic peace; and under conditions otherwise similar, nations will differ in their resort to such operations, as the national temperament is more or less sanguine and as tradition and habit have prepared the way, or the reverse. But to whatever extent credit is Introductory 7 thus used, it introduces not only the dangers of misplaced confidence, but the greater danger com- ing from the spirit of adventure. The tendency nuder the keen spur of a developed banking system to carry enterprises based upon credit beyond the point of safety, the infection of an entire com- munity by the fever of speculation, are too familiar for comment, and the errors of bankers in aiding and encouraging that which they should have striven to repress or control, have at times brought the utility of banking itself into question. The modern world, however, does not discard any great agency merely because its use is attended by danger. To secure a balance of gain by mini- mizing the risks, always recognizing their exist- ence and their deplorable character, has been the aim of most commercial communities in dealing with banking during at least four generations. The ignorant hostility to the system itself, instead of its abuses, of which traces were formerly to be found in the constitutions of a few of the United States, has generally given way to a wiser appre- ciation of the services rendered by banks and bankers in the development of the country. The difficulty of properly weighing these advan- tages and risks was greatly increased by the reckless imprudence with which banks in most countries, especially during the early stages in the develop- ment of the banking business, have managed their issues of notes. Such issues, although not a necessary adjunct of the business of lending and of 8 Introductory deposit-holding, are a natural and, in some condi- tions of society, a usual adjunct. Where they are made, the issuing banks or bankers at once become responsible for an important part of the visible circulating medium of the country. Their mis- takes or wrongdoing may affect a multitude of persons having no intentional or conscious share in or relation to the concerns of any bank; and may easily throw the affairs of a community into con- fusion. It is true, as we shall see hereafter, that the steps by which a bank issues its notes do not differ from those by which it assumes other less observed liabilities, and that its obligations in the two cases are the same in essence. Still, the wide diffusion of an issue of notes, the somewhat greater opportunities for mismanagement than of deposit credit, and the more visible and notorious nature of the resulting evils make such issues the object of extreme jealousy, and have often led to the indis- criminate condemnation of all banks. Although, therefore, the issue of notes is not one of what we have called "the prirhary and indispensable func- tions" of banking, it is a function which fills a large space in most discussions of banking theory, as well as in the history of the great banking systems and in legislation. The starting-point in the present exposition of the subject then must be an examination of the transactions involved in lending, deposit-holding, and note issue or circulation. CHAPTER II DISCOUNT, DEPOSIT, AND ISSUE A bank may be described, in general terms, as an establishment which makes to individuals such advances of money or other means of payment as may be required and safely made, and to which in- dividuals entrust money or other means of pay- ment, when not required by them for use. In other words, the business of a bank is said to be to lend or discount, and to hold deposits. With these two functions may be combined a third, that of issuing bank-notes, or the bank's own promises to pay, for use in general circulation as a substitute for money. The object of the present chapter is to inquire into the real nature of the operations, thus roughly classified and usually described by the terms Dis- count, Deposit, and Issue ; and for this purpose we shall analyze the transactions attending the ordin- ary and simple case of a loan made by a bank to one of its customers. The borrower who procures a loan from a bank does so in order to provide himself with the means, either of making some purchase, or of paying some debt. He seeks, therefore, to obtain, not necessarily 9 io Discount, Deposit, and Issue money, but a certain amount of purchasing power in available form, or of whatever may be the usual medium of payment, measured in terms of money. If we suppose him to be a merchant, buying and selling goods upon credit in the regular course of his business, he is likely at any given time to have in his hands a greater or less number of notes, not yet due, signed by the persons to whom he has heretofore made sales ; and it may be in the form of a loan, made upon the security of one or more of these notes and giving him immediate command of the amount which will become due upon them in the future, that he will procure what he needs from the bank. This loan may be supposed to take the form of what is termed a discount; in which case, in exchange for the note "discounted" the bor- rower is entitled to receive from the bank the amount promised in the note, less the interest on that amount computed at an agreed rate for the time which the note has still to run. 1 The dis- * If, e. g., the note discounted promises to pay $2,500, has 87 days to run, and the agreed rate is 6 per cent., then the interest to be deducted is $36.25, and the proceeds received by the bor- rower are $2,463.75. This process, which is commonly used and is known as "bank discount," gives a result somewhat different from that of discount in the strict sense of the term. Strictly speaking, discount consists in finding that sum which, if put at interest for 87 days at 6 per cent., will then amount to $2,500, or, in other words, in finding the present worth of $2,500 due under the conditions stated. As this present worth is $2,464.27, the es- tablished practice gives to the bank a slight profit in addition to that afforded by true discount. See on this point Agricultural Bank vs. Bissell, 12 Pick. 585. Discount, Deposit, and Issue n counted note becomes the property of the bank, to which the promisor is henceforward bound to make payment at maturity; and this payment when made obviously restores to the bank the amount advanced by it in exchange for the note, together with the interest which was the induce- ment for making the exchange. It is now clear that the operation which we have described, although spoken of as a loan by the bank to a borrower, is in fact something more than a loan. The note when given was evidence that its holder owned the right to receive at a fixed date a certain sum of money, and this right the so-called borrower has ceded to the bank. Passing over for the present all question as to what he has received in exchange, his cession of property by sale is as distinct and complete as if he had sold a bale of cotton to another merchant, instead of selling to a bank his right to receive money in the future. It is true that in parting with the note he probably endorsed it, and thus bound himself to make good its amount in case the promisor should fail to do so ; but he might equally bind himself by some war- ranty given to the purchaser, when selling any other description of property. The note has ceased to be his, and now takes its place among the investments or securities of the bank, although custom may lead to its classification as a "loan or discount. " z 1 In an account of the Bank of England, the note supposed, if taken, would be classified under "other securities," together with bonds or stocks owned by the Bank. 12 Discount, Deposit, and Issue The operation which we have here presented in its simplest form may easily change its shape according to circumstances. Thus, instead of offering for "discount" the notes of his customers, our merchant may offer his own note for the sum which he wishes to obtain, and attach to it, as security for its payment at maturity, one or more of the notes of his customers. In this case the principal note, his own, becomes the property of the bank, the right to receive from him at its maturity the sum promised in it being the real object of sale; and the attached notes, originally received by him for merchandise and now pledged to the bank as collateral security for the perform- ance of his contract, continue to be his property, subject to the right of the bank to be indemnified therefrom in case of his failure. So, too, he may offer his own note, securing it by the pledge of bonds, stocks, or other valuable property, the ownership of which he does not part with, while at the same time he sells as effectually as in the first case the right to receive from him a certain sum at a fixed date. Finally, following a practice which has become increasingly common in recent years, the bank may discount the unsecured note of the borrower. These unsecured notes are based on the character and financial position of the business of the borrower, and are generally limited to not more than half of his total working capital require- ments. Instead of the note of hand which we have supposed to be used, some other kind of Discount, Deposit, and Issue 13 negotiable paper, as, for example, the bill of exchange, may be preferred by local usage as the evidence of commercial obligation. Still, what- ever the form of the transaction by which a bank may make ' ' advances " or " loans, ' ' it will be found that in every case a right to demand and receive a certain sum of money has been acquired by the bank for a consideration. We now have to consider what it is that the bank gives in exchange for the right to demand and re- ceive money at a future time, acquired by it under these circumstances. To return to our first and simplest case of so-called discount ; the proceeds of the discounted note, or its nominal amount less the interest for the time for which it is to run, are in the first instance placed to the credit of the borrower, to be drawn out by him at once or at different times, as convenience or necessity may dictate. In thus crediting him with the proceeds, the bank plainly gives to him simply the right to call upon it at pleasure for that sum of money. Whether this right is exercised at once by demanding and receiv- ing the money, or whether the exercise of it is post- poned as regards the whole or a part of the amount, in either case the right to demand, or to "draw, " is the equivalent received by the customer in ex- change for the right, sold by him to the bank, of which the note discounted was the evidence. The sum which he is thus entitled to call for is said, so long as it stands to his credit, to be deposited in the bank, or to be a deposit standing in his name; 14 Discount, Deposit, and Issue so that the transaction is seen to be, both in form and in substance, an exchange of rights. The san* thing is true also in other cases of so-called "loans" or "discounts"; whatever form they take and whatever the collateral security held by the bank may be, the operation is after all essentially an exchange of rights, whereby the bank acquires the right to receive money, or the legal tender of the country, at some future time, and the individual acquires the right to call for money or legal tender at pleasure. The result is to give to him that immediate command of purchasing power or of the usual medium of payment which, as we have said, is the real object sought by him; but at the outset this result is usually secured and the relations of the bank and the "borrower" are settled, by the sale of one right for another, and without the intervention of money or any of its tangible substitutes. z But a deposit may owe its origin to a different operation from that which has just been examined. It happens every day that the merchant, having cash in hand, prefers not to hold it in his possession until it is required for use, but to "deposit" it with the bank where he usually transacts his busi- ness, until he needs to use it. In this case, when 1 The less usual case of a loan made in cash does not create a deposit, but is a case of issue if the bank gives its own notes to the borrower. It is, however, the sale of a right for a right in every case except where the loan is made in actual money, when it becomes the sale of a right for coin. Discount, Deposit and Issue 15 he makes his deposit, the property in the money or substitutes for money actually handed in by him passes to the bank, and he receives in exchange the right to demand and receive at pleasure, not that which he paid in, but an equivalent amount. r Here then, as in the former case, the transaction is in effect a sale, although the use of the word "deposit" seems at first to suggest an entirely different idea of its character. In the case of one important class of banking institutions, savings banks, and the savings departments of com- mercial banks as well, all the deposits are due to the receipt of money or substitutes for money. Savings banks do not create deposits when they make loans ; they simply invest or lend an amount which does not exceed their capital and surplus and the deposits previously acquired. Other banks do more than this. They lend their credit and are able to do so because they provide substi- tutes for coined money which are generally accept- able for most purposes. The other leading operations of banks, when analyzed, can also be resolved into cases of the exchange of rights against rights, or of rights 1 It is true that money may be left as a " special deposit " with a bank, just as plate, jewels, or other valuables may be, in which case, the identical money deposited is to be returned, and the bank consequently does not acquire the property in the thing deposited, but is merely entrusted with its temporary custody. This, however, is not a banking operation, and the deposit in this case is made with the bank, not because it is a bank, but because it owns a strong vault. 1 6 Discount, Deposit, and Issue against money. As, for example, when the bank, for the convenience of its customer or depositor, undertakes to collect a note due to him by some third party, in which case the amount paid to the bank in money by the promisor is passed to the credit of the promisee as a deposit. Here the bank has received money for the account of the depositor, and has given to him in exchange a right to draw at pleasure for the amount or any part thereof, the property in the money actually paid having passed absolutely to the bank in exchange for the right to draw. And again, when the bank buys from a merchant a bill of exchange, or when it sells a bill of exchange drawn by itself on some correspondent, it effects an exchange of money against a right, or of a right against money, strong- ly resembling those already considered. And so, too, if in any of these cases any substitute or equivalent for money is used, instead of money itself, the transaction is still an exchange of a right on the one side and some means of payment on the other, the latter becoming the property of the bank. We have thus far, for the sake of simplicity, spoken only of the "rights to receive" money bought by the bank in one class of cases, and sold by it in another. But where there is a right to receive on the part of a creditor, there is a corre- sponding duty to pay on the part of the debtor; and these rights or credits, when viewed from the other side, are, therefore, debts or liabilities. The Discount, Deposit, and Issue 17 deposit which is credited in making a loan is accord- ingly a liability to pay on demand, assumed by the bank in exchange for a security promising a pay- ment to the bank in the future; and the deposit credited upon the receipt of cash from the depositor is a similar liability, assumed in exchange for so much money or so much of its substitutes. In short, as any addition to the loans of a bank is an increase of its investments or resources, so any addition to its deposits is an increase of its debts or liabilities. A little consideration of the manner in which notes are issued by banks will show that in the bank-note we have only another form of liability, differing in appearance, but not in substance, from the liability for deposits. The bank-note is the duly certified promise of the bank to pay on de- mand, adapted for circulation as a convenient substitute for the money which it promises. It is issued by the bank and can be issued only to such persons as are willing to receive the engagement of the bank in this form instead of receiving money or instead of being credited with a deposit. Thus the so-called borrower, who in the first instance has been credited with a deposit and to whom the bank is therefore to this extent liable, may pre- fer to draw the amount in notes of the bank and to use them in making his payments. But, in this case, it is plain that the liability of the bank is changed only in form ; it is still a liability to pay a certain sum of money on demand. And so if the 1 8 Discount, Deposit and Issue depositor pays in money and receives notes, x or re- ceives notes in satisfaction of a demand of any kind against the bank, he, in fact, foregoes the use of the money itself and consents to receive in its stead a promise to pay upon demand, and to receive the evidence of that promise in the form of notes. The question, in which form he shall hold his right of demand against the bank, is one to be decided by the nature of his business or by his present conven- ience, but plainly the decision of this question in no way alters the relation between himself or any transferee of his right, on the one hand, and the bank on the other. The notes issued by a bank are thus a liability distinguishable in form only from its liability for deposits, and the functions of deposit and issue, spoken of at the opening of this chapter, instead of being distinct, as is often assumed, are one in substance. In the operations which have now been consid- ered the subject-matter involved is in every case either money or contracts for the payment thereof. No form of dealing in merchandise or real property comes properly within the province of banking. And, inasmuch as a contract for the payment of money may be viewed either as a credit or as a debt, according as it is looked at from the one side or the other, banking is sometimes described as the business of dealing in credits and sometimes as 1 In early English banking this was a common practice and no doubt explains the phrase "take up money on their notes, " used in legislation. See Bagehot, Lombard Street, p. 98. Discount, Deposit, and Issue 19 that of dealing in debts. For the transaction of this business in the modern world both of the func- tions "discount" and "deposit" are indispensable. In order to be a bank, at the present day, an estab- lishment must carry on the purchase of rights to demand money in the future, or securities; and unless it is a savings bank it must also lend its credit, using in some form or other its own engage- ments for the payment of money upon demand. * If it practises the former only, it is simply an in- vestor of its own money, as any private individual may be; if it practises the latter only, it may in- deed be said to be a bank of the obsolete type of the Bank of Amsterdam, but it then plainly ceases to answer one of the chief purposes of a modern bank, viz., that of enabling individuals to convert into immediate purchasing power such debts as may be due to them in the future. The use of the third function, however, that of issuing notes, is not indispensable to the exist- ence of a bank, for, as has been shown, issue is but a modification of deposit, adopted for convenience 'See in Bagehot's Lombard Street, p. 212, a remark that the Rothschilds are great capitalists, but are not bankers. The definition of a bank by the internal-revenue act of the United States of 1866 includes "every person, firm, or company having a place of business where credits are opened by the deposit or collection of money or currency, subject to be paid or remitted upon draft, check, or order, or where money is advanced or loaned on stocks, bonds, bullion, bills of exchange, or promissory notes, or where stocks, bonds, bullion, bills of exchange, or promissory notes are received for discount or sale." — 14 Statutes at Large, p. 115. 20 Discount, Deposit, and Issue and not from necessity. There are conditions under which the liability of the bank in the form of notes is desired for use, and there are also conditions under which the liability in the form of deposits better serves the convenience of individu- als or of the community. Many banks in every country, therefore, carry on their business success- fully without making any issue of notes whatever. In addition to these essential banking operations involving sales of rights to present payment for rights to future payment, banks engage in one im- portant transaction which involves no immediate right of payment. They accept bills of exchange drawn upon them by their customers. Such bills of exchange, known as bank acceptances, can be more readily discounted than trade bills accepted by the merchant's own customers. The bank acceptance is an indispensable instrument in for- eign trade, where, owing to the distance between buyer and seller, differences in legal arrangements and the constant fluctuations in foreign exchange rates, it is particularly necessary that certainty of payment shall be free from all doubt, and that the obligation shall be readily salable to dealers in foreign exchange. Until recently banks in the United States were not permitted to accept bills of exchange drawn upon them. This entirely proper power was granted to the national banks by the Federal Reserve Act of 1913, and legisla- tion to the same effect has also been passed in a number of the States. Discount, Deposit, and Issue 21 It must be added that incorporation by law is not a necessary condition of the existence of a bank. Discount and deposit, and if no legal pro- hibition exists, issue also, may be carried on by individuals and firms as well as by incorporated companies. It is true that in discussions of banking it is usual to give almost exclusive atten- tion to incorporated banks, partly because they are usually more important and conspicuous, and partly because their affairs are in some degree open to official inspection, so that the nature of their business is not easily concealed, whereas the trans- actions of private banks are usually known only to the persons concerned. Investment banking is still largely in the hands of private banking firms, but in all countries commercial banking is tending to be conducted almost exclusively under the corporate form of organization. CHAPTER III BANKING OPERATIONS AND ACCOUNTS Having thus taken a general view of the nature of banking operations, it is now necessary that we should enter upon the consideration of some of their details. For a bank, as well as for any other business, it is requisite that a capital should be provided at the outset. There can be no constant proportion between the amount of this capital and the extent of the business which may be built up by its means. The larger the business that can be carried on with safety with a given capital, the larger will be the field from which profits can be earned, and the higher the proportion which the profits will bear to the original investment; but the point at which the extension of the business passes the line of safety, varies with the circumstances of the particular bank, the kind of business carried on by those dealing with it, and the condition of the community in which it is established. The attempt has sometimes been made to limit by law for incorporated banks the proportion of trans- Banking Operations and Accounts 23 actions for a given amount of capital. 1 Recent legislation in a few of the Western States limits the acceptance of deposits to ten times the paid- in capital or capital and surplus. It is plausibly- argued that such provisions have no foundation except a conjectured average, too rough to be of service in any individual case, and that the judg- ment of the persons most interested, acting under the law of self-preservation, is far more trust- worthy than any legislative decision. But in the United States, where banking is conducted by thousands of local banks many of which are very small and managed by men of limited business experience, these considerations lose much of their force. The capital and surplus of a bank provide a margin of safety against loss to those whose funds have been entrusted to it. Those who man- age or control the undertaking should have some- thing at stake, and this stake may very properly be enlarged with the growth of the enterprise. It is therefore to be anticipated that an increasing number of States in which there are many small banks will adopt the policy of requiring a capital investment in some definite proportion to the deposits acquired. The capital to be provided at the outset is, of course, in the case of a private bank, the contri- bution of the partners, as in any other undertaking. ■ E. g., the law in Massachusetts formerly limited loans to double the amount of the capital. See General Statutes of i860, c 57. § 25- 24 Banking Operations and Accounts In the case of an incorporated bank the capital is divided by law into equal shares or units of fixed amount; as e. g., under the law of the United States, a capital of $100,000 is divided into 1,000 shares of $100 each; and these shares are contribu- ted by the individual shareholders, in such pro- portion as they please. The Jaw may as a matter of public policy limit the proportion of capital stock to be owned by any one individual or firm, and it may also limit the liability of shareholders for debts due by the bank, in case of its' failure ; but in general, in the absence of special provisions to the contrary, the powers, rights, and liabilities of every shareholder are now usually determined by the number of shares of the stock contributed or owned by him. In the election of directors and of other officers, for the immediate management of the business, every share entitles its owner to cast one vote ; the dividend of profit is allotted in the ratio of shares owned, and contributions to meet losses, if required by law, are called for in the same ratio. The capital subscribed by the intending share- holders must necessarily be paid in in money or in the legal tender of the country. It is not necessary that the whole should be paid in at the outset, but the payment of the whole usually precedes the full establishment of the business; and, in the case of incorporated banks, the law often requires that some definite proportion, as e. g., one half, shall be paid in before the opening of business, in order to Banking Operations and Accounts 25 insure good faith and a solid basis for the business undertaken. T If, now, we undertake to represent by a brief statement of account the condition of a bank hav- ing a capital of $100,000 paid in, in specie, on the morning when it opens its doors for business, we shall have the following : Resources Liabilities Specie . . . $100,000 Capital . . . $100,000 It may at first sight appear to be a contradiction in terms, that the capital should be set down as a liability and not as a resource. But we must here distinguish between the financial liability for what has been received from the shareholders and the right of property in the thing received. The bank has become accountable to its shareholders for the amounts paid in by them respectively, but the money actually paid in has become the property of the bank; or, in the language of accountants, the bank has become liable for its capital, and the money in hand is for the present its resource for 1 The English joint-stock banks present some remarkable cases of partially paid capital. Thus the Capital and Counties Bank has £10 of the £50 subscribed paid up, and the London Joint-Stock Bank has £15 in the £100. In these cases, the business having been fully established by means of a part only of the nominal capi- tal, the liability of the shareholders to contribute the remainder in case of need constitutes a species of guaranty fund of great amount. The value of this guaranty is sustained by the practice among English banks of requiring the approval of the board of directors before shares can be transferred. 26 Banking Operations and Accounts meeting this liability, or for explaining the dis- position made of what has been received. As the bank requires banking-rooms and a cer- tain supply of furniture and fixtures for the con- venient transaction of its business, we may suppose it to expend $5,000 of its cash in providing this equipment. The property thus procured, with the remaining $95,000 in cash, will then be the aggregate resources by means of which the capital is to be accounted for, and the account will stand as follows: Resources Liabilities Real estate, furniture fixtures, etc. $5,ooo Capital . . . $100,000 Specie . . . 95,000 $100,000 $100,000 The bank, however, cannot answer the purposes of its existence, or earn a profit for its shareholders, until its idle cash is converted into some kind of interest-bearing security. Nor is it enough that a permanent investment of the ordinary kind should be made, as by the simple exchange of the cash for government bonds or railway securities. It is the chief business of the bank to afford to pur- chasers and dealers the means of using, by antici- pation, funds which are receivable by them in the future, and this implies both the purchase of pri- vate securities or "business paper" to a consider- able extent, and also frequent change and renewal Banking Operations and Accounts 27 of purchases. Moreover, while the private capital- ist finds it advantageous to make simple invest- ments of a permanent sort, this would plainly be insufficient for the shareholders of a bank, who have to pay from its profits some serious expenses of management, and need, therefore, a larger field for earnings than the ordinary returns on their capital alone. Funds secured from other sources provide the means for the bulk of the operations of all banks. These funds in the case of savings banks are acquired entirely through the receipt of deposits. Commercial banks also receive deposits, but they are also able to extend their operations by lending their credit both in the form of notes and of deposits. Another fundamental difference between commercial banks and savings banks should also be noted. Money is commonly placed with savings banks for long periods. De- posits in commercial banks, whatever their ori- gin, are constantly being used. Security of the principal and the rate of return are therefore the essential considerations in the selection of invest- ments by savings banks. Commercial banks must, in addition, endeavor to keep themselves in a highly liquid condition at all times. Most of the conditions of the case are best answered by the "discount" of commercial paper as above described. The time for which such obligations have to run varies with the custom of the trade which gives rise to them, but is in most cases short enough to imply early repayment to the 28 Banking Operations and Accounts bank. And even where custom gives the paper longer time, if the paper itself is used only as a collateral security, the note which is the actual object of negotiation with the bank is by prefer- ence usually made not to exceed six months. It might seem easy then to arrange the purchases of paper with reference to the times of maturity, so as to provide for a steady succession of pay- ments to the bank, and thus facilitate the reduction of the business, if necessary, or its direction into new channels, as prudence or good policy may require. The certainty of prompt payment at maturity, needed for this end, is presented in a high degree by the paper created in the ordinary course of business. 1 Independently of the col- lateral security which the bank may hold, the written promise of a merchant or manufacturer to pay on a fixed day is an engagement which involves the credit of the promisor so far that failure is an act both of legal insolvency and of commercial dishonor. Selected with judgment, then, such paper is not only the investment which most completely answers the purposes of the bank's 1 The reports of a large commercial agency show that between 1879 and 1916 the number of failures in the United States was a little under one per cent, of the whole number of houses reported as in business. The highest per cent, of failures recorded in any one year was 1.5 per cent, in 1893. See Bradstreet's, Jan. 8, 1916. For a curious estimate showing that the liabilities of failed firms in 1874 amounted to less than one fourth of one per cent, of the total commercial liabilities of the country for the year, see Com- mercial and Financial Chronicle, February, 1875, p. 129. Banking Operations and Accounts 29 existence, but is probably as safe as any invest- ment which could be found. I It may easily happen, however, that the bank may find it desirable to invest a part of its resour- ces in some other form, either because good com- mercial loans cannot be procured in sufficient amount, or as a matter of policy. In this case it will purchase, such other securities as offer not only complete safety of investment, but the possibility of easy conversion into cash in case of need. 2 In this country United States bonds, and many descriptions of State, municipal, and corporation bonds might answer this purpose. Stocks would more rarely answer it, being more liable to the fluctuations in price caused by misfortune or the ordinary vicissitudes of business. Mortgages of real estate, however, would not be admissible, except when held as a security, collateral to some other which is more easily convertible, for even when the mortgaged property is so ample and sta- ble as to insure the goodness of the mortgage, the conversion of the mortgage into cash by sale is not always easy, and is especially difficult at those times when the bank most needs to have all its resources at command. Indeed, the danger to be 1 The liquidness of the various kinds of bank loans and other assets is further considered on p. 82 below. 2 See, in the reports of the Comptroller of the Currency, the "United States bonds" and "bonds and other securities, etc., " held by the national banks and amounting to $2,264,000,000 in May, 1916. 30 Banking Operations and Accounts apprehended from the locking up of resources, in securities which may be solid but are not easily realized, is so great, that it has been said to be the first duty of the banker to learn to distinguish between a note and a mortgage, his business lying with the former. As an investment for savings banks and for the deposits in the savings depart- ments of commercial banks, however, well-selected mortgages are entirely suitable, and accordingly in 1 913 the national banking law was modified to permit the national banks to invest a portion of their time deposits in this way. Real estate, of course, cannot be regarded as a banking security, however desirable it may be as an investment for individuals, for it is not only subject to great fluc- tuations in value, but is at times unsalable; and the law of the United States therefore wisely pro- hibits investments in it by the national banks, except so far as is necessary for the accommoda- tion of their business. The results of the process of investment in com- mercial paper and in other securities are best understood when we trace the effect in the account of the bank. Taking then the account as it stood on page 26, let us suppose that the bank buys paper or securities from those dealing with it, or, in the common phrase, makes "loans to its cus- tomers," to the amount of $90,000, the paper being in many pieces and having various lengths of time to run, but averaging about three months. Supposing the interest to be computed at six per Banking Operations and Accounts 31 cent., we should have the account changed by the operation as follows: Resources Liabilities. Loans . . . $90,000 Capital . . $100,000 Real estate, furniture, fixtures, etc. . 5,000 Undivided profits 1,350 Specie . . . 95,000 Deposits . . . 88,650 $190,000 $190,000 Here we have the securities which certify the right of the bank to demand and receive $90,000 at a future date placed among the resources ; the net proceeds of the securities, or the aggregate of the sums which the bank holds itself liable to pay for them on demand, stand among the liabilities as deposits; and the interest deducted in advance, or the profit on the operation, which the bank must at the proper time account for to the stockholders, also stands as a liability. 1 This, however, is the condition of the account at the moment of making the investment, when the bank has made its pur- chase of securities by merely creating a liability. As this liability is real and must be met, so far as the depositors at any time see fit to press it, let us suppose that depositors call for cash to the amount of $15,000 and we shall have a further change in the account as follows : 1 As this profit is not realized until the discounted paper is finally paid, the interest deducted in advance may be carried to a separate account for the time being, to be transferred later to the undivided profits. This method is not universal, however, and in the present discussion the simpler statement appears to be sufficient. 32 Banking Operations and Accounts Resources Loans Real estate, etc. . Specie Liabilities $90,000 Capital . . . $100,000 5,009 Undivided profits . 1,350 80,000 Deposits . . . 73,650 $175,000 $175,000 It is clear that, unless the enforcement of the lia- bility for deposits and consequent withdrawal of specie goes much farther than this, the bank can safely increase its loans or its purchase of securities, although its method of doing so is by the increase of its liabilities. We will suppose it, therefore, to have expanded its affairs until it has reached some- thing like the average condition of many of those banks in the United States, which, being incor- porated under the laws of the several States, are not authorized to issue notes. It will then stand thus: Resources Liabilities Loans $305,000 Capital . $100,000 Bonds and stocks 23,000 Surplus 29,000 Real estate 15,000 Undivided profits 10,000 Other assets 20,000 Deposits . . . 305,000 Expenses 1,000 Cash items . ) Specie v 80,000 Legal-tender notes i $444,000 $444,000 -Postponing for the present the consideration of some terms which here occur for the first time, it appears from the above account that loans and Banking Operations and Accounts 33 other investments have been made to more than three times the amount of the capital, and that this has been effected chiefly by the creation of liabilities in the form of deposits. What deter- mines the limit to which this process can be carried ? If depositors seldom demanded the payment to which they are entitled, and were contented with the mere transfer of their rights among themselves as a conventional currency, the bank might dis- pense with holding any large amount of specie or cash in any form and keep most of its resources em- ployed in its productive securities. The expansion of the deposits would then resemble in its effects the expansion of any other currency and might go on until a check should be interposed by the conse- quent rise of prices and demand for money for use outside the banks in the pockets of the people or for exportation. And it is true, as we shall see, that in communities where banking is largely practised, the use of deposits as currency by transfer between depositors is so extensive, that a bank in good credit can rely upon their being withdrawn so slowly, or rather to so small an extent, as to make it unnecessary to have cash in readiness for the pay- ment of more than a small proportion at any given moment. But in a period of financial disorder or alarm, withdrawals may be made earlier or more frequently, and a larger provision of cash may be needed for safety, than at other times; the kind of business carried on by depositors may expose one 34 Banking Operations and Accounts bank, or the banks in one place, to heavier occa- sional demands, or may on the other hand make demands steadier, than is the case elsewhere; and a city bank may be more subject to heavy calls from depositors than a country bank. In general, then, for every bank, in its place and under the circumstances of the time, there is some line below which its provision of cash cannot safely fall. This provision of cash, which in the account last given includes the cash items, specie, and legal- tender notes, is called the reserve, and the neces- sity of maintaining a certain minimum reserve fixes a limit to the ability of the bank to increase its securities. For obviously any increase of securities, that is, of loans or bonds, must ordin- arily be effected, either by an increase of deposits or by an actual expenditure of cash. In the one case the proportion of reserve to demand liabilities would be weakened by the increase of liabilities; in the other it would be weakened by the decrease of cash. If, then, the reserve were already as low as prudence would allow, or were threatened by approaching heavy demands from depositors, no increase of securities could be made without serious risk. What proportion the reserve should bear to the liabilities which it is to protect is a question which the law has sometimes attempted to settle, by re- quiring a certain minimum, leaving it to every in- dividual bank to determine for itself how much may be required in addition to this minimum. And this Banking Operations and Accounts 35 is no doubt as far as any general rule can go. As has already been suggested, the requirements for safety of different banks and in different places must vary, and so must the requirements of the same bank at different times. T In fact, the question as to the proper amount of reserve never depends simply on the absolute ratio of the reserve to the liabilities, but always involves further questions as to the probable receipts of cash by the bank and probable demands upon it, in the near future. It can only be said that the reserve should be large enough, not only to insure the. immediate payment of any probable demand from depositors, but also to secure the bank from being brought down to the "danger line" by any such demand. In the management of its reserve the bank itself necessarily feels a strong conflict of interests. On the one hand, it is impelled to increase its securities as far as possible, for it is from them that it derives its profits, and the retention of a large amount of idle cash is felt as a loss. On the other hand, the maintenance of a reserve sufficient, not only to en- able the bank to continue its payments but to inspire the public with confidence in its ability to continue them, is a necessity of its existence, even though a part of its resources do thus appear to be kept permanently idle. As a natural consequence, 1 The Bank of England may be content with a reserve amount- ing to 33 per cent, of its deposits, as in October, 1885, or it may be uneasy with a reserve exceeding 50 per cent., as in the autumn of 1896. 36 Banking Operations and Accounts the actual settlement of the question in favor of a large or of a small reserve in any particular case will depend in good measure on the temperament of the managers. In every banking community may be found "conservative" banks, the caution of whose managers forbids them to take risks by extending their business at the expense of an ample reserve; and by their side may be seen the more " active" banks, whose managers habitually spread all possible sail, and provide for the storm only when it comes. It is to be observed that the necessity of pro- viding a cash reserve is not met by the excellence of the securities held by the bank. Although their certainty of payment at maturity be absolute, still the demands upon the bank are demands for cash, and cannot be answered by the offer of even the best securities. If the depositor or creditor does not receive cash in full for his demand when it is made, the bank has failed, and any satis- faction of his claim by the delivery of a security is, as it were, only the beginning of a division of the property of the bank among its creditors. Specie, therefore, or the paper which is a substitute for it as a legal tender for debt, forms the real banking reserve. * The reserve of the bank may, however, be greatly strengthened by the judicious selection of securities. For example, if, in the ac- count above given, the "bonds and stocks" are, as 1 Bank reserves are further considered in Chapters VT and XXII. Banking Operations and Accounts 37 they should be, of descriptions which are readily salable, they afford in ordinary times the means of replenishing the reserve in case of need, without foregoing the enjoyment of an income from this amount of resources for the present. A more flexible method of securing the proper apportionment of resources between securities and reserve, under ordinary circumstances', is by increasing or diminishing the loans, or, in other words, the purchases of securities made from day to day in the regular course of business. That part of the securities which consists of the prom- ises of individuals or firms to pay to the bank at fixed dates, is made up of many such pieces of commercial paper, maturing, if properly mar- shalled, in tolerably steady succession. The pay- ment of one of these engagements when it becomes due may be made either in money, or by the sur- render to the bank of an equal amount of its own liabilities, as will be shown in the next chapter. In the former case, the payment of the maturing paper to the bank is in fact the conversion of a security into cash, and increases the reserve with- out change in the liabilities; in the latter, the reduction of securities is balanced by a reduction of liabilities which raises the proportion of reserve. If, then, the bank stops its "discounts" or its investments in new securities, or if it even slackens its usual activity in making such investments, the regular succession of maturing paper will gradually strengthen its reserve; if it increases its activity in 38 Banking Operations and Accounts investment, it will lower or weaken its reserve; and if it adjusts the amount of its new investments to the regular stream of payments made by its debtors, it may keep the strength of its reserve unaltered, until some change in the condition of affairs brings cash to it or takes cash away by some other process. This natural dependence of the reserve upon the more or less rapid reinvestment of its resources by the bank is distinctly recognized by the law of the United States, which provides that when the reserve of any national bank falls below the legal minimum, such bank "shall not increase its lia- bilities by making any new loans or, discounts" until its reserve has been restored to its required proportion. 1 By a less harsh application of the same principle, the Bank of England operates upon its reserve by lowering or raising its rate of discount, and thus encouraging or discouraging applications for loans. And it was with a view of facilitating the replenishment of the reserve by the curtailment of loans, that the law of Louisiana formerly provided that the banks in New Orleans should hold what were called "short bills," or paper maturing within ninety days, to the amount of two thirds of their cash liabilities, so that the constant stream of payments of such paper might always insure to every bank the early command of a large part of its resources. 2 1 Revised Statutes of the United States, § 5191. 2 See some remarks on the excellent effects of the Louisiana Banking Operations and Accounts 39 The reduction in liabilities and increase in cash through the payment of maturing loans will not be secured unless the bank refrains from making new loans to an equivalent extent, and this course of action is frequently beset with serious obstacles. If a bank is to continue as a going concern en- gaged in a profitable business, it cannot entirely discontinue its lending operations. It holds its business depositors largely through its readiness at all times to furnish them a reasonable amount of accommodation. Moreover, in times of acute financial strain general loan contraction has in- variably been found to be impossible. These are matters which will receive more detailed consider- ation in subsequent chapters. To return, in conclusion, to the account given on p. 32; we have there among the liabilities certain sums classified as "surplus" and as "undivided profits." Taken together these sums represent the profits which have been made, but not divided among the stockholders, and which are therefore to be accounted for by the bank. The surplus is that portion of these profits which as a matter of policy it has been determined not to divide and pay over to the stockholders, but to retain in the business, as in fact, although not in name, an addition to the capital. The remaining portion, the undivided profits, is the fund from which, system by Samuel Hooper, Theory and Effects of Laws Regulating Specie in Banks, i860. For the law itself, Acts of the Fifteenth Legislature of Louisiana, 1842, p. 34. 40 Banking Operations and Accounts after payment of current expenses and of any losses which may occur, the next dividend to the stockholders will be made. The current expenses are for the present entered on the other side of the account, as they represent a certain amount of cash which has disappeared; but at the periodical settlement of accounts they must be deducted from the undivided profits and will thus drop out from the statement. "Other assets," here set down as an investment, may be supposed to cover any form of property held by the bank and not otherwise classified, but especially the doubtful securities, or such property, not properly dealt in by a bank, as it may have been necessary to take and to hold temporarily, for the purpose of securing some debt not otherwise recoverable. For example, although the bank could not properly invest in a mortgage, it might be wise for it to accept a mortgage in set- tlement with an embarrassed debtor, and in this case the mortgage would stand among the "other assets." And, finally, "cash items" include such demands on individuals or other banks as are col- lectible in cash and can therefore fairly be deemed the equivalent of cash in hand. In the absence of any legal provision limiting the classification of such demands as reserve, they may be regarded as virtually a part of the reserve, which in the case before us may therefore be treated as made up of cash items, specie, and legal-tender notes. To illustrate what has been said in this chapter we will now suppose the bank, with its affairs stand- Banking Operations and Accounts 41 ing as on page 32, to make the following operations: c. To add to its securities $20,000, by discount of three-months paper at six per cent., three fourths being provided for by increasing liabilities, and one fourth by the expenditure of cash. The ac- count would then stand as follows: Resources Liabilities Loans . . . $325,000 Capital . . . $100,000 Bonds and stocks 23,000 Surplus . . 29,000 Real estate . 15,000 Undivided profits 10,300 Other assets 20,000 Deposits . . 319.775 Expenses . . 1,000 Reserve . . . 75,075 $459,075 $459,075 b. To retrace its steps, by diminishing its "dis- counts" or holding of securities to the extent of $50,000, of which four fifths are paid to it by the surrender of demands for deposits to a like amount and one fifth in cash; to pay $1,250 for current ex- penses; and further to increase its reserve by the sale of bonds and stocks to the amount of $10,000. The following would then be the state of the account: Resources Liabilities Loans $275,000 Capital . . $100,000 Bonds and stocks 13,000 Surplus . 29,000 Real estate 15,000 Undivided profits 10,300 Other assets 20,000 Deposits . . . 279,775 Expenses 2,250 Reserve 93.825 $419,075 $419,075 c. To sell $2,000 of its other assets for cash with 42 Banking Operations and Accounts a loss of $500; to make a semi-annual dividend of four per cent., of which one half is credited to stockholders who happen to be depositors also, and one half is paid in cash; to sell $4,000 of bonds at a profit of fifteen per cent. ; and to carry $1,000 of its undivided profits to surplus. The account would then stand at the beginning of the new half-year as follows: Resources Liabilities Loans . . $275,000 Capital . $100,000 Bonds and stocks 9,000 Surplus . 30,000 Real estate 15,000 Undivided profits 3.150 Other assets 18,000 Deposits . 281,775 Reserve . . 97.925 $114,925 ?4H.925 NOTE It will be observed that in the present chapter the term "re- serve" is used strictly as denoting the provision of cash which a bank keeps at command to meet its demand liabilities, — these being its liability for deposits in the case now under consideration, and for notes in cases to be taken up later. Balances with other banks, in particular those with central banking institutions, are also commonly regarded as a part of the reserve of a bank. It is in this sense that the term is now generally used in the discussion of banking questions in this country and in England and in the national bank legislation of the United States. The term is used, however, with a different application on the Continent of Europe, and occasionally even in English-speaking countries. In the French and German legislation it is used constantly in the sense of "surplus," as in the acts concerning the Bank of France and the Reichsbank, and so also in those concerning Italian and Austrian banks. It is also occasionally used, as in the phrase "reserve capital," to denote the unpaid capital which shareholders in many English joint-stock banks are bound to contribute in case of need, as explained at the beginning of this chapter. In the present discussion the term is used solely in the restricted sense noted above. CHAPTER IV THE CHECK SYSTEM In the preceding chapter reference has been made more than once to the transfer of deposits by one holder to another, and to their consequent use as currency. It is now necessary to examine more closely the simple machinery by which this transfer is effected. The depositor, or the creditor of a bank, who has to make a payment to some other person, has his choice between two methods of making it. He may demand money from the bank, in the exercise of his right as a creditor, and deliver this money; or, with the assent of the person to whom he has to make payment, he may give to this person an order on the bank for the money, or what is commonly called a check. If he adopts the latter method, a payment for goods or of a debt is effected by the simple transfer of a right to demand money from the bank; and so too if the recipient of the check gives it in payment to some third person, and he to a fourth, and so on. To this extent the check is plainly made a substitute for the sum of money for which it calls. It re- presents no particular money or group of coins, for, as we have seen, the deposit is likely to have 43 44 The Check System been created by the bank in exchange for some security bought by it, and is, therefore, a naked right to demand, and not a claim to any particular cash; and even if the deposit originated in the lodging of money by the depositor, it has in this case also become a naked right to demand and does not imply any claim to the money actually deposited. But the transfer of this naked right, in the case supposed, is made by the agreement of the parties to serve the same purpose as the transfer of money, and the right thus becomes a substitute for money. The effectiveness of this substitution, however, is increased and the use of the deposit greatly prolonged, where it is the practice for the trans- feree himself to deposit the check, instead of de- manding its payment by the bank, or seeking his opportunity to use it in some payment of his own. If we suppose all the parties concerned to keep their accounts with a single bank, and suppose a check for $2,000 to have been drawn by A against his deposit in the bank and given by him to B in payment for goods, B may deposit this check to his own credit as he would money. The bank then makes the necessary changes in its accounts, cancels its liability for $2,000 to A and recognizes a liability for a like amount to B, and thus the transfer of the right by A to B is made complete. This novation, or change of creditors, to which the bank has made itself a party, has not only secured The Check System 45 B against the possibility of finding A's deposit in the bank exhausted by other checks drawn by A fraudulently or by mistake, but it has also made B's right of demand against the bank divisible at pleasure, since this, instead of a right to de- mand a determinate sum, has now become a right to draw his own check or checks to an amount not exceeding $2,000 in all. In this way checks become the instruments by which rights to demand money may be transferred from one individual to another, in such amounts as the transactions be- tween them may require; and when we consider the great security and convenience of transfer by such means as compared with actual payment in money, there is little need of further explana- tion of the astonishing extent to which checks are now used, especially in English-speaking com- munities. If, now, we suppose the parties concerned to keep their accounts with different banks in the same city, we shall have results somewhat more complex but not different in kind. In this case we may suppose the check drawn by A upon Bank No. 1 to be deposited by B in Bank No. 2. If the transaction stands alone, the latter bank collects the money called for by the check, and holds itself liable to make payment to B on demand in sums to suit his pleasure. This makes a change not only of creditors, but of debtors, and yet at the close, after the payment by A to B has been com- pleted, we have in existence a bank liability of the 46 The Check System same amount as that with which we started. Probably, however, in a community where there were several banks, the transaction would not stand alone. At the end of a day's business every bank would be likely to have received in deposit checks upon several, and perhaps all, of the others; each would then have checks to meet as well as checks to collect; and each would naturally make its settlement with every other, not by making mutual demands and mutual payments, but by the offsetting of demands and the payment only of such balance as might then remain due from one or the other. Thus, if at the end of the day Bank No. i had received in deposit checks upon Bank No 2 to the amount of $25,000, and Bank No. 2, in like manner, checks upon Bank No. 1 amounting to $23,000, the account as between the banks would be settled easily by the payment of $2,000 by Bank No. 2 to Bank No. 1. And the result is the same if the operation here traced is multi- plied by the number of banks carrying on business with each other in a great city. The settlement of accounts by the banks with each other, however, still leaves the banks collectively under the same liability for payment on demand as before. The lia- bility rests upon the banks, it may be, in different proportions, and is differently distributed among the creditors: but so long as payments are made by checks and checks deposited, the right to demand from a bank which is called a deposit continues to exist in somebody's possession, and is as well The Check System 47 fitted to discharge the office of money as when it was first created. I This medium of payment acquires great perfec- tion wherever the Clearing House system is adopted. Under this system there is a daily meeting of clerks representing all the banks carry- ing on business at any common center. Every bank there turns in at a central office all the checks and cash demands which it holds against others and is credited therewith, and is also charged with all checks and demands brought against it in like manner by others. The checks and demands which have thus been credited to and charged against each bank are then summed up, and the balance found to be owed by or due to each bank, as the case may be, it then pays to or receives from the central office in money. By this means a great mass of transactions, which would other- wise require a series of demands by each bank upon every other in the same place, are settled at once, and the transportation of large sums in cash from one bank to another is to a great extent dispensed with. 2 1 A statement of the working of the check system, under cir- cumstances of different degrees of complexity, is given by Jevons, Money and the Mechanism of Exchange, pp. 252-257. 