fciiiiiiii^'iiaiijiiili^ii'p':^^^^ ■"')5/ 40769 4-13-23 Date Due QEClStPRf ; nHiKL-»«^ wwr -j^R=sin[^^ ^ JUL^^nwf' Cornell University Library HG1601 .D51 Banking and credit: olin 3 1924 032 523 742 Cornell University 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/cu31924032523742 BANKING AND CREDIT A TEXTBOOK FOR COLLEGES AND SCHOOLS OF BUSINESS ADMINISTRATION By DAVIS RICH DEWEY Professor of Economics and Statistics, Massachusetts Institute of Technology and MARTIN JOSEPH SHUGRUE Assistant Professor of Economics, Massachusetts Institute of Technology NEW YORK THE RONALD PRESS COMPANY 1922 Copyright, 1922, by The Ronald Press Company All Rights Reserved A5a.i55'^f PREFACE The field of banking and credit is so extensive that it is im- possible to describe all its features in a volume of moderate compass. This text is therefore restricted in its content. It is written primarily to meet the needs of the individual who uses the bank for credit accommodation; its aim is to explain the problems confronting the customers of a bank, and the significant factors that control the terms and conditions upon which credit may be obtained. The different forms of credit instruments are described and emphasis is placed upon procedure by which loans are obtained and the methods of determining credit risks. To make room for this, less attention is given to the history of banking, to invest- ment forms of banking, and to theoretical questions concerned with the nature and principles of money and credit. It is as- sumed that the reader has some familiarity with the chapters on money and banking which are found in all elementary texts on economics, and the purpose of this volume is to supplement these chapters by more detailed description and illustration of actual practice in the business world. A few specific references are given at the end of each chapter to aid those who wish to read further on particular topics; and in the Appendix will be found carefully chosen problems and exer- cises with solutions, designed to make clear the customary process of banking and credit operations. Davis R. Dewey Martin J. Shugrue Cambridge, Mass. May lo, 1922 CONTENTS Chapter Page I Money and Credit i II Stock of Money 8 III Commercial Credit Instruments 34 IV Commercial Credit Documents 58 V Letters of Credit 71 VI Negotiability ... 80 VII Business of Banking ... . . -94 VIII Various Kinds of Banking and Credit Institutions 102 IX The Balance Sheet of a Bank ... .126 X Funds Belonging to Stockholders .... 142 XI Deposits 150 XII National Bank Note Circulation ..... 164 XIII Commercial Loans 175 XIV Security for Loans 188 XV The Credit Statement 208 XVI Analysis Ratios .... 220 XVII Individual Items of a Credit Statement . . . 231 XVIII Analysis of Typical Credit Statements . . . . 255 XIX SecurS'y and Other Investments of Commercial Banks . . .... .263 XX Cash Holdings and Reserve of a Commercial Bank 270 XXI The Clearing House . . .... 289 XXII Defects of the National Banking System . . .301 XXIII Organization of Federal Reserve System . . . 309 XXIV Rediscounting by Federal Reserve Banks . . . 333 V VI CONTENTS Chapter Page XXV Other Operations of Federal Reserve Banks . 344 XXVI Acceptances .... 357 XXVII Principles of Foreign Exchange . . . .370 XXVIII The Process of Foreign Exchange . . 385 XXIX Typical Foreign Exchange Transactions . . . 395 XXX The New York Money Market . . . . 409 XXXI Monetary Problems 427 Appendix A — Problems with Solutions 453 B — Problems without Solutions . . . . 477 C — Interest Tables . . 483 D — Value of Foreign Coins 493 E — Bibliography 496 Forms Form Page 1. Bill of Exchange Drawn at 60 Days 35 2. Trade Acceptance 39 3. Bank Acceptance 39 4. Bank Check 41 5. Promissory Note 47 6. Travelers' Check 52 7. Certificate of Deposit 54 ' 8. Railroad Bill of Lading 61 9. Shipper's Invoice 62 10. Shipper's Draft 63 11. Warehouse Receipt 64 12. Trust Receipt 68 13. Import Letter of Credit (Dollars) 72 14. Travelers' Sterling Letter of Credit 76, 77 15. Collateral Loan Agreement 189 16. Borrower's Statement 213, 214 17. Map of Federal Reserve Districts 310 18. Chartof Reserve Percentages of Federal Reserve Banks 351 19. Diagram Illustrating the Financing of a Shipment of Goods by Means of Bankers' Acceptances 360 vu Banking and Credit CHAPTER I MONEY AND CREDIT 1. Close Relationship of Money and Credit. — In the highly complicated mechanism of economic processes which society has created for the carrying on of business, no parts have aroused more interest and inquiry than money and credit. They are closely allied with each other in their uses and are generally treated together under the heading of "exchange" by authors of systematic textbooks on the principles of economics. Notwith- standing this intimate relationship, they are fundamentally different in their origins and in many of their characteristics. It is therefore necessary to note briefly the essential nature of each before entering upon the explanation of the monetary system of the United States and the credit agencies and instruments which are in current use. 2. Meaning of " Money. " — Money, by time-honored de- scription, is a medium of exchange, a measure of value, a standard of deferred payments, and a store of value. These functions are so diverse that it is diflftcult to give a definition of money which will cover all its characteristics. Some authorities place the emphasis on the service which money renders as a standard of value; others on its use