2 For a further notice of the Clearing House system, see note on p. 57. The transportation of cash referred to in the text is reduced to its minimum by the practice sometimes adopted of using "Clearing House certificates" instead of , money or legal- tender notes. These certificates represent money or notes de- posited with the Clearing House, or with some bank which is its representative for this purpose, and are payable on demand; 48 The Check System Where, as in England, banking is conducted by institutions with head offices in large cities operat- ing numerous branches throughout the country, all checks can be handled without difficulty through Clearing Houses. Checks on other banks deposited at a branch are forwarded to the head office or to branches in the more important cities and are then cleared in the customary way. Aside from the mailing expense and the necessary entries on the books of the various branches the procedure is similar in all respects to that followed when a check is received drawn on a bank in the same place. In the United States, Where banking is conducted by thousands of local banks, the collection of checks drawn on a bank in one place and de- posited in a bank in another place involves greater complications. To send directly to all other banks the checks drawn on them would require a being made in convenient denominations they are used in pay- ments between the banks and for the purposes of reserve are recognized by the law of the United States as the equivalent of the cash which they represent. These certificates must be distinguished from Clearing House loan certificates described below, Ch. XI. In London banks and bankers keep large cash balances at the Bank of England and settle with each other by transfers made there. A similar method was adopted by the banks of Boston upon the opening of the Federal Reserve Bank of Boston in 1914. Banks in other cities in which there are Federal Reserve banks will probably make settlements in this way when all members of the various clearing houses become members of the Federal Reserve banks. The Check System 49 prohibitive amount of labor and expense, both for the sending and the remitting banks. It is necessary, therefore, for each bank to employ other banks for check collection purposes. The banks of each city are employed as collection agents, receiving checks drawn on banks in the vicinity from other banks throughout the country and from these neighboring banks checks on banks in other sections. If the check is drawn on a bank at a great distance from the bank in which it is deposited, it will ordinarily pass through a number of city institutions while in process of collection. Thus, for example, a check drawn on a rural bank near Des Moines, Iowa, and deposited in a bank in Manchester, New Hampshire, might be sent by it to a Boston bank, then to Chicago, whence it would be forwarded to Des Moines, and then finally to the bank on which it was drawn. If the collection of checks drawn on banks in other places had been developed in the United States without reference to other banking activities, doubtless the most economic possible arrangements for handling this business would have been every- where adopted. In Boston an arrangement for handling checks on New England banks through the Boston Clearing House was adopted in 1899. All checks on New England banks deposited in Boston banks may be sent by them to the Clearing House for collection. Checks on each bank are there assembled and sent in a single letter, remit- tance being made in a single draft payable to 50 The Check System the manager of the Clearing House. Banks in a few other cities have adopted similar arrange- ments, but in most parts of the country the keen competition of city banks for balances of country banks has proved an insuperable obstacle. In addition to interest at the customary rate of two per cent, city banks offer various services in return for bank balances. The most important of these services has long been the collection of checks. Taking advantage of the competition for balances, country banks in many parts of the country have made excessive exchange deductions in remitting to banks elsewhere in settlement of their own checks. Often these deductions have been far in excess of the cost of shipping currency, which indeed, it may be added, it is seldom neces- sary to send. The city banks have absorbed these exchange charges but to recoup themselves have required the maintenance of compensating balances far larger than it would have been necessary for country banks to maintain for other purposes. At the same time, wasteful time-consuming methods of routing checks have been resorted to by the city- banks, in order to reduce to a minimum the exchange charges which they were absorbing. Under the operation of the Federal Reserve banks, the system of check collections is being rapidly unified and improved. Each reserve bank collects for its members and also for non- member banks within its district checks drawn on all banks throughout the country which will remit The Check System 51 to any reserve bank at par. A charge is imposed to cover the cost of the service, but, through the reduction of balances with other banks and of clerical expense and postage made possible by concentrating the business of check collection, the system is likely to prove in the long run of advantage to most banks, even to those which have been reaping profits through exchange charges. The bank deposit, circulated by means of checks, is the most convenient medium of payment yet devised. A stroke of the pen transfers it in what- ever amount is needed for the largest transaction, and this transfer instantly becomes the basis for fresh operations, with as complete security against accidental loss as can be imagined. In the strict economic sense this medium no doubt has rapidity of circulation in a high degree, while in the sense of actual activity of movement in a given time it far outstrips money or notes, and has been well said to be the most volatile of all the mediums of exchange. Of the entire circulating medium of this country it forms incomparably the greatest, although the least considered, part. Depending for its efficiency solely upon convention, it for the most part eludes the regulations which legislatures so industriously enforce upon the other constitu- ents of the currency. Indeed, beyond the re- quirement of a minimum reserve made by the law of the United States, and of most of the several States, we may say that the subject is not touched 52 The Check System by legislation, in this country or elsewhere. The necessity for payment in specie or legal-tender paper upon demand, the chief safeguard of value, is the result of general provisions for the payment of debts of any kind. And the chief assurance against excessive expansion on the part of any single bank or banker is given by the certain demand for prompt and frequent settlement, occasioned by the voluntary establishment of the clearing house, or by the habits of the community but not by law. What natural limit is to be found then to the continued circulation of a liability for deposit, when once it is created and set in motion by the process of "discount"? .Plainly, if at any stage the holder of a check, in- stead of depositing it, demands its payment in money by the bank on which it is drawn, the pay- ment extinguishes the liability. It is, to be sure, quite possible that the money, after a brief circu- lation, may find its way back, in fresh deposits of cash made by one or more individuals, and so a new liability similar to the old one may come into existence; but, nevertheless, we may fairly say that the use of the original deposit as a substitute for money came to a natural close with the pay- ment of the check. Except, however, in the cases where money is required for some special purpose, as to be sent abroad or to some other part of the country, or for the increase of the stock in the hands of the public, this limit to the circulation of The Check System 53 deposits is not of great importance. For, as the withdrawal of specie under ordinary circumstances is merely the exchange of one medium of payment for another, any withdrawal on a large scale would imply such a change in the habits and preferences of the public as is not often or easily made. A more important limit is found, however, in the use of deposits for the payment of debts due to the bank. That the depositor can, to the extent of his deposit, pay a debt due from himself to the bank by the relinquishment of the bank's debt to him, needs no explanation. In practice he draws his own check in favor of the bank and exchanges it for the obligation held against him by the bank, this mutual release being for each side as effectual a discharge of liability as a pay- ment in money could have been. Such a payment of the debt due by the depositor, and previously standing among the securities or loans of the bank, finally cancels a liability of the bank equal in amount to that which was created when the loan was made. 1 It matters little by what pro- cess the deposit, or right of demand, finally used by the depositor in payment came into his posses- sion. If he is a merchant, he has probably col- lected smaller sums which were due to him, for the purpose of his payment to the bank, and these smaller sums are likely to have come to his hands to a great extent in the shape of checks, which, as we have seen, were the instruments for transferring 1 Compare the statement of account for operation b, on p. 41. 54 The Check System to him the rights of demand which others held against the bank. If he borrowed the means of payment, he in all probability received the amount in a check. Nor is the case different when there are several banks, and the depositor has received his collections in checks drawn upon other banks than his own. As was seen when we were considering this method of payment on page, 45 the deposit of these checks to his credit effects a transfer of the liability from the other banks to his own; and here also this liability is finally extinguished when he uses it in payment of his debt to the bank. It is possible, indeed, that the payment should be made by the debtor to the bank in money, or by a check drawn against a fresh deposit of money, and in this case either there is no extinguishment of bank liability by the payment, or only the new lia- bility created by the fresh deposit is extinguished. But in a community where banking is firmly and widely established, the large payments of com- merce and of general business are certain to be made, for the most part, in the medium which is most accessible and most convenient for use in large sums, and this medium is undoubtedly that which is commonly termed bank deposits. 1 •A series of investigations made by the Comptroller of the Currency show that more than ninety per cent, of the National Bank deposits consist of checks and similar instruments. The following table presents the relative percentage of money and credit substitutes for money in the deposits of the National Banks on particular days in the years 1896 and 1909: The Check System 55 It appears then that deposits are created by the act of the bank, when loans are increased, and that they are cancelled when loans are paid. * There is, therefore, a rough correspondence between the movements of loans and of deposits. This cor- respondence may be weakened by the actual flow of money to or from the bank, but in the ordinary movements of business it is tolerably close, and where it fails the apparent exception will be found to be explained by some special condition of the case. 2 It will be found in general that, at times when banks are increasing their operations, their deposits swell, and that when they are contracting, July i, i8g6 March 16, igog Money 7.5 4.7 Checks, etc. 92.5 95.3 Kinley, The Use of Credit Instruments for Payments in the United States, pp. 29, 184. 1 For some striking remarks on this subject, see Hamilton's report on a National Bank, Works (Lodge's edition), iii., 128. See also Quarterly Journal of Economics, i., 403. 2 The weekly statements of the New York banks for November, 1890, are a good illustration of the movement of loans and deposits, at a period of great financial disturbance, when there was a heavy contraction of loans and some serious withdrawals of cash. The aggregates, stated in millions, are as follows: Specie and Loans Deposits Legal Tender November 1 . ■ $399-8 $396.3 ?99-8 8 . ■ 398-9 392.2 95-5 " 15 • • 393-3 386.6 .95-8 22 . ■ 387-3 381.7 95-5 " 29 • . 384-6 378.6 95- For the special conditions affecting the banks during these weeks, see the Commercial and Financial Chronicle, passim. 56 The Check System their deposits fall. The true connection between these movements is often forgotten, but its nature cannot be mistaken by anybody who will observe the steps by which an ordinary "discount" is placed at the command of the borrower. It has already been suggested that the use of checks is most highly developed among the English- speaking peoples. The American or Englishman who is in the habit of receiving and making fre- quent payments avoids the keeping of cash in hand, deposits his receipts, and pays all except the smallest sums by checks. As a consequence, the establishment of a bank is an early symptom of the growth of trade in a small community of English blood. On the Continent the practice of depositing with a bank developed more slowly, and even now when this habit has become general de- posits are not made available for payment by the common use of the check. Coined money and bank notes are used for most payments and conse- quently the banks are unable to extend credit very far in the form of deposits. The imposition of stamp taxes and the failure to surround the check with simple and effective legal safeguards sufficiently account for the comparatively slight use of this important credit instrument. Its utility has in recent years come to be very gen- erally recognized, and in various European coun- tries payments by means of checks are being urged by banks and public authorities. The Check System 57 NOTE To illustrate the working of the Clearing-House system, we will suppose the case of six banks carrying on business in the same town. On a given morning we will suppose the messengers of these banks to meet at the Clearing House, each bringing the checks received by his bank in deposit on the previous day, as follows: No. i, checks on No. 2, $ 6,500 "_3, 9,200 " 4, 7,100 5, 6,250 6, 4,500 $33,550 No. 4, checks on No. 1, $ 8,750 "2, 4,700 " 3, 6,740 " 5, 5,820 " 6, 5,140 31,150 No. 2, checks on No. 1, $ 7,800 " 3, 4,ioo ' 4, 5,76o " 5, 6,340 6, 5,870 $29,870 No. 5, checks on No. I, $ 8,740 " 2, 4,620 " 3, 9,250 " 4, 7,68o 6, 5,940 $36,230 No. 3, checks on No. 1, $ 6,750 " 2, 4,270 " " 4, 5,9O0 " " 5, 6,400 6, 5,940 $29,260 No. 6, checks on No. 1, $ 3,700 "2, 4,100 " 3, 6,740 "4, 9,250 " 5, 7,850 The sum of all the checks brought in is $191,700. If, now, we credit each bank with the checks which it presents against the others, and charge it with the checks presented by them against it, we shall find that No. 1 is charged with $35,740 and credited with 58 The Check System $33,550. that No. 2 is charged with $24,190 and credited with $29,870, and so for the others, and, therefore, that, No. 1 owes a balance of $2,190 No. 2 is owed it it $ 5,680 No. 3 owes if a 6,770 No. 4 owes it it 4.540 No. 5 is owed it (i 3.570 No. 6 is owed if ft 4.250 $13,500 $13,500 If, then, the debtor banks, Nos. 1,3, and 4, pay into the Clearing House the sums due from them amounting to $13,500, and the Clearing House pays out to the creditor banks, Nos. 2, 5, and 6, the sums due to them, of like amount, the result will be that every bank will, in effect, have collected payment of all the checks which it had received, and will have made payment of all the checks drawn against it. This settlement of checks amounting in all to $191,700 will have been made by the payment of $13,500, and transactions apparently involving thirty separate demands, each bank being the creditor of five others, will have been settled by a series of additions made at a central office, followed by three payments to and three payments from a common fund. In 191 5 the New York Clearing House, one of the two largest in existence, settled the balances of sixty-two banks and trust com- panies, and of the Assistant Treasurer of the United States. During the year ended Sept. 30, 1915, the average daily ex- changes were $299,810,917; and these exchanges were settled by the payment of balances averaging daily only $17,626,557. Since the foundation of the establishment in 1853, the balances actually paid have amounted on the average to only 4.73 per cent, of the exchanges effected. For further details regarding Clearing House activities in this and in other countries see J. G. Cannon, Clearing Houses, one of the publications of the National Monetary Commission. CHAPTER V BANK-NOTES It has already been said that the notes of a bank are a liability distinguishable in form, but not in substance, from its deposits. The creditor of a bank of issue has his choice between taking the evidence of his right in the form of a note and taking it in the form of an entry in a book. For his use one form may be preferable to the other; if he desires to make payments in small sums, as for wages, he may prefer to take notes ; if he is to make large payments, or expects a little delay in the use of his funds, he is quite certain to prefer being credited with a deposit. But, whatever his choice, the liability of the bank to make payment in money on demand is the same, and it is under the same necessity of providing itself with a reserve, sufficient to meet any demand which experience shows to be probable. To illustrate this part of the subject we will take the account given on page 42, and suppose the depositors to have drawn one third of their deposits in notes of the bank, which have thus been thrown into circulation. 59 6o Bank-Notes Resources Loans . . . Bonds and stocks Real estate Other assets Reserve . £275,000 9,000 15,000 1 8 ,000 97,925 $414,925 Liabilities Capital Surplus . Undivided profits Notes Deposits . . $100,000 30,000 3.150 93.925 187,850 $414,925 It is obvious from inspection that if any demand upon the bank weakens its reserve, it makes no difference whether the demand is from depositors or note holders; the funds available to meet subse- quent demands for payment are reduced to the same degree in either case, and the same pre- cautionary measures for replenishment will have to be taken. And so, if fresh loans are made, the relation of reserve to demand liabilities is altered, whether the loans are effected by an increase of deposits or of notes. The law does not always recognize this close similarity of the two kinds of liability. It has sometimes required a reserve for the protection of notes alone, under the apparent impression that this must secure the solvency of the bank, and it sometimes makes a provision for a reserve of different amount for the notes, as in the national-bank system of the United States, having in view the different degrees of the probable demand for payment of notes and of deposits respectively. 1 Apart, however, from considera- 1 The National Banks are now required, by the Act of 1874, to have a reserve of only five per cent, for the protection of their notes, which is held by the Treasury as the central redeeming Bank-Notes 61 tions like the last, the two forms of liability seem to stand upon the same footing. The bank itself finds the same advantage in the one as in the other. Its profit is made from the securities which it holds, and whatever profit it makes beyond the mere interest on the investment of its capital results from the holding of securities purchased by means of its credit and of the funds deposited with it ; but the rate of this profit is in no way dependent upon the process by which that credit is transferred from one creditor to another. [ The bank, in short, is interested simply in pro- viding that form of credit which is most convenient for the use of the community on which it depends, for it is by that means that it can do the greatest amount of business and hold the greatest amount agency. 18 Statutes at Large, 123. The bonds deposited to secure the circulation against insolvency, it is to be noticed, are in no sense a reserve, and are not so described by the law. 1 Of the writers on banking, McLeod, Theory and Practice of Banking, has made the most careful analysis of the exchange which underlies every banking operation. Notwithstanding eccentricities of method and style, his exposition of the real meaning of "loans" and the ambiguities incident to our use of that term, the origin and purport of bank liabilities, and the substantial identity of the liabilities for deposits and notes, is clear and important, and might be cited in confirmation at many points in these pages. Reference may also be made with advantage to McLeod's smaller work, Elements of Banking. Among earlier discussions, attention is specially called to a striking letter by James Pennington, in Tooke's History of Prices, ii., p. 369, in which the strong analogy between the deposit accounts of the London private bankers and the notes of the country bankers is forcibly stated and explained. 62 Bank-Notes of securities. The deposit, transferred by check, is more convenient for large transactions than the note, being more expeditious and safer. The safety of the deposit is due to the fact that the check, being usually payable "to order," especially when the amount is considerable, cannot be drawn or credited to its holder unless endorsed by the payee. If lost or stolen, therefore, it cannot be paid unless the bank is deceived by a forged endorsement, in which case the loss falls upon the bank itself. Bank-notes, however, being payable to bearer are nearly as difficult to trace as money. It is in the cities that transactions occur on the largest scale, as well as in the largest number; and it is in the cities, therefore, that the strongest need is felt of the medium of exchange best adapted for the transfer of great sums. It is in the cities, moreover, that the condition of convenient access to banks, needed for the full development of the deposit and check system, is satisfied in the highest degree. City banks, therefore, on the whole, use their right of circulating notes but sparingly as compared with country banks, and sometimes prefer to forego its use altogether, while their de- posits attain an enormous expansion. Country banks, on the other hand, dealing on a smaller scale and in communities which have more need of a medium transferable without recourse to the bank, find the expansion of their deposits some- what restricted in comparison with the circulation Bank-Notes 63 of their notes. It is for the same reason that, as time goes on, the relative importance of the bank-note tends generally to diminish in compari- son with that of deposits. The swift development of modern commerce and means of communication is expanding in high proportion the field for the most convenient and efficient medium, while the transactions in which notes find their use are growing in slower ratio. It becomes more and more the business of banks, therefore, to extend the use of their credit in the form of deposits, the increase in their issue of notes being, in the most progressive communities, no longer a matter of great concern. 1 That governments have so frequently felt it their duty to take measures for the protection of the holders of bank-notes against the insolvency of the bank, but have so seldom legislated for the pro- tection of depositors, is due to several reasons. Legislators have generally failed to perceive the similarity of the two kinds of liability, and the claim for equal consideration which can be made, with some show of reason, on behalf of depositors. Moreover, the appropriate measures for the pro- tection of the note-holders are more obvious and of easier application; and it is doubtless true also that depositors, as a class, are better informed * Compare the condition of the State banks from 1834 to 1863 with that of the National Banks in recent years. Comptroller's Report, 1 876, p. 94. See especially the remarkable development of the New York banks during the former period. Ibid-., p. 102. 64 Bank-Notes and can more easily protect themselves, and so have less claim upon the sympathy and guardian- ship of the legislature. At all events, provision for the safety of notes is not infrequently made by law, and when made is apt to consist either of the easily understood requirement of a certain reserve of cash for the payment of the notes, or of a pre- ferred claim to some portion of the assets, allowed to the holders of notes in case a bank becomes insolvent. The effect of provisions for giving holders of notes a preferred claim may be illustrated easily, if we take the statement of account last given, and, without any change of liabilities, suppose the bank to have been led to make a change of invest- ments and to diminish its other assets and its reserve, until its affairs stand as follows: Resources Liabilities Loans $217,000 Capital . $100,000 Bonds and stocks 105,000 Surplus . 30,000 Real estate 15,000 Undivided profits 3.150 Other assets 4,000 Deposits . 187,850 Reserve . 73,925 Notes 93.925 $414,925 $414,925 The liabilities of the bank are plainly of two classes: the liability to stockholders for capital, surplus, and undivided profits, and the liability to general creditors for deposits and notes. If the affairs of the bank were to be wound up, by reason of losses, or for any other reason, it is clear that, in Bank-Notes 65 case of any deficiency of resources, the general creditors should be paid first in full, and that only the residue after such payment can be said to be the property of the stockholders and divisible among them. If, for example, it proved that, by reason of failures and losses, the loans, bonds, real estate, and other assets, instead of being worths $341,000, which was their original value, were worth only $225,000, we should then have a total of resources amounting to $298,925, leaving, after the payment of deposits and notes, only $17,150 to be divided among the stockholders, the disaster having swept away their supposed surplus and more than four fifths of their capital. We may go farther and suppose the depreciation to have reduced the value of the total resources to $250,000, in which case the creditors must be satisfied with a dividend of a fraction more than 92 per cent. I and the stockholders are seen to have lost all that they had embarked in the business. In these cases the depositors, holders of notes, and other outside creditors, all, in short, who can properly be regarded as creditors, stand upon the same footing, no favored class among them having any preference unless by virtue of some "If we suppose the law to make the stockholders liable as individuals for the debts of the bank, they would under these circumstances be subject to an assessment, in order to make full payment to the depositors and note-holders. For the liability of stockholders under the national-bank system of the United States, see Revised Statutes, § 5151; also United States vs. Knox, 102 U. S. Rep., 422. 5 66 Bank-Notes special legislative provision. We may now suppose that the legislature, for the protection of the holders of notes, has given them a right to be paid in full in preference to other creditors, if the assets of a bank in liquidation should fall short. r Upon this supposition, from the total resources amounting to $250,000, we should first have the notes paid in full, amounting to $93,925; and then the remain- ing $156,075 would be divided among the deposi- tors, giving them a dividend of a little more than 83 per cent. A provision of law, then, giving the holders of notes a preferred claim to the assets of the bank would be a natural and easy method of insuring this class of creditors, except in case of a very large issue or a very bad failure. But we may suppose the leg- islature to wish to go farther than this and to give the note-holders, not a general claim in preference to others, but a claim to specific property of the bank supposed to be of solid value and sufficient to insure payment of the notes in any case. Thus, . to return to the account on page 64, it appears that the bank holds bonds and stocks to the amount of $105,000 as a part of its securities. Suppose, then, that the law requires the bank to hold these bonds and stocks pledged to secure the ultimate payment of its $93,925 of notes. Under such an arrangement, the securities would not cease to be the property of the bank, and the 1 E. g., see New Hampshire Compiled Statutes of 1853, ch. 148, § 30. For objections see Comptroller's Report, 1898, p. xiii. et seqq. Bank-Notes 67 earnings of the securities would remain, as before, a part of the profits of the bank. The pledged property would be enjoyed, however, subject to the provision that, in case of the failure of the bank, the proceeds of the securities should be applied first to the payment of the outstanding notes. If the law should go farther and provide that only certain approved classes of securities should be used for this purpose, and that the securi- ties pledged should be lodged for safe-keeping in the hands of some public officer, the substance of the transaction would still be unchanged. It would still remain a simple case of the specific appropriation of a certain part of the property of the bank to the payment of a particular class of its liabilities in a given contingency. The essential structure of the bank would be unchanged and the sources of its profits would be neither more nor fewer than they were in the absence of this pledge of securities. The method described in this supposed case, of protecting the issue of notes by a deposit of securi- ties in the hands of some public officer, is that which was adopted by the State of New York in 1838 1 and was long known as the "free-banking" system. 2 Many other States followed the example 1 For an account of the New York system and its adoption by other States, see Dunbar, Economic Essays, pp. 317-329. 2 The term "free banking" was applied to this system because the law of 1838 was the first general banking law in New York. Previously a special charter was necessary in the case of each bank. 68 Bank-Notes of New York, and finally in 1863 the New York plan was adopted by Congress as the basis for the national-banking system. z If, now, we vary the above supposition so far as to imagine the property pledged for the protection of the notes to consist, not wholly of securities, but of securities to a certain amount and of specie for all notes issued in excess thereof, we shall have in substance the provision made by law in 1844 for the protection of the notes of the Bank of England. Besides other reasons, already adverted to, for seeking legislative protection for bank-notes, the belief has been common that banks are under a special and dangerous temptation to overissue notes, thus causing their depreciation with loss to the public. It has already been shown, how- ever, that the question whether notes shall be issued or not is one which in modern banking is not settled affirmatively by the bank, but is settled by the creditor, who determines for himself and with an eye to his own convenience whether to hold his right, as against the bank, in the form of a note or of a deposit. The really serious question would be whether the bank can extend the use of its credit, by deposits as well as by notes in excess. This is as much as to ask whether the bank can go too far in the purchase of securities, or in other words, can unduly stimulate borrowers, the making of loans being the purpose for which the bank extends its credit. But this question cannot 'See Dunbar, Economic Essays, -pp. 317-329. Bank-Notes 69 be answered without qualification. If we observe any period of ten years, we shall find some years in which banks have found the public depressed and spiritless, to such a degree that, with every motive for increasing their business, it has been impossible to find sound commercial paper in sufficient amount. So far from being able to extend their credit in excess, banks have at such times often reduced their capital because employ^ ment for it could not be found. Other years we shall find in which the public spirit was buoyant and adventurous, and in which the banks have fostered and increased the general tendency to speculation, by the facility with which they have given the use of their credit. It is true then that banks cannot extend their liabilities of either sort except in response to a demand from the public; it is also true that in certain states of business this demand may be unduly stimulated by their action, and that issues made in response to an unhealthy demand are in excess of the proper needs of the community. In any such period of general expansion of bank credit, however, bank- notes play the least important part. In the absence of special restrictions there is greater danger of excessive credit expansion in the form of bank-notes than in the form of deposits by particular banks if the number of banks issuing notes is large. Reference has been made in a preceding chapter to the system by which, in most banking centers of any importance at the 70 Bank-Notes present time, banks holding checks drawn upon each other settle their accounts by means of a Clearing House, where checks are exchanged and the resulting balances are paid in cash. A mo- ment's consideration will show that this method of systematic and early presentation of demands must act as a strong and salutary restraint upon the undue expansion of deposits by any particular bank. Against a general imprudent expansion by the banks of a community, acting under the impulse of some wave of overconfidence or of speculation, there appears to be no safeguard except that which may be found in the relations of the community in question with others. The larger volume of checks which a bank presents at the Clearing House will be offset by the larger volume of checks drawn upon it which other banks have received. Excessive credit expansion on the part of the banks generally can only be avoided by the adoption of a conservative loan policy. But if a single bank, or a group of banks, impru- dently expands its loans by the use of its credit, it must soon begin to face the effect in the demands for settlement made upon it through the Clearing House. It may be able to reckon with some con- fidence on the omission of some depositors to draw promptly for the amounts due to them, but whatever checks are drawn it must be prepared to meet without delay, for few checks for any con- siderable amount, when they have once left the hands of the drawer, will fail to make their way Bank-Notes 71 quickly into the deposits of some bank and to appear at the Clearing House on the following morning. It must be added that the operation by which demands are presented through the Clearing House is one in which the banks presenting the demands are scarcely voluntary agents. They are aware that they must meet checks drawn upon themselves, and are impelled in self-defense to present by way of offset all claims that they can bring forward against others. Demands which they might conceivably delay under a looser system, or press with less regularity, it is for their interest to bring forward at once as a part of their own provisions for the inevitable daily call to be made upon themselves. Even the possible dis- position to forbearance, which a creditor bank may feel in a particular case, must be weakened by the consideration that others will not fail to re- quire any payments that may be due to them, and that by forbearance the bank only consents to the preference of their claims over its own. The prompt presentation of checks for payment is therefore the established practice, implying no jealousy, hostility, or suspicion on the part of the creditor bank, — being in fact the natural disposi- tion to be made of an instrument of credit intended to be but short-lived. The differences of situation among banks are so great and convenience of intercourse varies so much even in any limited district, that the law 72 Bank-Notes would have found it difficult to create and enforce any such effective system of compulsory daily redemption of obligations as the banks of cities have developed and set in operation of their own accord. The observed tendency is, moreover, to enlarge the scope of the system, bringing out- lying banks more and more within its reach and quickening the course of business between different banking centers. This voluntary development of a system so searching and restrictive is unques- tionably due to two characteristics of the check, which hinder its continued circulation. In its ordinary form the check carries no guaranty or other recognition of obligation by the bank on which it is drawn, so that prudence calls for its speedy collection, unless the holder is willing to depend upon the signature of the drawer and such endorsements as the check may bear. More- over, as the amount for which the check is drawn is determined by the transaction in which it had its origin, it is little likely to be convenient for use in making any further payments, and its division or merger in any larger amount is not readily effected except by depositing it. The nature of the instrument then has led inevitably to the development of a practice which once adopted, is recognized as one of the most important of exist- ing safeguards against the abuse of bank credit by a single bank or a small number of banks. Bank-notes have no similar tendency to speedy return. Although the obligation expressed by Bank-Notes 73 them is, in origin, purpose, and most of its effects substantially identical with that which exists be- tween the bank and its depositors, the evidence of the obligation is essentially different. Bank-notes express a direct promise by the bank, of payment to be made to the bearer; they are also issued in con- venient denominations, and therefore adapted for continual circulation like coin. They may come back to the issuing bank in payments or may be deposited, but their return by these channels is uncertain, especially where there are many banks of issue. Their return is seriously hindered, more- over, by the fact that it is generally easier to use them than to present them for payment. For the holder, whether an individual or a bank, this is certain to be a controlling consideration, and one that is quite independent of any question as to the comparative abundance of currency or the extent to which bank credit is expanded. If there is but a single issuing bank, or if a large part of the circulation is issued by a few banks which make a compact group, the demand for specie for export, which is the natural corrective for an excess of currency, may sometimes be satisfied most con- veniently by presenting notes for redemption. But if the issuing banks are many, and especially if they are scattered geographically, the operation of this corrective will obviously be slower by reason of the number and inconvenience of the demands for redemption needed for making up any con- siderable amount of coin. Under such circum- 74 Bank-Notes stances a bank-note currency, once set afloat in excess or become excessive by a change in the condition of business, may be slow in coming to the mark to which, if really convertible, it must eventually adjust itself. The systematic reduction of bank-notes, as an insurance against their possible excess, is therefore developed with much less ease and certainty than the corresponding restraint upon the use of credit in the form of deposits. The end to be sought — a wholesome restraint of a kind of credit which is easily abused — is the same. Indeed, public opinion and the law generally proceed upon the assump- tion that the use of the right of note issue is practi- cally open to abuse, and that, for the protection of the public, special and sometimes elaborate precaution is necessary. Still the immediate convenience of the holder of bank-notes, for the reasons given above, is stronger than the more remote public interest, so that some form of pressure is usually needed for the development of an effective system of redemption among any large number of banks. The Suffolk bank system of New England, the most effective note-redemption system which has existed in the United States, was forced upon the banks of that section by the concerted action of a few strong city banks, which found their natural field of circulation in Boston seriously invaded by country issues. 1 The pressure thus 1 Whitney, History of the Suffolk Bank. Bank-Notes 75 established was finally made decisive by a legisla- tive act which, in Massachusetts, forbade any bank to pay out any notes except its own, and thus compelled every bank either to send in for redemption any notes of other banks received in payment or on deposit, or to hold them as dead cash. The agreement under which the few Scotch banks have for more than a century returned each other's notes throtigh a clearing house 1 is a striking case of competition by few competitors in a limited field, and so, too, is the practice by which the somewhat larger number of banks in Canada 2 send in for redemption the notes of their competi- tors. In each of these cases the struggle for a narrow field, intensified by the direct competition carried on by rival networks of branches, brings motives into play and creates a possibility of common action for mutual convenience which have no existence where the number of banks is large and their distribution greatly scattered. To take for illustration the 7600 national banks of the United States — no single bank can feel that its own power of circulation would be appreciably affected if it were to present for payment such notes of its 7699 competitors as it might chance to receive. The infinitesimal gain in this respect could not be counted in comparison with the 1 Graham, The One Pound Note, chs. xv. and xvi. 2 In Scotland there are only ten banks which are authorized to issue notes ; in Canada there are twenty- two, but, unlike Scotland, new banks enjoying the privilege of note issue may be established. 76 Bank-Notes inconvenience and delay to which it would have to submit. The natural course must be for each to extend its own circulation wherever the opportu- nity is found for doing so with profit, and to trouble itself as little as possible with respect to the circulation of others. Systems of regular redemption cannot prevent the overissue of notes by banks generally or loss to note-holders through the failure of particu- lar banks. They do limit these evils to such manageable proportions that they can be almost entirely eliminated by means of legislative safe- guards which do not take away the right of issue from the banks in general and do not deprive the note of its value as an instrument of credit. In Canada, for example, note-holders are adequately protected and excessive issuing has been avoided under laws which limit the circulation of each bank to its capital and a proportion of its surplus, give the note holder a prior hen on the assets of failed banks, and provide for a guaranty fund to which each bank contributes an amount equal to five per cent, of its outstanding notes. On the other hand, in countries where there has been no system of regular redemption the evils of excessive issues of notes and frequent loss to note -holders have required drastic remedies which have funda- mentally changed the character and utility of the bank-note. Two distinct and radically unlike policies have found expression in the legislation designed to Bank-No tes 77 provide a satisfactory bank-note currency. In the various States of the United States before the Civil War, banks generally were permitted to issue notes but subject to increasingly stringent condi- tions. The limitation of issue to the capital of each bank and a prior lien on all assets were found to be inadequate to safeguard note holders. In one State after another during the years immedi- ately preceding the Civil War the requirement was imposed of the pledge of particular securities, commonly the bonds of the various States. This method of safeguarding bank-notes was subse- quently adopted in the National Banking Law of 1863 with the further restriction that only United States bonds could serve as security of the notes of the National Banks. 1 Under this method of note issue a perfectly safe medium of payment is secured, but notes secured by bonds are fundamentally unlike notes issued generally by the banks without restriction, or those issued under restrictions such as are found in the Canadian Banking Law. In the 1 The unsatisfactory condition of the bank-note currency in the United States before the Civil War could not have been wholly corrected under redemption arrangements. The business of the country, mainly in the pioneer stage of agricultural develop- ment, did not provide the banks with loans having a high degree of liquidness and security. Means of communication were im- perfect and consequently even the notes of the strongest banks were at a discount when at a distance from the locality of the issuing bank. Finally, owing to the lack of uniformity in design, numerous counterfeit notes were a source of universal irritation, as well as of frequent loss to unfortunate individuals. 78 Bank-Notes case of bond-secured notes all other considerations are sacrificed in order to gain absolute safety. Such notes are not a credit instrument, expand- ing and contracting with the variations of activity of trade and in response to changes in the volume of bank loans. The amount of notes in circulation is primarily determined by the price of the bonds required as security. At the best, such notes are little more than a safe and economical substitute for coined money. They have little direct influ- ence upon the other operations of the banks by which they are issued. In fact, such notes are more analogous to convertible government paper money than to bank-notes which are issued as a form of credit. In England and in some of the other European countries, unsatisfactory experience with un- restricted issues of notes by numerous banks in the absence of arrangements for regular redemp- tion led to the adoption of the drastic remedy of the grant of a more or less complete monopoly of issue to a single bank. By this means a safe currency was secured without depriving the bank- note of its character as an instrument of credit. This method of controlling the issue of notes had, however, entirely unforeseen consequences of a mos| far-reaching nature. Wherever, and this is everywhere in the early stages of the development of banking, the bank-note was the principal instru- ment of bank credit, all other banks were placed in a position of constant dependence upon the Bank-Notes 79 institution to which the monopoly of issue was granted. At the same time these banks became inevitably responsible for the satisfactory working of the entire credit structure of the countries in which they were established. This responsibility was not clearly recognized at first by the manage- ment of these banks, but after much often unsatis- factory experience the special function and duties of these central institutions were clearly per- ceived. It became generally recognized that a banking system is greatly strengthened by the presence of a central institution which accepts responsibility for safeguarding the credit structure and consequently maintains itself in a condition of great strength at all times. Bank-notes issued by a single bank are in many ways unlike bank-notes issued by a large number of institutions. When numerous banks enjoy the right of issue, the notes never acquire that prestige which the note of a single institution possesses in its own country. The bank-note in such countries as France and Germany occupies a position midway between gold and the ordinary bank-note. It will be accepted for practically every purpose except for foreign payments. The power to issue an instrument which has this special sort of prestige is of very great value in emer- gencies. It enables the central institution to supply an almost indefinitely large demand for currency for domestic purposes without involving itself in any appreciable danger of loss of gold through the 80 Bank-Notes presentation of the notes for redemption. On the other hand, if notes are issued by many banks, in a serious emergency it may happen that the public loses confidence in the notes and manifests a preference for gold. Bank-notes issued by a single institution have, then, a very great practical advantage, they have a quality which the ordinary bank-note does not possess, at least in a country in which thousands of banks are permitted to issue notes. This consideration has been an important factor in shaping legislation regarding bank-notes in many countries. Central banks have been established, as in the case of the Federal Reserve banks in the United States, in order to secure the improvements in banking machinery and practice which they make possible. These institutions have then been granted a more or less complete monopoly of issue, not because it was impossible to secure a satisfactory currency issued by the banks generally but in order to enable the central banks to perform their special functions more effectively. CHAPTER VI CENTRAL BANKS It is necessary, as we have seen, for every bank to keep some money on hand to meet counter payments and what are commonly the more considerable requirements of settlements with other banks in the same place. Balances with banks elsewhere must also be maintained in order to facilitate payments to distant banks. The amount of money and balances required for these purposes in normal times is not large since receipts from all sources tend to offset withdrawals al- though of course not exactly from day to day. Banks having large pay-rolls to make up for de- positors must carry exceptionally large amounts of money on hand, but generally speaking re- serves of cash and balances in the neighborhood of ten per cent, of demand liabilities are found to be ample for ordinary requirements. In the experience of all banks, however, there will be occasions when withdrawals of funds will be exceptionally large. Not infrequently also these withdrawals will be accompanied by de- mands for additional loans from regular depositors, demands which as a going concern a bank will 6 81 82 Central Banks if possible endeavor to satisfy. A well managed bank with diversified loans and investments will ordinarily experience no difficulty in meeting a situation of this kind. It will reduce or entirely liquidate loans to borrowers who are not its own depositors; it may sell securities; and finally it may use its own loans as a basis for borrowing from other banks. The effectiveness of these measures, it is to be observed, depends upon the ability of other banks to extend additional accommodation. The market for securities becomes at once restricted when would-be purchasers are unable by means of bank loans to secure a part of the purchase price. Call loans against securities listed on stock ex- changes cannot be liquidated to any appreciable extent if the brokers to whom such loans are chiefly made are unable to borrow elsewhere. The payment of commercial loans as they mature is also largely dependent upon the continuance of the processes of production and marketing of goods and of the payment for them by purchasers in normal fashion. Ability of borrowers, however, to meet these obligations is at once weakened if those to whom they regularly sell commodities experience difficulty in securing the usual amount of accommodation from the banks. Payments for goods already sold are delayed and new pur- chases are curtailed. A diminution in the total amount of commercial loans will accompany a fall in prices, and a decline in the activity of Central Banks 83 trade, but for the banks to attempt to contract such loans quickly and in large amount subjects business to intolerable strain and if persisted in occasions failures so numerous and widespread as speedily to threaten even the solvency of the banks themselves. In short, business can- not suddenly be deprived of the volume of credit to which it has become adjusted without disastrous consequences both to lenders and bor- rowers. For the satisfactory conduct of the business of banking something more then is needed than reserves of cash sufficient for ordinary require- ments together with loans and other investments which can be readily liquidated when one or only a few banks find it necessary to strengthen them- selves. Somewhere in every banking system a reserve of cash and of lending power is needed to meet occasions when the banks find themselves confronted with unusual demands both for money and for loans. Provision for such occasions may be made through the maintenance by all banks of larger reserves than they regularly require, by a few banks or by a single bank. Where, as in Canada, banking is conducted by a few banks of large size this requirement has been recognized and adequately met by the several banks. But in countries in which banking has been conducted by numerous banks large and small the responsi- bility has been so widely diffused that this need has not been fully realized and consequently 84 Central Banks provision for periods of financial strain has generally been entirely inadequate. In an endeavor to remedy this defect which was repeatedly disclosed in the banking experience of the United States before the Civil War, the banks were subjected to legal reserve require- ments considerably higher than the reserves needed in normal times. But in periods of finan- cial strain the mere possession of reserves is not sufficient. They must be used. Where banks are numerous with no recognized leaders or strong combination among them, in any sharp crisis some of the bank managers may decide to take care of themselves by reducing their loans and filling up their reserves, and leave it to others to take care of the general welfare by enlarging discounts and satisfying demands of depositors for money. Knowledge that some may pursue a selfish course weakens the disposition and also the power of others to take a more liberal course, and this may lead all the banks to pursue a policy of contraction which is condemned by the judg- ment of the majority. This difficulty of securing united action among many banks in emergencies was strikingly evi- dent in successive crises in the United States after the establishment of the national banking system in 1863. Although the cash reserves of the banks were far in excess of what was needed for ordi- nary requirements, the banks in each crisis from 1873 to 1907 invariably endeavored to contract Central Banks 85 loans and in the more serious of these crises, those of 1873, 1893, and 1907, partially suspended cash payments. x The unhappy consequences to the community generally of the inability of the banks to cope successfully with emergencies finally led to the establishment of the Federal Reserve banks in 1 9 14. This group of banks is patterned after the central banks which are found in most Euro- pean countries as well as in Japan and thanks to which periods of financial strain had been handled far more satisfactorily than in the United States. In the analysis of banking operations in pre- ceding chapters it was assumed that each bank enjoyed similar powers, and consequently aside from differences of size was equally responsible for the maintenance of the mechanism of credit in a sound condition and in effective operation. The presence of a central bank relieves the other banks of some portion of this responsibility. It introduces important modifications both in the powers of these banks and in banking practice. In later chapters the history of the three most important central banks, those of Great Britain, France, and Germany, will be considered, but for the imderstanding of the significance of those chapters a preliminary analysis of the powers, functions, and policies of central banks will be helpful. The special, functions of central banks may be 1 For some account of these crises see Ch. XI below. 86 Central Banks grouped under three heads: they serve as fiscal agents of government; they have large powers of control over the currency through the more or less complete monopoly of note issue; and, finally, since they hold a large part of the reserve of the other banks, they are directly responsible for the foundation of the entire structure of credit. This last is by far the most important function of central banks. Indeed, in a general but very true sense, central banks may be said to have but this single function, — to insure the maintenance and smooth working of the systems of credit, of which they are the most important, though not necessarily the most considerable members. It is a duty which rests upon central banks because the other banks, which hold a little or no cash reserves, rely upon their deposits at the central bank and upon the expectation of being able to borrow from it through rediscounts or direct loans. r The centralization of bank reserves was not one of the objects in view when the first central banks were established. Historically, it is prob- able that it came about in large measure as an unintended result of the monopoly of note issue and of the government business handled by them. Such is quite certainly the case with the Bank of England, the earliest central bank in date and * The London banks do not ordinarily borrow directly from the Bank of England. They withdraw money lent to bill brokers, who in turn are obliged to borrow from the Bank. The difference is one of form rather than of substance. Central Banks 87 the model for all others of its kind. Through its government business other banks were inevitably brought into daily contact with it, and the con- venience of an account upon its books became readily apparent. Again, the partial monopoly of the right of note issue, in a period when banking methods were undeveloped, was an advantage which, along with its government business, gave the Bank of England a position of unquestioned superiority, both in size and in prestige. From keeping a balance to keeping their entire reserve in the central bank required no essential change in the every-day methods of business of the other banks. This stage had been reached in England before the close of the eighteenth century, and for generations English bankers have held in their own vaults only such amounts of money as are required for every-day purposes, — till money, as the English are wont to designate it. This custom was still further strengthened in 1854, when the plan was adopted, in the settlement of clearing balances, of simple transfers upon the books of the central institution. In other coun- tries, virtually the same situation has been reached. Although the other banks may hold slightly greater amounts of cash, they carry balances, larger or smaller, with the central bank, and are quite as dependent upon it to meet extraordi- nary requirements. In the exercise of their function in relation to the reserve the possession of government balances 88 Central Banks is of much advantage, and the privilege of note issue is in most countries indispensable. Govern- ment balances are indeed at times so small as to be of little service, and in the case of the Bank of England the right of issue is of little practical importance since the Bank of England note is virtually nothing more than a gold certificate. In Continental countries where there is slight use of checks the right of issue by a central bank would seem to be indispensable and it is a power which in any country adds greatly to the strength of a central bank. Owing to the general prefer- ence of people for paper money, as the stock of gold in a country increases much of it will be secured by a central bank in exchange for its notes. The great strength of the Bank of France is mainly a result of this process. The stock of money in circulation has increased and this gold instead of going directly into circulation has been taken to the Bank of France to be exchanged for bank notes. The activities of a central bank in normal times are of a comparatively simple and even routine nature, not very different from those of the other banks about it. In some countries on account of statutory requirements, and in all countries from motives of sound policy, the loans and other investments of central banks are con- fined to those which are deemed of the highest quality, a decided preference being given the trade bill over the collateral loan. The high Central Banks 89 quality of the assets is not, however, insisted upon with the intention of converting them into money in times of emergency. A central bank is then the refuge of last resort for the other banks. Any attempt to call in loans or realize on securities would be directly opposed to the working prin- ciples of a central reserve banking system. It invariably happens at such times that the loans of central banks are largely increased. * The good quality of the assets in general is important because it gives that prestige which is half the battle for a central bank. A reputa- tion for conservative, sound judgment is abso- lutely essential to the maintenance of universal faith in the strength of the central institution. For this reason, and even more in order to be able to meet the responsibilities of its position, it is equally essential that a central bank should hold a very large reserve against its credit lia- bilities. There is, of course, no precise proportion of reserve which is everywhere adequate amid varying circumstances. The general character of the economic activities of the country, its finan- cial position, and the size of its entire credit structure must be the determining considerations for each central bank. In all countries with such institutions there has been a distinct ten- dency to maintain a larger reserve than was for- 1 There is, indeed, one kind of loan to which this statement does not apply, — the foreign bills held by many of the Conti- nental central banks; but see p. 93 below. 90 Central Banks merly thought necessary. This seems to be due to a more clear recognition of their responsibilities, and because these responsibilities have increased with the growth of other banks and the more in- timate relations between the money markets of the world. After the Baring crisis in 1890 it was generally felt that the reserve of the Bank of England was too small. The proportion to de- posit liabilities which, in normal times, had been in the neighborhood of 40 per cent., was therefore increased to rather more than 45 per cent. The Bank of Germany holds about the same propor- tion of reserve to demand liabilities as does the Bank of England, and the reserve of the Bank of France, for many years, has been notably- greater than that of any other country. In securing business central banks experience no difficulty when the available funds of other banks are regularly insufficient to meet the de- mand for loans* This seems to have been the normal condition of affairs in England during the eighteenth, and the first quarter of the nineteenth century. It continued even later in other coun- tries, and in Russia and Japan banks are still constant borrowers at the central banks of those countries. Elsewhere, the demand of banks for loans at the central banks during periods of de- pression and of moderate trade activity is slight or even entirely absent. In some countries, notably in France, a large number of small bills of exchange are regularly rediscounted at the Central Banks 91 central banks in order to take advantage of the extensive collection facilities which they have provided. Particular banks, on account of cir- cumstances peculiar to themselves, will require occasional accommodation. There will also be a more general demand from many banks in con- nection with the various settlements and pay- ments which come at the end of each month, and especially at the end of each half year. Finally, in the northern hemisphere there is the seasonal demand which comes every autumn in connection with the harvesting and marketing of the great agricultural staples. But these various require- ments do not provide that steady volume of business which will keep a central bank in con- stant touch with the money market and at the same time provide earnings for necessary expenses and reasonable dividends. Central banks, there- fore, find it necessary to compete with the other banks entering the open market as lenders to individual borrowers. In this competition, how- ever, they are at a great disadvantage, and have been able to secure only a diminishing proportion of the total volume of banking business of all kinds. In part this is due to a relative increase in kinds of loans which central banks are unwill- ing to accept. The growth of purely domestic business in most countries has not been accom- panied by a corresponding growth in the volume of commercial paper in the form of bills of exchange — the variety of paper which central banks are 92 Central Banks most ready to take. They are at a further dis- advantage owing to the lack of flexibility in the terms upon which they are accustomed to accom- modate borrowers. There are two official rates at most central banks — the rate of discount, and a somewhat higher rate for collateral loans. The market rates, that is the rates of other banks and brokers, are highly flexible, corresponding to every slight variation in the character of the security, the duration, . and other conditions of the loan. The best paper is therefore ordinarily not taken by borrowers to the central bank. Recognizing this situation, the Bank of England for many years has followed the market rates in dealing with regular customers. The Reichs- bank adopted the same policy for a number of years, but discontinued it in 1896 largely on account of agrarian protest. During periods of intense trade and speculative activity the demand of banks for accommoda- tion at central banks becomes more frequent and assumes larger proportions, though it may still continue to be highly irregular. Positive action must then he taken by a central bank if it is to maintain itself in a strong position. Measures designed to prevent the depletion of its reserve, and if possible to increase it, must be taken. The central bank no longer leaves the money market free to follow its own course but endeavors to subject it to some measure of control and to confine the expansion of credit within safe limits. Central Banks 93 A variety of devices are made use of in putting into effect the precautionary policy which is required amid the conditions which develop during periods of general prosperity and widespread optimism. Some of these devices are entirely within the direct sphere of operation of the central bank, while others require the co-operation;of the other banks or the control of their operations. The Bank of France has relied in the past largely upon the device, peculiar to itself, of a premium upon gold withdrawn for export. In Germany the Reichsbank is said to have prevented gold exports by agreement with other banks even when there would be a clear and immediate profit from the operation. Many of the central banks facilitate gold imports by advances upon gold in transit. The Bank of England can within narrow limits change its buying and selling prices for gold in bars and for foreign coin. Most of the Continental central banks regularly hold considerable quantities of foreign bills, which can be used to check gold exports and to secure gold imports. This device is the main reliance of the Bank of Belgium; it is of very great importance in the case of the Bank of Austria- Hungary; and it seems to be regarded with increasing favor at the Reichsbank. The effective- ness of the policy would largely disappear if it were universally adopted. It is noteworthy that the bulk of the foreign bills thus held are upon London, on which the rest of the world for many 94 Central Banks years has relied as the one certain and immediate resource in times of emergency. These various devices, with the exception of the premium policy of the Bank of France to be considered later in connection with the history of that institution, are all of secondary importance, serving only temporarily and to a slight extent either to enlarge the reserve or to obstruct its depletion. They do not enable a central bank to check, much less prevent, further credit ex- pansion which is invariably the fundamental cause of the difficulties with which the central bank is confronted. There remains for consideration, however, one device, the sliding scale of discount, which is made use of by all central banks and which is of pre-eminent importance. This device, though in varying degree in different circumstances, is a means both of safeguarding the reserve and of moderating the influences tending toward exces- sive credit expansion. Two specific objects are in view when the rate of discount is advanced — the diminution of the domestic demand for loans and a modification in foreign exchange rates so that gold exports may be checked and gold imports perhaps be stimu- lated. But an advance in the rate of discount by a central bank is of little service unless market rates follow the bank rate. To bring this about is the most difficult problem with which a central bank is confronted. When the strain upon the Central Banks 95 reserve is merely anticipated or of moderate pro- portions, it is frequently difficult to make the market follow the bank. If the other banks have abundant funds and if the necessity of caution is not obvious, the immediate effect of the advance of the bank rate upon the market rate may be imperceptible. The central bank will then secure little new business. In countries where its proportion of the lending business is large, it is true that the increased demand for loans at the other banks will soon force up the market rate. But, as the business of central banks is small in proportion to the total credit business in most countries, it frequently happens that the outside market is able to shoulder the entire lending business without advancing rates to the point desired by the central banks. In recent years both the Bank of England and the Bank of Germany have found it necessary with increasing frequency to deprive the market of its surplus funds. This is accomplished in Eng- land by the sale of government securities, and in Germany by the rediscounting of Treasury bills. This device has answered its purpose to a striking degree. Its effectiveness is a direct consequence of the narrow foundation of balances with the central bank, upon which rest the vast liabilities of the other banks. In London, for example, it is supposed that bankers' balances may amount to half the deposits of the Bank of England, say £25,000,000. If these balances are reduced even 96 Central Banks by a million pounds through the sale of govern- ment securities by the Bank of England, 1 the other banks are obliged to contract their loans and reduce their deposits by many times that amount, in order to preserve the customary proportion of balances to their credit liabilities. The credit structure is so delicately poised upon its founda- tion of Bank of England balances that it is sensi- tive to very slight influences. The effectiveness of this device of withdrawing funds from the market, it is important to note, is in large measure limited to periods when the resources of the other banks are already well employed and no additional resources are becom- ing available. While it is of much utility in preparation for a period of financial strain which is in imminent prospect, it cannot be used to give constant control over the credit situation. When, for example, the course of foreign payments is such as to bring large supplies of gold into a coun- try, a central bank is powerless to prevent the rapid expansion of credit on the part of other banks, even though such expansion may be re- 1 The balances of the other banks would almost certainly be reduced by this step unless the securities were sold to individual depositors of the Bank of England. If the securities were pur- chased by the other banks or by their customers, checks in payment would swell the clearing-house exchanges of the Bank of England. If they were sold to bill brokers or their customers, the result would be the same, though there would be one or more additional transfe-s of credit required to complete the operation. Central Banks 97 sponsible for the development of a highly hazard- ous state of affairs. Even should a central bank be able at such times to bring about a moderate advance in rates it is by no means certain that this would greatly strengthen the domestic bank- ing situation. In periods of great business and speculative activity very high discount rates may indeed reduce somewhat the demand for loans for purely domestic purposes, but not necessarily the demand for those which are most undesirable. A central bank is not an institution with powers sufficient to remove the causes of all financial ills. At times it can control, but more frequently it must rely upon the potent influence which a conservatively managed central institution ac- quires as the result of long years of wise operation. By example and precept the dangerously rapid expansion of credit by the banks as a whole in periods of active business may be somewhat diminished, but it would require an impossible and indeed undesirable exercise of power to control such tendencies. The measures which a central bank takes to keep itself in position to meet periods of financial strain, will to some extent moderate tendencies toward the danger- ously rapid expansion of credit by the banks as a whole, but they will not eliminate such tenden- cies. General speculative movements have been less violent in Europe than in the United States, but this difference is properly ascribable, not to the absence of a central bank, but to the greater 98 Central Banks opportunities for rapid development in a new country with large undeveloped natural resources. Germany, which in late years has been in manu- factures and commerce virtually a new country, has experienced highly speculative movements, which the Reichsbank has been seemingly powerless to control. After all, a central bank can do little more than husband its own resources for the future, at a time when the other banks have abundant funds and a spirit of general over-confidence pervades the business community. It is significant that the exportation of gold or the movement of the foreign exchanges toward the gold export point is the most frequent occasion of an advance in the rate of discount by central banks. Gold exports are not by any means always an indication of an unsound condition of affairs and the approach of a period of financial strain, but in periods of great trade activity and of rapid credit expansion they are commonly an indication that precautionary measures may well be taken. Ordinarily, the foreign exchanges are distinctly more sensitive to an advance in dis- count rates than the domestic demand for loans. There is a large volume of business of various kinds which can be financed by borrowers in the money markets of more than one country. Bills of exchange accepted by leading banks and bank- ers arising out of foreign trade or based on secu- rities as collateral furnish the bulk of the material for these international loans. These bills are Central Banks 99 offered for discount in the market in which the lowest rates can be secured. For an understand- ing of the somewhat complicated processes of international borrowing some knowledge of foreign exchange operations is required. This is a subject which will be considered in the next chapter. Here it is sufficient to note that an advance in discount rates in any money market tends to induce foreign borrowers to finance their requirements more largely either at home or in the money markets of other countries. Foreign creditors also may be induced to employ money in the market in which rates have advanced instead of drawing it home as they might have done if rates had remained stationary. The foreign trade and financial operations of the leading European countries are of enormous magnitude, both absolutely and relative to the total business of those countries. Many of the great crises during the nineteenth century were precipitated, and at least in part caused, by events occurring in other parts of the world with which Europe has close financial relations. The purely domestic economic activities of old countries are comparatively stable, and seldom give occasion to inordinate speculation. Any arrangement, therefore, which succeeds both in strengthening the central bank and also in placing a restraining in- fluence upon foreign speculative operations, is one which affords protection against the most serious weaknessthreatening the European financial world. ioo Central Banks In times of severe financial strain the central bank plays an active dominating rfile. Upon it rests the responsibility for maintaining specie payments, and also in large measure for the con- tinuance of lending facilities to the business com- munity. This responsibility was not clearly recognized, and the policy which should be fol- lowed in such situations was not clearly under- stood in the latter part of the eighteenth century and the early years of the nineteenth century. In some instances, loans were restricted, with dis- astrous consequences not only to business but to the central banks as well. In other instances, loans were granted freely, but without that con- comitant advance in the rate of discount required to influence foreign exchange rates and to drive away borrowers whose needs were not urgent. 1 For the last forty years at least the policy which should be followed has been clearly understood, largely owing to Bagehot's reiterated expositions in the Economist, finally embodied in more per- manent form in his Lombard Street. The policy of liberal loans though at high rates and the payment of money or notes to all who for any reason whatever may demand cash are now everywhere recognized as the guiding principles of action in emergencies. Experience in many crises show that alarm can be allayed and that the 1 Macleod's Theory and Practice of Banking contains the best account of English banking experience during crises before i860. See Chapters IX., XI, and XII. Central Banks 101 actual withdrawals of cash and also the demand for loans will not be very considerable if a central bank possesses ample means to supply cash and to grant additional credit, and manifests no hesitation in making use of its resources. In carrying out its crisis policy as to loans and cash a central bank does not require any previous agreement with other banks, but in recent years still another method of relief which does require their cooperation has been adopted in practice if not in theory. Central banks have taken the lead, as in the Baring instance in 1890, in arrangements for the conservation of the assets of large banks which are not hopelessly insolvent and by preventing sudden liquidation have con- fined the disturbance within narrow limits. The machinery for such united action will hardly be set in motion in the absence of some person or institution of commanding influence in whom the business community has confidence. The practice of making settlements between banks on the books of a central bank greatly reduces the withdrawals of cash during a crisis. Banks borrowing from the central bank take the proceeds of their loans mainly in the form of deposits since, aside from the case of a run by depositors, their requirements are chiefly for the purpose of making payments to other banks. The mere presence of a central bank removes the danger that other banks will adopt the short- sighted policy of hoarding their reserves, since io2 Central Banks the central bank is in position to insist that each bank shall use them if it is to secure such accom- modation as it may require. From the preceding ^ pages the reasons will be evident for the general widespread adoption of a central bank as an essential part of a well-ordered banking system. Through such institutions there is gained a high degree of certainty that a reserve of cash and lending power available for emergen- cies will be maintained. The use of these resources in an effective manner and without hesitation when occasion requires is also assured. The community at large is relieved from the danger of attempts at wholesale loan contraction and confidence in the ability of the banks to maintain payments at all times is established. CHAPTER VII FOREIGN EXCHANGE Foreign Exchange is the business which is concerned with buying and selling in one country of rights to the payment of money in other coun- tries either immediately or in the near future. Payments and collections between different parts of single countries, especially those of large area, give rise to dealings which in some respects are similar to those which appear in the conduct of the foreign exchanges. Thus, in the United States domestic exchange rates rise and fall within lim- its set by the costs of shipping currency between different parts of the country. Charges on cur- rency shipments of $i ,000 are taken as the basis for quotations. If, therefore, it costs fifty cents to ship currency between two cities, domestic ex- change rates between them will range from a premium of fifty cents to a discount of a similar amount. Demand rates of foreign exchange similarly fluctuate between limits set by the costs of ship- ping, not currency, but gold. Since, for example, it costs in the neighborhood of four dollars to ship $1,000 in gold between New York and London, four 103 104 Foreign Exchange dollars sets the limits to the normal variation in the rate of sight exchange between England and the United States. Quotations might be ex- pressed as in domestic exchange dealings but in practice a different method is used. Changes in foreign exchange rates are quoted in slight fractional or decimal variations from the pars of exchange. Between most countries the par of exchange it- self, instead of being quoted in a large monetary unit as in American domestic exchange, is expressed by taking the specie value of the gold or silver coin commonly used as a measure of value in each country in a similar coin in other countries. Thus, the par of exchange between England and the United States is $4.8665, the exact amount of dollars which can be coined from the gold in the pound sterling. As the cost of shipment of gold between the two countries is in the neighbor- hood of two cents per pound, exchange rates may normally rise to about $4.88, the gold export point, and fall to about $4.84^, the gold import point. Exchange between the United States and Ger- many, like that with England, is quoted in the money of the United States, but instead of using the mark, four marks are made the basis of the quotation. The gold in four marks has a value of 95^ cents, consequently German ex- change may rise above and fall below this point by the amount that it costs to send gold to Berlin. In the case of France the quotation is not ex- pressed in United States money but in francs — in Foreign Exchange 105 the number of francs which the gold in the dollar will make, 5 francs 18 J centimes. When exchange is expressed in United States currency, a rising quotation indicates an approach toward the export point. "When, however, quota- tions are expressed in the currency of a foreign country, the opposite is true. A fall in the quota- tions then indicates an approach to the export point. For example, a payment of one thousand pounds is to be made in London. If exchange is near the export point more will be paid than if it is near the import point, since at the export point the gold value of the sovereign plus the cost of shipping will be paid. If the rate were $4.88, more would be paid to remit one thousand pounds to London than if the rate were $4.86. But suppose it is desired to pay one thousand francs in Paris. Clearly more will be paid if only 5 francs 16 centimes are obtainable for a dollar than if 5 francs 18 centimes for a dollar were obtainable. The expenses incurred in shipping gold determine the export and import points, the gold or specie points as they are commonly designated. The obvious expenses are freight, insurance, commis- sion, and the cost of packing the gold. All these elements of expense are somewhat variable. Freight charges may not be uniform, and it makes a difference as to the kind of gold available for shipment. The most inexpensive form for the purpose is gold in bars. Bars can be packed more handily, are of full weight, and there is less loss 106 Foreign Exchange from abrasion than in the case of shipments of coin. The great European central banks have a sliding scale of rates for gold, buying bars and foreign coin at coinage value as a maximum price and at that price less the loss of interest during the period required for coinage as a minimum price. In selling gold they impose rates which offset in varying degree the advantage of shipping bars or foreign coin rather than more or less worn domestic coin. By these means the importation of gold is at times stimulated, or its exportation obstructed, but the influence is slight and temporary. In the long run they have no appreciable influence upon the distribution of the precious metal throughout the world. Another element of expense in gold shipments is time. If a fast express steamer is sailing the specie points are somewhat nearer par than dur- ing a week when only the slower boats are avail- able. It should also be noted that foreign central banks frequently allow immediate credit for gold while in transit. This, of course, brings the import point still nearer the par of ex- change. Improvements in means of communica- tion have reduced the normal range of demand exchange fluctuations. Twenty or thirty years ago the export point to London was above $4.89. It is now normally in the neighborhood of $4.88. The import point was then in the vicin- ity of $4.83. It is now normally above $4,84. Foreign Exchange 107 But from what has been said it will be seen that the exact point at which it is possible to export or import gold at a profit is subject to much variation even within short periods of time. The cable transfer rate is always above the demand rate. It gives the purchaser the amount of his purchase immediately, whereas in the case of demand exchange the proceeds will not be placed to his credit until the steamer arrives on the other side six to ten days later. The seller of cable transfers loses interest on the amount of his sales at once, since his balances in the foreign banks, which uniformly draw interest, are at once reduced. The interest rate on these balances is not, however, constant. There is, therefore, a varying spread between the cable transfer rate and the demand rate. If, for instance, a foreign exchange dealer is getting i>£% upon his balance in London at one time, and at another time is getting 2%, he will naturally charge more for a cable transfer in the second case than he would in the first. There are also special causes of fluctua- tion in cable transfers. It sometimes happens that many persons defer making necessary re- mittances in expectation that rates will go down at the last moment. They must meet their en- gagements on the other side, and the demand at such times for cable transfers may cause the rate to move abnormally far from the demand rate. A glance at a newspaper will show that in addi- tion to cable transfer and demand rates there 108 Foreign Exchange are a variety of other rates generally quoted — bankers' bills and various kinds of commercial bills drawn for varying periods of time. Rates for these bills are always lower than demand rates. If the demand rate on London was $4.86, the rate on bankers' 60-day bills might be $4.83, and it might be found that the rate on a certain class of commercial bills was $4.82^ and on an- other kind $4.82. The quotations on time bills are less than those for demand exchange by the amount of the varying costs of discounting them in the foreign country on which they are drawn, and by the stable costs of commissions and stamp taxes. If the rate of discount on a 60-day bank- er's bill is 3% in London, then the quotation for a bill of similar kind in New York will be the sight rate of exchange less the discount and other charges on the bill in London. Should the dis- count rate in London advance on that particular kind of bill, then the quotation will move some- what farther away from the sight rate. The reason for the different prices or quotations for the various kinds of time bills is that there is a scale of discount rates in the London market dependent upon the character of the bill, the lowest rate being on bills drawn for acceptance on a London bank or acceptance house. Bills without documents, known as clean bills, can be marketed by drawers of well-known and established credit, but most foreign trade gives rise' to documentary bills of exchange. The seller Foreign Exchange 109 draws a bill of exchange upon the purchaser, or upon the bank of the purchaser, attaching to the bill various documents, the most important being the bill of lading, without which it is impossible to secure possession of the goods. Documentary- bills are of two kinds, documentary for payment of and documentary acceptance bills. In the case of documentary payment bills the purchaser of the goods cannot get possession of them until he has paid the bill of exchange. These payment bills, again, may be classified as those drawn against sales of perishable goods and such other goods as the purchaser is fairly certain to want immedi- ately upon arrival, and those drawn in connection with goods which the purchaser may not want until the bill matures. If the purchaser desires the goods immediately and makes payment, he is allowed a rebate, which, in the case of English bills, is 1% below the current Bank of England rate. Therefore the maximum price of such bills is the sight rate of exchange, less the rebate and the ordinary commission and stamp tax. If the goods are of a kind which are not likely to be wanted by the purchaser until maturity of the bill of exchange, then the dealer purchasing the bill may be obliged to hold it until maturity. It cannot be discounted, because the purchaser of the goods may at any time exercise his right of taking up the bill. The exchange dealer may, however, use such bills as collateral, drawing his own bills upon his foreign correspondent. no Foreign Exchange Documentary acceptance bills are of two kinds — those which are drawn for acceptance on a merchant, and those which are drawn on a bank or acceptance house. Documentary acceptance bills on merchants are regularly discounted at a slightly higher rate in London, and consequently the price of such a bill in this country will be slightly lower than documentary bills on London banks and bankers. For this reason, to an in- creasing extent the bank acceptance is displacing the commercial bill in foreign trade throughout the world. The importer, for example, secures an acceptance credit for some definite amount with a well-known bank in his own or some other country. He then instructs his agent, or those from whom he purchases goods, to draw bills accompanied by shipping documents upon the accepting bank. Similarly the exporter may draw bills on banks in his own or in some other country with which his customers have established acceptance credits. The United States, like other rapidly developing countries, has not in the past financed any appreci- able amount of its foreign trade, either of exports or of imports. Demands for capital within the country have been so great that rates for loans have regularly been above those in Eu- ropean money centers, and especially in London. London, and to the same extent other European money markets, have, therefore, financed not only the trade between Europe and the rest of Foreign Exchange in the world, but also trade between non-European countries. Let us take, for example, the case of an importa- tion of wool to the United States from Australia. The most common way of arranging payment has been through the commercial letter of credit on a London bank. Let us suppose that a Boston wool house is about to purchase a cargo of wool. It will secure through some foreign exchange banker in this country an acceptance credit with a London bank. Under the terms of this credit, the agent in Australia of the Boston wool house will be empowered to draw documentary accept- ance bills up to a certain amount on the London bank. Upon the purchase of the wool a bill on the London bank is drawn, and with shipping documents attached is sold to some Australian bank. Thus the funds are provided with which to pay for the wool. The Australian bank sends the bill with the documents to its London cor- respondent, and at the same time ordinarily will sell an equivalent amount of sight exchange against the credit which it will secure in London through the discount of the documentary bill. No one in Australia has any further connection with this transaction. The correspondent of the Australian bank in London takes the bill with its documents to the London bank on which it is drawn for acceptance. Having been accepted by the London bank, which takes the shipping documents, the bill is discounted in the open market by the ii2 Foreign Exchange London agent of the Australian bank. This provides funds to meet the sight exchange which the Australian bank had sold. The London bank which accepted the bill then sends the documents to this country to the foreign exchange banker through whom the arrangement was made or perhaps to a shipping broker. The wool house cannot get possession of the wool until it can get the bill of lading, and the exchange banker need not give up this document until he is provided with funds to purchase the sight exchange on London necessary to meet the payment of the bill accepted by the London bank. Thus everyone is secured at each stage in the transaction, in so far as the wool itself may be regarded as security. To illustrate the financing of exports, we may take the case of a shipment of goods from the United States to South America. The financing is handled in a number of different ways, but one of them will serve for illustrative purposes. A commission house exporting goods to South America will commonly be paid in 90-day drafts on some London bank, drawn by the South Ameri- can purchaser of the goods. If the commission house waits until these bills mature, it will be a long time out of its money — the time that the goods are in transit to South America, the time that is required in sending the bill of exchange to London, and ninety days thereafter. Something like six months will elapse before the maturity of Foreign Exchange 113 the bill. But the commission house in New York wants its money at once. It may itself, therefore, draw a 90-day bill upon a London bank and get the cash by selling this bill in the New York market. This 90-day bill will be sent to London and discounted in the London market. Thus it will be seen that London really finances the ship- ment of goods from New York to South America. When the 90-day bill falls due the New York house must provide payment, since the South American bill is not yet due. This it can manage by discounting the South American bill in the London market. Finally, when this bill matures, means of payment will have been provided by the South American purchaser of the goods. Thus during the period of six months London has financed the transaction; first, by discounting the bill of the New York commission house, and then by discounting the bill drawn by the South Ameri- can purchaser. A considerable number of banks throughout the United States have established foreign exchange departments in recent years. They have entered into the necessary arrangements with foreign banks, establishing balances with them, and are thus able to provide their customers directly with cable transfers, sight drafts, and also letters of credit, both travelers' and commercial. A foreign exchange department of this kind does not require any considerable amount of capital. It will purchase time bills of exchange drawn against ii4 Foreign Exchange merchandise shipments, which it can secure either from New York or direct at the rate at which these bills on receipt will be discounted in London or elsewhere. It therefore incurs no risk from fluctuations in foreign rates of discount — fluctuations which the American banker would hardly be in position to forecast. Having pur- chased time bills at a rate which is less than the demand rate of exchange by the amount of the discount on arrival, stamp tax, and commission, the bills may be at once sent on for discount, and at the same time the foreign exchange depart- ment may sell an equivalent amount of demand exchange. Of course, if the foreign exchange manager cares to assume the risk, he need not sell demand exchange equivalent to his purchases of time bills; but if he has not very much capital to work with, and wishes to avoid practically all risk from fluctuations in exchange rates, it is ordinarily possible to do so. The many banks scattered all over the country which have foreign exchange departments do not directly have anything to do with the determi- nation of the sight rates of exchange. They are determined by the operations of a comparatively small number of dealers in exchange in New York City. Some of them are private banking firms, and others are the managers of foreign exchange de- partments of banks and trust companies. These institutions and firms necessarily incur a certain amount of risk in connection with foreign ex- Foreign Exchange 115 change dealings. They buy and sell a more or less indefinitely large amount of sight exchange. If it is believed by one of them that rates are going down, he will be likely to offer a good-sized block of sight exchange, and if another takes the opposite view he will be prepared to buy. Dealings be- tween the large foreign exchange houses are re- flected in constant slight variations in demand rates of exchange. Sometimes the exchange market is quiet, but at times it is in a feverish condition. Those who are engaged in the foreign exchange business in New York must take account of every influence which may ^increase or diminish the amount of foreign exchange material. What may be called the foreign exchange material con- sists in the first place of all sorts of time bills drawn against or resulting from exports and imports of merchandise. All of the commercial bills drawn against cotton shipments, grain, petroleum shipments, etc., build up balances on the other side against which exchange may be sold. Interest payments, shipping charges, tour- ist expenses, dealings in securities, issues of American securities marketed abroad or resold to this country, all provide foreign exchange material. In addition to all these exchange creating factors, there are temporary loans made by one foreign market in another foreign market, by means of finance bills. These loans may be made in a variety of different ways. The foreign exchange n6 Foreign Exchange house in New York enjoying good credit may, for example, draw bills upon a London correspondent payable in three months. These bills, on accept- ance by the London correspondent, may be readily discounted, thus giving the American exchange house a balance to the amount of the bills, and enabling it to sell an equivalent amount of sight exchange in New York. This is what ordinarily happens in the case of foreign borrowing. No actual money commonly moves between the two markets. Similarly, borrowing may be arranged by an exchange dealer for one of his clients who may deposit collateral as security. Profit on these foreign loans is largely determined by the course of the sight exchange rate. Suppose, for example, that the sight rate of exchange is $4.86, and that a long bill is drawn and sold at $4.82, a difference reflecting the discount rate on London. When the long bill matures, the borrower must purchase sight exchange with which to take it up. If the sight exchange rate is then still at $4.86 he will have paid only four cents on each pound for the use of the money during the period. But in the event that the sight rate has gone up to $4.87 his loan is more costly, as he will be paying five cents for each pound. Foreign short-time loans do not ordinarily occasion movements of money into the borrowing country, but they frequently check gold exports. They are seldom made except when rates for loans are relatively low in the lending market and Foreign Exchange 117 the rate of exchange is high toward the export point in the borrowing market. Let us sup- pose, for example, that the rate in New York for three months' collateral loans is 5%, and that the discount rate in London is 3%. It may then be advantageous to borrow in London if the sight rate is at least as high as $4.87. It cannot go much above $4.88, and it may be at a much lower point three months hence, when it becomes neces- sary to purchase demand exchange. If the rate does go down, it reduces the cost of the loan to the borrower. If, however, he should enter upon this transaction when the sight exchange rate was $4.85, he would incur the risk of a possible advance to $4.88, making the loan an extremely costly affair. Whenever there is a large balance of payments against a country, temporary borrowing cannot prevent exchange rates in the long run from moving to the export point. But within limits it is possible to postpone gold movements if interest rates go to a much higher level than those pre- vailing in the foreign countries to which heavy payments are due. In such circumstances, so long as the credit of the debtor market remains good in foreign countries, very considerable temporary loans may be made, thus providing sight exchange. But if a large number of three- month bills are drawn now, at the end of that period it will be necessary to make payments or secure renewals and renewals cannot be continued indefinitely. n8 Foreign Exchange Within moderate limits, borrowing by means of bankers' time bills serves a useful purpose, tending to steady the sight rate of exchange. In the absence of these bills a comparatively slight excess in the demand for or supply of exchange would cause rates to move violently between the export and import points. When drawn for the purpose of steadying the exchanges they are sometimes spoken of as anticipatory bills. Bank- ers' bills, for example, are regularly drawn by New York in the early summer months, because it is known that in the autumn a great quantity of commercial bills will come into the market in connection with exports of cotton and grain. Anticipatory bills are in no sense different from other bankers' bills. It is simply that within limits and at certain times they really are anticipa- tory. The term finance bills is sometimes used in a derogatory sense, as if commercial bills were the only perfectly reputable variety of bills of exchange. Bankers' bills are, however, essential for the smooth working of the exchanges, and the danger that they may be drawn to an excessive extent and contribute to the creation of an un- sound situation is not peculiar to this method of borrowing. From the foregoing discussion it may have been observed that there are two more or less distinct groups of foreign exchange markets — borrowing markets and lending markets. The borrowing markets are numerous, while the lending markets Foreign Exchange 119 are few, with a strong tendency for a single market to acquire nearly the entire business. In many ways it is advantageous to have one city in the world which serves as a center for international payments. London became the central money market of the world, reaping all the advantages of that position, because it has been able to absorb whatever amount of foreign bills might be sent thither for discount. This is an essential condi- tion for the normal working of the exchanges un- der a system of settlements largely concentrated in a single market. The market on which bills of exchange are drawn must be prepared to discount them. In order to avoid the risk of loss from fluctuations in exchange, bankers purchasing time bills drawn on another country must be able to discount them at once in that market, so that they may be able to sell demand exchange against the proceeds. Exchange bankers in New York and in all other exchange markets each day, and oftener if rates change, receive spot and forward delivery quota- tions from London correspondents. Spot quota- tions, as the name implies, are discount rates on bills already in London. Forward delivery quota- tions are the rates at which London bankers and discount houses agree to take bills arriving in the next mail from the market to which they are quoted. These arrival rates enable exchange bankers in New York and elsewhere to purchase time bills without running any risk from changes 120 Foreign Exchange in London discount rates while the bills are in transit. When downward tendencies in London discount rates seem probable, the banker may not take advantage of the arrival rate; just as in the belief that exchange rates are to advance he may decide to hold the bills to maturity. In fact the advantages and uses of forward delivery.quotations are in every way analogous to those arising from discounting bills which have already been delivered. In one case the arrangement eliminates risk during the transit period, in the other during the entire life of the bill after it reaches the country on which it is drawn. It is evident therefore that if time bills of exchange are to be handled with a minimum of risk it must always be possible to discount them in the country on which they are drawn. This has always been possible in London, and at rates which have averaged somewhat below those pre- vailing in other money markets. For this reason and because it facilitates settlements and makes possible a broad exchange market in all countries, foreign bills of exchange throughout the world for many years preceding the European War had been principally drawn on London. Persistent efforts to give bills on other money centers, nota- bly Berlin, the standing of the sterling bill, have not succeeded. In addition to its readiness to absorb the indefinitely large volume of foreign bills, London also has exercised most effectively another essential function — that of accepting Foreign Exchange 121 bills for banks and traders in all parts of the world. Until recently the acceptance business in London was conducted almost entirely by pri- vate banking firms known as accepting houses, the value of the London acceptance being due not so much to the financial strength of the acceptors as to the knowledge of the financial standing of banks and traders throughout the world which they had acquired, and the skill and restraint which they had manifested in the conduct of this important branch of the banking business. Of late years the joint-stock banks have entered this field and in London, as elsewhere, the bulk of the accepting business will probably come to be handled by incorporated banks. These two indispensable foreign exchange func- tions were developed during a long period in which peace had become the normal condition of the world. It is, therefore, no more than was to have been expected that with the approach of the European War the entire mechanism of foreign exchanges should be so seriously dislocated as to come almost to a standstill. On Saturday, July 25, 1914, foreign exchange operations were still being conducted in normal fashion through- out the world. Demand exchange in New York was quoted at $4.8830. Gold exports in consider- able quantities seemed imminent, but nothing more serious seems to have been expected. Over Sunday the outbreak of a general European war, which had been commonly regarded as a vague 122 Foreign Exchange possibility, became alarmingly probable. On Mon- day demand exchange opened at $4.92 and the foreign exchange market was completely disor- ganized. This condition was in no way peculiar to New York. Foreign exchange dealings between all of the money markets of the world were in a similar abnormal state. In no other business was the effect of the approach of the war felt so immediately, generally, and severely. The com- plicated and delicately balanced mechanism of the foreign exchanges, developed during long years of peaceful intercourse, collapsed like a house of cards. Two operations essential for the working of the foreign exchanges had been instantly interrupted and, indeed, practically discontinued, the business of accepting and that of discounting foreign bills of exchange in London. When London ceased to perform these two functions, the mechanism of the foreign exchanges throughout the world inevita- bly and at once became completely disorganized. Acceptors in London were under heavy obligations on bills of exchange drawn by banks and mer- chants throughout the world, who in turn were under obligation to remit funds to them before the maturity of the bills. Among these bills ac- cepted in the ordinary course of business were a large number, amounting in the aggregate to many millions of pounds, for banks and merchants in the countries which were rapidly drifting toward war. Remittances could not be expected from Foreign Exchange 123 hostile countries until after the restoration of peace. It was also certain that remittances would be delayed in many instances in the case of bills accepted for clients in allied and also in neutral countries, owing to the disturbances occasioned by the outbreak of the war. In these circumstances acceptors in London were in no position to make new acceptances, and the value of the acceptance itself was impaired. It should further be noted that exchange banks in New York and in all other markets were under heavy contingent lia- bilities on account of endorsements of bills drawn on London acceptors. In the event of the failure of London accepting houses, these bankers would have to supply funds to take up the bills and in the disturbed conditions prevailing might incur seri- ous loss through the failure of drawers, to whom they would have recourse. Uncertainty regarding the value of the London acceptance completely transformed the character of the business of buying commercial bills of exchange. A business which normally is highly secure and even routine in character was in a moment changed to one surrounded with uncertainties of a most un- familiar and incalculable nature. At the same time shipping hazards, and uncertainty as to market conditions in foreign countries, were taking away much of the value of the security which the bill of lading ordinarily gives in the case of bills drawn against exports. Both exporters and those who might purchase their bills would 124 Foreign Exchange therefore be embarking upon venturesome trans- actions, utterly lacking the highly developed safeguards which normally protect international dealings, both in commodities and in bills of ex- change. The consequences of the uncertain position in which London acceptors were placed by the ap- proach of the war do not seem to have been at once fully realized even in foreign exchange circles. They were perhaps overshadowed by the presence of another disorganizing influence, the full force of which was immediate and obvious. Prom Monday, July 27th, to the middle of August, the business of discounting foreign bills in London was almost entirely suspended. With the ap- proach of the war it might well have been presumed that London would decline to quote forward delivery rates before the discounting of bills already in London was discontinued. As it happened, both spot and forward delivery quota- tions were discontinued at the same time, on Monday, July 27th, striking evidence of the great change for the worse which affairs had taken over Sunday. This discontinuance of discount quotations by London was the most important single factor in the exchange market in New York and elsewhere throughout the world on Monday, July 27th. It involved a complete transformation, not only of the business of buying commercial bills, but also of conditions in the demand exchange market Foreign Exchange 125 as well. On Saturday the exchange banker purchasing commercial bills could arrange dis- count terms at once in London and sell demand exchange against the proceeds. On Monday the purchase of such bills involved the investment of capital until the date of maturity in a far from