as a medium of exchange. As a result some limit the use of the term "money" to the instruments of exchange which have intrinsic or commodity value, thus exclud- 2 BANKING AND CREDIT [I ing all forms of paper money; others include under the term all instruments which effect exchange. The exchange of values is effected by a variety of instruments. Included in the list are gold bullion, coins minted by the govern- ment, promissory notes issued by the government, bank notes, checks of individuals and corporations, drafts, bills of exchange, acceptances, travelers' checks, certificates of deposit, postal money-orders, bills receivable, and promissory notes of individ- uals and corporations. For the ordinary transactions of retail trade and wage payments, small coins and paper money issued by the government or by banks are in familiar use, and to an increasing extent individual checks are employed in these settle- ments of indebtedness. In transactions involving larger sums checks are commonly used; and for pa3anents at a distance, bills of exchange and drafts occupy a prominent place. Not all of these instruments, however, are serviceable as a standard of value, although they are highly convenient as a medium of exchange. Gold, because of the worldwide estimation in which it is held, most completely satisfies the requirements .of a standard of value, and to a certain degree it is a medium of ex- change. Other instruments, however, may perform much of the exchange work of the community better than gold. A check is an excellent medium of exchange, but is worthless as a standard of deferred payments. 3. Various Definitions of Money. — The conflict of opinion in regard to the definition of money is well summed up by Conant in the opening pages of his treatise on "The Principles of Money and Banking." After limiting the definition of money to that "commodity of intrinsic value acceptable in exchanges which has become by law or custom the usual tender for debt," he continues: Put into more popular language, this means that the term money, under existing social conditions, is applicable to gold or I] MONEY AND CREDIT 3 silver coin, and should not be extended to the various forms of paper which economize the use of money. For most practical purposes, gold bullion held in bank reserves is properly classed as money, and falls within the definition given. . . . The use of the word money is extended by many authorities to different forms of credit obligations — by some to redeemable government paper or redeemable bank-notes; by others to irredeemable paper of either type; and by still others to the checks, deposit entries, and various written instruments which are employed in carrying on exchanges. The difficulty about these extensions of the defini- tion beyond coined metal of intrinsic value is that there is no logical point at which the things included in the definition of money terminate. If the definition is extended to instruments of paper credit, it is not clear why it should stop with legal tender instruments and faU to include bank-notes which are not legal tender. If it is extended to the latter, it is not clear why it should not extend also to foreign biUs of exchange, which are kept by many of the European banks as a part of their coin reserves, ready to be sold for coin whenever they have need for it. ' Although there is a wide difference between a gold coin and a check representing an order upon a bank to pay a certain sum, it is not necessary in a preliminary description of the various in- struments of exchange which serve the needs of business society, to make a definitive and final choice of the media which are to be included under the term "money." Such a definition is impor- tant in the analysis of certain applications of monetary theory, as the quantity theory of money and the relation of money to prices, but further discussion on this point is deferred to a subse- quent chapter. 4. The Nature of Credit. — The nature of credit can best be approached by considering some of the operations involved in the production of wealth. Among the agents which co-operate in ' Vol. I, pp. 4-S. For further definitions of money, see W. A. Scott, Money and Bank- ing, p. l; F, M. Taylor, Some Chapters on Money, pp. 11-12; F. A. Walker, Money, Trade and Industry, p. 4: D. Kinley, Money, pp. 70-71 ; E. W. Kemmerer, Money and Prices, pp. 27-28; J. F. Johnson, Money ana Currency, pp. 6-7. 4 BANKING AND CREDIT [ I production is capital. It may exist in the form of tools, machin- ery, workshops, factories, railway equipment, shipping, as well as of cash or money. For nearly all forms of industry the work of producing an individual commodity stretches over a considerable period of time. When the article is finished there is often a further addition of time before the commodity is purchased, and even then there may be a delay in the payment. The producer, therefore, must have the use of wealth not only to provide the initial equipment, to purchase raw material, to hire laborers who must be paid long before there are any returns, and to pay insur- ance and taxes which are imposed though the goods are not yet sold, but also to bridge over the delays before payment is received for the goods sold. The producer needs present purchasing power; he may have saved the capital which he uses, or he may borrow it. If he borrows it he employs the service of credit and the essential characteristic of this is the possession of present pur- chasing power in return for a promise to pay in the future. If the producer borrows in order to establish the initial enterprise he will probably borrow for a long period of time, obtaining capital from those who do not wish to employ it under their own super- vision. The evidence of such borrowing will appear as long-time notes, bonds, and similar instruments. But even if borrowing is not necessary for the establishment of the initial undertaking, it is likely to occur before a final settlement is made in the sale of goods. Economic organization is highly complex and there are many interruptions in the marketing of goods. Moreover, if there be an increasing demand for the goods in the production of which this producer is engaged, the use of more capital is required. Every effort is therefore made to obtain control of capital by the use of credit. Finished goods, even before they are sold, may be pledged to secure capital; and if the goods are sold but not paid for, the accounts may be pledged. If the producer has a previous record of success which inspires confidence, capital may be I ] MONEY AND CREDIT 5 borrowed without the pledge of any specific property. To pro- vide these credits, a specialized economic mechanism has been devised, consisting of banking institutions and credit instruments. Thus by means of credit, capital as one of the agents of production is placed where it can be made more effective, and undoubtedly the development of these facilities is one of the most powerful influences in the creation of wealth on the scale which the world now enjoys. 5. Credit as an Exchange Factor. — Inasmuch as credit pre- sumes the payment of money — and payment within a short time if the credit be of early maturity — credit instruments are often as convenient for the purposes of exchange as the money commodity itself. Communities in their economic development have con- stantly struggled to improve their methods of exchanging wealth; from primitive barter they passed to the use of monetary media which became standards of value. But with the growth of com- merce and trade they have utilized a great variety of credit in- struments which have become serviceable for exchange purposes. The credit tools devised to make capital more productive have also been found available for carrying on the work of exchange. Some forms of credit, as the promissory notes of the govern- ment and of banks, may prove so acceptable that they readily circulate and become a part of the money stock. Their credit significance, however, must always be kept in mind, for they do not, simply through their creation, add to the wealth of the nation. The addition of $100,000,000 in gold increases the national wealth; the addition of an equal sum of promissory notes does not at the moment increase the total wealth. It may set in motion forces which will ultimately create wealth, for, as Mill states it, "although the production funds of the country are not increased by credit, they are called into a more complete state of productive activity. ' ' ^ 2 J. S. Mill, Principles of Political Economy, Book III, Ch. XI. 6 BANKING AND CREDIT [ I The great increase in the production of wealth witnessed during the past century is due not only to the discovery of new mechanical processes and applications of natural and physical science, but in large measure also to the extension of credit facili- ties. So remarkable has been this extension of credit and so ser- viceable has been its uses in effecting the transfer of values, that some have been led into the error that commodity money could be abandoned and that all exchange operations might be satis- factorily performed through credit substitutes. Authors of textbooks on economics usually treat the subject - imder four main headings: production of wealth, exchange of wealth, distribution of wealth, and consumption of wealth. As credit has become so large a factor in the operations of exchange, it is generally discussed under the second of the above headings. Exchange, therefore, includes not only the characteristics and functions of money, but also the use, development, and influence of credit instruments, the character of banking institutions which enlarge the use of credit, and the relation of the quantity of money, including credit substitutes, to prices and the money market. It must, however, be ever kept in mind that credit primarily has to do with the transfer of wealth in the form of capital as a productive agent. Because of its serviceability as a tool of exchange, however, it is allied to money, and the discussion of the one involves the discussion of the other. 6. Credit in Relation to Prices. — One further point should be raised before entering upon the following descriptive chapters. The use of credit makes available a mass of values as a medium of exchange. Does the addition of these credit media affect the value of the commodity money medium, and thus affect prices? Do credit tools, which undoubtedly aid money, under its narrow- est definition, in the work of exchange, modify the value of money? If so, the development of credit assumes a new impor- tance and its use becomes a price-making factor. This is a ques- I] MONEY AND CREDIT 7 tion which has aroused much dispute, but its discussion is for the present deferred. It is raised at this point in order that the reader may recognize that credit may be more than an agency in render- ing capital productive, or simply a part of the machinery whereby values are