satisfactory security, owing to the position of London acceptors. On Saturday every commer- cial bill offered in the market provided the means for an immediate sale of demand exchange. On Monday the immediate supply of demand exchange could no longer be enlarged to the slightest extent by this means. The principal source of an immediate supply of a demand exchange was entirely cut off. Demand exchange could still be sold against foreign balances, but these were not large. The exportation of gold was a further source of supply of demand exchange, but could not go on indefinitely without endangering the foundation of the domestic credit structure. In these circumstances, although exchange transac- tions were not entirely suspended, there was a complete cessation of certain exchange operations, in the absence of which there can be no broad exchange market. Each dealer made every effort to provide the exchange urgently needed by regular customers, but transactions between dealers were almost altogether discontinued. In normal times, by offering to buy exchange at higher prices, a dealer can secure whatever amount he may require. At such times changes in rates serve 126 Foreign Exchange to adjust supply and demand in the exchange market. Beginning with Monday, July 27th, rates merely reflected the urgent and even frantic efforts of particular purchasers to secure exchange. Rates fluctuated widely, but as each transaction stood by itself they had no general market signifi- cance. Through the assistance of the British Govern- ment, London was able to resume, toward the end of August, 19 14, both the accepting and discount- ing of bills. But a few months later a new cause of difficulty presented itself. Sterling exchange, which throughout the world had ruled far above par for some time after the outbreak of the war, gradually began to decline, at first slowly, then more rapidly, until it was far below the gold export point from London. By August, 19 15, sterling exchange in New York had dropped to $4.50, and fluctuated widely over short periods of time. In other words, the base rate from which rates on all time bills are calculated no longer fluctuated within narrow and definite limits between the export and import points. It con- sequently became an unsatisfactory medium in which to enter into contracts for payment at a future date. This unsatisfactory position of the sterling rate was due to the enormous importations of supplies to Great Britain on account of the war. Toward the end of 191 5 arrangements were finally made for financing these purchases largely through the negotiation of loans in the United States; and Foreign Exchange 127 thereafter the sterling rate was pegged at about $4.76. The establishment of a stationary base in this artificial manner could not, however, give that confidence in sterling which it enjoyed when subject only to slight changes due to normal trade and credit influences. The European War, it will thus be seen, created conditions favorable to the development of the business of drawing bills of exchange on other markets than London, and in particular on New York, the most important financial center outside the zone of military activities. Fortunately the power to accept bills of exchange had been granted to the national banks by the Federal Reserve Act of 19 13, and also to state banks and trust companies in a number of the States. Moreover, after the disturbance occasioned by the outbreak of the war had been overcome, discount rates in New York fell to a level distinctly below that in London. Under these favorable cir- cumstances American bankers entered the foreign exchange field as acceptors and lenders, but whether this business will be retained and enlarged is uncertain. It is advantageous, both to im- porters and exporters, to have bills drawn on a single central world market, rather than on cities in each of the countries with which they are trading. There has been a broad market every- where for sterling bills, because not only trade with England but with all countries has been handled by means of bills drawn on London. If a 128 Foreign Exchange prolonged period of peace is to be anticipated at the close of the present war, the supremacy of the London foreign exchange market will probably continue. On the other hand if national enmities are to be continued and strife is merely trans- ferred from the battlefield to the marketplace, the convenience of a central money market will presumably not be sufficient to warrant the risk in the event of further outbreaks. Moreover, if, unhappily, international trade is to be developed by national organizations, primarily for national objects, rather than for individual profit, it will be necessary for each important country to organize the financial machinery needed for handling its own trade. A creditor position in the international loan market is of great advantage in periods of financial strain with the possible exception of those occa- sioned by the outbreak of great wars. The contrac- tion of loans to borrowers entirely dependent on the local banks of a country cannot, as we have already seen, be carried very far without serious disturbances. In the case of foreign loans far more considerable contraction can be carried through without difficulty. Loans of an international character can be placed elsewhere, both by foreign borrowers and those belonging to the country which is seeking to strengthen its position. Moreover, in the event that positive liquidation becomes necessary, since it is spread over a wide area, it will cause far less disturbance than a Foreign Exchange 129 much smaller amount of liquidation confined to domestic borrowers. In the preceding chapter it was noted that advances in the rate of discount were the chief reliance of central banks in safeguarding their reserves from depletion. It will now be evident that this device is by no means equally effective in all countries and circumstances. It is a certain safeguard affording immediate protection only for those money markets which occupy a creditor position in the international loan market. Such is the constant situation of London, Paris, and Amsterdam. Other markets, notably Berlin, oc- cupy sometimes a creditor and at times a debtor position ; still other markets, among which may be mentioned Vienna and New York, are normally debtors on balance to the rest of the world. For London it has been absolutely certain, at all times during the last fifty years or more, that an advance in discount rates if pushed far enough would not only serve to check gold exports, but would also induce gold imports if the rest of the world met its obligations as they matured. More- over, since the London market was regularly lend- ing in all parts of the world, a large volume of indebtedness in the aggregate could be liquidated without occasioning such a considerable amount of contraction at any one point as to disorganize business and destroy ability to make payments. In these circumstances it has not been necessary for the Bank of England to hold a large reserve 130 Foreign Exchange of cash in order to give stability and strength to the English credit structure. It has also been a comparatively easy matter to maintain in London a free gold market, and without exciting apprehen- sions in the business community, even though at times there might be large quantities of gold taken for export. The foreign short- time loans of the other creditor markets, such as Paris and Amsterdam, have been less widely distributed than those of London, and consequently the possibilities of contraction have been somewhat less. A somewhat larger gold reserve at the Bank of France than at the Bank of England would, therefore, seem to be necessary to give the same degree of strength to the credit structures of the two countries. In fact the reserve of the Bank of France has been many times greater than that of the Bank of England, and no effort has been made to establish a free gold market in Paris. French economic and financial activities would not have subjected the country to danger of depletion of its gold supplies, even if no restraint had been placed on gold movements, but the policy of the Bank of France in this matter has been determined by other considerations, to which attention will be given in a later chapter. It may, however, be observed that in France, and indeed in most other countries, undue importance has been attached to the outflow of gold with a consequent un- willingness to allow time and opportunity for un- Foreign Exchange 131 derlying economic forces to bring back exchange rates from the gold export point to a normal position. For markets in a debtor position in the inter- national loan market it is necessary to possess a large gold reserve in order to be able to meet all contingencies. Creditor markets can compel pay- ment. Debtor markets must rely upon the much less certain resource of being able to retain foreign balances and perhaps attract additional funds from other markets. They must possess sufficient funds to meet foreign payments in case foreign balances are withdrawn. The smaller debtor markets are accustomed to rely, to a considerable extent, upon holdings of foreign bills, especially those drawn on London. Such a resource is, however, inadequate for large countries, such as Germany and the United States. The central banks, in such countries, particularly if free gold markets are to be maintained, must accumulate large reserves of gold in normal times and be prepared to supply from these reserves whatever amounts of gold may be needed for export or other purposes in periods of financial strain. CHAPTER VIII THE ENGLISH BANKING SYSTEM The Bank of England owes its origin to the financial straits to which the government of William and Mary found itself reduced in carrying on the war with Louis the Fourteenth. The revenues of the kingdom were small, the public credit weak, and the very title of the dynasty unsettled. The growing wealth and business of the country had caused private banking houses to spring up. The paper given by these houses to their creditors had acquired a circulation, limited indeed, but sufficient to show its convenience, 1 and projects for the establishment of a public institution on the scale, if not on the model, of the great continental banks had been discussed for 1 McLeod, Theory and Practice of Banking, i., p. 210, prints a "goldsmith's note" which is still preserved, dated 1684. And see Macaulay's History, vii., p. 134. A curious pamphlet of 1676 (?) on the introduction of private banking in London is given in fac- simile by Martin in The Grasshopper (history of Martin & Co.'s bank), London, 1892, p. 285, and was also reprinted in the Quarterly Journal of Economics, January, 1888. And see ibid., July, 1888, p. 482, for notes of schemes for a national bank, broached at various dates in the seventeenth century. 132 The English Banking System 133 many years. 1 Under these circumstances, as an expedient for raising a million sterling, for which no other resource could be found, the government in 1694 adopted the scheme proposed by William Pa^erson, a Scotch adventurer, and proposed to Parliament that a loan should be offered for public subscription and made attractive by a grant of in- corporation, with banking privileges to be enjoyed by the subscribers and their successors. The meas- ure seems to have been contested chiefly, although not wholly, on party grounds, and was passed after a severe struggle, and thus the Bank of England came into existence as a Whig corporation. The act of 1694 provided for a loan to the government of £1,200,000, bearing interest at eight per cent., and incorporated the subscribers, with this amount of nominal capital, as the Governor and Company of the Bank of England,- — a title which has never been changed. The cor- poration was empowered to deal in coin, bullion, and exchange, and to lend upon security, but was forbidden to deal in merchandise in any form. It could not borrow nor give security by bill, bond, or agreement, for an amount exceeding its capital; no provision was made for the transfer of its bills, "obligatory or of credit," except by indorsement; nor was any monopoly created in its favor. In this 1 These institutions, among which the Bank of Amsterdam and the Bank of Venice were the most important, were not banks in the complete modern sense of the term since they were not authorized to make loans. ' 134 The English Banking System form the charter of the Bank gave little promise of its future importance. ' Three years later, however, the necessities of the government and the em- barrassments of the Bank, which had been obliged to suspend payment in 1696, led to a revision of the charter, in which the outlines of the great structure begin to appear. The issue of notes payable to bearer on demand was authorized, thus laying the foundation for a true bank-note circulation 1 ; the monopoly of corporate organiza- tion was granted by providing that, during the continuance of the charter, no other bank or cor- poration in the nature of a bank should be allowed in the kingdom; and, on the other hand, the capital was doubled by a fresh advance from the stockholders to the government, and the interest payable by the latter was reduced to six per cent. From this point the growth of the Bank and the increase of its influence were rapid. The corpora- tion became the chief depository of the public money, and the agent of the Treasury in many financial operations. In 1720 it carried on a mad struggle with the South Sea Company for the control of the business of refunding the national debt, and managed, although with difficulty, to save its own credit in the crisis which destroyed its 1 The notes issued under the act of 1694 appear to have borne interest, and, being made to order, could have had but a limited circulation. No notes of less than £20 were issued until in 1759 the Bank began the issue of notes for £15 and £10. Anderson's Origin of Commerce, ii., p. 413. The English Banking System 135 rival. Further loans to the government and additions to the capital of the Bank were made in quick succession. In 1722 its capital stood at nearly nine millions, and it was also able to estab- lish from its profits the surplus fund now called "the Rest," and thus to save its dividends from serious fluctuation. In 1782 the capital had risen to more than eleven millions and a half, and in 1816 it had risen to £14,553,000, at which figure it has stood ever since. Of the loans to the government, which had risen in nearly the same proportion as the capital, one fourth was repaid in 1834, reducing the total to £1 1,015, I00 > which is its present amount. By the year 1750 the govern- ment had succeeded in reducing the interest on most of its debt to the Bank to three per cent., and it has since used the opportunity afforded by the periodical necessity for a renewal of the charter, to lessen still more the burden of its interest, by requiring from the Bank an annual bonus and other pecuniary concessions, in consideration of the extension of its monopoly. This monopoly, dating, as has just been said, from the act of 1697, and confirmed by the act of 1707, was further defined by the act of 1742 1 as the right of "exclusive banking," the true intent be- ing, as is declared in the latter year, that No other Bank shall be erected, established, or al- lowed by Parliament, and that it shall not be lawful 1 6 Anne, ch. 22; 15 George II., ch. 13. 136 The English Banking System for any Body Politick or Corporate whatsoever, erected or to be erected, or for any other Persons whatsoever, united or to be united, in Covenants or Partnership, exceeding the number of six Persons, 1 ! in that Part of Great Britain called England, to borrow, owe, or take up, any Sum or Sums of Money on their Bills or Notes, payable at Demand, or at any less Time than six Months from the borrowing thereof, during the Continuance of such said Privilege to the said Gov- ernor and Company. It is clear from this language that Parliament understood by "banking" only the issue of notes, and that the exclusive privilege of the Bank did not prevent the issue of such notes by partnerships having only six partners or less, nor the performance of the other banking func- tions by companies or partnerships of a greater number of partners. Notes continued to be issued by the London private banking houses, some of which were of longer standing than the Bank of England itself, and by country bankers, of whom the number increased rapidly in the second half of the eighteenth century. The London bankers, it is true, began not far from the year 1772 to discontinue the issue of notes, finding the check system identical in its advantages and more convenient in practice; but their right of issue was merely in abeyance, until it was formally taken away in 1844. The country bankers, however, with many vicissitudes of fortune, have continued the issue of notes to this day, subject to The English Banking System 137 the restrictions contained in the Bank Charter Act of 1844, presently to be described. That the Bank monopoly in its strict interpreta- tion also permitted the exercise of all banking functions, except issue, by joint-stock banks and companies of more than six persons, had indeed been noticed, but seems to have been little con- sidered, until the discussions of 1826, which were renewed upon the revision of the charter in 1833. The growing demands of the country for banking facilities, and the slowness with which the Bank of England responded to these demands by the estab- lishment of branches, caused much unsound bank- ing by private firms, while a lingering doubt as to the meaning of the monopoly prevented the foundation of joint-stock banks with large capital. Lord Liverpool is reported as declaring in 1826, that the effect of the law "is to permit every description of banking, except that which is solid and secure." The result of this state of things was that, notwithstanding the resistance of the Bank of England, an act was passed in 1826, giving to companies of more than six persons the right of issuing notes, when established at a greater distance than sixty-five miles from London, thus creating an important exception to the monopoly hitherto enjoyed by the Bank. The act of 1833, for renewing the charter, also expressly declared that companies and partnerships, al- though composed of more than six persons, might carry on the business of banking in London, or 138 The English Banking System within the radius of sixty-five miles, provided they should issue no circulating notes. * This legislation was followed by a great exten- sion of joint-stock banking. The London and Westminster Joint-Stock Bank, still one of the leading banks of deposit in England, was estab- lished the next year, 2 and many banks of issue began business outside of the geographical limit. The extension, however, was too rapid to be sound; the disturbed condition of business affairs for a large part of the next decade stimulated agitation; and public opinion was disposed to find in a vicious note circulation the cause of the repeated commercial crises. The terms of the act renewing the charter of the Bank of England gave to the government of Sir Robert Peel in 1844 an opportunity, both for revising the organization of the Bank, and for putting an end to the increase of the issues of the joint-stock banks, and the result was the passage of the measure known as- the "Bank Charter Act of 1844," or "Peel's Act," in which are embodied the leading pro- visions by which the bank note circulation of England and Wales is now regulated. By this act, Parliament undertook to make the notes of the Bank of England secure, and to 1 7 George IV., ch. 46; 3 and 4 William IV., ch. 98. 2 The London and Westminster was for many years under the management of James W. Gilbart, . author of several works on banking, and owes its existence largely to his sagacity. For a short account of its early struggles, see Gilbart, Principles and Practice of Banking (ed. of 1873), p. 462. The English Banking System 139 limit the issue of bank-notes of all other kinds in England and Wales. To accomplish the first of these objects the act provided for the division of the Bank into two departments, the Issue Department and the Banking Department. The former was charged exclusively with the issue and redemption of notes; the latter was charged with the other functions of banking, including the ordinary business of discount and deposit; and in all dealings with each other the two departments were made as independent as if they belonged to distinct corpora- tions. For all notes issued by it the Issue Depart- ment was required to hold either government securities, or coin or bullion; and the amount of securities which it could hold being limited by the original provision to £14,000,000, it followed that for all notes outstanding in excess of that amount it must have an equivalent in the precious metals. z As experience had shown that the ordinary uses of the country never failed to require an amount of notes higher than £14,000,000, this provision insured the presence of coin or bullion for the redemption of all notes whose presentation for 1 The act provides that of the coin and bullion held by the Issue Department one fifth may be silver. For the reason for this provision see Hansard's Debates, May 20, 1844, p. 1334. The Bank ceased to hold silver for this purpose in September, 1853, but temporarily exchanged $2,000,000 of gold for silver with the Bank of France in i860. Economist, Nov. 24, i860. The condi- tions on which silver might again be held were stated by the Bank in 1881. Conference Monitaire Internationale, ii., p. 139. 140 The English Banking System payment could be deemed morally possible, and made it unnecessary to fix any limit to the issue. The ordinary business of the Issue Department was thus reduced to the automatic function of giving out notes for coin, or coin for notes, 1 to whatever extent and from whatever quarter such exchange might be required. Under this arrangement the Banking Depart- ment carries on its business of buying securities and using its credit in the form of deposit accounts, on the same general principles on which any bank of deposit and discount is conducted. It is bound to meet all its demand liabilities in cash, and for this purpose it habitually maintains a reserve, consisting either of specie or of notes issued by the Issue Department, which are convertible into specie. It is bound to make its payments in gold, if so required, like other banks; but it may make payment in notes with the consent of the payee ; and if, for the convenience of its customers, it finds occasion to pay out a greater amount of notes than it receives in payments made to it, or in deposits, it must, procure such notes, as any other bank or any private person must, by taking an equivalent amount of gold to the Issue Depart- 1 The Issue Department is also made an intermediary between the public and the Mint, being required to buy all gold bullion offered at 77s. 9d. per standard ounce. The ounce is coined into 77s. lo}4d., the "difference being the estimated equivalent for a loss of interest, caused by the delay incident to the actual coining at the Mint. Hankey, On Banking, p. 98. The English Banking System 141 merit and procuring notes therefor. Indeed, so completely is the Banking Department deprived of all special facilities or privileges in dealing with the Issue Department, that it has often been said that, for all practical purposes, the notes might as well be issued by a public office at Westminster as by a department of the Bank itself. I The second purpose of Peel's Act is accom- plished by a series of provisions which prevent any increase of the note issues of joint-stock and private banks, beyond the « average at which they stood for the twelve weeks preceding April 27, 1844. No bank not then engaged in the issue of notes is allowed to issue them, and no bank then existing can carry its issue beyond the limit thus fixed for it. It is provided, however, that if any bank issuing notes at the time when the act was passed shall close its business, or become bank- rupt, or discontinue its issues by agreement with the Bank of England or otherwise, then the latter may add to the amount of securities held in its Issue Department, or in other words to the amount of notes for which it holds securities and not coin, to the extent of two thirds of the amount of the joint-stock or private bank-notes thus withdrawn 1 In Ricardo's pamphlet, A Plan for a National Bank (Works, p. 499), it is proposed that notes should be issued to the Bank by public commissioners, holding securities and gold substantially as at present. This pamphlet, left in MS. at Ricardo's death and first published in 1824, is the first distinct proposition for the separation of the issue and banking departments. Public discus- sion of the subject seems to have begun as early as 1837. 142 The English Banking System from circulation. The act thus plainly looks forward to the ultimate withdrawal of all other notes than those of the Bank of England, and to the filling of the vacant place by the latter, in a certain measure. T No new issues being permitted, every change, however brought about, diminishes the amount of country bank-notes left in use. The progress towards extinction has been slower than was expected. Still since 1 844 the authorized country bank issue has been reduced, by the wind- ing up of banks or »by the surrender of the right, from £8,648,853 to £335,000 in March, 1917, issued by nine banks and the Bank of England has added, under the authority of the act, to its own issues covered by securities only, until the limit has risen to £18,450,000. But it is plainly not the policy of this legislation that there should ever be a large circulation of bank-notes. The smallest note is- sued by the Bank, indeed the smallest lawfully issued by any bank since 1829, is for £5, a de- nomination too large to make its way far from cities and large towns, and of but limited use even in those places. 2 A large circulation of 1 For some comments on the intention of the act of 1844 m this respect, see Economist, 1889, pp. 505, 697. Some intimations of measures for ending the issue by country banks were given by Mr. Goschen in his budget speech, April 15, 1889. Hansard's Debates, P- 535- 2 The Bank issued no notes so small as £5 until 1795. Francis, History of the Bank of England (Amer. ed.), p. no. In I797,after the suspension, it was authorized to issue notes of £1, but with- drew them after the return to specie. It made a temporary The English Banking System 143 sovereigns, affording a solid basis of specie in the hands of the people, with a small amount of con- vertible notes for convenient use in the larger cash transactions, is the ideal condition towards which the uniform current of English law has been directed for nearly fifty years. In this matter Scotland with its convenient one-pound note, which has so long been safely issued, presents a striking contrast, and Scotch example has been frequently appealed to by those who have urged the issue of such notes by the Bank of England. The substitution of one-pound notes for sovereigns on any large scale would change materially the practical conditions under which the Bank of England has long issued its circulation. Legisla- tion for that purpose in the near future may be adopted to take the place of the one-pound and ten-shilling currency notes issued by the British Government during the European War. To illustrate more clearly the operation of the act we will take the account of the Bank as it stood September 7, 1844, being the account on which the act first took effect. The situation of the Bank at that date 1 was as follows: issue of them during the crisis at the end of 1825 and in 1826, but these also were withdrawn before 1829, in conformity with an act passed in 1826. The issue of £1 notes by country bankers was forbidden as early as 1777, but was permitted from 1797 to 1829. 1 In the Bank of England statements, Rest (i. e., the balance of the account) means the net profits on hand; Other Deposits comprise individual deposits and deposits by banks; Seven-day Bills are post-notes, still issued to a small amount; Government i44 The English Banking System Resources Liabilities Government debt £11. m'ns Capital . . £14.6 m'ns " securities 17.6 " Rest. . 3.6 " Other securities 7.8 " Public deposits 3.6 " Coin and bullion . 15.2 " Other " . 8.6 " Seven-day bills 1. . Notes . . . 20.2 £51-6 £51-6 As no attempt was made by law to protect by preference any special class of liabilities, before the passage of Peel's Act, it follows that the resources set down in this statement were held equally for notes and deposits; and it is at least conceivable that there might be so strong a demand for coin by depositors or note-holders, or both, as to exhaust the reserve, while a large issue of notes was still out- standing, in which case payment of the notes must be suspended. Thus in the extreme panic of December, 1825, the coin and bullion of the Bank was reduced to £1,027,000 and suspension was imminent, while notes were still outstanding to the amount of £23,359,840. Such a possibility became still more serious after the act of 1833 declared that the notes of the Bank, so long as they continued to be redeemed on presentation, should be a legal tender in England and Wales in all payments except those at the Bank itself. It was, therefore, an important object, in separating Debt is the loan made by the Bank to the government, in order to secure its charter; and Other Securities include loans and advances to customers upon security. The English Banking System 145 the departments, to insure the payment of the notes in any event by pledging for that purpose a sufficient amount of securities and of specie. 1 How this result was accomplished is easily seen in the form of statement of the Bank account, adopted upon the passage of the act, and ever since adhered to : Issue Department Government debt Other government securities Coin and bullion . £11. m'ns Notes . 3- " 6.2 *' £20.2 m'ns £20.2 " £20.2 " Banking Department Government securities£i4.6 m'ns Capital . Other securities . 7.8 " Rest. Notes 2 . . . Public deposits Coin and bullion . 9. " Other " . Seven-day bills £3M " £14.6 m'ns 3-6 " 3-6 " 8.6 " 1. " £314 " 1 Whether in case of the insolvency of the Bank the securities and specie in the Issue Department would be held for the pre- ferred claim of the notes, or would become a part of the general assets, to be divided among all the creditors, is not explicitly' declared by the act and has been doubted. But it has no doubt been the common understanding, from the first, that the devotion of the resources of the Issue Department to the payment of its notes is indefeasible. See Parliamentary Documents, 1857-58, v., p. 427. 2 The above shows the effect of the separation of accounts taken by itself. For convenience the Banking Department also transferred 8.2 millions of coin and bullion to the Issue Depart- ment and received notes therefor, so that in the published ac- 146 The English Banking System The thoroughness of the provision here made for the security of the bank-note is attested by the fact, that since the passage of the act there has never been a moment when the convertibility of the note has been open to doubt. The lowest point to which the notes in actual circulation out- side of the Bank have ever been reduced was a little below £17,000,000 in December, 1848, and this left in the vaults of the Issue Department nearly £14,000,000 in specie, with no demand for it on the part of the public. Indeed, the Bank of England note, under the act of 1844, has become little .more than a warrant entitling the holder to so much gold actually lying in the Bank vaults, and thus the whole question as to the solvency of the paper currency has been removed from the field of debate, where it had been agitated for so many years. The Issue Department gains nothing from an increase of the circulation, and can lose nothing by its diminution. The whole problem^ as to the bank-note is reduced to a mere inquiry as to the preference of the public for coin or for a certificate calling for coin. It is evident also that to the Banking Depart- ment it is of no consequence, except as regards convenience, whether it uses notes or gold in its business. If it prefers gold it has only to send in for redemption such notes as it holds or receives counts the banking reserve was 8.2 millions of notes and .8 million of coin, and both the notes and the coin and bullion in the account of the Issue Department were raised by 8.2 millions. The English Banking System 147 in the course of its business; if it prefers notes it has only to send in its gold for exchange. Its reserve is in fact composed like that of any other bank, of gold or of notes which are good for gold, or of both; and this reserve it must procure, must maintain, and in case of need must replenish, as any other bank must, by properly adjusting its purchases of securities. Its profits would obvi- ously be the same as now if it discontinued the use of notes altogether, except so far as its business might be affected by the mere difference of conven- ience to its customers. Indeed, nearly the whole income of the Bank of England, beyond the simple return on the investment of its capital, is derived from the use of its credit in the form of deposits in the Banking Department. So far as concerns the Issue Department, the only possible source of in- come open to it under the act of 1844 is limited to the interest received on the government debt and securities held by it now amounting, as has been said, to £18,450,000. This interest is offset, how- ever, by payments to the government and by other charges,, to such an extent that the question has been raised seriously, whether it would not be for the advantage of the stockholders if the Bank were relieved from all connection with the issue of notes. Complete as is the separation between the de- partments in theory, and generally even in fact, it has nevertheless happened several times, under the exceptional conditions of a financial crisis, that the embarrassments of the Banking Depart- 148 The English Banking System ment have affected the issue of notes, in a manner not originally contemplated by the framers of the act. On four occasions it has been found necessary to disregard that provision which limits the securi- ties held by the Issue Department, and more than once besides this extreme measure has been escaped with difficulty. r In order to understand the real significance of these occurrences, it is neces- sary to take into consideration the circumstances under which the Bank of England holds its banking reserve. The most striking fact in the situation of the Bank of England is that the Bank is the center of a great system of joint-stock and private banks, whose aggregate business and liabilities are many times greater than its own, and that to this system of banks are confided the financial affairs of the city which may almost be said to be the Clearing House of the world. It is at all events true that many of the largest trades in the world make their settlement in London, and that especially the world's supply of gold there finds its natural point of distribution. From this it would follow, even if England were not herself a great lender of capital, that many of the operations of lending and paying undertaken in other countries must be 1 The limiting clause of the act of 1844 was disregarded, or, as is commonly said, "suspended," October 25, 1847, November 12, 1857, May 12, 1866, and July 31, 1914. In February, 1861, and in May and September, 1864, the condition of things was critical; and in November, 1873, the suspension of the act appeared for some days not improbable. The English Banking System 149 carried on through London. The banks through which a cosmopolitan business of this kind passes must at times find themselves subject to great and sudden demands. The nature of their liabilities is not constant; it varies with every change in the condition of any foreign country of importance, and is at one time steady, and at another time uncertain. The reserves, therefore, which are at one time adequate for the protection of these liabilities, are at another time too small. These reserves, however, which belong to the individual members of the great system of banks, are in practice not held by the banks themselves. The London banks, from long habit, keep their chief reserves as private persons might, deposited in the Bank of England, retaining in their own hands only such small amounts as are needed for the demands of the moment, and drawing upon the Bank for more important sums. Of the "other deposits" of the Bank of England a large part represents the liability of the Bank to its neighbors incurred in this manner. * 1 In 1877, when the bankers' deposits in the Bank of Eng- land were reported on, their maximum and minimum points were in January and May respectively, the deposit accounts standing as follows: January 10. May 10. Exchequer deposits . £1.2 millions. £ 4.4 millions. Bankers' " . . 13-3 " 8 - All other " . . 18.3 " _I5£ " Total . . £32.8 " £28.3 " For this report see Parliamentary Documents, 1878, xlvi. 150 The English Banking System The position of the Bank of England, then, is not simply that of a bank whose deposits are liable to sudden fluctuations of a peculiar nature ; it is also a position of great responsibility. The Bank holds in its charge that on which the solvency of the banks in general, the safety of the commercial public, and the credit of England alike depend. Its managers have sometimes professed to regard it as simply a bank carried on for the profit of its own stockholders; but so long as it holds the banking deposits it has in its hands the financial safety of the whole community and the real leader- ship of the money-market, and cannot escape its accountability for the manner in which it per- forms the duties of its position. As regards the issue of notes its duties are too plain and even mechanical to throw upon it any serious burden of this kind, but as the depository of the other banks it is in effect charged with the duty of providing in large measure for the safety of all. Its sources of profit being the same, however, as those of other banks, the Bank of England finds its interest, as they do, in the conversion of idle cash into loans and interest-bearing securities, and in holding, therefore, no larger cash reserve than is required for safety. Acting on this reserve by raising or lowering its rate of dis- count, it may defer too long the diminution of its business by the raising of its rate, and may thus keep itself weak, down to the moment when it needs to be strong. And it may happen, moreover, The English Banking System' 151 that the reserve, being suddenly reduced by causes not to be foreseen, cannot be raised by the slow- action of the rate of discount, in time to escape all the consequences of such misfortune. 1 In every case of remarkable pressure which has occurred since the separation of the two departments, and in most of those which happened before, the real difficulty presented will be found to have been that of meeting liabilities for deposits with a reserve which had become insufficient, either from continued negligence in the past, or from the sudden possibility of demands on a great scale. Of these cases we will take as an illustration of the present topic, the critical situation of the Bank in the great commercial panic of November, 1857, a case which may fairly be regarded as typical. There is no doubt that in England the materials for a crisis had been long in preparation. Rapid commercial expansion and a great extension of credit had brought the usual results in the form of unsound business, of speculative prices, and of extreme sensitiveness to any threatening influence. If no unusual pressure had occurred all might have passed off in a mere subsidence of activity and in general depression ; but the sudden occurrence of a disastrous revulsion in the United States, bringing ruin to some and carrying apprehension to all, developed a crisis which took the whole community of Great Britain by surprise. In August the state •That the Bank may lead, but cannot control the market, by changes of rate, see Bagehot's Lombard Street, p. 1 14. 152 The English Banking System of things was reported to be "not unsatisfactory, " and no fear seems to have been felt until the middle of September, when heavy failures in New York, beginning with that of the Ohio Life Insurance and Trust Company on the 24th of August, became known in London. Still, although gold began to leave England for the continent, and the pressure in New York had caused the cessation of specie exports to England, the directors of the Bank of England seem not to have thought the difficulty serious. It was not until October 8th, when the news of the general suspension of pay- ments in Philadelphia and Baltimore proved that something more than an ordinary embarrassment existed, that they determined to raise their rate of discount, from the point at which it had stood since July 16th, to six per cent. At this point the condition of the Bank was disquieting. In the course of three weeks it had materially increased its loans, but was losing seriously from its reserve, so that the proportion of reserve to liabilities had changed much for the worse, at a time when general uneasiness was beginning to make the commercial public more than ever anxious to bor- row, as a prudent provision for the uncertainties of the immediate future. It may fairly be said then, we believe, that a singular tardiness of action on the part of the Bank was the immediate cause of much that ensued. Without following the steps by which the crisis from this point was converted into panic, we will The English Banking System 153 take the state of things existing in the early days of November, when the Bank rate stood at eight per cent. At this juncture, the alarm caused by the failure of several large firms and of one or two provincial banks of some importance had intensi- fied the demand for loans, both upon the Bank of England and the other banks in the city. The increasing disposition of -the latter to strengthen their own position, in view of the possible heavy demands to which their great liabilities exposed them, not only threw much of the increased pressure for loans upon the Bank of England, but also led to a marked increase in the bankers' balances — that is, in the deposits of reserve by other banks. At the same time with this serious change in the amount and character of the liabilities, the cash resources of the Bank were falling. An active export of specie to the United States had taken a considerable amount from the reserve, the rise of rates on the continent of Europe had made it impossible to draw specie from that quarter, and the apprehension of banks in the interior led to a serious absorption of cash by them. In short, at a time when it was called upon to extend its use of its own credit, the Bank found itself acted upon by what has been called an internal drain as well as an external one. The Bank met this dilemma by raising its rate of discount on the 5th to nine per cent., in the hope of repelling the least necessitous borrowers, and by making in the course of the next week an increase 154 The English Banking System of loans to the amount of three millions and a half. Before the end of the week, however, the state of affairs had become desperate. The general alarm had deepened with the rapid succession of failures in the commercial world and the suspen- sion of the great Western Bank of Scotland, and the moderate increase of loans by the Bank of England had done nothing toward quieting the public. Some sales of securities had been effected by the Bank, but the drain upon its reserve as well as the increasing liability for bankers' deposits continued. The rate of discount was raised on the 9th to ten per cent, but without avail. The joint-stock banks and private bankers had finally ceased dis- counting, so that from Monday, the 9th, the whole demand for loans was thrown upon the Bank of England, whose reserve by the nth had fallen to little more than one tenth of its "other deposits." On that day came the suspension of the City of Glasgow Bank, caused by the general alarm created by the failure of the Western Bank; other banks called for assistance; and a great discounting firm in the city failed on the same day. In four days, beginning with the 9th, the Bank advanced to the public over five millions sterling, but without the effect of subduing the panic or stopping the drain of its reserve. On the evening of the 1 2th it found itself with a liability for deposits amounting to thirteen millions, and a reserve of cash in its Banking Department of only £581,000,' 1 Of this only £384,000 was in London, the remainder being The English Banking System 155 an amount which more than one depositor could exhaust by his single check. This feeble reserve might be expected to disappear before the close of the next day. In all this there had been nothing resembling a run upon the Issue Department. Gold required for export or for the interior was indeed drawn ulti- mately from that department, for it was provided by those who were directly or indirectly creditors of the Banking Department, who drew therefore from the banking reserve and thus caused notes held in that reserve to be presented to the Issue Depart- ment for redemption. But the gold was not obtained by the presentation of notes hitherto in circulation or held outside of the Bank, for from the 10th of October to the nth of November, the amount of notes thus in the hands of the public is shown by the account to have been almost without change. What had occurred was that the Banking Department had been caught, at the beginning of a severe pressure, with an insufficient banking reserve and had been slow in taking measures for escape. The position of the Bank was such as that of the London and Westminster Bank might have been, had its reserve of cash run down while its liability was large, except that the latter had no chain of dependent banks. It was a case of near approach of failure, as simple in its essentials as that of any private banker who is unable to meet held by the branches of the Bank. See Parliamentary Documents, 1857-58, v., p. 55- 156 The English Banking System his depositors, or any incorporated bank which is not a bank of issue and meets with similar mis- fortune. Thus the Bank, on the 12th of November, reached the end of its tether. Following the precedent of the year 1847, therefore, the man- agement informed the [government of the criti- cal condition in which they stood, and received in return a virtual authority for the issue by the Issue Department of a further amount of notes secured by government securities. 1 Thus em- powered, the Banking Department transferred to the Issue Department securities to the amount of two millions, and in exchange therefor received notes which were placed in the reserve. The operation was in effect a sale of securities to the Issue Department, in default of other purchasers, and the receipt of payment in notes, redeemable on presentation. The effect on the Issue Department was to increase the absolute amount as well as the proportion of notes issued by it upon securities instead of coin or bullion, but the notes did not 1 This practical setting aside of an act of Parliament was in the form of an assurance that, if the Bank found it necessary to take the step proposed, the ministry would ask Parliament to indem- nify the Governor and Company for any consequences of such illegal action. Besides the publication of the entire correspond- ence in the Parliamentary documents, which has been made on every occasion of the suspension of the Bank Act, the "govern- ment letter "is given by the Economist of November 14, 1857, and all the correspondence for 1866 in the Annual Register of that year, P- 3°5- The English Banking System 157 cease to be redeemed in the regular course of business. Carried to a great extent the operation might plainly have weakened the notes by en- dangering their convertibility. Restricted as it was, however, it cannot be said to have had any real influence on the credit of the note issue. It gave to the Banking Department an immediate accession of means to the amount of two millions, with the assurance that more could be had if needed, the only discernible limit to the relief being the conceivable inability of the Issue Depart- ment to continue the redemption of an indefinitely enlarged issue of notes — a theoretical limit too distant to have any practical bearing. z The real assistance given to the Banking Depart- ment, however, did not consist so much in the actual addition of cash to its resources, as in the quieting effect of the measure on the public mind. In every such state of affairs it is a factor of prime consequence that much of the public excitement is pure panic, — an unreasoning terror, which multiplies danger by destroying presence of mind. For the easy movement of business under the credit system, confidence in each other and in the future is necessary. The producer or merchant, using borrowed capital, relies upon the sale of goods and upon fresh loans for the means of repaying former advances, and if the current is 2 This whole subject was reported upon, with evidence, by a select committee, in Parliamentary Documents, 1857-58, vol. v. 158 The English Banking System interrupted, if doubt on the part of buyers pre- vents sales, or embarrassment of lenders pre- vents or diminishes loans, the fears of debtors to whom the failure to make their payments punctu- ally means bankruptcy and ruin, become at times ungovernable. No man is any longer sure of any- thing except his own indebtedness and its near maturity; there is a universal pressure to borrow, even beyond the real needs of the moment, lest borrowing should presently become impossible; and there is a universal tightening of the grasp on all ready means by such as are so fortunate as to have them. The sauve qui peut of merchants, who are desperate as to their means of payment, is as mutually destructive and as fatal to their hopes of escape, as is the crush of a panic-stricken audience, blocking the exit from a burning building. To a community thus dominated by universal terror, the Bank of England was able to say that its potential reserve was now so enlarged as to fix no limit to its ability to extend its loans and meet all consequent liabilities. The effect of this assurance in allaying the panic was instantaneous. Men ceased to press for what might not be needed after all, and the other banks in the city, no longer dreading demands from their own depositors, re- sumed their operations. Confidence had indeed suffered too severe a shock to recover without that process of liquidation which is called a revulsion of business; but the liquidation, instead of being im- mediate, could now be gradual enough to enable The English Banking System 159 debtors to collect and realize upon their resources with some deliberation. It was not then so much the four millions which the Bank felt safe in adding to its securities in a week after the suspension of the act of 1844, as the moral relief given to the public, which constituted the real remedy by which the crisis was ended. As for the change in the amount of the note issues of the Bank, we may fairly deny that in itself it had any influence whatever, so trifling was its amount. The notes issued in excess of the statutory limit, and actually in the hands of the public, stood at their highest point on the 20th of November, when they amounted to £928,000, and by the end of the month the Issue Department had returned to its normal condition. 1 Indeed the difference between the minimum and maximum of the out- standing notes for the month was only £1,300,000. The conditions on which this singular abandon- ment of the terms of the Bank charter has been allowed are jealously guarded. The Bank has been required to pay over to the government all profits made by it from any increase of issues above the statutory limit, 2 and both in 1857 and 1866 it 1 This opinion, that the relief given by the suspension of the limit fixed by the act is a moral relief and is not to be found in the actual issue of notes, is confirmed by the fact that neither in October, 1847, nor in May, 1866, was the issue of notes upon v securities increased at all, — the mere announcement that such issue would be made, if needed for the reserve, being sufficient to quell the panic. 2 The profit on the increase of issues above the limit in 1857 was 160 The English Banking System was required to maintain its rate of discount at ten per cent., so long as it should use the permission given to it. As this rate would drive away business from the Bank as soon as the rate in the gen- eral market should fall, this condition insures as speedy a return to the legal limit of the issue as is practicable. Whatever the conditions, however, the repeated resort to this extra-legal measure is a remarkable departure from an elaborate scheme of legislation in favor of a crude expedient, and does not easily find its parallel, even in English administration. And the question has been raised, with good reason, as to the real value of a legal limit, which everybody believes will be set aside when it begins to press. No such mistakes of manage- ment could now occur as marked the whole course of the history of the Bank in the first half of the last century. The Bank was not quick to learn the real risks of its position and its responsibilities; but still it has learned them, and now guards its reserve with vigilance, by appropriate means, and with general success. It takes the alarm sooner than formerly, it sets its customary line of sup- posed safety higher, and thus, in the great crisis of 1873, it escaped the disaster which befell it in 1857 in a condition of affairs not more dangerous. Upon the outbreak of the European War in 1914 the act was again suspended by an Order-in- calculated on £2,000,000, for 41 days at the rate of two per cent., Parliamentary Documents, 1857-58, xxxiii., 271, 275. The English Banking System 161 Council. On this occasion there was a small excess issue for a period of only five days, pending the preparation of currency notes issued by the gov- ernment. Legal authority for the suspension of the restriction on note issue in future emergencies was granted by Parliament in August, 1914. But the perfection of the provisions of law, even after this change, is doubtful. An elastic provision like that contained in the German legislation would be easier in operation and equally effectual. Power, such as that possessed by the Bank of France, to issue notes unfettered by special restrictions would seem to be even more effective and at the same time entirely consistent with safety for a well managed central bank, like the Bank of England, strong in the confidence of the people. From what has been said, it will be seen that the Bank of England, although a highly privileged establishment, is not a government institution. It has a partial monopoly of the right of issuing notes, which in theory is destined to become com- plete; it has the distinction of having its notes the only paper legal tender in the United Kingdom; it is the chief depository of a government which maintains no public treasury; it is charged with the duty of keeping the registry of the public debt, and of paying the interest thereon; still it is a private corporation of the familiar type, managed by its own officers, in whose selection the govern- ment has no share, and whose responsibility is to their own stockholders alone. The Bank has 162 The English Banking System duties thrown upon it, partly by law and partly by force of circumstances, which make it a highly important member of the body politic, and yet it is in form a corporation intended to earn dividends for the owners of its stock. For many years after its foundation it was even forbidden by law to lend to the government, beyond a certain narrow limit, without the express sanction of Parliament, 1 and although it has now for a long time been a trusted agent, and has at times com- promised its own safety by its financial support of the Exchequer, it has never failed in its dealings with the authorities to assert its own essential independence. The peculiarities of this position, which some- times lead to an erroneous classification of the Bank of England as a government bank, have been much emphasized by the manner in which the other constituents of the English banking system have developed in recent years. The private banking houses have steadily declined in number. The advantages of joint-stock organization and limited liability have led in many cases to their absorption or conversion into companies of larger capital, and have hindered the opening of new private banks, even if establishments of such a decaying type could any longer command the credit once given to them in the English financial world. On the other hand, the joint-stock and limited companies have grown rapidly in the last 1 This prohibition continued until the year 1793. The English Banking System 163 two generations, both in relative and in absolute- importance. 1 They have felt the strong modern tendency to concentration and by consolidations have greatly diminished their number, but with a vast increase, not only of individual, but of ag- gregate importance. At the same time, by the establishment of branches they have everywhere brought themselves into close contact with the general commercial life of the country, so that most of the banking of English trade and com- merce is now carried on by their agency. The Bank of England, on the other hand, having established eleven branches before the year 1830, has gone no farther in that direction. 2 It enters into little competition with its younger neighbors for the business which is offered by the growing industry and wealth of the nation, but is satisfied with the scope which its position as the head of the banking hierarchy affords for employing its capital and the energies of its managers. Its long-existing prestige and prescriptive leader- ship have enabled it to maintain relations and acquire an influence whose importance is not measured by the magnitude of its banking opera- tions. This influence, it must be added, is due 1 In May, 1890, there were 104 joint-stock banks in England and Wales, with nearly two thousand branches. In May, 1917, there were only 35 joint-stock banks, but with more than six thousand branches. For English banking statistics generally, see the Banking Supplement published by the Economist in May and October. 2 The location of its branches has undergone some changes. 164 The English Banking System only indirectly and in a small degree to any con- nection between the Bank and the government. The fact that the Bank is the depository of the public moneys and performs for a consideration some other public functions, does not give it in any special way the protection or support of the government, nor place it in any way under the control or direction of any public officer. Its present position and power over the London money market is a development from a long train of causes which have finally imposed upon the Bank some of the responsibilities of a public institution. It is only by degrees and reluctantly that its management have been led to recognize the fact that the Bank is under obligations essen- tially different in kind and in range from those resting upon any of its neighbors. Perhaps the most striking illustration of an extra legal obligation recognized and acted upon by the Bank is the action taken by it in the emergency created by the suspension of the great firm of Bar- ing Brothers & Co. in November, 1890. The Bank then undertook, with great judgment and energy, to save the public from a possibly disastrous panic. To do this, it not only strengthened its reserve by borrowing £3,000,000 from the Bank of France and £1,600,000 from the Russian government, but it undertook, with the aid of other banks and bankers, to guarantee the payment at maturity of all obligations of the failing house, and to look for repayment to the gradual collection of its The English Banking System 165 assets. To this guarantee the Bank was the largest subscriber, the directors agreeing to risk £1,000,000 in the liquidation of an indebted- ness of £21,000,000, and the marketing of a corre- sponding mass of assets, a considerable part of which were supposed to be of uncertain value. 1 It is true that this risk, assumed by the Bank in order to quiet public apprehension, was to be weighed against the loss which might fall upon it if a general panic were to break out and run its course of ruin. Still, it was the general opinion at the time that the directors deliberately set at risk a substantial part of the property of their stock- holders in a manner required neither by any legal obligation nor by a calculation of probable advan- tage, and their right to deal in this manner with the interests entrusted to their care was questioned by some writers. By a natural although illogical process, the success of the operation disarmed criticism, 2 objection died away, and thus a pre- cedent was established which in any future case of the same kind the Bank would find it hard to set aside. The Bank is governed by twenty-four direc- tors, who, by long established custom, must not be bankers, and by a governor and deputy gov- ernor. The directors are elected annually, and 1 Two or three of the large joint-stock banks subscribed £750,- 000 each. The total guarantee was £17,250,000. 2 The liquidation was finally closed in January, 1895, with a balance of more than half a million pounds in securities to be returned to the firm. 166 The English Banking System by usage a part of the board is changed every year; but the changes take place among the younger members, so that after some years of possibly intermittent service, the director's tenure of his position is practically for life. After many years he usually becomes deputy governor for two years in due rotation, and then governor for the like term, after which and for the remainder of his official life he is a member of an executive council of directors known as the committee of treasury. The director enters upon office, therefore, at an early age, and reaches the positions of most active responsibility only after a long training in the Bank itself. Such an organization would hardly be proposed if the case were new, but it is, no doubt, well fitted, to preserve the traditions of policy and of management which secure the Bank from rapid change. 1 1 On the government of the Bank, see Bagehot, Lombard Street, ch. viii. CHAPTER IX THE FRENCH BANKING SYSTEM Prom 1793 to the latter part of 1796, banking can hardly be said to have existed in France. The government tolerated no issue of paper except its own; the Caisse d'Escompte, which for many years before had been the only public bank, had been suppressed, and the times were too disturbed for private banking to nourish. With the dis- appearance from circulation of the assignats, and of their successors, the mandats territoriaux, the issue of notes appears to have become a matter of common right, to be undertaken by anybody who could gain the confidence of the public; and accordingly a bank of issue called the Caisse des Comptes Courants was organized in Paris in the last half of 1796, and began its opera- tions with fair success. Two others of some importance were established by the year 1800, besides some smaller ones of which little is now known; and in Rouen a bank of dis- count and issue was in active business as early as 1798. It is clear that, with the return of orderly government and the revival of credit, the need of banks began to press. 167 168 The French Banking System" Under these circumstances the Bank of France was also established in Paris in 1800, with the encouragement of the government and even with the First Consul as one of its stockholders, but still upon a footing not essentially different from that of its neighbors. Its capital of 30,000,000 francs was the largest yet proposed, and the diffi- culty for raising it led to a fusion with the Caisse des Comptes Courants, but no monopoly was created. One public bureau, holding a large amount of funds, was required to invest them in shares of the new bank, and large deposits were made in it by the government; still, although favored, the Bank of France stood legally upon an equality with the rest and nothing more. 1 So far it might be said that the field was open in France for a wide and free diffusion of banking facilities, and that by the new establishment the government pointed out the way for its citizens. In 1803, however, Napoleon announced a com- plete change of policy, and the Bank of France was endowed with the exclusive privilege of issue in Paris 2 until September 24, 18 18, and its capital 1 Courtois, Histoire des Banques en France, pp. 108-112. The articles of association, containing the statutes of the Bank, adopted by the shareholders at the start, are in the Moniteur, 5 Pluv. VIII. (25 January, 1800). 2 Banks of issue could be formed outside Paris with the consent of the government, but none were established until after the Restoration. For evidence of the active hostility of Napoleon towards other banks of issue, see Courcelle-Seneuil, TraitS des Operations de Banque, p. 216. The French Banking System 169 was raised to 45,000,000 francs. * All other issues of notes were at once withdrawn, one of the rival banks in Paris was absorbed by the rising mo- nopoly, and another assumed for a time the hum- ble place of intermediary between the great bank and its less important customers. No provin- cial bank could thereafter be established except by authority of the government. Under this arrange- ment, and notwithstanding the provision that no notes should be issued in Paris for less than 500 francs, the circulation of the Bank rapidly in- creased with its expanding discounts. It is plain in fact that the strong preference of the public for bank credit in the form of notes left but a narrow field for those banks which could only open deposit accounts, and justified the government in its opin- ion of the importance then to be attached to the right of emission. And the fact that in the existing state of things, with the existing habits of business, credit in the form of notes was so strongly pre- ferred gave to the monopoly of the Bank an influ- ence on the future history of banking in France far beyond that which a similar monopoly could have exercised in the same years in England. Although the Bank of France still chose its own officers and enjoyed a nominal independence, it 1 The law of 24 Germinal XI. (14 April, 1803) is in the Bulletin des Lois, and, with most of the subsequent legislation concerning the Bank down to 1857, is also given in Wolowski, La Question des Bangues, p. 425. The statutes of the Bank of 1803 are in the Moniteur, 15 Brumaire, XII. (7 November, 1803). 170 The French Banking System was now becoming involved in the bold operations of the French Treasury. Complications thus arising reduced the cash in the Bank, in the latter part of 1805, so far that it was found necessary to limit the redemption of notes to 600,000 francs daily, until such time as specie could be collected in sufficient quantity for complete resumption. The result of this crisis, however, was not to sepa- rate the Bank from the government, but to connect them still more closely; and in the spring of 1806 a measure was therefore adopted which definitely settled the character of the Bank as a public in- stitution, but without any alteration in the es- sential principles of its organization as a bank. By the doubling of its capital and the extension of its privilege to 1843, 1 not only its preeminence in the financial affairs of France, but its absolute importance in the European world, was assured, so far as depended on legislation. At the same time 1 the direction of the Bank, hitherto confided to a board of regents chosen by the stockholders, was transferred to a governor and two sub-governors, to be nominated by the chief of the state. Under a government not inclined to use power for its own ends, this species of control might easily have become a mere trusteeship on the part of the state ; under an emperor like Napoleon it made the bank an engine of the state, — a private corporation, indeed, as regards the legal ownership of its prop- * In 1840 the privilege was extended to 1867, in 1857 to J 897. and in 1897 to the end of 1920. The French Banking System 171 erty, but a public office as regards the actual employment of the property. Successive govern- ments in France have used this opportunity in different ways as the case has seemed to require; but such as Napoleon made the Bank, in pursuance of the law of 1806, it has remained ever since, — an institution subject to the control, and often available for the needs, of the government of the day. 1 In the closing years of the Empire this subjection of the Bank to the government caused a great increase of transactions with the Treasury, which became more and more compromising and finally far exceeded in amount the advances made to the commercial public. When, therefore, France was invaded by the allies in the winter of 1813-14, a run by the note-holders began, caused, it is prob- able, chiefly by the fact that the Bank appeared to have no independent existence of its own, and it again became necessary for three months to limit the amount of the daily redemption of notes to 500,000 francs. Full payment was resumed in April, 1814, but the settlement of the affairs of the Bank was pushed on both sides, until its loans were reduced to less than 3,000,000 francs 1 The statutes of the Bank, under the law of April 22, 1806, were established by the Emperor, January 16, 1808. See Wolow- ski as above, Bulletin des Lois, and Moniteur, January 18, 1808. In Block's Dictionnaire de V Administration is a detailed account of the organization of the Bank. See also Say, Dictionnaire des Finances. 172 The French Banking System and its circulation had fallen from 95,000,000 francs to 15,700,000. z The enlarged capital of the Bank had been found, even in the latter years of Napoleon's reign, to be greater than could be used with profit, and the Bank had therefore, as early as 18 12, made large purchases of its own stock. These were continued in 18 16, until the capital was reduced to 67,900,000 francs, at which point it remained until 1848. By the decree of 1808 the Bank had been author- ized to establish branches {comptoirs d'escompte), subject to approval by the government, plainly with the design of centralizing the banking interests of the Empire under the lead of the great Bank in Paris. Under this decree the establishment of branches in Lyons and Lille was undertaken, although with little success, and one was set in operation at Rouen. The Bourbon government in 18 1 7 and 18 18 closed these branches and estab- lished independent banks at Rouen, Nantes, and Bordeaux, giving to them the right of emission, and thus reversing the policy of Napoleon. The government of July, following a similar course for a time, established independent banks at Lyons, Marseilles, Lille, Havre, Toulouse, and Orleans, and also authorized the Bank of France to open 1 The Moniteur for January 31, 1815, contains a report by Lafitte, then provisional governor of the Bank, giving in some detail the operations for the year 1814. For tables giving the leading figures of the accounts of the Bank from 1800 to 1879, see Courtois, Histoire, pp. 344, 360. The French Banking System 173 branches in fifteen other provincial towns and cities, with the monopoly of issue for every place in which a branch was established. Vigorously pursued, this mixed system of branches and of in- dependent banks might easily have been made the means of introducing banking facilities through- out the kingdom, to the great advantage of the country. But no strong policy was adopted; the government established new banks for a time with reluctance and under hard conditions, and after 1838 withheld its encouragement altogether; and the Bank of France, opening its branches fitfully and with little regard for public needs, seemed to prefer that affairs should drift. The revolution of 1848 found in existence, then, the Bank of France, with its fifteen branches, and also nine independent banks of issue. No system of exchanges or of redemption at a common center had been adopted by the latter; even the branches of the great Bank redeemed each other's notes only at pleasure ; so that France felt all the inconveni- ences of having many issues of notes with but local credit. The suspension of specie payment and the legal-tender power given to the notes of the Bank of France, and to those of the independent banks alike, added to the confusion, and in the spring of 1848 the provisional government finally cut the knot, by making all the independent banks branches of the Bank of France. Their share- holders, in exchange for their old stock, received shares in the Bank, and the capital of the latter 174 The ^rench Banking System was thus raised to 91,250,000 francs. At the same time the issue of notes of 100 francs was author- ized and the total issue of the Bank was limited to 452,000,000 francs. Political and socialist agitation had destroyed all commercial confidence and a rapid liquidation went on; the discounts of the Bank fell off, specie flowed in, and in June specie payment was practically re- sumed, and the legal-tender provision might perhaps have been abrogated with safety, had the Bank been left to itself. The Treasury, however, was embarrassed, the Bank saw few opportunities of using its resources profitably, and advances to a considerable amount were therefore made by it to the government. Partly as a consequence of these advances the limit of the note circulation was raised in December, 1849, to 525,000,000 francs; and the suspension of specie payment was not ended and the legal-tender power of the notes destroyed, until August 6, 1850. By these means, aided by its own great prudence, the Bank not only passed through the gloomy years from 1848 to 1852 without serious loss, but continued when affairs were at their worst to earn a modest profit for its stockholders. Moreover, its monopoly of note issue had been reestablished in practically the form in which it had been projected by Napo- leon, and all subsequent legislation has tended to strengthen the existing system. A great expansion of the business of the Bank began in 1852. The coup d'etat, which opened the The French Banking System 175 way for a restoration of imperial government, at all events removed political uncertainty. Com- mercial confidence thereupon revived, and the discounts and advances made by the Bank rapidly increased, and in 1853 touched a higher point than was ever before known. In view of the general expansion it is not surprising that in 1857 the government determined to double the capital of the Bank, raising it to 182,500,000 francs, at which it now stands. In return for the extension of its charter to 1897 the Bank was required to make a permanent three per cent, loan of 100,000,000 francs to the government, the entire amount derived from the issue of new stock which was taken by the shareholders at a premium. Per- haps the most important of the new features of the charter was the provision made as to the rate of dis- count. For the greater part of its existence the Bank had striven to maintain the uniform rate of four per cent. The statutes of 1808 had fixed at three months the maximum length of the paper to be admitted to discount, but in periods of difficulty the Bank had sometimes lowered this limit to seventy-five, sixty, and even forty-five days. In 1854, however, and for some years after, it tried at variable rate of discount, but then found itself hampered by a law passed in 1807, which made six per cent, the limit of legally chargeable interest. The charter of 1857 freed the Bank by special exemption from this restriction, allowing it to charge such rate as it might find advisable, with the 176 The French Banking System provision, however, that the profits earned by charging a rate above six per cent, should not be divided but carried to a permanent surplus. The charter of 1857 also authorized the issue of notes as small as fifty francs, and the govern- ment was empowered after 1867 to require the opening of a branch in every department. The Bank was reluctant, but before 1869 sixty-five branches had been authorized. The republican government in 1873 again applied the spur, and in 1880 all the required branches had been author- ized, although a few were not brought into opera- tion until as late as 1882. Since that time the number of communities directly served by the Bank has been further increased, in part upon the initiative of the Bank, but in some measure in response to requirements imposed when its charter was revised in 1897 and again in 191 1. In 1 9 14 there were 142 branches and a great num- ber of auxiliary offices, "making in all 583 "places bancables." Although branches of the Bank of Prance do not perform all the functions of the ordinary bank, ', the insistent pressure for the extension of its facili- ties affords striking evidence of the slow develop- 'ment in France of adequate banking facilities. In addition to the necessity resting upon it as a central bank to keep itself in a highly liquid con- dition, the Bank of France is subject to a special statutory restriction which narrows the field of its operations. The Bank may discount only paper The French Banking System 177 bearing three signatures, unless accompanied by a limited range of securities or by warehouse receipts which may be taken in lieu of one signature. The practical effect of this restriction is to limit the business of the Bank almost entirely to rediscounts for other banks and bankers except in localities in which such lending agencies are lacking or in- sufficient. In England and in the United States, countries in which banking facilities are widely diffused, little or no business except from banks would be secured by a central bank which re- - quired three signatures. In France a considerable part of the business at the smaller branches comes from individual borrowers. The slow development of adequate banking agencies in France is to be attributed to a variety of causes. The monopoly of note issue has worked powerfully against the spread of banking facilities among a people which has manifested a strong preference for coin and notes as a medium of payment. Aside from the Bank of France and the short-lived provincial banks of issue, the business of banking until after 1848 was conducted entirely by private banking firms working with their own capital and the funds left with them more or less permanently by a limited circle of depositors. Some of these firms were financially powerful, but many were weak and failures were numerous, especially in 1830 and in 1848, the years of revolu- tionary changes in government. The first incorporated banks of discount and 178 The French Banking System deposit were established during the period of rapid economic advance which marked the early- years of the regime of the third Napoleon. The number of deposit banks in France has, however, at no time been large, and since the last decade of the nineteenth century four large credit institu- tions operating numerous branches have virtually monopolized the entire field. The considerable though declining number of private banking firms find it increasingly difficult to hold their own in competition with the credit banks. These institutions compete vigorously with each other, but only within the narrow limits which are largely determined for them by the magnitude of their operations and the wide geographical diffusion of their branches. Little initiative can be allowed the managers of the branches, who are subject to rigid rules and constant supervision from the head office. Loans based on confidence in the character and ability of the borrower the branch manager cannot be permitted to grant since he is commonly a stranger only temporarily in the locality. Small regional banks operating a few branches could make such loans with less danger of frequent losses, but banks of this kind have not been able to live in competition with the great Paris banks which absorb the bulk of the loans of the highest quality throughout the entire country. With the opening of the Franco-German war in July, 1870, the Bank of France entered upon the most remarkable period of its existence, — The French Banking System 179 that in which its vicissitudes were most startling and critical, its services to the country most distinguished, and the success of its management most brilliant. Three weeks before the breaking out of hostilities the Bank of France had in its vaults a reserve of cash almost equal to its notes, and amounting to nearly two thirds of all its cash liabilities. * The approach of war caused a heavy pressure upon the Bank for loans, and both notes and specie were drawn from it in large amounts, and began to find their way either into private hoards or into foreign hands. Neither the government nor the public could see with patience this dis- persion of a stock of specie which, it was felt, might be an important resource in the desperate struggle with Germany, and suspension of pay- ment as a precautionary step thus became probable early in August. Shortly afterward the govern- ment resolved upon the adoption of a measure sus- 1 The chief movements in the account of the Bank of France, caused by the war, can be seen in the following table, given in millions and tenths; Disc'd Public Notes Deposits Cash Paper Loans 1870, June 23 . . 1,374. 431-9 i,3i8-5 558-1 Aug. ii . . 1,583.6 582.2 1,028.6 1,181.7 Sept. 8 . . i,745- 441-8 808. 1,428.3 1871, June 29 . . 2,213. 524.1 549.8 741.9 1,403 June 23d was the day when the cash was at its maximum for 1870; August nth was the day before the suspension; no account was published between September 8, 1870, and June 29, 1871. 180 The French Banking System pending the collection of commercial obligations, and this made the suspension of the Bank a neces- sity. On the 1 2th of August, then, four weeks from the beginning of the war, a law was passed, as a government measure, and with but one dissent- ing vote in each house, authorizing the Bank to refuse payment of its notes in specie, and for the I second time in its history making its notes a I legal tender for debts public and private. The issue was at the same time limited to 1,800,000,000 francs, and authority was given for the emission of notes as small as 25 francs each. On the next day, August 13th, was passed the first of the measures establishing a moratorium which post- poned all commercial debts for one month, and then, by successive extensions of time, until July, 1871, without other burden to the debtor than liability for interest until the final payment. 1 And finally, on the 14th of August, the limit of issues by the Bank was raised to 2,400,000,000 francs, on the ground that for the Bank to continue its discounts it must have a wider margin than was allowed by the law of the 12th. This completed the series of measures under the authority of which the Bank was administered during the war. 1 Under the operation of this law the Bank of France held sus- pended paper to the amount of nearly 870,000,000 francs. Of this more than two thirds was paid in before the expiration of the legal term of indulgence; and of principal and interest less than one per cent, was still unpaid at the end of 1874. Courtois, Histoire, p. 263. The French Banking System 181 The state had at the outbreak of the war ob- tained a small advance from the Bank, and called for others soon after the suspension. During the siege of Paris the branch of the Bank at Tours became the agency by which considerable ad- vances were made to the provisional government at Tours, while the Bank itself was in like manner aiding the government in Paris. When the war with the Commune succeeded that with Germany, these advances had risen in all to 761,000,000 francs, besides a loan of 210,000,000 francs to the city of Paris. The Bank resisted with great difficulty the efforts of the Commune to use its resources in defense of the city, and for several weeks escape from open pillage, or from demands not to be distinguished from it, seemed hopeless. The prudence of the managers, the devotion of their subordinates, and the steady support of one or two members of the revolutionary body itself, carried the Bank safely through the most dangerous episode of its history, and enabled it, upon the suppression of the Commune, once more to give its aid freely to the government. 1 In July, 1 87 1, the loans thus made to the state amounted in all to 1,425,000,000 francs, and the government now happily found itself in such a po- sition that it could cease drawing from this source. 2 1 For minute details of the history of the Bank under the Com- mune, and of the means by which it was saved, see Du Camp, Les Convulsions de Paris, iii., ch. ii. 2 In the Bulletin de Statistique et de legislation Comparee for 182 The French Banking System The brief statement given on p. 180 shows dis- tinctly enough the change which a year of war had wrought in the affairs of the Bank. An enormous loan had been made to the state simul- taneously with an increase of discounts for in- dividuals, and this had been effected partly by the sacrifice of cash and partly by an increase of notes, the volume of which now stood nearly 800,000,000 francs above the highest point ever before reached. This increase of notes had been managed with great caution, so that while it necessarily expelled from circulation a considerable amount of specie, it had nevertheless brought about but a slight depreciation of the paper 1 ; and with the repay- ment by the government of the advances made to it by the Bank, the restoration of specie payment promised to be easy. The government, however, was for the time in no condition to under- take the payment of a domestic debt. It had before it the problem of paying to Germany, in the next two or three years, the great indemnity of five April and May, 1880, is a careful report upon these loans and upon their subsequent payment. 1 During the war quotations were made of exchange on London and occasionally of gold, indicating in one extraordinary case a premium of four per cent, on specie. After the restoration of order gold ceased to be quoted, and the price of exchange on London fell to a level of about 1 per cent/ premium. See the Economist for quotations both in London and in Paris. Leon Say's Rapport sur le Payement de I'Indemnite de la Guerr gives a chart showing the rates of exchange in Paris on London from June, 1871, to September, 1873. The French Banking System 183 thousand millions of francs, to which it was bound by the treaty of peace; it had yet to learn how far its credit would enable it to make this payment by borrowing in the general market, and the most that could be hoped was that it should not have to call upon the Bank for further aid. The latter could not expect, therefore, for several years to come, to extricate the resources which it had lent to the state. But while the Bank thus saw its resources un- available for a movement towards specie pay- ments, it was also called upon to increase at once the assistance given by it to commerce. It was of paramount necessity that productive industry should resume its activity without delay, for it was after all in the production of wealth and its proper use that France must find the means of escape from the economic misery caused by the war, and it was the thrift and prosperity of in- dividuals that must support the credit, on which the country now relied in making its settlement with Germany. Special precaution was needed to insure industry from being starved of its needed supplies of capital, while the government was borrowing the vast sum to be paid to Germany. The Bank therefore took the bold course of rapidly enlarging its discounts and advances to individuals; and to make this possible, in a country where deposit accounts and checks are but little used, it was authorized in December, 1871, to increase its issue of notes to not more than 2,800,- 184 The French Banking System 000,000 francs, and in July, 1872, the limit was further extended to 3,200,000,000. Such an in- crease of paper with a forced circulation required, as the condition of possible safety from serious depreciation, a further expulsion of specie from use. The smallest notes thus far issued by the Bank were notes for 20 francs authorized by a law of December, 1870; but the law of December, 1 87 1, raising the limit of the total issue of notes, now authorized the issue of notes as low as 5 francs, and thus facilitated the introduction of the bank paper into all the channels of circulation, small as well as great. With the ground thus prepared, the great scheme for the simultaneous payment of Germany and revival of France was carried through. The gov- ernment borrowed in all the markets of Europe, including that of Germany, but called upon the Bank of France for nothing more than two or three temporary advances, not large in amount and soon repaid. The Bank doubled its discounts of commercial paper for the next three years, and for this purpose increased the note circulation until at its maximum at the end of October, 1873, it nearly reached 3,072,000,000 francs. From the data subsequently published it appears that the whole of the increase was made by the issue of notes of not above 100 francs, and the greater part of it by means of notes of 50 francs and less. The risks of the operation were amply compensated by its gains. Although the govern- The French Banking System 185 ment, in view of the valuable privilege enjoyed by the Bank of making a great issue of notes without the obligation of payment, reduced to one per cent, the interest on its own debt to the Bank, the profits from the immense increase of discounts were heavy. Dividends of 20 per cent, for the second half of 1871, 32 per cent, for 1872, and 35 per cent, for 1873, amply justified the conduct of the management in the eyes of stockholders, and once more proved that in periods of specie suspen- sion no trade flourishes like that of the dealers in credit. The government was able in 1872 to begin its payment to the Bank at the rate of 200,000,000 francs per year; the payment of the indemnity to Germany was completed in August, 1873, and in 1874 the Bank began its preparations for the resumption of specie payment. France, having a less expanded state of credit than most other commercial countries, had felt the revulsion of 1873 but little, and it was, therefore, possible to make a large reduction in the discounts of the Bank, and thus to carry on the double operation of accumulating specie and withdrawing notes. The withdrawal of small notes of 25 francs and less was carried on even faster than the general lowering of the circulation, in order to force the introduction of specie into general use and thus to insure the presence of a large mass of metal in the hands of the public, before the Bank should begin its pay- ments. The specie in the Bank reached its highest 1 86? , The French Banking System point in June, 1877, when it stood at 2,281,000,000 francs, showing an accumulation by the Bank of over 1,500,000,000 francs in three years and a half, independently of any made by the public. Of this specie, not far from sixty per cent, was gold, it being the policy of the Bank to hold much gold, partly because gold alone could answer demands for use in foreign trade, and partly because of the uncertainty which obscured the future value of silver. The precise period at which specie payments should be resumed was determined by the law of August 3, 1875, in which it was provided that when the advances made by the Bank to the State should have been reduced to 300,000,000 francs, payment of the notes in specie should begin. By the end of 1876 only 338,000,000 francs remained unpaid, and it would not have been difficult at any time in 1877 to complete the operation. The year was permitted to pass, however, without taking the final step, the Bank in the meantime dealing upon the specie basis. A payment of 10,000,000 francs, which lowered the government debt to the required point, was at last made pro forma December 31, 1877, and specie payment was resumed with the opening of the new year without shock and without much thought on the part of the public. By the terms of the law the notes continued to be a legal tender for all debts, as they are to-day, but their forced circulation by non-payment was at an end. The French Banking System 187 At the moment of resumption the outstanding notes of the Bank amounted to nearly 2,462,000,- 000 francs. This was a great reduction from the maximum reached in 1873, but the amount was still nearly double that which had been usual before the war. It soon became clear that, with the free choice between specie and paper afforded by resumption, France had adopted a permanently larger paper circulation. This was in large measure due to the change of habit produced by any protracted use of forced paper, — a change which makes it highly improbable that any nation, after such an experience, will easily return to the use of paper and coin in proportions the same as were once found satisfactory. Unfavorable conditions in 1878, 1879, and 1880 caused a moderate decline, which at one moment lowered the issue to 2,107,000,000 francs. Defi- cient crops, especially in 1879 and 1880, caused large imports of wheat and heavy exports of gold, a large proportion of the latter finding its resting- place in the United States. The Bank of France relieved the situation by some increase of its loans, but parted with not less than 500,000,000 francs of its gold. With the return of good harvests the loss of specie was made up, and the increased demand of the public for notes soon began to show itself. Perhaps to some extent by the direct exchange of specie for notes, and in general by an increased proportional call for paper in payments received from the Bank as compared with the use 1 88 The French Banking System of paper in payments to it, the notes outstanding and the specie holdings of the Bank both began to increase, and the growth of that part of the cir- culation which simply represents specie in hand, and is not an extension of bank credits in profitable operations, became rapid. In 1884, the issue having risen to 3,162,000,000, the limit was raised to 3,500,000,000 francs. This limit was raised four times during the next twenty years, finally giving the Bank the right to issue 6,800,000,000 francs. The importance of maintaining a limit of circulation which is certain to be raised before it can be reached is not clear, but it is probably to be found, if at all, in the frequent opportunity thus afforded for legislative review of the use which the Bank makes of its extensive privileges. * During 1913 the circulation of the Bank varied from 5,350,000,000 to 6,050,000,000 francs, and its specie ranged from 3,815,000,000 to 4,175,- 000,000 francs, being usually not far from seventy per cent, of the issue. By the force of circumstances, then, rather than by positive legislation, the Bank of France has been made the storehouse for a vast mass of specie, conveniently represented in circulation by bank-notes, and thus holds in its charge a large 1 The committee which, in 1897, reported to the Chamber of Deputies the bill extending the charter, frankly recognized the futility of the limit, but acceded to it as probably harmless, and agreed to the advance from 4000 to 5000 millions as affording an ample margin for some time to come. — Journal Officiel, 1897, Doc. Pari. Chambre, p. 176. The French Banking System 189 part of the currency of the country. As the specie thus held becomes in fact a reserve protecting all the cash liabilities of the bank, it is clear that it is an effective safeguard against the ordinary chances of an insufficient banking reserve, and that the Bank of France thus secures great steadiness of movement in its ordinary operations in com- pensation for the heavy responsibility thrown upon it. The composition of this vast reserve is hardly less remarkable than its growth. The resumption of specie payments by France took place after the fall in the value of silver had compelled the countries of the Latin Union to suspend its free coinage at their mints. At that moment the Bank held approximately 1,200,000,000 of gold and 867,000,000 of silver. During the years of specie export, referred to above, the Bank parted with gold until its stock in the winter of 1880-81 was reduced to less than 540,000,000, and accumulated silver to the amount of more than 1,200,000,000. With the return of favoring conditions the Bank was not slow to replenish its stock of gold, and soon showed that it had adopted a definite policy of restricting its holding of silver and strengthening its holding of gold. Its silver after fluctuating within moderate limits has declined slowly but almost continuously since about 1890 and in 191 3 was less than 700,- 000,000 francs. Its gold, on the other hand, with some important fluctuations, has tended upwards, 190 The French Banking System exceeding 3,000,000,000 francs in 1913 and usually making about four fifths of the cash reserve, often rising above that proportion and less frequently falling below it. The success of this course of action has been, in part but not mainly, due to the advantage enjoyed by the Bank of Prance, as a debtor, under the bimetallic system of the Latin Union. Having the legal right to make in silver any pay- ments which it does not care to make in gold, the Bank is able to protect itself against any demands for the latter. The harshness ( of this policy, which if strictly carried out would isolate the interests of the Bank to the great inconvenience and disadvantage of the community, has been softened by the practice of making gold payments at a premium in cases where such concession appeared advisable. The line which separates such a practice from a depreciation of the local standard is narrow, but the Bank of France appears to have managed this delicate business with such caution as to be able to satisfy the occasional strong demand made upon it for gold, without disturbing in any serious degree that sensitive index, the rate of exchange upon London. * 1 "La Banque de France, grace a notre regime monetaire qui permet de payer en or ou en argent, a pu recluire les sorties d'or a ce qui e'tait reellement necessaire aux besions legitimes du com- merce international. "La prime defensive sur Tor a montre une fois de plus son efficacit6, elle nous a permis de maintenir le taux de l'escompte le plus stable et le plus modere" du monde entier, sans gener en The French Banking System 191 This gold premium device is an effective means of preventing withdrawal of gold for export at any given moment. It has also been one, though by no means the most important, of the influences which have occasioned the inflow and retention of the additional gold which has been acquired by the Bank of France. The share of France in the distribution of the world's stock of gold is a resultant of all the various influences which have shaped the economic situation and de- termined the financial position not only of France but of. all other countries as well. If Paris had maintained a free gold market, it would have experienced a far more considerable demand from foreign borrowers for short-time loans. On the assumption that such accommodation had been granted to the extent of many hundreds of millions of francs and to an increasing extent during the last twenty years or more, it is certain that gold would have been somewhat differently distributed throughout the world, a little less in France, a little more elsewhere. To check this tendency it would have been necessary in periods of intense demand for loans to advance discount rates. By this means virtually the same result could have been reached, but it would have involved more aucune facon les affaires puisque le change sur Londres ... est toujours rest6 tres voisin du pair." — Compte Rendu au Norn du Conseil Gen&ral de la Banque, 1897, p. 12. For some account and criticism of this policy, see George Clare, Money Market Primer, pp. 110-115. 192 The French Banking System variable and on the average somewhat higher discount rates in Paris than it has been found possible to maintain through the protection afforded by the premium on gold. It has not been possible to maintain an invariable rate of discount, but changes have been far less frequent and rates have not been advanced so far as in London or Berlin. In those countries the policy of a low stable discount rate could hardly have been adopted with safety owing to the spirit of active enterprise which pervades the business community. In France with its station- ary thrifty and, generally speaking, financially conservative population, the policy has not been out of accord with the business situation. But the obvious advantages of relatively low and stable rates for loans to the industry of the country have not been secured without loss of other advan- tages. The gold premium policy has deprived Paris of the place which it would otherwise occupy among the international money markets. This consequence of the gold premium policy is recog- nized, but opinion is widespread in France that it is not too high a price to pay when account is taken of the benefit of the low stable rates to the large number of small-scale producers and dealers which is still a characteristic feature of French economic organization. A large part of the loans made by the Bank of France upon commercial paper take the form of a rediscount of paper, on which advances have The French Banking System 193 already been made by the banking houses which are the immediate customers of the Bank. The endorsement by the banking house offering such paper gives the third signature required by the statutes, 1 and the difference between the rate charged by the endorsing names to the original borrowers and that charged by the Bank for rediscounting is the profit reaped by the inter- mediaries, who thus give the paper the added strength of their names. It is a natural, if not a necessary, result of this system of operation, that the Bank, both in Paris and in the country, is a lender on a large scale to the class of small traders, as is shown by the vast number of bills of exchange discounted by it, and by their small average amounts. 2 The rate charged by the Bank for advances made upon collateral security is higher by one per cent, than its published rate of dis- count, but even of the advances a considerable 1 In 1897 a motion to authorize the Bank to discount paper with two good signatures was rejected after debate in the Chamber by a vote of 295 to 255. — Journal Officiel, June 16, 1897, p. 1540. 2 The annual reports of the Bank show that the average of bills discounted are for sums under 700 francs, and their average time of maturity about twenty-seven days. The policy of favoring the small trade of Paris was established by Napoleon in the statutes of the Bank in 1808, where it is provided that "il sera pris des mesures pour que les avantages resultant de l'gtablisse- ment de la banque se fassent sentir au petit commerce de Paris. ..." Some of the paper discounted by the Bank in masses for bankers and others is extraordinarily minute. In 1897 the minimum denomination of paper acceptable for discount was reduced by law from 10 to 5 francs. Over four million pieces under 10 francs were discounted in 1913. 13 194 The French Banking System fraction is made up of sums not exceeding 500 francs, the minimum being fixed at 250 francs. Experience has shown that the business thus carried on with the class of small dealers is singu- larly free from loss, and generally steady in its movement, and it is for the interest of all con- cerned, as well as a matter of some moment to the general public, that the vast body of actual bor- rowers thus ultimately depending upon the Bank should be as little disturbed as possible by changes of rate and uncertainty of accommodation. That the small borrowers should be absolutely secured against a rising money market, even by such a system as this, is not to be expected. The intermediary who obtains his own loans from the Bank at a rate lower than that generally prevailing must still feel a strong inducement to raise the rate which he charges to his own customers. The tendency of such a network of established relation is, however, to moderate this temporary induce- ment and to secure for the small borrower a part at least of the relief afforded by the flow of loans at a steady rate from the great bank. The term for which the law of 1857 continued the exclusive privileges of the Bank of France — or, to use the customary phrase, "extended the charter" — ended with the year 1897. A bill providing for a further extension was presented by the government in 1889 and reported by a com- mittee in the Chamber of Deputies in 189 1. The complete change which thirty years had wrought The French Banking System 195 in the political, social, and financial conditions of the question caused the debate to take a wide range, and the project was still before the Chamber at its dissolution in 1893. The measure returned' with some modification in 1896, and finally became a law, November 17, 1897, extending the charter to the close of 1920, but reserving to the legislature the power to terminate it with the year 1912 by a law to that effect adopted in 191 1. The changes of 1897 and also those of 191 1 were mainly de- signed to secure for the government a larger share in the profits of the Bank, and the wider diffusion of its branches and agencies throughout the country. No important alteration was made in the general structure of the Bank or in its administrative organization. It continues to be a bank of the primitive type, with no special provisions by law for the limitation of its liabilities, except the maxi- mum arranged for its issue of notes, and with no provision as to any reserve to be maintained or for the special protection of any particular class of liabilities. In its government it is still where Napoleon placed it, under the immediate direction of a governor and two sub-governors, appointed and removable by the chief of the state, but aided by a board of fifteen regents, who are elected by the two hundred largest, shareholders, and whose action is subject to a veto by the governor. Easily as the authority of the governor might seem to lead to the absorption of the Bank as a part of the political machinery of the state, the 196 The French Banking System Bank has for a large part of its life maintained a considerable degree of independence. Material changes in legislation and important financial operations for the benefit of the government have generally been the subject of treaty and agree- ment. Even at the crisis of the war of 1870-71, the aid given by the Bank was for the most part wisely measured with careful reference to the maintenance of the credit of the Bank as an independent institution. The law has from the first recognized the importance of guarding the Bank in this respect, by requiring that the governor shall at all times hold at least one hundred shares of its stock, and each sub-governor fifty shares. But the private interests of these officers, so far identified with the interests of the Bank, could not have protected it if the government of the day had not generally used great discretion and forbearance in their relations with it. The governorship of the Bank appears to have been treated but rarely as a political office, and has remained unchanged even by revolution. Whatever takes place in the political world, the Bank has been regarded and has acted as the supporter rather of government than of an administration, and has thus main- tained an unquestioned credit, which is among the most valuable of the national resources for a great emergency. In the repeated discussions which ended in the passage of the law of 1897, the plan of state owner- ship of the Bank was urged with great ability by a The French Banking System 197 minority of the Chamber of Deputies. J The argu- ments for and against the proposition turned for the most part upon the financial considerations bearing upon the absorption of functions by the state, and upon the expediency of altering arrange- ments found to work well in practice. It is in- teresting to observe that it was pointed out more than once by those who supported the bill as it was passed, that in case of invasion, a public bank, like any other public establishment, would be subject to seizure by a hostile army, and that a bank under private ownership would be exempted like other private property by the laws of war, and in support of this view the decision of the German government recognizing the immunity of the Strasburg branch of the Bank in the war of 1870 was cited with great confidence. The same arguments were used, mutatis mutandis, in the debates in the German Reichstag a year later, when the bill for extending the charter of the Reichsbank was on its passage and there also the question of absorption by the state had come up. Attention was called to the credit which the Bank enjoys by reason of its independent existence and it was stated by the ministry that provision had been made, by an agreement between the government and the Bank defining the kind and amount of support to be given by the latter in a case of public extremity, and affording what was 1 The vote finally stood 114 for and 405 against ownership by the state. — Journal Officiel, June io, 1897, p. 1451. 198 The French Banking System described as "precieuses garanties." The terms and even the nature of this support were declared to be a state secret, no more to be made public than the contents of the arsenals, but the arrange- ment was vouched for by the ministry as sufficient. * By a vote of 298 to 236 the Chamber refused to press for further information, and by nearly the same vote it rejected a proposition for placing the cash of the Bank and its right of issue at the command of the government to be used in the national defense in the event of a general mobili- zation. 1 Since the outbreak of the European War, it has become known that the Bank had agreed to advance the State 3,000,000,- 000 francs at one per cent, during the war and one year thereafter. In September, 1914, the amount of this advance was doubled. CHAPTER X THE GERMAN BANKING SYSTEM When the present German Empire was estab- lished in 1 87 1, the reform of the legislation upon currency and banking was felt to be a pressing necessity. In their coinage some German states had ranged themselves under the thaler system and others under the gulden, but in all there was a mass of old coin in circulation of obsolete denomi- nations. The silver standard had been adhered to by all. Every member of the North German confederation,' except the cities Hamburg, Lubeck, and Bremen, and the principality of Lippe, was issuing paper currency for the supply of its own wants. And finally thirty-three banks of issue, with capitals ranging from 1,200,000 marks to 35,000,000, had been established, each upon such basis as the state or city establishing it found good, some holding perpetual charters, some in- corporated for terms of years, and some holding only rights revocable at pleasure. These banks differed materially as to the limit of their author- ized issues, and were under different obligations as to the holding of reserve. To reduce this mass of confusion to order and to establish unity of 199 200 The German Banking System system in currency and banking, was a problem which constantly taxed the German mind for the first four or five years of the new Empire. The law of December, 1871, provided for unity of coinage and prepared the way for the subsequent introduction of the gold standard by the act of July, 1873. J Another law of April, 1874, provided for the extinction of the paper currency issued by the several German states, by creating a currency of imperial treasury notes (reichs-kassenscheine), convertible into gold upon demand at the Treasury, but not a legal tender, and authorizing the dis- tribution of the notes to the several states, to be used by them in taking up their local issues. Of the imperial paper 120,000,000 marks were distributed to the states in the ratio of population, and 55,000,000 more were advanced in amounts as required, and with this aid twenty local issues, amounting in the aggregate to rather more than ' 180,000,000 marks, were extinguished. And finally by a law of March,' 1875, the banks of issue 1 The coinage laws of 1871 and 1873 are to be found, with copious annotations by Soetbeer, in Bezold's Gesetzgebung des Deutschen Reichs, Th. II., Band i., this part of the volume being also issued separately as Soetbeer's Deutsche Munzverfassung. See pp. 35, 67. For a translation see Laughlin, Bimetallism in the United States, p. 237. The German law of July, 1873, is often spoken of as a law "de- monetizing" silver. In fact it provided for coining gold money and substituting this for silver, but it did not demonetize the silver remaining in circulation. A part of this silver was sold in London between 1873 and 1879, and the remainder is being gradually absorbed by its conversion into subsidiary coin. The German Banking System 201 were brought under a common system, and the reform may be said to have been completed. x The new system required the establishment of a central bank to be under the immediate super- vision and direction of the imperial government, and the subjection of all other banks of issue to a uniform set of regulations and also to imperial supervision. To secure the first of these two objects, advantage was taken of the peculiar position of the Bank of Prussia. Originally established as a government bank, with a capital of 2,000,000 thalers supplied by the state, this bank had been enlarged by the admission of private stockholders until its capital had risen to 20,000,000 thalers, but without the surrender by the state of its power of control or of its disproportionate share of the profits. As a part of the new system, the Bank of Prussia now became the Bank of the Empire (Reichsbank) . The Prussian government was paid for its share of the capital and surplus, and also received 15,000,000 marks for its interest in the goodwill of the establishment; and the capital was then raised by subscription to 120,- 000,000 marks, the whole of which was thus placed in private hands. The imperial government re- served to itself a direct power of control through 1 The bank law of 1875 is to be found with Soetbeer's annota- tions in Bezold, Gesetzgebung, Th. II., Band i., p. 255. A translation of this and of later German legislation relating to banking is to be found among the publications of the National Monetary Commission. 