exchanged. References Practically all treatises and textbooks on general economics devote paragraphs to the nature and functions of money and credit. Specific references are not needed, as these texts are indexed. Money Conant, C. A. Principles oi Money and Banking. Vol. I, pp. 17-31. Holdsworth, J. T. Money and Banking, pp. 12-16. Jevons, W. H. Money and the Mechanism of Exchange. On the functions of money, pp. 14-18. Johnson, J. F. Money and Currency, pp. 11-17. Kinley, D. Money, pp. 59-70. Laughlin, J. L. Principles of Money. On the functions of money, pp. 1-22. Scott, W. A. Money and Banking, pp. 2-13. Taylor, F. M. Some Chapters on Money, pp. 11-33. Walker, F. A. Money. On the primitive functions of money and contains generous quota- tions from other writers, pp. 1-123. Credit Johnson, J. F. Money and Currency, pp. 34-41. Laughlin, J. L. Principles of Money, pp. 71-114. Moulton, H. G. Financial Organization of Society, pp. 121-131. Principles of Money and Banking, pp. 5-12. Phillips, C. A. Readings in Money and Banking, pp. 1-9. Westerfield, R. B. Banking Principles and Practice. Vol. I, pp. 35-47- CHAPTER II STOCK OF MONEY I. Legal Tender and Lawful Money. — Preliminary to the description of the different kinds of money, one special attribute of money — its use as legal tender or as lawful money — requires explanation. As will be presently noted, the United States has a composite body of monetary instrvmients. When our coinage system was established in 1792, silver as a monetary standard held an important position throughout the world. Congress authorized the use of both gold and silver as standard money. There were at the time few banks and their note issues were not large in comparison with metallic money. Within a few years banks began to multiply and their issues were large. These notes however had no special legal attributes; they were simply the promissory notes of the institutions creating them and their acceptance depended only on public confidence. Again, as the result of urgent financial need of the government, Congress at various times authorized the issue of promissory notes by the government, and during the Civil War, in order to strengthen this financial prop, made the notes legal tender. State bank notes were driven out of circulation by taxation and national bank notes took their place. The inconvenience of using gold and silver as media led to the use of substitutes in the form of certificate money. And more recently, in the attempt to reform our banking system, the Federal Reserve Act provided for a new form of note designed ultimately to eliminate the national bank note. Thus from time to time new forms of money have been added. But as the government is slow in every department of political activity to discard old forms, so in the money system it has re- 8 II] STOCK OF MONEY 9 tained varieties of money which have no immediate significance and which would probably find no place if a new monetary system should be established in accordance with present economic needs. Silver, for example, has been discarded as a standard by nearly all nations; but although the United States no longer provides for free coinage of silver dollars, it retains a certain portion inherited from the period when silver was recognized as a standard money. So, too, the federal government issued a large amount of promis- sory notes during the Civil War. It redeemed a portion of these obligations but left the liquidation incomplete. There is there- fore still in circulation a considerable volume of United States notes, although the government is abundantly able to meet this indebtedness. The plan to abolish the national bank note circu- lation by the substitution of federal reserve notes has been in- terrupted by the recent war. As a result of this past experience we possess a heterogeneous mass of monetary instruments. Not all of them are legal tender or lawful money; that is, creditors cannot be forced by law to accept them in payment of indebtedness. The statutes define which kinds of money are legal tender and, in the absence of special contracts, these forms must be accepted, if tendered, whenever the amount of the pay- ment is expressed in dollars. 2. Various Forms of American Paper Money. — This point may be illustrated by reference to the statements made on the various forms of paper money in circulation at the present time : United States note, popularly known as "greenback": This note is a legal tender at its face value for all debts public and private, except duties on imports and interest on the public debt. Gold certificate: This certifies that there have been deposited in the Treasury of the United States of America dollars in gold coin pay- 10 BANKING AND CREDIT [ II able to the bearer on demand. [More specifically the federal statutes declare that] Such certificates shall be receivable for customs, taxes, and all public dues, and when so received may be reissued, and when held by any banking association may be counted as a part of its lawful reserve. (Act of March 14, 1900. sec. 6.) By later legislation (December 24, 1919) these notes have been given full legal tender power. Silver certificate : This certifies that there have been deposited in the Treasury of the United States silver dollars payable to the bearer on demand. This certificate is receivable for customs, taxes, and all public dues, and when so received may be reissued. National bank note : This note is receivable at par in all parts of