202 The German Banking System the imperial chancellor and also by the appoint- ment of the board of direction, giving to the shareholders the election of a committee charged with certain duties of consultation. Government control is therefore far greater than that exercised \over the Reserve banks in the United States and somewhat more complete than in the case >f the Bank of France. The Bank was required ;o receive and make payments, and to conduct i )ther financial operations for the imperial treasury, without compensation, and also to manage free of cost the receipts and payments of the several states of the Empire. It was thus made in every- thing except its ownership a national bank on a large scale, although not the largest, and had its privileges secured to it for fifteen years. Certain general regulations adapted the thirty- two existing independent 1 banks of issue to the new system. The exclusive right of issuing bank-notes was then given to them and to the Reichsbank, with a provision for transferring to the latter any right of issue which may be surrendered by any of the others. No limit was fixed for the aggregate circulation, but the possible aggregate of notes which could be issued without being covered by cash in hand was fixed at 385,000,000 marks. This total was then apportioned among 'The banks which are here called "independent" are often designated as "private banks," to distinguish them from the Reichsbank. But as they are incorporated, the term "independ- ent" appears less likely to be equivocal for American readers. The German Banking System 203 the banks, having due regard to the amount of the notes previously issued by each and to their probable needs in the future 1 ; and by this appor- tionment the limit for the allowed uncovered issue of every bank taken by itself was determined. For all notes issued by any bank beyond this limit of uncovered issue, the law requires that cash shall be held, the bank being allowed to count as cash for this purpose German coin, gold bullion, and foreign gold, imperial-treasury notes, and the notes of other banks ; and if any notes are issued beyond the limit, and not thus covered by cash, a tax must be paid on them at the rate of five per cent, per annum. To insure the prompt application of this rule, every bank is required to report its condition at four fixed dates in every month; and any excess of notes, shown by any such report, above the allowed limit and not covered by cash, is then taxed 5 of one per cent. It is also required that the cash held, exclusive of the notes of other banks, shall in any case be equal to at least one third of the total circulation, and that the remainder shall be protected by dis- counted paper, having not more than three months to run. The notes issued under this system thus rest upon a solid basis of specie. By a provision prohibiting the issue of any notes of lower denomi- nation than one hundred marks the presence of an ample specie circulation in the country was 1 As to this apportionment see Soetbeer's Bankverfassung, ir Bezold, as above, p. 273. 204 The German Banking .System secured and also a field for the reichs-kassenscheine the minimum denomination of which was ten marks. The application of these provisions is best seen by reference to the accounts of the Reichsbank. The limit of uncovered issue allowed to the Reichs- bank by the original apportionment was 250,000,- 000 out of the total 385,000,000 marks. Fifteen other banks, however, declined to issue notes under the conditions required by the law and ten more withdrew their issue before 1894; so that by the transfer of these abandoned rights of issue, the uncovered limit of the Reichsbank was raised to 293,400,000 marks. The significance of the limit may be understood easily by taking any account of the Reichsbank, as for example that of March 23, 1900. As the notes then outstanding were 1034.4 millions, and the cash reserve 895, the notes exceeded the cash by 139.4; but as the allowed limit of uncovered notes was then 293.4, the Bank could still increase its issue by 154 million marks, without subjecting itself to the five per cent, tax. 'It should further be noted that the circula- tion could have been increased by more than 1600 million marks before encountering the absolute limit of the one third rule. The distinguishing novelty of the German law, however, is the im- portant provision by which the tax of five per cent, is imposed upon any excess of notes above the uncovered limit, not offset by cash in hand. The law makes clear the general design of the law- The German Banking System 205 making power, to secure the protection of all issues beyond a certain point by cash, and the tax of five per cent, was designed to effect this object, under ordinary circumstances, by taking away the inducement for carrying the issues beyond the line at which taxation begins. But the law has at the same time left open the possibility of an extension of circulation beyond the line thus indi- cated, whenever the reasons for such extension are strong enough to outweigh the tax. A certain de- gree of elasticity is thus gained at the point where, under the English law, the rigidity of the line drawn by Peel's Act has sometimes presented a serious dilemma. In the familiar case then of a commercial pressure, when the demand for loans is imperative and the market rate is high, it is possible for a bank, under this regulation, to meet the necessities of borrowers and thus to relieve the public apprehension, although it is practically forbidden to reap any important profit from this action. In the absence of any such pressure it was anticipated that the issues would be kept within the line, and that the business of issu- ing notes as gold accumulates, and of paying out gold as notes come in for redemption, would go on naturally and automatically. In these provisions for the issue of notes are easily traceable the general outlines of the Eng- lish Bank Charter Act of 1844. The suggested absorption of the entire right of issue by the Reichsbank, emphasized as it is by a provision 206 The German Banking System that the government upon giving due notice may- withdraw the right from any bank in 1891, or at the end of any decade thereafter; the fixed limit of notes to be issued without specie ; and the automa- tic arrangement for the issue of notes against cash above that limit, — all are closely copied from the English model. But there are striking differences which are of fundamental significance. The requirement that the cash shall amount in any case to one third of the notes is unusual, although the ratio thus insisted upon has long been familiar in discussions of banking. The notes of the German bank unlike those of the Bank of England are not secured by any special pledge of the specie or discounted paper which the law requires to be held for their protection. Not only does this paper as well as the specie remain in the possession of the issuing banks, but the law gives to the note-holders no special lien upon the paper or specie or right of payment in preference to other creditors. The law in short has simply provided by suitable measures that the affairs of each bank, including its issue of notes and the money and securities held by it, shall meet certain tests of soundness, believing that both the ultimate sol- vency of the bank and the prompt payment of its circulation are 'thus made secure. The credit of the notes is maintained by their strict converti- bility and by the law which makes them every- where current in payments to any bank of issue. Every bank is required to pay. its own notes on The German Banking System 207 presentation ; the Reichsbank also, under ordinary circumstances, pays its notes at its branches; and every independent bank is required to redeem its notes at an agency in Berlin or in Frankfort, as the government may determine, in addition to redeeming at its own counter. Every bank of issue is also required to receive at par in payment, the notes of every other bank, with the pro- vision that all notes thus received, except those of the Reichsbank, must be either presented for re- demption, or used in payments made to the issuing bank or in the city where it is established. This provision, which imposes a safe restraint upon the smaller banks, is also significant from its tendency to allow the Reichsbank alone to obtain anything resembling a national circulation. The note-issue of the Reichsbank, though sub- ject to considerable fluctuation over short periods, has shown a strong upward tendency, the average yearly circulation ranging from 600,000,000 to 800,000,000 marks between 1876 and 1886, and from 1,000,000,000 to 1,400,000,000 marks be- tween 1890 and 1900. During this period the Bank increased its stock of coin in almost the same ratio. Its original holdings were but little more than 500,000,000 marks, while in the closing years of the century they averaged nearly 900,000,- 000 marks. A part of this specie, as in the Bank of France, was silver, a heritage from the years of silver coinage before 1873. The amount of this silver, first disclosed in 1894, was not far from one 208 The German Banking System third of the entire stock of specie held by the Bank. The proportion of coin and its equivalents 1 to the note-issue had never fallen below 55 per cent., and was usually in the neighborhood of 70 per cent. It follows, then, that the one-third rule had never been of any importance in the operations of the .Reichsbank, since the notes had always been less by many hundred million marks than three times its cash reserve. From 1876 to 1895 the note-issue not covered by cash seldom exceeded the limit at which taxa- tion begins. During that time the device of the elastic limit was resorted to on ten occasions: five times for one week, four times for two weeks, and once for three weeks. The excess of issue varied from 19 to 109 million marks, but was never as much as ten per cent, of the total circula- tion. The effectiveness of the elastic limit in time of crisis was never severely tested during this period of twenty years but it was found to meet with much success exceptional temporary demands for currency which under the rigid English system of issue can be satisfied only by the withdrawal of specie or notes from the reserve of the Bank of England. On account of the slight use of checks in Germany the demand for notes is so considerable that the Reichsbank would have experienced great 1 The legal equivalents for coin^ imperial treasury notes, and notes of other banks have not been subject to marked variation, seldom going above thirty-five million or below twenty-five million marks. The German Banking System 209 difficulty in meeting the requirements of ordinary- years if it had been obliged to work under a rigid system of note-issue. It is noteworthy that before 1895 with one exception 1 the limit had been exceeded only at the end of September and the beginning of October or at the end of December and the beginning of January, at the opening of the autumn or winter quarters of the year, when for various reasons there is regularly an increased demand for currency. These demands the Reichs- bank was able to meet without difficulty through the device of the elastic limit. If the limit is exceeded when the rate of dis- count is under five per cent., the Bank suffers a distinct loss, since it must then pay more in taxes than it receives for the accommodation which it has given its customers. A five per cent, rate is so far above the normal rate that at times the Bank has paid the five per cent, tax when the return it has received upon discounts has been but four per cent., and on some occasions as low as three per cent. For this reason an increase of the uncovered issue not subject to tax was urged in 1899, when the regular decennial renewal of the charter of the Bank afforded an opportunity to change the law under which its operations are carried on. It was further urged that, in consequence of the growth of population and the rapid economic development of the country, its normal currency requirements were greater than in the early seventies, and that 1 October 31, 1890. 14 210 The German Banking System they were neither readily nor economically satisfied under a system of issue which permitted no per- manent increase except in proportion to the inflow of specie to the Bank. In support of this conten- tion, attention was called to the frequent resort to the elastic limit in the four preceding years. * Dur- ing these years the tax was paid for thirty-four weeks, the excess on fourteen occasions being above 100,000,000 marks, and more than once rising to nearly 300,000,000 marks. The law of June 6, 1 899, renewing the charter, accordingly authorized an increase of the uncovered issue not subject to tax to 450,000,000 marks, a limit which had been exceeded but seven times in the history of the Bank. This increase in the uncovered issue not subject to tax proved inadequate. During the period of ten years to the next revision of its charter, there was only a moderate increase in the cash holdings of the Reichsbank, and the limit was exceeded far more frequently and to a much greater extent than ever before. With the exception of years of business inactivity, the issue of taxed notes became an almost constant' feature of the opera- tions of the Bank. The elimination of the taxa- tion arrangement would have been the simplest and most logical course, since the Reichsbank has never allowed liability to the tax to influence its policy in the determination of the rate of discount or 1 In 1 895 the tax was paid for three weeks, in 1 896 for six weeks, in 1897 for nine weeks, and in 1898 for sixteen weeks. The German Banking System 211 the amount of credit to be granted. At the out- set, before experience with the working of the Bank had created unquestioned confidence in the man- agement of the institution, the tax on the notes doubtless served a useful purpose. For the con- tinuance of the tax it was urged that it served as a danger signal to the business community, but evidently, as an indication of the need of caution, it could have little or no value if taxed notes were to be constantly in circulation. In 1909 the limit on untaxed notes was raised to 550,000,000 marks and it was further provided that for the last week of each quarter the untaxed limit should be 750,000,- 000 marks. This interesting modification of the law was designed to enable the Bank to meet the heavy requirements for cash which came at the end of each quarter of the year when in Germany, to a greater extent than in most other countries, a great variety of obligations are payable. Under these new arrangements and also owing to some slackening in the activity of trade, the frequency and the amount of taxed issues of notes were greatly reduced though not entirely eliminated during the years immediately following the revision of the charter of the Reichsbank in 1909. The act of 1909 also made the notes of the Reichsbank a legal tender. This attribute of notes issued by, a central bank has little positive importance of a purely banking nature. In the experience of the Reichsbank the notes had been taken as readily as if they had been a legal 212 The German Banking System tender, and although in discussions of the subject much was said of the importance of strengthening the Bank, it is certain that military considerations prompted the change. Upon the outbreak of the European War in 1914, the redemption of Reichs- bank notes was immediately discontinued, and every effort was made to substitute the notes for the coin in circulation. The making the notes a legal tender in 1909 was unquestionably a wise measure paving the way for the monetary arrange- ments which were to be adopted if the country should engage in a great war. It was expected when the system was established in 1875 that the Reichsbank would ultimately ab- sorb the issues of all the other banks, either through the relinquishment of these rights by the banks or in consequence of the intervention of the imperial government, but the seven independent banks which continued to exercise that privilege after 1893 did not appear likely to give up their issues. The Bank of Frankfort alone excepted, they were all outside Prussia, each in one of the other states of the Empire, * holding a sort of territorial position, and sustained by the same influences which in so many other directions oppose the com- plete unification of the Empire.. Their aggregate note-issue was small in comparison with that of the 1 They were the banks of Saxony, Bavaria, Baden, South Germany (Hesse), Wurttemberg, and Brunswick. The notes of the last could circulate only in Brunswick l since the bank re- fused to subject itself to the general restriction of the law of 1875. The German Banking System 213 Reichsbank, amounting to less than 200,000,000 marks, and their operations did not affect seri- ously its leading position among German banks. At the renewal of the charter of the Reichsbank in 1899, however, these banks were subjected to an entirely novel measure of restriction which at once led three of them to relinquish the privilege of issue. r They were forbidden to discount at a rate lower than that of the Reichsbank when its rate is as high as four per cent., and were allowed to discount but one fourth of one per cent. 3 below its rate when it is under four per cent. For an understanding of the purpose of these restrictions, it must be remembered that an increase of the rate of discount by a central bank will not accom- plish the end in view unless the general rate for money in the outside market goes up as well. The rate of discount of the banks which issue notes had ranged somewhat below that of the Reichs- bank, and their operations had no doubt rendered somewhat less effective its control of the market. But that the restriction upon their action greatly helped the Reichsbank may be questioned, as the general market rate of discount in Germany is chiefly influenced by the action of banks which •The banks of Saxony, Bavaria, Baden, and Wurttemberg continued to issue notes. 2 The Reichsbank must not cut its official rate when it is as high as four per cent., and when below four per cent, must publish its actual as well as its official rate, and then the other banks may discount one eighth of one per cent, below its actual rate. 214 The German Banking System do not issue notes, and whose operations have not been regulated in this matter by law. The use of notes is still far more important in Germany than in English-speaking countries, though deposit banking has been increasing rapidly in recent years. A considerable number of joint-stock banks, many of which were originally established primarily to facilitate the organization and development of large corporate enterprises and the sale of their shares to the public, have de- veloped the business of deposit banking upon a great scale. The relations of these banks to the Reichsbank are analogous to, though in some respects strikingly unlike, those of the London joint-stock banks to the Bank of England. The German deposit banks do not maintain large reserve balances with the Reichsbank but resort to it for re-discounts whenever they experience any considerable demand for money. The Reichsbank possesses the only available store of specie in the country upon which the German banking world can rely to meet any extraordinary demand. x The policy of the Bank is therefore primarily deter- mined by the necessity of guarding its reserve, not because it issues notes, but because the credit system of the country is built upon the foundation of specie in its vaults. The right of issue has given the Bank prestige, and has been an important 1 The other note-issuing banks must, to be sure, keep their own reserve against their notes, but their aggregate holdings of specie do not commonly rise much above 80,000,000 marks. The German Banking System 215 factor in the accumulation of the large store of specie in its possession; but the dangers of its depletion, against which the Bank must be ever on its guard, do not come from the note-holders, but are due to its central position in the German money market. Like the Bank of England, the Reichsbank resorts to the variable rate of discount to protect its reserve, raising its rate in times of danger in order to restrain the extension of credit and check the outflow of specie. The importance of the action of the Bank in this matter is clearly- recognized in Germany, though at times, like the Bank of England, it experiences difficulty in, bringing the outside rates of the general money market up to a close approximation with its own rate. The French method of the premium on gold, though strongly urged upon the Bank, has never been adopted, its managers pointing out that the present policy has been successful in the past for the accumulation and protection of its stock of specie. x The specie held by the Bank is not looked upon solely as the banking reserve of the country, but is also regarded as a most important resource for the Empire in time of war. Any loss of its gold is accordingly a matter of general concern, quite apart from the particular degree of importance which it may have at a given time in purely banking aspects. 1 The well-known disapproval with which the withdrawal of gold for export is regarded at the Bank, is said by English writer? to be a potent factor in the protection of its reserve. 216 The German Banking System Some increase in the stock of gold held by the Reichsbank came with the expansion of the world's supply of gold which began in the closing years of the last century, but the increase was far less considerable than in France and hardly in propor- tion to the expansion of credit which was taking place in Germany. During the years of active business preceding the crisis of 1907, the demand for accommodation at the Reichsbank increased greatly and at times the issue of notes approached the rigid limit of the one third cash reserve re- quirement. After the crisis of 1907, which like that in 1901 was handled effectively by the Reichsbank, two effective means of strengthening its position were adopted. Rates of discount were maintained at a somewhat higher level than the policy followed in previous years in similar cir- cumstances would have required. By this means the further expansion of credit was in some meas- ure checked, and a low price level relative to other countries established which would tend to increase the inflow of gold. The accumulation of gold was also furthered by the passage of a law in 1906 authorizing a limited issue of notes by the Reichs- bank in denominations of fifty and twenty marks. These small notes entered into circulation slowly at first, but gradually the habit of making small payments in coin was weakened and by 1912 the notes had become so acceptable that an increase in the issue was required. As a result of these measures the Reichsbank secured a large addition The German Banking System 217 to its stock of gold, which increased from about 500,000,000 marks in 1907 to more than 1,200,- 000,000 in 1913. Like the Bank of France and unlike the Bank of England, deposits are a small part of the liabilities of the Reichsbank in comparison with its liability in the form of notes. Although the German deposit banks like those in England hold little cash in their own vaults, they do not maintain large re- serve balances at the Reichsbank. They rely absolutely upon the conversion of earning assets into cash, through rediscounts at the Reichsbank as an assured means of meeting all unusual de- mands that may be made upon them for money. In the common American sense of the term, Ger- man deposit banks have no reserve. It is their concern to possess a good supply of the particular assets which the Reichsbank will readily discount, and all past experience goes to show that no other safeguard is necessary. Temporarily idle funds are regularly deposited at the Reichsbank by the other banks and they are obliged to maintain balances with it in order to make use of the admirable service for making settlements between different parts of the Empire which the Bank has established. Compensating balances are required of all who make use of the service in amounts determined by the extent of the use. The balances required from banks are, therefore, relatively large, but obviously such permanent balances are quite unlike the reserve 218 The German Banking System balances maintained by English banks at the Bank of England. The system of settlement by transfer on its books, by means of which payments and transfers of funds can be made between all those having ac- counts on its books wherever situated within the Empire, furnishes a most striking example of the energy which the management of the Reichsbank has manifested in modernizing and improving German banking methods. Unlike the Bank of France, the spur of legislation has not been needed to bring about the diffusion of its branches, of which nearly five hundred of various grades have been put in operation. Banking facilities through other agencies have also been developed far more adequately than in France. As in France the first banks of deposit date from about the middle of the last century. Most of these banks were es- tablished primarily for the purpose of initiating and financing industrial undertakings which re- quired large investments of capital. It was only after long years of gradual development that commercial loans and the receipt of deposits from the people generally became the chief business of the German deposit banks. The original function has not, however, been discarded. They are still the most important source from which capital for new enterprises is derived, and through them the securities of companies which have passed suc- cessfully through the initial stages of development are marketed among investors. These financial The German Banking System 219 activities, so contrary to the practice of the division of functions between commercial and in- vestment bankers, traditional in Anglo-Saxon coun- tries, have not involved any apparent loss of strength in the German banking system. No more than the capital and a part of the surplus of the banks is employed in development work and the capital of the banks is for this reason greater in proportion to deposits than in most other countries. Banking concentration has reached an advanced stage in Germany, but it has taken a direction quite unlike that in France and in England. Re- cognizing the inevitable necessity of limiting the activities of a bank operating numerous branches to business, the safety of which can be tested by routine standards, the leading German banks have neither opened many branches nor entirely ab- sorbed large numbers of existing banks. They have preferred to acquire control or at least a voice in the management by the acquisition of shares in provincial banks and have thus secured most of the advantages of centralized organization with- out sacrificing the advantages of local interest and intimate knowledge of the affairs and needs of borrowers in all parts of the country. CHAPTER XI THE NATIONAL BANKS OF THE UNITED STATES The national banking system owes its existence to'the Civil War. Although in the majority of the States the banks incorporated under State author- ity were badly organized and insecure, and al- though even such as were on a solid foundation could enjoy little more than local credit, the cur- rent of opinion before the war was by no means favorable to any consolidation of banking interests. Discontent with existing systems more frequently took the form of opposition to the existence of any banks of issue at all; the party then apparently holding permanent control of the national admin- istration cherished with pride the traditions of its victorious struggle with the United States Bank, and of its devotion to a gold currency; and prob- ably neither the friends nor the opponents of banks would have then thought the government of the United States able to reorganize upon a com- mon plan the note-issues of all the States. But in 1863 a system of national banks was established with widespread, although not unanimous, con- sent, and without solid opposition, except from National Banks of the U. S. 221 some existing interests threatened or alarmed by the change. For effecting the revolution thus brought about in little more than three years, the favoring con- ditions were the unusual assumption of powers by the United States government then becoming habitual under the pressure of a struggle for exist- ence, and the imperious necessity of finding a market for United States bonds for the supply of a Treasury drained by war. In the great borrowing operations of 1861 the Secretary of the Treasury had sold a large amount of securities to the banks of the Eastern and Middle States, but the banks had found themselves embarrassed by the impos- sibility of using their own notes or their credit in any form in transactions with the government, and both banks and Treasury had been compelled to suspend specie payments at the end of the year. The Secretary had already laid before Congress his plan for the strengthening of bank circulation by a national system of secured bank issues, urging its adoption chiefly as a reformatory measure which might give to the country a solid currency, pre- ferable, in his opinion, to an increase of government notes which must always involve "the risk of a depreciated, depreciating, and finally worthless paper money." 1 Events moved rapidly, and the first resort to legal-tender government notes was authorized by Congress, with the acquiescence of the Secretary, in less than two months after the 1 Finance Report, Dec. 9, 186 1, p. 18. 222 National Banks of the U. S. suspension. The bank proposition, which, con- sidered simply as a reform, would then have had small prospect of success, began to gain ground as affording a possible escape from the final flood of legal-tender paper which seemed to threaten. When the Secretary again urged his plan upon the attention of Congress, * it had acquired new signifi- cance in its bearing upon the finances of the govern- ment. Immediate relief to the Treasury by the sale of bonds to the banks to be used as security for their issues was not to be expected, for the organi- zation of banks under the proposed system could not be effected without much delay, and many of the strong banks which the Secretary hoped to see converted into national banks already owned bonds in large amounts. Indeed the Secretary contented himself with saying that "in a very few years" the proposed national banks would require bonds to the amount of $250,000,000, and in fact the war was over before their deposits of bonds had risen much above $100,000,000. 2 But the banks were looked upon as important agencies for the govern- ment in placing new loans, and their circulation as a medium needed for use in default of specie and likely to facilitate the return to specie payments. In short as the national bank system slowly passed 1 Ibid., Dec. 4, 1862, p. 17. * In November, 1863, the Massachusetts banks held United States securities amounting to fifty-three million dollars, and the banks of New York, city and country, probably more than one hundred million dollars. National Banks of the U. S. 223 through its successive stages of development from 1863 to 1865, its importance as affording in itself a market for United States bonds pretty well dis- appeared, and its importance as a valuable part of the commercial organization and as the source of a paper currency of remarkable credit and security came to be more and more fully recognized. The act authorizing a system of national banks was passed in February, 1863, T but in many points of detail ft proved to be so unsatisfactory and incomplete that only 134 banks were organized under it in the next nine months, and the number had risen to less than 450 in sixteen months. A revised act, making important changes, was there- fore passed in June, 1864, 2 and ample provision having been made, under which banks chartered by the States could be reorganized as national banks, the extension of the new system went on rapidly. Its adoption was further stimulated by an act laying a tax of ten per cent, on all notes of State banks paid out by any bank after July 1, 1866. 3 The certainty of the practical exclusion of all State banks from the field of circulation caused the speedy reorganization of the greater part of them as national banks; and thus the national system, numbering 1634 banks on July 1, 1866, at once assumed the preeminence which it has since maintained. 1 12 Statutes at Large, 665. 5 13 Statutes at Large, 484. 2 13 Ibid., 99. 224 National Banks of the U. S. There is no doubt that, in adopting the national bank system, Congress understood that it was establishing the agency by which the sole paper currency of the country should be issued in the future. The legal-tender issues were still regarded as a temporary expedient, resting upon the over- whelming exigency of the moment for their justification; the bank act is entitled "An act to provide a national currency, " emphasizing by its title the permanence of the substitute which was to fill the place left vacant when the legal-tender notes should be paid; and the text of the act plainly looks forward to the return of specie payment, which should leave specie the only tender for debt. r Establishing a permanent system of banks, Con- gress surrounded them by many of the safeguards which had been adopted in one or another of the various States, providing minutely for their 1 In 1870, when the return to specie payments finally seemed to have been postponed indefinitely, an act was passed authorizing the establishment of gold banks, issuing notes redeemable in gold coin, and secured by the deposit of "United States bonds bearing interest payable in gold " with the treasurer of the United States. The notes were not to exceed eighty per cent, of the value of the bonds, and were not to be subject to those provisions of law which then limited the aggregate circulation of bank-notes. Several gold banks were organized, chiefly in the Pacific States; but after the return to specie payments, the distinction between the gold banks and others ceasing to be of importance, provision was made by the act of 1880 for their conversion into national banks of the usual type, and there are now no national gold banks in existence. 21 Statutes at Large, 66. Comptroller's Report, 1890, P-53- National Banks oft he U. S. 225 organization and superintendence, and for the publication of their accounts at rather short in- tervals, z and laying down rules, wholesome so far as they go, restricting the kinds of business in which the banks should engage. It was provided also that the shareholders should be responsible ratably for the debts of the banks, each to the amount of his stock in addition to the capital actually invested by him. 2 A system of banks thus guarded and under the charge of the government itself could hardly be treated by Congress as unworthy of being en- trusted with the public funds, as the State banks had been under the Independent Treasury Act of 1846, and provision was therefore made for desig- nating banks as depositories of public money when occasion should require, and for their em- ployment as financial agents of the government, upon their giving satisfactory security, by the deposit of United States bonds and otherwise, for the faithful discharge of these functions. The 1 A summary statement of the number and condition of the national banks, at five dates in every year, and for every year since the adoption of the system, is given annually in the Report of the Comptroller of the Currency. 2 From this liability to contribution beyond the amount in- vested, the law made an exception in favor of the stockholders of any existing State bank, having a capital of not less than five millions and a surplus of twenty per cent., in case of its reorganiza- tion as a national bank. This exception was made in order to secure the adhesion of the Bank of Commerce of New York City, — the only bank in the United States which could meet these conditions. is 226 National Banks of the U. S. framers of the measure no doubt looked forward at one time to a more consolidated system of banks, and to a closer intimacy with the government than was in fact established ; but their action as it stands marks an extraordinary change of policy, made under the pressure of war, by a government which, hardly more than two years before, trusted no agency whatever with the custody of its funds, recognized no medium of payment except specie, and carefully disclaimed all connection with, or responsibility for, any possible system of banks. The general provisions of the national banking system have for their starting-point the restriction of the right of note-issue to national banks, the other functions of banking being left free for banks chartered by State authority, and for private banks. Any national bank, proposing to issue notes, is required to secure them by a deposit of registered bonds of the United States, the bonds being transferred to and held by the Treasurer at Washington, but the interest thereon collected by the bank, whose property the bonds continue to be. The deposit of bonds under these provisions en- titled the bank making such deposit to receive from the Comptroller of the Currency, who has the general charge of the system, notes to the amount of ninety per cent, of the market value of the bonds deposited, but not exceeding ninety per cent, of their par value; a restriction which con- tinued from 1863 to 1900, when the limit on note issue was raised to one hundred per cent. These National Banks of the U. S. , 227 notes when received are in blank, certifying only the fact that the security for them is in the hands of the government; but when signed by the proper officers of the bank, they become its promises to pay upon demand, and can then be issued for cir- culation. The effect of this arrangement, it will be seen, is simply that a sufficient amount of the property of the bank, required to be held in the form of bonds, is pledged with proper safeguards to insure the ultimate payment of all notes issued by the bank. The notes are also, of course, to be paid by the issuing bank whenever presented, are to be received in payment by all other national banks, and can be paid to or be used in payments by the . government in all cases where specie is not required by law; but they have never been a legal tender as between individuals. These provisions have secured for the notes a uniform value and give to those of every bank an unimpeded circulation in every part of the Union. If, indeed, the law, as in the act of 1863, still made no further provision for redemption than to require every bank to redeem its own notes when presented at its own counter, the return of notes for payment would rarely take place and their substantial con- vertibility would be nearly destroyed. But the law of 1864 made provision for redemption by all banks at agencies in the principal cities, and this arrangement continued in force until June, 1874, when the present system was adopted, making the Treasury of the United States the sole redeeming 228 National Banks of the U. S. agency for all of the national banks, and requiring every bank to maintain in the Treasury, to be used in redemption of its notes, a reserve equal to five per cent, of its circulation. The chief effect of this system of redemption, except in the case of insolvent banks or of banks reducing their issues, has been the easy removal from circulation of notes which are worn, soiled, or otherwise unfit for use. For the establishment of a system which should test effectively and continuously the power of every bank to convert its notes into specie on demand, it would probably be necessary to require that no national bank should pay out any notes except its own. x For the general purpose however of maintaining the convertibility of the aggregate note-issue of the banks, the present arrangement is well devised. The national bank-note when issued is the prom- ise of the issuing bank, and must be punctually met by it, when payment is required, as any other liability must be. The note, however, also carries with it certain engagements binding upon the government of the United States. The provision for redemption at the Treasury binds the govern- ment to pay on demand all notes when presented in due form, and not merely notes to the extent of the reserve. And in case of the failure of a bank, 1 Such a prohibition was the basis on which the "Suffolk bank system" of New England rested, from 1819 to 1866, and main- tained at par a note circulation which had otherwise but slender provision for convertibility. National Banks of the U. S. 229 the law provides for the immediate redemption of all its notes at the Treasury. The government has thus made itself fully liable in any event for the whole amount of the notes. On the other hand it has taken ample security for its reimbursement, by requiring the deposit of bonds as above stated, by requiring that this deposit shall be increased if the value of the bonds declines, by the provision for a reserve of cash to be held by the Treasury, and also by taking for itself a first lien upon all the assets of a bank and upon the personal liability of the stockholders, for the purpose of making good any possible deficiency in the security already provided. An ingenious provision in the act of 1882 also secures for the government any gain that may ultimately accrue from the destruction of notes while outstanding, or from the failure of holders to call for their redemption. And finally, although the expenses of printing the notes (but not of engraving the plates), of superintending the system, and of providing for the safe-keeping of the bonds deposited, are paid by the government, these charges are offset by a tax of one per cent, per annum on the average amount of notes in cir- culation, or since 1900 of one half of one per cent, on notes secured by government 2 per cent, bonds. On the whole, therefore, whatever may be gained by the banks from this system, it cannot be said that the liability of the government is onerous. Much controversy has been excited by the ques- tion as to the rate of profits which the national 230 National Banks of the U. S. banks have obtained from their right of issuing notes secured by a deposit of bonds. It follows from what has been shown in the preceding chap- ters that their case is in no respect different as regards profits from that of banks which use their credit in the form of deposits, in order to make investments in interest-bearing securities. The notion often entertained that the national banks have some peculiar opportunity of making a double profit, "by receiving both interest earned by then- bonds, and interest earned by the loan of the notes issued upon the bonds," overlooks the fact that every bank uses, as its means for obtaining securi- ties, its capital and whatever credit it can employ in addition. Every bank, then, as a consequence of its use of its credit in any form, must receive interest earned by the investment of its capital and also interest earned by what we may call the investment of its credit; and the fact that the national banks, like others, have the opportunity for making credit as well as capital yield a profit, neither springs from the system on which their notes are secured, nor depends upon it. Indeed, it must be manifest that their deposits yield them a profit in precisely the same way as their notes, and usually much greater in amount. The con- clusive practical answer to the idea of a supposed extraordinary profit is to be found, however, in the conduct of the banks themselves, especially after the passage of the act of 1874, which, recog- nizing the desire of many banks to reduce their cir- National Banks of the U. S. 231 culation and secure possession of their bonds, provided that any bank might deposit "lawful money" with the Treasurer of the United States to enable him to redeem its notes, and thereupon withdraw pro tanto the bonds deposited, provided the amount of its bonds left in deposit were not reduced below $50,000. J Several important na- tional banks had never chosen to issue notes, al- though required by the law to maintain a deposit of bonds; under this provision a considerable number of others reduced their notes to the $45,000 which the required minimum deposit of bonds would support. The withdrawals of notes con- tinued for several years, and although new banks were formed and the note circulation increased in some sections, the total banking capital and note circulation alike declined, until the summer of 1878. Both increased after the resumption of specie payments, but the circulation of bank-notes did not reach the amount outstanding in 1873 of $341 ,000,000. 2 1 Banks with a capital of less than $150,000 remained subject to the original requirement of a deposit of bonds equal to one third of their capital until 1882, when it was reduced to one fourth and became applicable to all banks with a capital of less than $200,000. All bond requirements were repealed by the act of June 21, 1917. a Although in its general theory the national banking system is one of "free banking," under which the business of banking in all its branches is open to all persons who comply with the formalities provided by the law, it was nevertheless felt to be dangerous to allow the issue of an unlimited circulation so long as the currency remained irredeemable. Without restricting 232 National Banks of the U. S. The highest point reached by the circulation of the national banks during the twenty-one years ' following the resumption of specie payments in January, 1879, was a t the end of 1881, when it stood above $325,000,000. From that point, its decline was rapid, with hardly a break in the continuous fall, until at the end of 1890 it was little over $123,000,000. The proximate cause of this re- markable disappearance of what was originally the chief feature of the system was the steady pay- ment of the national debt and rise of the national credit, and the natural disinclination of banks to hold, on any considerable scale, investments which could no longer be relied upon to yield the holder so much as 2^ per cent. The extraordinary fi- nancial conditions of 1891 and 1892, culminating in the crisis, both commercial and monetary, of 1893, increased the return to the holder of bonds to three per cent., and the bank circulation, for this reason and others, rose to nearly $183,000,000 in October, 1893. In the disturbed years which followed the issue fell slightly, then rose to nearly $211,000,000 at the end of 1896, with a further increase of the earning power of the investment in bonds, and during the three years following fluc- tuated between $191,000,000 and $215,000,000. the establishment of banks, the acts of 1863 and 1864 therefore limited the aggregate amount of notes to 1300,000,000. In 1870 the limit was raised to $354,000,000, and finally by the act of January, 1875, f° r the resumption of specie payments, all re- strictions upon the aggregate circulation of the national banks were removed. National Banks of the U. S. 233 The experience of these years proved that the ex- pansion or diminution of national-bank currency was powerfully affected by an influence quite dis- tinct from the need of bank currency for use by the public. Mr. Chase, when advocating the adoption of the national system, had foreseen the possibility that payment of the public debt might compel "a future generation" to find for the bank-notes some security other than United States bonds, but it probably did not occur to him or to the other founders of the system that the rise of public credit by itself might cause the curtailment and even threaten the extinguishment of the note- issue. These unexpected results of the bond requirement were moderated by provisions of the Currency Act of 1900 relating to the issue of notes. Banks were allowed to issue notes to the amount of the paid-in capital and to one hundred per cent, of the market value of the bonds deposited, but not ex- ceeding one hundred per cent, of their par value. The act authorized the refunding of the greater part of the funded debt into two per cent, bonds, payable after thirty years, in exchange for several former issues paying higher rates of interest but all redeemable before 1909. Upon notes secured by the new bonds the tax on circulation was reduced from one to one half of one per cent. For at least another generation, then, an ample basis of bonds to secure circulation was provided, and for the time being at any rate the profit to be gained from 234 National Banks of the U. S. the issue of notes was slightly increased. Within less than four months after the passage of the law the note-issue, which had remained almost station- ary for more than a year, rose from $214,000,000 to $265,000,000 and thereafter continued to expand slowly but almost continuously until 19 12 when there was more than $700,000,000 of the notes in circulation. But the system of note-issue was not essentially altered by the act of 1900. The ag- gregate circulation continued to depend proxi- mately upon the current price of bonds and not upon the demand of the community for that form of bank currency. Real elasticity, whether for contraction or expansion, was still lacking. In its regulation of the deposit business of the national banks, the act of 1863 followed the ex- ample of legislation adopted in many of the States in the years immediately preceding the Civil War, and prescribed a minimum reserve to be held for the protection of the liability for deposits which continued with no fundamental change until the Federal Reserve banks were established in 1914. For banks in the "reserve cities," named in the original act of Congress or provided for by later legislation, x a reserve of twenty-five per cent, of the deposits was required; for all other banks, 1 By an act of 1887, any city having fifty thousand inhabitants could be made a reserve city, upon application made by three fourths of the national banks established in it. Since 1913 the power to designate reserve cities has been lodged with the Federal Reserve Board. National Banks of the U. S. » 235 fifteen per cent. The provisions for determining what should be counted as reserve were, however, less simple. The general requirement was that the reserve shall be "lawful money, " or in other words gold and silver coin and certificates and also legal- tender notes of the United States. But Clearing House certificates, which represent lawful money specially deposited for the purposes of the Clearing House association, of which the bank owning them may be a member, and the cash reserve of five per cent, of its circulation, which every bank is re- quired to keep in the Treasury, could also be counted as a part of the reserve against deposits. And it was further provided that, for any bank in a reserve city one half of its reserve might consist of cash deposits in the city of New York, or in any other "central reserve city," 1 and for any bank outside of the reserve cities three fifths of its re- serve might in like manner consist of deposits with banks in reserve or in central reserve cities. For the enforcement of the provisions as to re- serve, the law provides that whenever the reserve of any bank falls below the prescribed limit, the bank shall neither "increase its liabilities by mak- ing any new loans or discounts, " otherwise than 1 After 1887, a city having two hundred thousand inhabitants could be made a central reserve city upon application made by three fourths of the national banks established in it. Chicago and St. Louis at once became central reserve cities but the banks of other cities manifested no inclination to follow their example. 236 National Banks of the U. S. by the purchase of sight bills of exchange, nor shall it make any dividend, until the reserve has been restored to its due proportion. The Comp- troller of the Currency is also authorized to notify any bank whose reserve is insufficient that it must be made good, and in case of failure to comply within thirty days, he may, with the concurrence of the Secretary of the Treasury, appoint a receiver to wind up the business of the bank. Although the ample discretion thus given to the Comptroller has been used with moderation, the prohibition of further discounts, when the reserve falls below a given point, makes a hard and fast line, the ap- proach to which never fails to cause uneasiness, while in any actual crisis, the fear that the usual accommodation of the public must stop and liquidation must begin is the surest means of increasing the pressure for loans and of thus con- verting a crisis into a panic. The permission to count as reserve balances with other banks, which were in fact only demands for cash, had a marked effect upon the composition of the reserve held by the banks as an aggregate, and therefore upon the strength of the whole mass of banks at any given moment. If we take for example the returns of the national banks for September 7, 1899, we find their deposits amount- ing in the aggregate to $3,031.5 millions, requiring a reserve of $630.8 millions. They were returned as holding $890.5 millions of reserve in all, and were, therefore, on the average, far above the legal National Banks of the U. S. 237 minimum. But this great apparent reserve was composed as follows : Specie .... Other lawful money Redemption fund Due from agents . Total $338.6 millions. 127.8 10.1 4I4-I $890.6 Of actual cash, then, the banks of the country at this date held but 466.4 millions, much less than the amount of reserve required for their liabilities, — the remaining sum, which apparently made their condition remarkably strong, consisting chiefly of debts due from one bank to another. The ability of the mass of banks, therefore, to meet the pressure of a financial crisis was dependent on the ability of the debtor banks, to pay upon demand the sums deposited with them and relied upon by the others as a part of their reserve, and in par- ticular, on the ability of the banks of New York City to meet their demand liabilities. The reserve of those banks, however, on which all the others rested, was but little above the legal minimum at the date named, and sometimes under similar conditions has been below that point, so that with an apparently high reserve for the country at large, there was such weakness at the central and most exposed point as to impair seriously the value of this precaution. * 1 The reserve September 7, 1899, was divided between city and country, and classified as follows, in millions: 238 National Banks of the. U. S. The relation of the New York banks to the other banks of the country, as the depository of their reserves, 1 was plainly quite analogous to that of the Bank of England as the depository of the joint- stock and private banks of Great Britain. It was a relationship which had developed before the Civil War from motives of business convenience, step by step with the more intimate commercial relations which improvements in transportation made possible. Each city is a natural center for the settlement of payments for its surrounding territory. To facilitate these payments, banks in the vicinity of any city find it necessary to main- tain balances with the banks of that city, even if such balances cannot be included as a part of their reserve. A few cities become centers for settle- ments for entire regions within a large country, and some one city is certain to become the center for settlements between all parts of a country and with foreign countries. It therefore came about that, as for example banks in the vicinity of Portland, Maine, found it convenient to maintain Classification of Reserve. Reserve Reserve Legal Ten- S t'r c't Due from required held Specie, der, etc. fund. agents New York City $176.9 $178.3 $140.7 $36.9 $ .8 $ - Other Res. cities • 263.3 307.2 "3-7 5i-5 i-9 1 40. 1 Country I90.6 4°5- 84.2 39-3 7-5 274. Totals . . $630.8 $890.5 $338.6 $127.7 $10.2 $414. 1 The central position of New York was not seriously affected by the conversion of Chicago and St. Louis into central reserve cities, under the act of 1887. National Banks of the U. S. 239 balances with Portland banks, and the Portland and all other New England banks to maintain balances with Boston banks, so all banks of any importance throughout the country found it desirable to maintain balances in New York, the central money market of the country. In fram- ing the national banking law these arrangements were recognized in the provisions authorizing within certain limits the inclusion of balances with other banks in meeting reserve requirements. The central money market of a country is, however, much more than a center for making settlements. It is the one place in any country in which there is at all times an indefinitely large demand for loans. This is because average rates for loans in the central money market are lower than elsewhere in the country. Borrowers from all quarters resort to it for accommodation and financial business of every kind tends to become concentrated there. Elsewhere the demand for loans is more local and cannot be stimulated to any very considerable extent in short periods of time by the offer of a reduction in lending rates. Tem- porarily idle funds of all the banks of a country can therefore find employment in its central money market or may be attracted thither by the offer of interest on bankers' deposits. By the with- drawal of such funds, on the other hand, outside banks are able to shift to the central money market virtually the entire burden of meeting the situa- tion in periods of financial strain. In the United 240 National Banks of the U. S. States with its thousands of independent local banks the burden resting on the New York banks in emergencies has been particularly heavy. When banking is conducted by a small number of banks operating numerous branches, united action can be secured with comparative ease. New York, alone among money markets, has been obliged to contend against the efforts of thousands of out- side banks to strengthen themselves, a cause of trouble which in successive crises proved far more serious than the withdrawal of funds by individual depositors. For meeting the peculiarly heavy strain to which, as the central money market of a decentralized system of banking, it was subject in emergencies, the New York money market itself was not ef- fectively organized. Banking was conducted by nearly a hundred banks, large and small, but none of commanding influence. None of these banks were accustomed to maintain in normal times reserves very much in excess of legal requirements, and although these requirements were imposed so that the banks might have cash on hand avail- able for emergencies, the managers of most of the banks manifested a pronounced reluctance to make liberal use of it. Acting singly each bank was certain to adopt the policy of loan contraction, which, as we have seen in an earlier chapter, can- not be carried far without spreading universal disaster and which is certain to involve the banks in a general suspension of payments. This National Banks of the U. S. 241 course was adopted in the crisis of 1857 with such disastrous consequences 1 that in the crisis of i860 and in subsequent crises arrangements were adopted for securing some measure of common action among the banks. For accomplishing this, the Clearing House Association, in which the banks were already united for important purposes, and from which no bank would willingly find itself excluded, was the natural agency. A plan of operation was therefore settled upon, which should become binding upon all the banks in the Association, when adopted by three fourths of them. By this plan the banks agreed that, for the purpose of enabling them to expand their loans, the specie reserves held, by them should be treated as a common fund and, if necessary, should be equalized among the banks by assessments laid upon the stronger for the benefit of the weaker; and that, for the purpose of settling balances between the banks, a committee should be appointed with power to issue certificates of deposit to any bank placing with them adequate security in the shape of stocks, bonds, or bills receivable, and that these certificates should be received in payment by creditor banks. The effect of this arrangment was that any bank which experienced an unusual de- mand for specie would be supported by the whole of the common stock, and that the debt to the others, which it thus incurred, could be met by a pledge of its securities. Whatever course might 1 C. P. Dunbar, Economic Essays, pp. 278-83. 16 242 National Banks of the U. S. be taken then, any bank was as strong in specie as any other. A general increase of loans and lia- bilities might for the time weaken all, and if there were a further loss of confidence in the community might expose all to a common danger; but no one bank, by holding back its loans, could strengthen itself above the others, since the specie which it might thus collect must be held subject to assess- ments for the common benefit. The effect of this arrangement was instantaneous. The announcement that it had been made quieted the money-market and ended the panic. In the next week the banks increased their loans rapidly, and nearly the whole of the additional loans went to swell the mass of deposits, with only an incon- siderable loss of specie. The expansion was con- tinued at a more moderate rate for several weeks until, under the natural effect of the revulsion in business, the demands for loans fell off and specie began to accumulate. The issue of Clearing House loan certificates and the equalization of reserves were again resorted to in 1 86 1 with equally good results. The situa- tion in 1873 was more serious. The money supply of the country could not be enlarged in any way, even by the importation of gold, since it consisted of a definite amount of irredeemable government paper and bank-notes. The reserve strength of the banks, while sufficient to carry them through the worst of the storm, was not enough to enable them to avoid the resort to suspension. National Banks of the U. S. 243 In 1884, the next occasion when Clearing House loan certificates were issued, the opposition to the provision for the equalization of reserves was so widespread that it does not appear that it was even formally considered. The ground for this oppo- sition can be readily understood. In 1873 the practice of paying interest upon bankers' deposits was generally regarded with disfavor. Only twelve of the Clearing House banks offered this inducement to attract deposits ; but by this means they had secured the bulk of the balances of out- side banks. It was in meeting the requirements of these banks that the reserves of all the banks were exhausted at that time. The non-interest paying banks entered into the arrangement for the equalization of reserves in expectation of se- curing a Clearing House rule against the practice of paying interest on deposits. But their efforts had resulted in failure. Some of them had em- ployed their reserves for the common good most reluctantly in 1873, and the feeling against a sim- ilar arrangement in 1884 was naturally far stronger and more general. Moreover, the working of the pooling agreement in 1873 had occasioned heart- burnings which had not entirely disappeared with the lapse of time. It was believed, and doubtless with reason, that some of the banks had evaded the obligations of the pooling agreement. It was said that some of the banks had encouraged special currency deposits so as not to be obliged to turn money into the common fund. Further, as the 244 National Banks of the U. S. arrangement had not included bank-notes, banks exchanged greenbacks for notes in order either to increase their holdings of cash or to secure money for payment over the counter. Here we come upon an objection to the pooling arrangement which doubtless had much weight with the spe- cially strong banks, although it is more apparent than real. In order to supply the pressing require- ments of some banks, others who believed that they would have been able to meet all the demands of their depositors were obliged to restrict payments. That such an expectation ,would have proved il- lusory later experience affords ample proof. When a large number of the banks in any locality suspend the others cannot escape adopting the same course. But in 1884 the erroneousness of the belief had not been made clear by recent experience. The New York banks weathered the moderate storms of 1884 and 1890 without suspension, by means of the Clearing House loan certificate alone, and in the course of time all recollection of the arrangement for the equalization of reserves seems to have faded from the memory of the banking community. There was, however, in those years another potent influence which tended to lessen the likelihood of suspension following the issue of loan certificates. Many banks were unwilling to take them out, fearing that such action would be re- garded as a confession of weakness, and continued the payment of cash in the settlement of Clearing House balances. In 1893 also only a small part of National Banks of the U. S. 245 the balances between the banks was settled in cer- tificates at first; but by the end of July practically all balances were settled in that way and sus- pension followed at once. In 1907 all the banks having unfavorable balances, with but one im- portant exception, took out certificates on the first day that their issue was authorized, and suspension was then for the first time simultaneous with their issue. The connection between suspension and the use of Clearing House loan certificates as the sole me- dium of payment between the banks was simple and direct. The bank which receives a relatively large amount of drafts and checks on other banks from its customers cannot pay out cash indefinitely if it is unable to secure any money from the banks on which they are drawn. So long as only a few banks are taking out certificates and the bulk of payments are made in money, no difficulty is experienced ; but as soon as all the banks make use of that medium, the suspension of the banks which have large numbers of correspondents soon be- comes inevitable. The contention of bankers both in 1893 and in 1907 that they had not sus- pended since they had only refused to honor drafts on other banks was untenable. The Clearing House loan certificate was a device which the banks themselves had adopted and they had failed to provide any means for preventing partial suspen- sion as the result of its use. That the arrangement for equalizing the reserves 246 National Banks of the U. S. adopted in 1873 would have availed to prevent suspension on subsequent occasions is highly- probable, indeed a practical certainty. In 1893 events proved that the banks had maintained pay- ments up to the very last of the succession of dis- asters with the results of which they had been contending. During August the number of bank failures was not large and none of them was of great importance. We cannot, of course, know how soon money would have begun to flow back to New York, but certainly the suspension of pay- ments could hardly have hastened the movement. From the beginning of September the reported movements of currency showed a gain for the New York banks, and for the week ending September 16th the gain was no less than $8,000,000. One month more of drain, therefore, was the most that the banks would have been obliged to endure, and for the needs of that month the banks would not, as in 1873, have been confined to the single resource of the $79,000,000 of the cash in their vaults. Similarly, the enormous increase in the money supply of the country in November and December, 1907, would have offset much of the loss of reserve which the banks would have incurred, if they had continued to meet all the demands of their custom- ers for cash. And, finally, it may be observed that in the unlikely event that alarm had not been allayed and suspension in the end had become un- avoidable, it would not have made any practical National Banks of the U. S. 247 difference to depositors whether the reserves of the banks had been but ten per cent, rather than twenty per cent, of their demand liabilities. The fundamental defects in the banking system of the United States, in particular the absence of adequate lending power and inability tq make effective use of the cash reserves of the banks, were disclosed not only during the serious crises of 1873, 1893, and 1907, but also on frequent occasions of more moderate financial strain. But the need of radical change in the banking arrangements of the country was not clearly recognized until after the crisis of 1907. The attention of bankers as well as of the public was for many years absorbed by the more urgent needs of monetary reform — after 1873, the resumption of specie payments, and after 1893, the repeal of the silver purchase law secured at once, and the establishment of the gold stand- ard upon a firm basis which was finally accom- plished with the passage of the Currency Act of 1900. Difficulties due to monetary causes were entirely absent in the crisis of 1907, and conse- quently the unsatisfactory state of the banking machinery and practice of the country at length became clearly evident. As a temporary measure, pending more thoroughgoing legislation, an act was passed in 1908 empowering the banks to issue bank-notes secured by bonds other than United States bonds and by commercial paper, but sub- ject to taxation sufficiently onerous to prevent issue except in emergencies and to insure speedy 248 National Banks of the U. S. retirement. These notes proved of great service during the crisis which came in August, 1914, with the outbreak of the European War. Somewhat more than $300,000,000 of the notes were is- sued and, although Clearing House loan certifi- cates were also used, the suspension of currency payments was avoided. As a means of overcom- ing the most serious of the difficulties encountered in previous crises, the notes proved an effective device, but it was rightly believed that the banking legislation of the country was antiquated and that many and, in some directions, very fundamental changes must be made if the banks were to be placed in position to render the greatest possible service to the community in normal times as well as in emergencies. This view of the situation found expression in the Federal Reserve Act of December 23, 1913, a measure which gave the necessary legal authority for incomparably greater changes in the banking structure and practice of the country than followed the passage of the National Banking Act fifty years before. CHAPTER XII FEDERAL RESERVE BANKS By Henry Parker Willis The Federal Reserve Act was not, however, a departure from past precedent. Its foundation had been deeply laid in American banking ex- perience. Although opinion was slow in crystalliz- ing about any specific plan of change, it was true that from and after the year 1890 dissatisfaction with the working of our national banking system was increasingly general. This dissatisfaction may be assigned to several causes which are worthy of specific enumeration as follows : (a) The gradual shrinking of the outstanding public debt, and the fluctuations in the price of government bonds, had made it difficult to obtain a regular and elastic supply of bonds for use as a basis of currency issue ; hence a constant tendency on the part of the currency either to shrink or at best only to hold its own at times when it should have exhibited power of steady growth. (b) The uncoordinated and entirely independent character of our banking system, with its great diffusion of reserves, had rendered it impossible 24P 250 Federal Reserve Banks for the banks to furnish relief to others, or to protect themselves, in times of special stress, when exceptional domestic demand, due either to lack of confidence or to need for sudden enlargement of credit, had compelled heavy drafts to be made upon the various institutions. (c) The control of specie movements exerted in most foreign countries by the local central bank- ing mechanism, and esteemed necessary in all, to the proper working and control of the reserve system of such countries, was entirely absent in our banking system, so that the nation had no way of protecting itself against the specie demands due to unfavorable merchandise balances. (d) Even in spite of fairly good Federal over- sight and examination, and in spite of state ex- amination which varied from excellent to poor in quality, there was so much inefficiency and bad banking as to render it obvious that some central control of the business was desirable. It must not be supposed that recognition of these defects in so concrete and definite a way was arrived at, either early in the period after 1890 or indeed at any specified time. Indeed, the be- ginnings of dissatisfaction with the national system took form as a demand for elastic note issues, and there was a proposal after 1893 merely to imitate the Canadian system of currency, thereby provid- ing safe and elastic notes. But as time went on, it was more and more realized that a thoroughgoing type of banking reform, embodying the essentials Federal Reserve Banks 251 of the experience of other parts of the world, would be necessary. After the election of 1896 many proposals were made for the rectification of various elements in our banking practice, but there was no general plan for an inclusive piece of legislation until after 1905, when the House Banking and Currency Committee, whose Chairman was then Hon. Charles N. Fowler of New Jersey, began to work out tentative banking measures based on the idea of a general organization of the banks which should embody the principles developed by the Clearing House Associations in years past. These efforts reached a greater degree of co- herence after the panic of 1907, when various plans of reform were attempted, culminating, however, in the measure of only partial reform known as the Aldrich-Vreeland Law. The basic thought in this law, as has been seen in the preceding chapter, was the establishment of so-called currency asso- ciations representing the local banking strength of various communities and designed to bring into effective operation the combined resources of the banks participating therein. The Aldrich-Vree- land Act, however, was a purely emergency plan. The immediate results of the panic of 1907 were soon over and the new measure was not called into effective use during the years between its passage and the adoption of the Federal Reserve Act. During its development, however, there had been a fairly thorough threshing out of the pre- vailing views and ideas concerning what was then 252 Federal Reserve Banks called currency reform, while the Act itself pro- vided for the organization of a body known as the National Monetary Commission. This Commis- sion, consisting entirely of members of Congress, eventually proposed a bill whose purpose it was to provide for a national reserve association or central bank with fifteen branches located at various points throughout the country. The measure had not been developed until just before a change in the political control of Congress occurred. But the Democratic Party having succeeded to the majority power in the legislative body was, in 1910, urgently pressed to proceed with the consideration of the National Monetary Commission Bill or else to substitute something else for it. What was done by Congress in 1912-13 was thus a continuation of the efforts which had been on foot ever since ^1890 or soon after that date, and it was the logical outcome of those years of discussion. During 1912-13 the many bills which had been devised and put before Congress in the course of the two decades since 1890, including the National Monetary Commission Bill, were taken under advisement, and as a result the bill which later became known as the Federal Reserve Act was introduced into Congress in June, 1913, becoming law on the 23d of the following December. While it was the outgrowth of a long period of banking discussion it nevertheless represented a great ad- vance over any preceding measure, largely because it did not hesitate to select and include the best Federal Reserve Banks 253 elements which had been worked out in previous discussion of the subject, regardless of their politi- cal origin. It, however, followed very closely none of the bills which had preceded it, nor did it model itself upon any of the plans for banking re- organization which were suggested from time to time by members of Congress, by outside business organizations or by individuals. It moreover embodied several fundamental features none of which had appeared in preceding bills, although they had been for years past regarded by financiers as measures whose introduction was desirable. The bill as eventually passed went through Con- gress by a narrow majority, consisting of votes drawn from both of the principal parties, and was signed by President Wilson who had steadily sup- ported its proponents. The Federal Reserve Act was essentially a plan for banking cooperation and self-government. It provided for the establishment of not less than eight nor more than twelve institutions to be known as reserve banks to be located each in a separate "district." Membership in the Federal Reserve System implied subscription to the stock of the local Federal Reserve Bank, in an amount equal to 6 per cent, of the capital stock and surplus of the members. Of this sum one half was payable in installments upon assuming membership and at specified dates thereafter, while one half was callable at a later date under described conditions. Subscription for such stock (that is to say, member- 254 Federal Reserve Banks ship in the system) was compulsory for national banks and was voluntary for incorporated State banks and trust companies. A further obligation of membership (in addition to subscription for capital stock) was seen in the requirement that each member bank should establish with the Federal Reserve Bank in its district a "reserve balance" or balance on the books of that Federal Reserve Bank in an amount equal to a specified percentage of outstanding deposits. This per- centage was fixed at 7 per cent, of the demand deposits and 5 per cent, of time deposits for central reserve city banks, 6 per cent, of demand deposits and 5 per cent, of time for reserve city banks, and 5 per cent, of demand and 5 per cent, of time for country banks. But in the case of banks outside of New York, Chicago and St. Louis a period of three years was allowed for the completion of the transfer of reserves. Such reserves might be established by actually transferring either cash or currency to the reserve banks or by discount- ing with the reserve banks paper of specified kinds. Such paper, now described as "eligible, " was to be the outgrowth of commercial, agricultural or industrial transactions and was to comply with certain requirements. It was not to be of specula- tive origin, but must represent genuine bona fide transactions. It must not exceed ninety days maturity (i.e., must not at the time of rediscount have more than ninety days to run before reaching Federal Reserve Banks 255 maturity) in the case of the commercial and indus- trial or more than one hundred and eighty days in the case of agricultural paper. The member banks must keep in cash in their vaults 6 per cent, for central reserve city banks, 5 per cent, for reserve city banks, and 5 per cent, for country banks, but might, if they chose, transfer all their reserves above these figures to the reserve banks (and might further be allowed to establish such reserves both in the amounts already specified above as required and in those referred to as voluntary, — making roughly two thirds of their entire reserves, — through the rediscount of paper) . This left them obliged to keep only about one third of their entire reserves in actual cash in their own vaults. The reserve banks on the other hand thus had opened to them a large field of business in rediscounting paper which might be brought to them by their members. They themselves were obliged to keep a reserve of 40 per cent, (gold) against notes and 35 per cent, (lawful money) against deposits ; and accordingly had a very large power of increasing the volume of credit in the community. In addi- tion to this regular work of rediscounting paper the reserve banks were ordered to receive on deposit checks and drafts left with them for collection and to perform the functions of a clearing house for their members. A broad field of other duties, some optional, some required, was also opened to them under the terms of the Act. Dividends at 6 per cent, (cumulative) were allowed to members but 256 Federal Reserve Banks all earnings above that figure were to go to the government. The central controlling mechanism of the new system was to be a governmentally appointed body known as the Federal Reserve Board, con- sisting of seven members, five appointed for that specific purpose by the President by and with the advice of the Senate (no two from any one district, two to be men of banking experience). These with the Secretary of the Treasury and the Comp- troller of the Currency made up the entire per- sonnel. To this body were given the general functions of what may be called "pure banking." Such functions included the definition or selection of paper for discount through the issuance of regu- lations designed to determine the character of this paper; the passing upon rates of discount (first to be named or suggested in the several banking districts), and the establishment of salaries and personnel as well as the general type of organiza- tion in the several reserve banks. In this connec- tion there was given to the Board the power to name three out of nine directors who made up the board of each Federal Reserve Bank, the other six directors in each district (three bankers and three business men) being chosen by the banks of the district voting in three groups or sections, estab- lished in accord with the size of the institutions, and electing one banker and one business man in each such group. An important function which was entrusted to the Federal Reserve Board was Federal Reserve Banks 257 that of acting as a super-clearing house for the various Federal Reserve Banks. Before the Act could take effect it was, however, necessary to lay out the eight to twelve districts and to determine their exact number, to incor- porate the Federal Reserve Bank in each district and to secure the election of its six banking and business directors, to choose the Federal Reserve Board and put it into office, while the latter body had to name the remaining three directors of each reserve bank and to exact from the completed boards in each district the collection of capital and the receipt of reserves on behalf of the member banks in such district. Of these functions, all except those relating to the Federal Reserve Board and its duties were to be discharged by a body known as the "Organization Committee" pro- vided for in the Act and including the Secretary of the Treasury, the Secretary of Agriculture, and the Comptroller of the Currency. The committee in question took office immediately after the adoption of the Reserve Act and completed its work early in the following spring. It mapped out twelve districts, the full number allowed by law, and secured the incorporation of a Federal Reserve Bank in each. The President selected the Federal Reserve Board and nominations thereto were eventually confirmed by the Senate, the Board taking office on August 12, 1914, while the banks were fully called into operation through the pay- ment of capital, an operation which was completed 17 258 Federal Reserve Banks (so far as the first installment of about $18,000,000 was concerned) on November 1 following. The first installment of reserves was paid to them on November 16. While the Organization Committee originally established twelve districts, it did not succeed in drawing the lines between them altogether satis- factorily. Recognizing that such might be the outcome of unavoidably hasty work in the new field, the Federal Reserve Act had provided for appeals from banks desiring to transfer from one district to another, such appeals to be filed with the Federal Reserve Board under regulations to be framed by that body. During the years 1915- 16 a number of such appeals were filed and minor changes were made in the district lines. The Federal Reserve Board at one time contemplated the idea of reducing the number of districts and of making very extensive changes in the composition of those which remained, but these plans were never matured. The outcome was to leave the general division of the country into districts sub- ject to but little modification and practically on the same basis which had been outlined by the organization committee. Closely connected with this question of districting was found to be a matter which is ordinarily treated apart from it. This was the question of branches. When the Federal Reserve Act was first under consideration it had been thought that a number of banks corresponding roughly to the reserve cities of Federal Reserve Banks 259 the country — then about fifty in number — might not be too many. Further discussion determined the reduction of the number to a maximum of twelve, but with the provision that any reserve bank might establish branches within its own dis- trict. Eventually the result of the exercise of this power was to create some twenty-three branches, leaving the total number of banks and branches thirty-five. It was seen from the outset that the power to establish branches was to render not only the exact conformation of the districts but also the location of the parent banks a matter relatively of secondary importance owing to the fact that with a thorough branch system in effect, the mere location of the actual points of redis- counting or holding reserves would be of no pri- mary significance. This in fact turned out to be the case, and save for the psychological atmosphere and local influences which always affect the per- sonnel of every institution, it is probable that the exact site of Federal Reserve Banks or the exact conformation of their districts has become a secondary matter. Certainly it is one which dropped from view within a comparatively short time after the organization of the system. As thus finally developed the system with its districts and branches assumed by the close of 192 1 the form indicated in the accompanying map : Selection of directors has continued to be made throughout succeeding years after substantially the manner provided in the original Federal Re- 260 Federal Reserve Banks serve Act, although at a later time some modifica- tions were introduced into the method of voting. On the whole, the plan of choosing directors in such a way as to give representation to the smaller Federal Reserve Banks 261 banks ("one bank, one vote") has not served to inspire these institutions with a very much greater sense of responsibility, but it has undoubtedly tended to avoid criticism. The real control of the reserve banks has remained in the hands of the more influential banks of the country. A striking illustration of this fact is seen in the action of the country banks in some districts in not choosing one of their own number but inviting a city banker to represent them. The Federal Reserve Act had made only very general provisions regarding the organization of the reserve banks themselves, and this therefore remained for the Board to work out in conjunction with the several directors. A standard set of by-laws was developed and agree- ment was reached that the chief executive officer of each bank should be chosen by the directors and designated as the "Governor" of the institution. As the organization later developed itself this governor came to be assisted by one or more deputy governors and virtually became the head of the institution. Although the Federal Reserve Act had contemplated an institution in which the Federal Reserve Agent (appointed by the Board as one of the three Government directors) would be, by virtue of his commanding position as chair- man, the leading factor in the management of the bank, this has in few, if any, cases actually turned out to be true. The Federal Reserve Agent in almost all instances has allowed himself to fall under the direction or control of the governor of 262 Federal Reserve Banks the bank and in some has performed practically the functions of a deputy governor although himself the chairman of the board of directors. This anomalous situation has perhaps been the most conspicuous failure of the administrative machin- ery of the Federal Reserve System. The first payment of capital and reserves had left the reserve banks at the month of November, 1914, with cash funds approximating $248,000,000, and thus able to undertake practically any work that was likely to be assigned them. At the outset, however, the direct activity of the system was small and the first months of its history were spent in helping to clear away the emergency currency issues which the bank suspension at the opening of the war had necessitated, in preparing its own internal staff and organization, and in putting into operation regulations designed to control and direct the relations between the reserve and member institutions. As the later installments of capital and reserves were paid into the system, the reserve banks naturally increased in power and resources. Their natural growth was accelerated by action of Con- gress in 191 6 which terminated the installment process of reserve payment and called for full transfer at once. It was again greatly increased by the act of June 21, 191 7, which increased the percentage of reserves required to be kept in reserve banks, raising it to 13 per cent, of demand deposits for banks in central reserve cities, 10 per Federal Reserve Banks 263 cent, for banks in reserve cities, and 7 per cent, for other banks. Members gradually fell into the habit of placing all their funds with the reserve insti- tutions and at one time their combined assets were more than $6,000,000,000. At the close of 1921 the combined position of the twelve banks of the system was as shown in the statement given below. Before proceeding, however, to a brief review of the history of the operations by which the system gradually advanced to the position thus indicated, it is necessary to sketch certain essential aspects of its organization whose understanding is neces- sary to comprehension of the position reached at the present time. In thinking of this new system as one of the world's great central banking organizations it is desirable to bear in mind certain very fundamental differences between it and other central banking systems. First of all, it should be noted that in most foreign countries the central bank or reserve bank is the nucleus of a banking structure which has later grown up around the institution. The central bank itself is in most cases older than the majority of the banking institutions about it. It has been established because of the weakness or defect of previously existing banking systems and because of the fact that it was desired to provide a means for the attainment of some very definite object; usually the development of a government plan of fiscal reform. The Federal Reserve Sys- tem, on the other hand, was superimposed upon an w o\ M Ol 0\0 o N WO o a oo m o -* MO < « "3 r-o O P0 O N oo »o COO OOlH HO M O (*)« ino"co~ aoo m fOfiOi 0,00 ON** to ro O* row « OlOO M O O ro O O o o 0_ O M CO M ■<*o 0\0 OO I-O N O oo ■^0\ CO HI fOO o o»*t-* COOlH ^fO H fO « o -* O « *t ONro Ol N MO H O (V) lO fJOO O fo oT inOO oo m ■* HI TfOO O O t- IOH00 O w ■* O TflO f0 Oi & I^-O t- co ■*■ « CO N O OOn) >ftfO WW o o>o O C* lO N OO o :« -a fe o c-e • o « coco I 264 ooo t^io &ONO t-oo r*- n CO oo h o. f)0O Oi o rooo t- « oo »o-o 1— rooo Oi *t HI *t^r~ro w aoo ro ror- -«fOi m fOM lO MOO -* OHT O moo MQO Ol o -o io Tj-t^OO O ro ■4ro^ao to o -"too «o N O O MOO r*ioi»« Oi 00 -vfoo Ol « r-4 ** O t>Oi-*« hD t-O t-oo t»r» ro Oi to N Woo cm"io t}-Oi t*«o « r» co io N CO O t» ** oo f)l> 0~tO m i> t> m m OO on io«0 f*5 O«0 OiW CO O O) I- CO NO lO N ^ t> ro Tt . O - CO l«1 e SgJJ CQfef < if a oi 8*8 •; S a S o o ~ "•5.2 . ca +j * ■■3.2 S '•ags "S.5.U •a la& n o a ■ « M ° ft _C aj 2.s§|s Pi Ills pi Pi 265 266 Eederal Reserve Banks already active and widely diffused banking system whose service was entirely satisfactory to the community in all ordinary particulars, although there was need for the aid which could be rendered by a centralizing and coordinating institution. For this reason the Federal Reserve System differs in sundry very essential particulars from any other central bank. It is worth while to enumerate the chief of these points of individuality. (a) The Federal Reserve System deals only with banks (and with the Government) and not in any particular with individuals so far as redis- counting is concerned. (b) The Federal Reserve System is owned by banks and neither the Government nor individuals own any stock in it. (c) The directors of the Federal Reserve Bank are to the extent of two thirds elected by banks, the one third who represent the Government being the holders of an indirect power of control in cer- tain circumstances. From these considerations it will appear that the Federal Reserve Banks are in a very real and genuine sense what has been termed by some as a matter of analogy "bankers' banks, " or a means of extending aid and support on behalf of the entire banking community to banks who need such accommodation from time to time, thus indirectly redistributing the supply of credit between differ- ent regions and individuals. As already remarked, the reasons why the Federal Reserve Banks 267 Federal Reserve System has been given this unique position and why its functions even in the Act as ultimately passed were so greatly limited in their scope, are obvious, being traceable to the circum- stance, already mentioned, that the system was grafted upon an already existing banking stem instead of being developed from the root as with European banking systems. Whatever may be the reasons for the situation, however, the effect of it, as already noted, is one which necessarily arouses question and doubt as to the future. Its first problem clearly lay, after organization had been effected, in securing the participation of a number of banks sufficient to make it really representative of the commercial banking of the country. The Act had required all national banks to accept membership and all except less than a score of obscure institutions did so. There re- mained the problem of securing the membership of state institutions. This involved several issues of competition and banking cooperation not altogether obvious on the surface. The state banks and trust companies had at the outset been very insistent that they should be accorded the privilege of joining the system, and such privilege had eventually been included in the Act. When the Federal Reserve Board was formed it found a long list of applicants for membership. During the few months following the organization of the Board a decided change in the attitude of the trust companies and State banks took place, and by the 268 Federal Reserve Banks time that the regulations covering their admission had been formulated in May, 1915, few, if any, were desirous of entering. The reason assigned was that while they believed the conditions laid down by the Board for entrance were fair, they did not think that the Act had made satisfactory provision for permitting their withdrawal, and they doubted whether the Board could assure them the power to retire at will. Such provision was accordingly incorporated in the Federal Reserve Act as a part of the law by an amendment which was adopted in 1916. The effect was greatly to encourage the movement of banks into the system and this movement was materially aided by the final entrance of the United States into the Euro- pean War and the feeling on the part of State institutions that it was both a wise and patriotic step for them to affiliate themselves with the re- serve system. Thus the Federal Reserve Banks came to include by the close of 1921 about 10,000 members of which 1631 were organized under State charters, and to represent about 80 per cent, of the commercial bank assets of the country. Closely connected with this question of member- ship was another problem which involved the functions of national banks. Practically through- out the world the tendency for many years past had been in the direction of banking 'specialization. In the European countries a sharp line was early drawn between the investment bank and the commercial institution, while the latter in its Federal Reserve Banks 269 turn was subdivided into many special groups. The United States had been an exception to this general trend of development. So-called trust companies authorized to act as guardian, executor, trustee, registrar, and the like, had been developed in many States and had found it profitable to combine with their fiduciary functions a general banking business. Some of them had gone so far as to develop their commercial banking, much beyond their fiduciary, duties. When the Federal Reserve Act was first taken under advisement, there was an effort to confine membership in the proposed system strictly to national . banks, it being believed that such banks were much more narrowly limited in the scope of their business and hence more desirable members of a commercial banking system. Political pressure while the Act was under consideration led to the modification of this view. State banks and trust companies were admitted to membership and from this the conclusion was naturally drawn that logic required the granting of fiduciary powers to national banks. Such an extension was accordingly made, and although the actual exercise of the powers was resisted by State institutions, a test case in the Supreme Court brought a favorable verdict. * Con- gress materially enlarged the scope of the powers which could be granted and by the close of 1921 some 1200 national banks had applied for and had 1 Bank of Bay City v. Fellows; Federal Reserve Bulletin, Vol. iii., p. 534. 270 Federal Reserve Banks received authority to exercise fiduciary functions. In reaching conclusions regarding the effective- ness and success of the Act as it stands, or with reference to its probable future, experience is a far better guide than theory. Yet the years which have passed since the adoption of the law have been singularly unfruitful in settling dis- puted issues. This is because of the unusual character of the banking problems that have been presented during that time. The history of the Federal Reserve System may be roughly divided into three periods, the first extending from shortly after its formal organiza- tion up to the date of our entry into the European War on April 6, 1917; the second extending from this latter date to a period shortly after the Armi- stice on November 11, 191 8 ; and the third covering the years since the close of the second period. It would be practicable to make several distinct sub- divisions within these periods, but for general pur- poses the history of the system is well marked off into the three main chronological divisions. During the two and one half years prior to our entry into the European War the Federal Reserve System may be regarded as having passed through a purely formative stage. Its operations were small and its direct influence upon the banking and discount situation limited. Indirectly it was a factor of very great influence because of the knowl- edge that a satisfactory organization had been provided around which the individual banks could, Federal Reserve Banks 271 if they chose, at any time consolidate their forces. Nevertheless during this early period it was always doubtful what part the system would be able to play. Several reasons may be mentioned for this state of things. In the first place, the Federal Reserve Act, by reason of its having reduced re- serve requirements and limited the necessities of the national banks, and thereby of the banks in general, for immediate accommodation, had es- tablished a margin of credit-granting power which was sufficient to carry the banks through a period of very considerable increase in demand without subjecting them to the necessity of resorting to Federal Reserve banks. During this first period, however, very abnormal conditions had also mani- fested themselves. Not long after the opening of the European War an immense trade in munitions, supplies and food had sprung up between this country and the belligerent nations. In a general way our sellers of goods demanded payment in cash or American securities and the result was a great inflow of both gold and American securities into the United States. This tended to lessen the degree of commercial dependence upon the bank- ing system, or of banks on Federal Reserve banks, and would have done so regardless of the type of organization. Furthermore, there was a very general attitude on the part of city banks that was hostile to the reserve system itself. Bankers who would ordinarily have rediscounted sought to avoid doing so in order to refrain from having any 272 Federal Reserve Banks business dealings with the reserve system. Finally, the system had not yet learned to adapt itself completely to the needs of the community and some of its regulations were of a nature that tended to limit or restrict the conditions under which free use could be made of the new banks. Altogether, therefore, the first two and one half years of its history were years in which growth was directed along lines that were abnormal or unusual. The second period of the Federal Reserve System's history was even more greatly disturbed by unusual and abnormal conditions than the first. With our entry into the war it became necessary for us to take over in very large measure the business of financing it. During the two years from June, 1917, to June, 1919, we had provided various foreign countries with $9,500,000,000 of advances besides incurring expenses on our own account which probably ran to about $34,000,000,- 000, of which latter sum some $24,000,000,000 con- stituted additions to our public debt. From the outset of the war it was a serious question how far to rely on borrowing and how far on taxation, in the effort to take practically the entire available surplus of savings or new wealth produced by the country from month to month. The eventual basis of our war finance theoretically contemplated the policy of levying a dollar in taxes for every three dollars in bonds or certificates of indebtedness sold, but it was subsequently found that the pro- gram of financing was so large as to exceed the Federal Reserve Banks 273 actual capacity of the community to pay by any direct means. Stated in another way, the situation was such as to make the rapid sale of the enormous issues of bonds which were being poured upon the market very difficult except through the provision of abnormally easy means of borrowing at banks the funds with which to purchase and hold such bonds. Very early in our participation in the war, therefore, the Treasury Department quite def- initely committed itself to a policy of inflation and practically compelled the Federal Reserve banks to reduce their rates to a point not above the coupon rate on Liberty bonds, which had been fixed at 4% per cent. The effort, in other words, was to require Federal Reserve banks to redis- count all of the government secured paper that might be necessary in order to sustain banks which were buying bonds or were financing such of their customers as were making these purchases. At the same time the government had found itself obliged to go into the market as practically the greatest buyer of goods and services in the history of the world. It not only took over many plants but controlled many others and undertook great building programs. There was a tendency for ordinary forms of paper to disappear and the whole country accordingly shifted over to a basis of government financing and borrowing. The evil of this situation was clearly reflected in the portfolios of Federal Reserve banks. Not only did these portfolios enormously expand under the 18 274 Federal Reserve Banks pressure of continuous and heavy rediscounting, but they came to consist very largely of the direct notes of member banks collateralled by govern- ment bonds, or certificates of indebtedness. The Federal Reserve banks themselves, on the other hand, became the nucleus around which was built up the organization whose mission it was to sell bonds to the community, while in the banks themselves no small part of the actual routine labor consisted in clearing, collecting, and routing the checks growing out of government receipts and payments. As will be seen at another point, the banks themselves had eventually been obliged to take over the function of holding government de- posits, and as a result of the enormously increasing operations of the Treasury attendant upon the expansion of the budget from something like $1,000,000,000 in pre-war years to over $5,000,- 000,000 in 1919, there was a correspondingly great increase in the scope of the routine activities of the Federal Reserve banks. Altogether, therefore, the service of the Federal Reserve banks during the war, although invaluable from the national stand- point, was very different from any service that would ordinarily be expected from such institu- tions in time of peace. One of the factors in the general financial situa- tion which had contributed largely to the troubles that existed before the war had been the method of collecting, keeping, and disbursing government funds. Ever since 1846 we had had in operation Federal Reserve Banks 275 the so-called Independent Treasury Act which had superseded the older system of keeping public funds in State institutions subject to all of the current dangers of loss and suspension of payment. Under the Independent Treasury Act provision was made for collecting, keeping, and paying out public funds in cash. The method was injurious, as experience showed, not merely because it was inconvenient and expensive but because it resulted in withdrawing large sums at times when they were needed in the market, while on other occa- sions they were suddenly poured out into current use, or were placed in parts of the country where they were not needed, by the plan of depositing them in specially favored banks. This system had for a long time been so unsatis- factory that when the Federal Reserve Act was framed effort was made to relieve the situation by the plan of constituting the reserve banks official depositories, requiring the Secretary of the Treasury to place his funds with them, and then constituting the reserve banks "fiscal agents" of the government. The effort of Treasury authori- ties resulted in making these provisions as carried in the final Act permissive instead of mandatory, and it was two years after the organization of the reserve banks before much progress had been made in giving them even full depository functions. Indeed, at the time of our entry into the European War in 1917, there was still a considerable sum of public funds on deposit in the so-called ' ' pet banks " 276 Federal Reserve Banks — national banks scattered through the country — while no real effort had been made by the Treasury to adapt its method of management of public resources to the new system of banking. The opening of the war changed these conditions by compelling the Treasury to arrange for support and to make use of the reserve banks as agencies for the actual handling of the public finances. As great sums were offered in bonds and certificates of indebtedness the Treasury authorities soon found it a matter of convenience to use the reserve bank organization not only as a recipient, conservator and disburser of funds, but also as a mechanism for the issue of bonds and for their redemption .and conversion. Around them gradually grew up the so-called "Liberty Loan Organization" whose duty it was to diffuse as widely as possible the current subscriptions for the successive loans, and to manage through their discount departments the whole machinery for the subscription to, and the "carrying" of, the bonds. As the war advanced, public receipts and pay- ments came to be made practically wholly in bank credit instead of, as formerly, in cash. Eventually Congress ordered the sub-treasuries closed (July 1, 1920) and with the suspension of these institutions a new era in the management of public funds set in. The third period of Federal Reserve bank his- tory has been far less uniform in its characteristics or transactions than either of its two predecessors, although in some aspects the work of the system Federal Reserve Banks 277 since the close of the European War has been quite as unusual and abnormal as it had been before our entry into the struggle. After the armistice there ensued a continuous expansion or inflation of business in all countries, which in the United States worked up to a "peak" in May, 1920, and was followed by rapid decline both in prices, volume of business, production, and bank credit accommodation. The Federal Reserve System, which had been subjected to so terrible a strain during the war, had emerged from the war in a strong and reasonably liquid condition. At the close of the year 1 9 1 8 it had on hand approximately $2,000,000,000 of gold, while its ratio of reserve to demand liabilities was in the neighborhood of 50 per cent. It was now to be subjected to a new strain which involved loss of gold due to changed conditions supervening after the close of the war, and tremendous expansion of demand for accom- modation, partly due to the continuing rise of prices as well as to the sustained requirements of the government for heavy borrowing resulting from the fact that war necessities did hot close with the end of the war but continued to make themselves felt for a good while thereafter. After the peak point of expansion had been reached in May, 1920, when the price level sto6d at about 270 (compared with a level of 100 in 1 913), a new type of service was called for. This was the service of controlling and regulating the process of credit withdrawal or reduction, and of ensuring that there 278 Federal Reserve Banks should be no serious shock or disaster to business conditions, while it was in progress. Abstractly speaking, the duty of the Federal Reserve System, or of any central banking system, was that of re- tarding or slowing down as much as possible the progress of the business community toward the peak of activity and of prices in 1920, and in the same way, after the peak had been passed, of re- tarding the descent to a low point of prices and volume of business. Such a low point was reached about the middle of the year 1921 when the price level touched 140. In the effort to perform its service most satisfactorily during these years, the system naturally sought to make use of the in- strument which had been found effective in foreign countries during past years of banking experience — periodic changes in the central bank discount rate. In order to understand the working of the Federal Reserve System during the post-war years and to appreciate in its true value much of the dis- cussion and financial criticism which has centered around this phase of its activity, a brief reference to the theory of credit control through discount rates is necessary. In classical banking practice during the latter part of the nineteenth century, it had become customary to view changes in the discount rate as an effective means of performing two services — the control of the supply of credit in the aggregate and the regulation of the amount of gold flowing into and out of the country. The use of the rate Federal Reserve Banks 279 of discount in this way had been given a conspicu- ous and convincing demonstration in the expe- rience of the Bank of England. That Bank habitu- ally maintained a rate of discount slightly higher than the prevailing market rate so that those who needed accommodation were under no temptation to borrow in order to make a profit. When the Bank raised its rate it practically refused to the market further accommodation except at an increasing penalty or cost. Furthermore, as the Bank of England was the chief holder of specie in the country the exportation of such specie usually involved the necessity of borrowing at the bank in order to build up the reserves of the commercial banks which had been depleted through the with- drawal of such specie from the Bank of England, and the consequent lessening of their own balances on its books. The use of changes in the rate of discount was thus a very effective means of regula- tion in a country whose financial affairs and whose relations with others were as delicately balanced as those of Great Britain. Other countries sought to imitate the British method and had more or less success in so doing. One of the principal difficulties in the United States, before the organization of the Federal Reserve System, was the lack of any central bank which could be relied upon in this way to control credit and specie movements. When the Federal Reserve System was organ- ized many supposed that it would follow the same plan that had been pursued by the Bank of 280 Federal Reserve Banks England. The conditions, however, were found to be such as almost totally to prohibit any very consistent use of the British policy. Experience has shown that in a disturbed state of international trade, with the current of gold setting all in one direction, — toward the United States, — and with the majority of countries on a paper basis, — as they were soon after the war had fairly opened, — many of the old principles of banking were im- practicable in operation. The Federal , Reserve System in its early years made various experiments with rates of discount, but none of them were conclusive. Neither the conditions of the market nor of the world in general would have permitted the use of the old methods of control, while the Federal Reserve System itself was too small a factor in the discount market of the United States to have much influence in any event. When the United States entered the war, conditions changed very radically, for it was at once seen that the sale of Government bonds in huge quantities would necessitate extensive, resort to the reserve banks, and that the rate they fixed would have a con- trolling influence on the market. Pressure was consequently brought to bear upon them to make their rates no higher than those which had been established by the government on its own bonds, and this policy was accepted. Thus was estab- lished a rate of interest which was much below the normal or natural rate in the market, with the result that there was a strong tendency to what is Federal Reserve Banks 281 called "inflation" — in this case undue reliance upon banks for loans whose proceeds were used in the purchase of bonds. The rate policy of the Federal Reserve System continued to be fixed by the cost of government credit for a good while after the war, the fifth and final large government loan itself being placed on the market some five months after the armistice had been signed. During the months immediately following the war a great development of speculative manufacture and trade took place. The stock market, which had been strictly controlled during the war, sprang into renewed activity several months after the armistice, and was allowed to get the advantage of the funds drawn from the reserve system through loans collateralled by government bonds. Eventually the Federal Reserve Board endeavored to restrain the debauch of credit which was going on, and as one means thereto raised its rate of discount. This advance was at first tentatively made in the autumn of 191 9, but still further advances were effected in 1920. The decline from the peak of prices had begun in May, 1920. This decline was attributed to the higher discount rates of the Federal Reserve Board, which were supposed to have had the effect of contracting credit. The facts, however, seem to be opposed to any such supposition. The maximum expansion of Federal Reserve advances did not come until about the end of 1920, or some eight months after the recession had actually begun. Careful analysis 282 Federal Reserve Banks of the policy of the Federal Reserve banking sys- tem during these months would seem to indicate that a much more effective instrumentality than the rate of discount in bringing about a lessening of credit expansion was found in the effort made by both Federal Reserve banks and member banks to reduce the volume of loans which they had made upon the strength of government securities as well as upon long-term and investment obligations of all kinds. The control of the volume of credit through variations in the rate of discount, which had been successfully exercised under the nicely balanced system of credit and of specie holdings which existed in Europe prior to the European War, was impossible under the wholly altered conditions produced by war, and the influence of the changes in the rate of discount made by the Federal Reserve System must be regarded as primarily psychological. So outstanding was the service of the Federal Reserve banks in the financing of the war and in the management of post-war financial conditions, that it has in no small measure tended to obscure the broader and more normal functions of reserve banking. These have always been, in the United States, a matter of controversy. The service of the Reserve System in its domestic relations was originally conceived of by many bankers as being confined entirely to the rendering of "relief" or the stopping of "panic" in "emer- gencies." The Act itself had not, however, been Federal Reserve Banks 283 drawn with any such idea in mind, but in the belief that in order to avoid the danger of panic or "crisis" it was necessary to have wise and sound banking service constantly at the disposal of the community. Two fundamental problems in con- nection with reserve bank policy accordingly presented themselves from the beginning; the first, the method and extent to which the system should endeavor to get its funds actually into the hands of the public ; the second, that of regulating the process of distribution, or as some express it, of controlling the supply, of credit. In studying the problem of placing funds at the disposal of the community, two specific sub-prob- lems have always presented themselves. Of these, the first is that of the regular or systematic dis- counting of paper, while the other is the making of provision for exceptional or seasonal needs such as crop moving. A study of the mechanism provided by the Federal Reserve Act shows that the system had some difficult problems to deal with from the internal standpoint besides confronting a question in itself of no mean difficulty. In foreign banking systems two classes of operations are recognized — direct rediscounting and open market operations. The various bills which had preceded the Federal Reserve Act had in most cases attempted to limit the operations of the central reserve institutions to direct rediscounting on behalf of member banks. In this class of business a reserve bank merely waited for an application or offering of paper to 284 Federal Reserve Banks come to it from a member, whereupon it redis- counted the offered paper (if eligible) and placed the proceeds to the credit of the member on its books. The Federal Reserve Act, of course, provided for this kind of business but it also did what none of its predecessors had proposed to do — provided for open market operations by permitting reserve banks to buy or sell bills of the same kinds that were eligible for discount. This meant that a large field of banking transactions, otherwise closed to the reserve banks, was now open to them. They could purchase or sell with or without the endorsement of a member bank either to or from any bank or individual as they might see fit, and they could undertake this business either in domes- tic or foreign trade. Such open market operations always constitute a means by which central banks may, without waiting for applications from de- positors or customers, pour funds into, or with- draw them from, the general money market, thereby relieving stringency or reducing the avail- able supply of credit as circumstances may re- quire. The wise exercise of this ability on the part of any central bank gives to it a very great au- thority in the community, particularly when, as is the case in most countries, it represents a larger reservoir of fluid funds than exists anywhere else The early regulations of the Federal Reserve Board naturally dealt first of all with direct re- discounts and eventually established a fairly broad system whereby the single name notes of ordinary Federal Reserve Banks 285 bank borrowers in any amount large or small might be presented to and discounted by a Federal Reserve bank. 1 However, the system never extended its open market purchases very widely, and in practice all that was ever done was to deal (usually through brokers) in non-member bank paper, so that in fact it confined itself strictly to a comparatively narrow area of operations. The circumstance that the Federal Reserve System has used its buying ability only in a limited degree, is more or less hampered in its exercise of open mar- ket functions by the terms of existing law, and in any event has so surrounded its performance of such functions with restrictions and limitations that it has greatly reduced its power of market control has tended to hold it to the status of an emergency institution. Whether it will continue to retain that status is a serious question and one which is already being discussed by careful stu- 1 How extensively the banks of the country have used the direct rediscount privilege may be inferred from the following table: Number of Banks Accommodated Through the Discount of Paper During Specified Months, 1917-1921 Month March June September December. 1917 3i5 900 953 1,701 1918 1,568 3,021 3,464 3,288 1919 4,758 4-047 3.722 3>659 1920 3,670 4,948 4,758 5,551 1921 5,332 5,740 5,622 286 Federal Reserve Banks dents of the banking situation, some of whom be- lieve that a policy more nearly patterned after the European model is called for. The success experienced in dealing with the problem of seasonal extensions of credit has, how- ever, been much greater than that enjoyed in connection with general credit. Limitation of open market operations has been due in no small measure to the fears of member banks that they The following table shows the distribution and size of the re- discount operations for two selected months chosen as represent- ative at a period of special activity in operation. Average Size and Number of Items, Paper Rediscounted with Federal Reserve Banks, January and July, 1920 January July District Average Size of Items Number of Items Average Size of Items Number of Items No. 1 — Boston $17,990 58,284 62,092 24,897 9,664 13,340 20,522 H,992 9,202 6,947 4,605 13,638 2,723 8,131 1,833 1,606 2,040 1,769 5,269 3,724 1,955 3,873 1,350 3,415 $ 20,982 327,769 140,199 20,160 4,979 7,292 16,209 18,226 5,983 5,156 3,646 8,646 2,485 4,352 1,425 2,594 7,971 8,627 12,342 5,034 6,282 8,289 9,435 9,607 No. 2 — New York No. 3 — Philadelphia No. 4 — Cleveland No. 6 — Atlanta No. 7 — Chicago No. 8— St. Louis No. 9 — Minneapolis No. 10 — Kansas City No. 1 1 — Dallas No. 12 — San Francisco. . . Entire system 26,047 37,688 29,232 79,463 Federal Reserve Banks 287 might be prevented from getting, or might lose, valuable business, or might be restricted in their rates of interest. The seasonal extension of credit presented a quite different problem and one in which the jealousies of members played no part. It involved the establishment of a plan whereby the reserve banks could deal with other reserve banks in order to get aid from them for the pur- pose of enlarging the loans granted in their own districts. In all countries which have a seasonal type of agriculture or other industry, there is a peak of credit representing very intensive de- mands in certain parts of the country at certain seasons of the year, these demands falling off at a later date as productive conditions change and as seasonal needs decline. In the United States in former years it was customary for banks in the cotton- and grain-growing States to rely on the banks of the North and East for special aid. This was rendered unnecessary under the Federal Reserve System, at least in large measure, through a provision which, as applied by the Federal Reserve Board, compelled reserve banks with high reserves to purchase paper from other reserve banks with low reserves, transferring the proceeds of such purchases through the gold settlement fund to the selling bank and thereby placing it in posi- tion to go on enlarging its discount accommoda- tions. Such operations have been carried on at the express direction of the Federal Reserve Board under the terms of the Act. *d . 3 O O fe& " +> *-* s . V W N "^-00 ONOOOO^Oi- to 3 o 1 oo^hio ooa ■* a 1 l-t io o_ c^so o o^ 9* *" : *?. n 3 « i-i ■d vO m 1/ ■> SO a " o io ooo V0 3 1 o o\ o~rC C\ & r6 ON "■SI io <-T o" *C in Ttco co o\ ^f '53 m r*» oovO «« « rOON 00 W (O r*2 « t-< m m r-. 3~ 3 O woooooovoooooa m 2 Tl-O IO IOO u ^ Ml oo o ii o c- « "o a Ooo ovo c WO •-• i- »-i < «. M • ti : : : f ■sl-s-i 'w > 5,0 : c I (J 1 3 1 MlTjjmT i i I 4 W M K 4 oooooooooooc 5 2 ;£* ;2 ;z \* ^ :* ;? 52 32 :2 28? Federal Reserve Banks 289 This inter-reserve bank rediscounting, as it was called, served to equalize funds between different parts of the country and took the place, therefore, of the older system in which aid was extended by member banks in cities to their country corre- spondents. How extensively the services of inter- reserve bank rediscounting were availed of can be seen from the foregoing table which represents its volume of operations undertaken when this class of business was at the height of its activity during the period of credit strain in 1920; as compared with the corresponding situation a year later when demand had been greatly reduced. The seasonal fluctuation in such inter-reserve bank demand may be followed in the table below, which shows from month to month the changes in sectional requirements taken in the aggregate : Rediscounts and Sales of Discounted and Purchased Paper Between Federal Reserve Banks [In thousands of dollars.] 192 1 January February March April May June July 19 Discounted Bills 98,458 39.500 33,000 47,000 77,000 111,000 123,507 Purchased Bills 51.138 7,848 Total 149.596 47.348 33,000 47,000 77,000 111,000 123,507 290 Federal Reserve Banks The effect of the system thus was that of trans- ferring liquid reserves from one district to another and making payment for them at a later date when current sales of products had proceeded far enough to provide the means requisite for that purpose. As this system accordingly developed, the reliance of country banks upon city institutions fell off and the total volume of accommodation obtained in that way was undoubtedly much lessened. In thus surveying the general service of the reserve banks in the distribution of credit, there is one technical phase of the domestic operations of the system which should be carefully noted. The Federal Reserve Act had in a degree been based upon a preference for so-called two-name paper, — paper of the acceptance variety, whether bankers or trade, — as against paper with one name repre- senting the direct borrowing of a bank customer. The Federal Reserve Board, endeavoring to carry out the direct intent of the law, had established highly preferential rates for bankers acceptances and had also granted a moderate preference to commercial or trade acceptances when endorsed by a banker. The effort thus conservatively made to encourage the growth of two-name paper did not prove entirely successful. This was largely because, over a period of almost half a century, the American business man as well as the American banker had steadily accustomed himself to the single name type of borrowing based upon a line of credit granted by a bank. In order to differen- Federal Reserve Banks 291 tiate between the customer of high credit and prompt payment and the customer whose necessi- ties called for longer term accommodation, most American manufacturers and dealers generally have adopted the practice of allowing a discount for cash. Terms are habitually quoted as from 2 to 5 per cent, off for cash within ten days of date of invoice, with 1 to 2 per cent, off for cash within thirty or sixty days, and full payment thereafter. It was difficult to adjust this system to the use of two-name paper drawn for a specified amount at the time of shipment of goods since the shipper could not, and the buyer often did not, know which method of payment he would probably employ. The effort to encourage the use of such trade or commercial acceptances was urgently pressed during the years 191 8-1920, and there was a general disposition to claim for the trade accept- ance many merits which it did not possess. Un- f amiliarity with it and lack of conservatism in its use stimulated the growth of abuses and severe losses were incurred by banks which had dis- counted such paper with too little restraint. The reserve banks themselves never held many accept- ances growing out of domestic business. Both the trade acceptances and the domestic bankers acceptances held by them have been small in volume, but considerable harm was done to the banking system in general by unskillful use of both instruments. The conclusion is unavoidable that the acceptance movement in the United States has 292 Federal Reserve Banks been only partially successful. Whether two-name paper of this kind will ever be largely introduced in the United States is doubtful. Greater success was experienced in developing the use of the acceptance for the financing of the foreign trade. From a non-existent type of paper in 1 91 3 the bankers acceptance (including both paper made by non-members as well as that made by members) rose to a level estimated at the close of 1920 as high as $1 ,000,000,000. Reserve banks discounted such acceptances at times in large volume and while they succeeded in 1920-21 in inducing member banks to purchase and hold one another's acceptances in considerable quantity as investments, the amount in their own portfolios was always large. Since the adoption of the Federal Reserve Act, the various problems growing out of the general credit situation have been so serious as largely to obscure the old controversy about note issues and elastic currency. These matters had, however, as already seen, been among the principal factors leading to the movement for banking reform. While elastic note issues were not, in a country like the United States, an absolute fundamental they were nevertheless a very desirable means of meeting the credit necessities of member banks and of the country at large. In many parts of the South and West the use of checks instead of cur- rency had, and still has, reached only a relatively low stage of advancement. In such regions re- Federal Reserve Banks 293 discount accommodation was most easily and conveniently extended by means of note issues. Accordingly in the original draft of the Federal Reserve Act provision was made for a note cur- rency which should be the joint liability of all of the reserve banks combined and which was to be secured by commercial paper dollar for dollar. As banks desired to withdraw commercial paper, either because it had reached maturity or for some other reason, they were to be allowed to deposit an equal amount of gold with the Federal Reserve agent, who was made the holder of this collateral as well as the medium through which notes were to be received from the Treasury department where alone they were to be printed. The political discussion centering around the Act developed as one of its principal elements a demand that these notes should be given a quality as government currency and eventually, as a concession to this view, they were made liabilities of the government, such action being palliated by the fact that every effort was made to provide for their safety, secur- ity, and elasticity so that the government guarantee was of only technical significance. Soon after the new banks had been organized, however, the note issue controversy assumed a new form. Banks found that it was desirable for them to get notes as a matter of convenience to their customers in exchange for gold or legal tender money, and while this could be effected through a shifting of commercial paper back and forth be- 294 Federal Reserve Banks tween the reserve agent and his bank, that wasnot a convenient or satisfactory way of dealing with the matter. On the other hand, there had always been a desire to be allowed to use bank notes as a constituent in reserves — a policy indefensible from the standpoint of banking soundness. It was argued that inasmuch as credit on the books of the reserve bank counted as reserves, and inasmuch as reserve bank notes could be redeposited with the issuing bank and thus immediately give rise to reserve credit, there was no reason why the notes should not be permitted to count directly in the reserves of banks. Hence a demand for permission thus to count them in reserves and a well-organized movement to bring this about. Such a request would probably not have received much considera- tion had it not been for the entry of the United States into the war. When this event occurred it was, however, urged that reserve banks should be put into position to grant the maximum amount of credit and it was argued that by allowing their notes to count as vault reserves very much more flexible conditions would be established. A com- promise was finally arrived at with the result that reserve ratios were cut down from 18, 12, and 7, according to the location of the bank affected, to 13, 10, and 7 per cent with the proviso that the entire amount should be carried in the reserve banks, no vault reserves being required. This left the mem- ber banks free to use reserve bank notes as "till money " if they chose, and since experience showed Federal Reserve Banks 295 that about 4 or 5 per cent, of deposits must be carried in the vaults of members in the form of cash, it left the banks free to hold Federal Reserve notes to that extent as what was practically but not technically an element in their reserves. The measure tended to increase the amount of circulation outstanding and also to keep it out very much longer than would otherwise have been the case, that being the injurious effect always ob- served under similar conditions. Shortly after the United States entered the war there was developed a feeling that gold should be closely "conserved." Such conservation had become fashionable in Europe and while there was no occasion for it in the United States, owing to the fact that the balance of trade had been continuously and enor- mously favorable to us ever since the outbreak of the war in 1914, it was determined to follow Euro- pean methods. The export of gold was forbidden, foreign exchange was subjected to strict govern- ment regulation, banks were encouraged to de- posit their specie of every kind in the reserve in- stitutions, and the public was practically (although never technically) refused the redemption of notes in gold. Gold certificates had constituted an im- portant part of the general circulating medium, while United States notes (greenbacks) had been another element of some, although decreasing, significance. Both now disappeared from common use and their place was taken by Federal Reserve notes or by Federal Reserve bank notes. Owing 296 Federal Reserve Banks to these many and influential elements the circula- tion of reserve notes enormously increased and at the close of 1920 reached a figure close to $3,400,- 000,000. Meanwhile the policy of lending upon the direct obligations of member banks secured by government bonds, instead of rediscounting com- mercial paper, had become fixed as a result of our war finance policy so that the ideal of a note circu- lation resting on "commercial paper" was again lost, the real basis of the currency being the new so-called Liberty bonds. During the year or two after the war many came to the conclusion that the Federal Reserve notes had become an instrument of inflation and, that while they could be expanded very rapidly, con- traction of them was out of the question. This notion, however, was in a measure proved erro- neous after May, 1920, when a very rapid decline of prices and slowing down of business decreased the amount of hand to hand currency that was needed, while it also curtailed the amount of applications to reserve banks for credit. The note issue in the space of a year shrank by very nearly a third, reaching a figure of about $2,400,000,000 at the close of 1 92 1. This rapid reduction was referred to as an evidence of elasticity, in popular discus- sion, but could not properly be so regarded by scientific students of the banking situation. It was an adjustment due to the change in the level of prices and to the reduction in the general volume of business, but had only a remote, if any, connec- Federal Reserve Banks 297 tion with the seasonal changes in the volume of demand for accommodation which are ordinarily thought of in discussions of elasticity in the cur- rency. The reserve banks have provided a uni- form, reliable and easily expansible currency which has served a valuable purpose, but the changes made by Congress in the fundamental provisions of the law have completely altered its effects in the establishment of an elastic currency, and such a circulation has never yet been developed. An essential but little understood feature of the Federal Reserve system is found in the so-called clearance and collection provisions of the law. These were simple in the extreme. They author- ized every Federal Reserve bank to act as a clear- ing house for its members and they further au- thorized the Federal Reserve Board to act as a clearing house for all the Federal Reserve banks. The provision was a new one which had never figured in the legislative proposals for banking and currency reform that had been prominent during the twenty-five years preceding the adop- tion of the Act. No mention had been made of it in the work of the National Monetary Commission. It is difficult to see why so serious an omission should have been made . There is nothing in bank- ing experience to show that a banking system es- tablished in a country where the bulk of the business is done on a credit deposit basis can exist and render much service unless it has a steady flow of deposit items to it. And yet such a flow cannot 298 Federal Reserve Banks be maintained without performing the service of collection. This truth had for many years been recognized by the reserve-holding banks of the cities ; indeed, one of their principal forms of com- petition with one another had been furnished by the terms which they held out for the collection and deposit of items sent them by their correspondents all over the country. The Federal Reserve Act, however, was bitterly opposed by the banks which had been in the habit of charging high rates of exchange not merely for the cashing of items drawn upon other banks, but also for those drawn upon themselves, if such items came from institutions outside of their immediate locality. Their opposi- tion was continued after the Act had been passed, and rendered it doubtful how far the Federal Reserve System would go in introducing the collec- tion system. Nevertheless, it became so clear within a very few months after the organization of the reserve banks that a means of communication and settle- ment among them was essential, that the Federal Reserve Board ordered the establishment of a gold clearance system at Washington known as the "gold settlement fund." The plan for the estab- lishment of this fund had been carefully worked out in advance by the committee of technical ex- perts which had framed the plans for the reorgani- zation of reserve banks. These plans were followed in detail and the result was the establishment on June 1, 191 5, of a fund formed by the deposit of Federal Reserve Banks 299 $1,000,000 gold by each Federal Reserve bank with the Board at Washington. I Clearance was effected telegraphically each week. Later, gold settlement was effected every day, and the fund in the hands of the Board gradually increased to a maximum (for the banks and reserve agents com- bined) of near $1,000,000,000. The effect of the working of the fund was to convert items held by reserve banks upon one another into immediate reserve claims, the gold in the hands of the Board at Washington being reckoned as a part of the vault reserves of the Federal Reserve banks them- selves. Transactions under the gold settlement fund have run as high as $500,000,000 a day over long periods, and the service of this method of clearance both during and since the war has been invaluable, resulting as it has in largely terminat- ing the shipment of gold. 2 1 Later deposits were to be made when required through deple- tion of balances. 2 The facts as to the use of the settlement fund may be briefly reviewed as follows: Daily Average Number and Amount of Items Handled By the Federal Reserve Collection System During 6-Month Period Ending- June 15, 1917 Dec. 15, 1917 June 15, 1918 Dec. 15, 1918 June 15, 1919 Number 227,233 271,226 373-HO 644,762 891.952 Amount $118,630,693 197,352,152 289,316,239 408,363,076 410,883,755 3oo Federal Reserve Banks The next step was the introduction of a clearing service within the districts themselves. To this the strong opposition of member banks was en- countered from the beginning especially from two sources — city banks which believed that the assumption of such a duty would lessen their country bank deposits, and country banks which believed that such action on the part of reserve banks would impair their income from high ex- change charges. The necessity of doing something, however, became so evident that representatives of the reserve banks devised a plan of voluntary clearance permitting members to deposit items for collection if they chose to do so. Only about a year was required to prove this plan a failure, and on July I, 1 916, there was introduced a plan of involuntary or compulsory collection. Under this, if Bank A deposited with a Federal Reserve bank a check drawn upon another bank (whether a During 6- Month Period Ending- Dec. 15, 1919 June 15, 1920 Dec. 15, 1920 June 15, 1921 Dec. 15, 1921 Number 1,090,695 I.397.67I L579.900 1,698,587 1,751.427 Amount 487,836,000 532,164,000 517,753.613 408,448,973 383,702,680 Note. — Items drawn on Treasurer of the United States are included. Items handled by more than one Federal Reserve bank or branch have been counted only once, except in the figures for the first three months of the period ending June 15, 1917, when separate figures covering such items were not reported. Federal Reserve Banks 301 member of the system or not) , the Federal Reserve bank would take the necessary measures to collect the check. If the check was drawn on another member bank, the Reserve Bank would give the depositing member credit for it as soon as sufficient time had been allowed to have the check reach the bank on which it was drawn. The Reserve Bank, thereupon, charged the amount against the reserve account of the latter institution. Where a bank was not a member it was invited to join the collec- tion system by undertaking to remit at par, and, in the event that it did not care to do so, arrange- ments were made to collect in cash. The system worked fairly well and had the effect of main- taining reserves, eliminating a large part of the "float" (uncollected checks in the mails which were routed by roundabout methods in order to enlarge the amount of "deposits" on the books of various banks), and considerably reducing extrava- gant collection charges. In 1920 suit was brought by some Southern banks to secure the complete discontinuance of this method of collecting non- member checks, but up to the close of 192 1 no final decision had been reached. Due to hostile action in the legislatures of a number of Southern States, the collection system, which at one time had been almost countrywide, has been somewhat limited in area. It is still of first importance as a factor in the operation of the reserve system. The effect of the European War upon banking institutions both in England and on the Continent 302 Federal Reserve Banks was, of course, wholly disastrous. The principal outstanding results of the war from the standpoint of banking pure and simple may be summarized as : (i) a very great increase in government obliga- tions discounted with banks, and hence a tendency to render their portfolios very unliquid; (2) an enormous expansion in the volume of paper cur- rency and a complete retirement of specie from the field of circulation ; and (3) in many countries the substitution of a government irredeemable note as the standard of value, superseding gold and con- stituting the basis for "redemption" of bank notes. The closing of the war found banks in nearly all countries in an extremely feeble condi- tion. Gold reserves had been in some of them practically exhausted; in others they had become inadequate to the maintenance of specie redemp- tion. In practically all, the movement of gold into and out of the country had been prohibited. Ex- change relations between the United States and European countries, as well as among some of the latter themselves, had been subjected to stringent government regulation, the administra- tions of the several countries undertaking to convert the local currency of one into that of another at a fixed rate. Thus during the latter part of the war and for some months after the close of the struggle the British government suc- ceeded in maintaining a fixed exchange rate of $4.76 per pound sterling, both supplying ex- change on Great Britain and redeeming all ex- Federal Reserve Banks 303 change that was offered to it in New York at that rate. Due to these and other abnormal conditions there had been a complete redistribution of gold on an artificial basis and at the close of the war the United States had become the possessor of a very large share of the free gold of the world. This share was somewhat diminished after the end of the war by reason of the fact that when the United States removed her own gold embargo (July 1, 191 9) some minor exportations occurred. The outflow was not very long continued, however, and comparatively soon there was a backward move- ment both of gold and securities which hardly offset the enormous excess of merchandise which the United States continued to export to foreign countries. By the close of the year 1921 the stock of gold in Federal Reserve banks was nearly $3,000,000,000. European countries had in corre- sponding measure lost their gold, and exchange had, with some ups ■ and downs, quite steadily deteriorated throughout the whole period. Al- together the Federal Reserve System had been subjected to a new and peculiar condition, some- times described as "gold inflation." This would in ordinary circumstances have led to a fresh rise in prices, but the price level, after its tremendous drop from about 270 in May, 1920, to about 140 in July, 1 92 1, remained practically stable. Com- petition with European countries was gradually restored, particularly in South American and 304 Federal Reserve Banks Eastern markets, but instead of a great inrush of foreign goods into the United States, such as had been predicted, both our exports and our imports fell off very greatly, — our imports, however, more seri- ously than did exports — down to the close of 192 1 . In these circumstances, as will readily appear, there was offered an unusual opportunity to the member banks of the reserve system to finance not only the trade of the United States but that of the world as well. This, however, was availed of only in a partial and hesitating way, and eventually the banks, during the year 1921, largely withdrew from any substantial part in such foreign trade operations. Precisely why this unique oppor- tunity was thus neglected or misused can be better understood from a survey of the relation of the Act to the foreign trade situation. From the very beginning the relation of Federal Reserve banks to foreign countries and their bank- ing systems constituted a serious problem. This would have been true in any case because the American banking system had occupied so isolated a position and had been able to do so little in the direction of financing American foreign trade. It became of exceptional importance during the war because of the fact that most foreign currencies had become so largely depreciated while military danger to London and Paris led many banks and individuals throughout the world to transfer their balances to New York. In addition to this, how- ever, American foreign trade assumed a far greater Federal Reserve Banks 305 importance during the war than it had ever had before. The Federal Reserve Act provided three means for bringing the American banking system into closer relations with those of foreign countries. It authorized the national banks under specified conditions to establish foreign branches, and to create bankers' acceptances in the financing of foreign trade; it provided (in an amendatory act of 1 916) for the establishment of institutions to engage in foreign banking exclusively, whose stock might be owned by national banks; and it pro- vided for the establishment of branches and agencies abroad by Federal Reserve banks. These provisions had been hopefully viewed by American bankers and soon after the Federal Reserve Act was adopted a few large national banks endeavored to create a series of foreign branches, paying special attention to South America and the West Indies and to the Far East. Some other banks preferred the plan of organizing independent institutions and several such were created and likewise began the es- tablishment of foreign branches. Some progress was made by both groups of institutions, a total of about one hundred and fifty foreign branches being established. The provisions which had been included in the Federal Reserve Act for the making of bankers' acceptances up to the amount of 50 per cent, of the capital of each bank engaging in the business, had been extended through an amend- ment to the Federal Reserve Act (1916) which 306 Federal Reserve Banks increased the amount of such acceptances to ioo per cent, of capital and surplus, while of this amount one half might be acceptances drawn against domestic transactions pure and simple. L Unfortunately the acceptance even in foreign trade was often drawn for the purpose of pro- moting speculative operations designed to assist in the holding and storing of commodities or to anticipate their movement. The latter evil was aggravated by a further amendment to the Federal Reserve Act (1916) which authorized the drawing of acceptances to create what was called "dollar exchange" in favor of countries which might be approved by the Federal Reserve Board. Partly as the result of generally unfavorable commercial conditions affecting the whole world during the reaction which set in after the spring of 1920, partly as the result of poor management of foreign branches, and partly owing to the abuse of the acceptance, the spring of 192 1 found many foreign branches losing money rapidly and not a few American banks faced with the necessity of renew- ing their outstanding acceptances or of taking a heavy loss on them. The result was the closing, during 1921, of a good many of the foreign branches which had been previously established while the total volume of acceptances which had been afloat in the market was cut from a total of possibly $1,000,000,000 (including both member and non-member paper) to about $400,000,000. At Federal Reserve Banks 307 the same time several foreign credit institutions were either liquidated or curtailed operations. In the meantime Federal Reserve banks had been hesitant in taking any direct part in the financing of foreign trade. The Federal Reserve Board had at the outset defined the paper which they could discount in such a way as to require it to be drawn in terms of dollars. They purchased and discounted large quantities of member and non-member acceptances, but only when drawn in dollars, the reason assigned being that a like prac- tice (of dealing only in bills drawn in sterling) had long been prevalent at the Bank of England, while on the other hand, it was asserted that the danger of loss due to fluctuation of currency as the war progressed was too great to be incurred by reserve banks. For similar reasons there had been refusal to establish agencies abroad. Soon after the United States entered the war, pressure from the government led Reserve banks to establish agency relations with the Bank of England, subject, how- ever, to a private agreement which specified that . during war there should be no actual operation by either the reserve system or the Bank of England in the market of the other. The arrangement was largely one for the fiscal convenience of the govern- ments concerned and for the holding of coin with- out danger of transoceanic shipment. In these aspects it was well worth while, but it had little significance as a commercial banking relationship. Similar relations were subsequently established 308 Federal Reserve Banks with various foreign banks but upon an equally limited basis. The Federal Reserve System never acquired a portfolio of foreign bills nor did it ever undertake to support the operations of American banks in the markets where branches were estab- lished. Neither did it ever undertake to supply exchange or remittances to foreign countries save in a limited way for the Government of the United States, and during the latter part of the war for business uses through arrangements with certain South American states. While there had been much sporadic discussion of the financing of foreign trade before the Federal Reserve System was established, and while there had been well-grounded criticism of the conditions in our legislation which necessitated applications to English banks for the opening of acceptance credits, the lack of foreign trade financing had never been so important in its effect as to con- stitute an evil of first proportions. Contrary to the condition in such a country as Great Britain, the . United States depends only in a secondary degree upon its foreign trade, although such trade is un- questionably essential as a regulator and supple- ment to domestic commerce. A new situation, came into existence soon after the war opened, due to the fact that European countries found it necessary to rely very largely upon the United States as a source of supply for munitions and food. In order to pay for these necessaries various means were found. Large quantities of foreign- Federal Reserve Banks 309 held American securities were shipped to the United States and sold in this market. Great sums in gqld as already noted, followed them. Finally European bonds were placed in considerable quan- tities with American banks and individuals. Dis- trusting the financial position of foreign countries, American bankers and business men hesitated to extend credit and in most cases depended upon payments made prior to shipment of goods. When we ourselves became participants in the war, the Federal Government sold its own bonds to our citizens and lent the proceeds to foreign coun- tries which used them in paying for our goods here, and thus a great foreign trade continued to be financed. This continued until several months after the armistice had been signed on November 11, 191 8. It then became evident that the one- sided trade which had developed and which had produced our immense export balance could not be indefinitely maintained but must be taken care of in some other way. Hence the growth of foreign branches, to which reference has already been made. These, however, were necessarily institu- tions lending upon short term. The need of a more permanent system of financing led to the adoption of a measure amendatory of the Federal Reserve Act and known as the "Edge Foreign Banking Act." This became effective in December, 1919, and authorized the creation of institutions allowed to invest in foreign countries and to sell their bonds to American investors who would thus become 310 Federal Reserve Banks creditors of the banks, supplying them with funds wherewith to make foreign investments. All this had however, taken time, and the organization of new institutions under the Edge Act was slow partly because of the impractical provisions of the law and partly because of the increasing economic confusion in Europe. The Edge Act further made provision for acceptance business to be under- taken by Edge corporations organized for that purpose but there was little success in this direction. Very few Edge banks were ever organized (two in active operation at the close of 1 921), but during the years 191 9-1 921 our foreign trade was largely financed by manufacturers and merchants who extended open book credits to their customers, financing themselves by direct borrowing at their own commercial banks. Through this means there was built up an enormous unfunded balance due the United States and estimated at the close of 192 1 as something like $3,500,000,000. Reserve banks in the meantime had discounted foreign bills growing out of ordinary trade operations in con- siderable quantities, but only when stated in terms of dollars. With the shrinkage of prices after May, 1920, and the closing down of business which accompanied it, the volume of such paper fell off and the service rendered by reserve banks in the financing of foreign trade, which had always been more or less limited, became even less important. In its relation to foreign business the Federal Federal Reserve Banks 311 Reserve System has perhaps been less efficient and, serviceable than in any other aspect. A critical estimate of the service of the Federal Reserve System is necessarily very mixed in char- acter. The gloomy forebodings expressed when it was first organized have been warranted in no essential respect. Loans have not been made on a "political" basis, and there has been but little difficulty in organizing and conducting the several banks in substantial harmony one with another; — in short, the administrative mechanism, while far from perfect, has been serviceable and efficient. On the other hand, the banking mechanisms of the system — its handling of reserves, its clearance and collection system, its plan of note issues, and other basic features, have been very satisfactory in their operation and, indeed, have worked more nearly perfectly perhaps than any similar systems now in operation. Moreover, the general service of the reserve banks has been far greater and more nationally essential than could have been hoped. No one could have foreseen the coming on of the European War or the fact that we should find our- selves obliged to furnish the means for carrying it through its later stages. Few would have believed that the Reserve System would prove adequate to the task of handling and conducting the finances of such a war. Yet it was in this very field that the system was found most effi- cient and satisfactory — it might be said most fundamentally essential to the maintenance of 312 Federal Reserve Banks national solvency and financial success during the conflict. The defects of the system have been found in unexpected directions but have been real and to- day present serious obstacles to its success. Start- ing with the idea of a small fundamental reserve contributed by commercial banks, the reserve resources of the system have been greatly expanded through gold importations, through deposits by members, and through changes in reserve require- ments. Yet there has been no corresponding change in the methods of releasing these funds for market use, and in consequence the operations of the system, unless carefully handled, may tend somewhat toward constriction of credit at various times. A natural and available remedy is the free use of the funds in open market transactions, or their application to the financing of foreign trans- actions. Neither course, as already seen, has been followed, but the system has refrained from the open market type of transactions, while conditions have not been favorable for the undertaking of foreign operations. Whether a different situation will supervene at a later date it is difficult to say, but in the meantime the great accumulation of gold and the enormous unused lending power of the system have aroused the persistent hostility of many elements of ihe community. During the year 1921 legislation of various kinds was considered by Congress in the attempt to secure application of reserve funds on a freer basis Federal Reserve Banks 313 to agricultural and other needs. The demands of farmers who had suffered severely from the tre- mendous fall in the price of their products un- accompanied by a similar fall in the value of manufactures during the latter part of 1920, and the early months of 1921, led to a Congressional investigation of the reserve system, carried on during the late summer of the year 1921. This investigation developed not only the general theories upon which Federal Reserve banks had been conducted, but also the facts with respect to the distribution of credit among different types of business. Most 'of these data had already been presented by the Board in its monthly and annual publications, as well as the publications of the several Federal Reserve banks, but the investiga- tion at least afforded a new synthesis of them. The showing thus made did not, however, appar- ently relieve the criticism which had been directed against the system and the belief has undoubtedly gained ground in many minds that it is an organi- zation which works primarily in the interests of the manufacturing or industrial classes and against the farming population. Careful scrutiny of the facts and figures relating to the system's operations affords little warrant for any such belief, but the fact remains that the peculiar banking character of the system and its lack of contact with the average man tend to make it unpopular and to furnish a ground for the growth of political pre- judices which would not be afforded were the type 314 Federal Reserve Banks of organization somewhat different. This state of things, of course, furnishes no reflection upon the scientific or financial merit of the system, but must be taken as indicating a reason why the organiza- tion has not fitted comfortably into the general business and economic structure of the nation. The Federal Reserve System, in short, has proved its practicability and service to the com- munity ; has been indispensable in aiding in financ- ing the war and post-war operations of the govern- ment; has performed, and is to-day performing, without cost both for the government and for the banks, functions in the transfer and care of money which are almost invaluable ; has shown itself able to expand its credit-granting powers and to resist almost any ordinary strain to which it can be sub- jected ; has been free from undue political influence, and has been, on the whole, reasonably efficient and careful in its use of funds. It has failed to come into contact with the rank and file of the public ; to control rates of interest and discount as many had expected that it might; has done little to correct existing inequalities in the distribution of credit among individuals; has abstained entirely from participation in foreign trade financing or international operations except those of a stereo- typed sort; and, in the opinion of large classes of the community, has been relatively indifferent to their needs or requirements. Its services are thus substantial and the criticisms directed against it, although in part well founded, are also in part Federal Reserve Banks 315 imaginary or exaggerated. Nevertheless, the or- ganization has still to make a definite place for itself in American banking although its service has been so conspicuous that the destruction, or even very far reaching modification of it, does not now seem immediately probable. INDEX Acceptances, bank, 20, no; Federal Reserve Bank, 290- 292 Acceptors, London and the European War, 121-126 Account, explanations of bank- ing, 22-42 Assets, limited possibilities of liquidating, 81-83 B Bagehot, W., 18 n., 19 n., 100, 15m. Bank of Amsterdam, 4, 19, I33n. . Bank of Austria-Hungary, 93 Bank of Belgium, 93 Bank of England, 4, 1 1 n., 35 n., 38, 68 ; v development of its central banking functions, 86-88, 90, 95, 100; small reserve, why adequate, 129; history of, to 1844, 132-138; and the act of 1844, 138- 148; relations of, to other banks, 148-151; and the crisis of 1857, 151-161; later history and organization, 161-166; compared with the Reichsbank, 204-206 Bank of France, 88, 90, 130; early history of, 168-172; monopoly of note issue and its effects, 173-17 8 . opera- tions of, during the Franco- German War, 179-186; note issue and reserve of, 187- 190; gold premium policy of, 190-192; loans of, 193-194; organization of, and relation to the State, 194-198 Bank of Japan, 85-90 Bank of Prussia, 201 Bank of Russia, 90 Bank of Venice, 4, 133 n. Banking, simplicity of, 1; beginnings of, 4; effects of, 5; dangers of, 6; essentials of, 9, 18, 26; denned, 19 n. Bank notes, similar in nature to deposits, 8, 17. See Notes and Note Issue Baring crisis, 90, 101, 164 Bonds, as investments for banks, 29; as a basis for the issue for bank notes, 66-68 Boston, Federal Bank of, 48 n. Branch banking, and the col- lection of checks, 48; and the redemption of notes, 75 ; in England, 162-163; in France, 172-173, 177-178; in Germany, 218-219 Caisse d'Escompte, 167 Caisse des Comptes Courant, 167 Canadian bank, notes of, 75, 77; in crisis, 83 Cannon, J. G., 58 n. Capital, and size of banks, 22-23; °f Bank of England, 133, 135; of Bank of France, 168, 172, 175; of the Reichs- 317 3i8 Index Ca pital — Continued bank, 201 ; of German banks, 219 Cash items, explanations of, 40 Central banks, notes of, 79- 80, 88; functions of, 83-88; activities of . in normal times, 88-92 ; devices of, to protect reserve, 92-94; rate of dis- count of, 94-100; activities of, during crises, 100; clear- ing functions of, 1 01; in debtor and creditor money markets, 128-131 Central reserve cities, 235 Chase, Salmon P., 220-222, 233 Checks, as currency, 43-46; clearing of, 47; collection of, on distant banks, 49; col- lection of, by Federal Re- serve banks, 50; collection of, and the expansion of credit, 69-71 Clearing House, operation of, 47-49, 57; restrains expan- sion of credit by particular banks but not by all banks, 69-71; of London, 48; of Boston, 49; certificates, 47 n., loan certificates, history of, in successive crises, i860- 1907, 241-246 Commercial loans, 10-13, 2 7 - 29; liquidness of, 81 Comptroller of the Currency, 226, 236, 256, 257 Crises, situation and policy of banks during, 82-84, 10 °; m the United States, 1857- 1907, 84, 241-246; of 1890, 90, 101, 164; of 1914, 121- 126, 160, 248; of 1825, 144; of 1857, 151-161, 241 Currency Act of 1900, 247 D Deposits from loans, 13, 55; from other operations, 14; nature of liability, 16; limits on expansion of, 33, 52-55; how transferred, 43-46; similar to bank notes, 60-62 Discount, explanation of, 12; rate of, and protection of reserve, 33, 94-98; change in rate of, in Federal reserve banks, 278-282 Documentary bills of exchange, 109 Domestic exchange, rates of, 103 E "Edge Foreign Banking Act," 309 English joint-stock banks, capital of, 25 n. ; growth of, 138, 162; relation of, to Bank of England, 149, 162 Expenses, place of, in bank accounts, 40 Exports, financing of, 112 Failures in the United States, 28 n. Federal Advisory Council, 259 Federal Reserve banks, collec- tion of checks by, 50; are central banks, 80; reasons for establishment of, 85, 249, 250; organization of, 249- 258, 261; branches of, 258- 259; districts of, 258-260; directors of, 259-260; com- parison' of other national banking systems with, 263, 266; tables of resources and liabilities, 264, 265; services of, during war, 273-276; after war, 277-282; in domestic operations, 282- 290; and discount and re- discount, 285 n., 286 n., 288, 289; seasonal extension of credit, 283, 286, 287, 289; acceptance movement, 290- Index 319 Federal Reserve Bants — Cont. 292; and note issue, 292- 297 ; clearance and collection, provisions for, 297-301 ; and relations to foreign banking systems, 304-311 Fedeial Reserve Board, com- position of, 256; duties of, 256, 297 Federal Reserve System, mem- bers of, 267-269; history of, 270-278; and foreign banks, 305-308 Finance bills, 1 1 5-1 1 8 Foreign bills of exchange, in- vestments in, by central banks, 93, 131 Foreign exchange and discount rates, 98-99, 107-108; de- fined, 103; demand rates of, 103-107 ; cable transfer rates, 107; varieties of time bills, 108-110; financing exports and imports, 110-114; deter- mination of sight rates, 114- 115; finance bills, 115-118; borrowing and lending markets, 1 18-120; place of Londonin, 119-121; and the European War, 121-127; de- velopment of, by banks in the United States, 127 France, banks of issue other than the Bank of France in, 172; slow development of banking agencies in, 176; deposit banks in, 177 Franco-German War, opera- tions of the Bank of France during, 178-186 G Germany, currency of, 199- 201; independent banks of, issue of, 202, 212; deposit banks of, 216 Gilbart, J. W., 138 n. Gold, means of checking ex- ports of, 93, 106; costs of shipment, 104-106; accumu- lation of, by the Bank of France, 187-189; by the Reichsbank, 215, by Federal Reserve Bank, 277 "Gold settlement fund," 298 H Hamilton, Alexander, 55 n. Hankey, T., 140 n. I Imports, methods of financing, in Interest, payment of, on bankers' deposits, 243 Issue, see Note issue Japan, 85, 90 Jevons, W. S., 47 n. K Kinley, D., 55 n. Liabilities, ratio of reserve to, 34-35- 81 Liberty Loans Organization, 276 Liverpool, Lord, 137 Loans, nature of bank, 9-12; varieties of, 12-13, 27-29; limits on, increase of, 33; liquidness of, 81, 272; dis- astrous consequences of wholesale contraction of, 82; of central banks, 88-92; of small amounts of the Bank of France, 192 London, the central money market of the world, 119, 148 ; and the European War, 121-127 320 Index London and Westminster Bank, 138 Louisiana, regulation of the banks of, 38 M McLeod, H. D., 61 n., 100 n., 132 n. Moratorium of 1870 in France, 180 Mortgage loans, proper em- ployment for savings de- posits, 30 N National bank of the United States, foundation of, 220- 223; general safe-guards, 224; gold banks, 224 n.; public functions of, 225; condition of note issue, 226- 229, 233; profit from issue, 229-231; amount of issue, 231-233 ; regulation and com- position of reserve, 234-237; defects of, in successive crises, 238-248; emergency notes issued by, in 1914, 247; members of the Federal Reserve banks, 267-269 New York, free banking sys- tem of, 67 Notes, danger of over-issue, 7; use of, in various countries, 56; reasons for restrictions on, 60-64; methods of safe- guarding, 64-68; over-issue of, and of deposits compared, 68-72; regular redemption of, 72-75; bonds as a safe- guard, 77-79; special charac- ter of, when issued by central banks, 79-80 Note issue, importance of, to central banks, 87-88; of London private banks, 132; of Bank of England before 1844, 134-136; of joint-stock banks before 1844, 136; of Bank of England after 1844, 139-141; of other English banks, 141-142; and sus- pension of Peel's Act, 145, 156-160; of the Bank of France, 173-178, 187-190; of the Reichsbank, 202-207; of national banks, 226-229, 233; of Federal Reserve banks, 292-297 O Other assets, 40 P Paterson, Wm., 133 Pennington, J., 61 n. Peel's Act, 138-146; suspension of, 156-161 ; and the German law relating to bank notes, 204-207 Rate of discount, and pro- tection of reserve, 33, 84- 99; and foreign exchange rates, 108; of the Bank of France, 175, 192; of the Reichsbank and other Ger- man banks of issue, 213, of Federal Reserve Bank, 278- 282 Redemption of bank notes, under Suffolk System, and in Scotland and Canada, 74- 75; difficulties of, where banks are numerous, 75; advantages of, 76; of na- tional banks, 227 Reichsbank, the, 98; origin of, 199-201 ; organization of, 201-202 ; note issue of, 202- 207; increase in, untaxed issue of, 208-211; notes of, made legal tender, an; and other German banks of issue. Index 321 K eichsbank — Continued 212-213; and German deposit banks, 214; reserve of, 215; accumulation of gold by, 216; settlement system of, 218 Reichs-kassenscheine, 200 Reserve, proportion of, to liabilities, 34; management °f» 35 - 36; various meanings of, 42 n. ; ordinary and extraordinary requirements, 81-84; advantages of, cen- tralized, 86; responsibility of central banks for protection of, and methods of safe- guarding, 86-99; adequacy of, in creditor and debtor markets, 129-131. See Bank of England, Bank of France, Reichsbank, National banks, and Federal Reserve banks Reserve banks, branches of, 259 Reserve cities, 234, 258 Rest, 143 n. Ricardo, D., 141 n. Savings banks, r5, 19, 27, 30 Scotch bank, 75, 143 Securities as a quasi-reservei 36, 82 Shareholders, liability of bank, 24 Silver, and the Bank of Eng- land, 139 n.; the Bank of France, 189- 190; the Reichs- bank, 207 Smith, Adam, 1 South Sea Company, 134 State banks, note issue of, before the Civil War, 77, 223 ; and the Federal Reserve banks, 267, 268, 269 Stocks, not a proper bank investment, 29 Suffolk bank system, 74 Surplus denned, 39 Treasury of the United States and national banks, 225 Trust companies, 267, 268, 269 U United States bonds, and national bank-notes, 226, 229-233 Undivided profits, 31, 39 !Si!!'jii;iii :i ;;iii!;i;>;i^i;'i