the United States in payment of all taxes and excises and all other dues to the United States except duties on imports and also for all salaries and other debts and demands owing by the United States to individuals, corporations and associations within the United States except interest on the public debt. Federal reserve note : This note is receivable by all national and member banks and federal reserve banks and for all taxes, customs and other public dues. It is redeemable in gold on demand at the Treasury De- partment of the United States in the City of Washington, District of Columbia, or in gold or lawful money at any federal reserve bank. Federal reserve bank note: This note is receivable at par in all parts of the United States in payment of all taxes and excises and all other dues to the United States except duties on imports and also for all salaries and other debts and demands owing by the United States to in- dividuals, corporations and associations within the United States except interest on public debt. II] STOCK OF MONEY II Some kinds of money are' full legal tender in the satisfaction of all kinds of debt, both public and private; some are receivable for one purpose and not for another. Others have no legal tender attribute but because of their general acceptability perform most of the functions characteristic of money instruments. Gold coins and gold certificates of whatever denomination are legal tender ; so are silver dollars. Subsidiary silver coins and minor coins are legal tender for limited amounts. United States notes are legal tender, though they may be excluded from certain governmental payments; and silver certificates are acceptable for some public debts but not for private debts. National bank notes and federal reserve bank notes are not legal tender but are receivable for all public dues except duties on imports, while federal reserve notes, though not legal tender, are receivable for all public dues without any restriction. In common business practice little regard is paid to these differences, but banking institutions which must hold reserves in legal tender money against outstanding obligations, whether of deposits or note issues, must note these distinctions, and to them the quality of the money held in their vaults is important. The terms "legal tender" money and "lawful" money are not always synonymous. The term "legal tender" is explicit: It includes all forms of money, whether coins or paper credit notes, which the law compels creditors to accept. The signifi- cance of " lawful " money is not so exact. Although contracts and mortgages are frequently made pledging the payment of a certain sum of "lawful money of the United States" the courts have construed this phrase in some cases as meaning "legal tender"; in others, as any currency which is lawfully employed in buying and selling. Under this interpretation bank notes would be law- ful money though not legal tender. The significance of the legal tender quality is frequently over- emphasized. Confusion of thought in regard to the attributes of money has led to a claim that because government promissory 12 BANKING AND CREDIT [II notes are a good medium of exchange, they can be made to serve as a standard of deferred payments, simply by conferring upon the notes the legal tender quality. Legal tender legislation is an incident to a clearer definition of contracts. Value is determined by public estimation, a force far deeper than statute. If the government changes one term of the value ratio, buyers and sellers will through price adjustments change the other accordingly. 3. Monetary Stock and Money in Circulation.^ — A distinction is to be made between monetary stock, or the general stock of money, and money in circulation. According to official practice the Treasury Department includes under "monetary stock" gold coin, including bullion in the Treasury, standard silver dollars, subsidiary silver, United States notes, treasury notes of 1890, federal reserve notes, federal reserve bank notes, and national bank notes. In 1920 (July i), this monetary stock amounted to $7,894.4 million classified as follows : Millions Gold coin (including bullion in the Treasury) $2,694.0 Silver dollars 267.0 Subsidiary silver 258.9 United States notes 346.7 Treasury notes of 1890 1.7 Federal reserve notes 3.405.9 Federal reserve bank notes 201.2 National bank notes 719-0 Total $7,894.4 In addition there were about $87 million of minor coins not included in the monthly statement of monetary circulation. This table does not include gold and silver certificates, for these are simply claims on other forms of money listed in the table. On the other hand, this table overstates the amount of money which is actually in circulation. Not all of the above stock is in circula- tion at the same time. Some of the gold is held by the Treasury II] STOCK OP MONEY 13 as a reserve against government promissory notes or greenbacks, and some is held by federal reserve banks as reserve against federal reserve notes. Moreover, the item, federal reserve notes, includes several hundred million dollars of notes not as yet issued for circulation. Of the general stock, $7,894 million, a part was held in the Treasury as assets of the government and a part by federal reserve banks and federal reserve agents against issues of federal reserve notes. This left for "money in circulation,"' only about three-fourths of the " general stock, " or $6,088 million. This gives a per capita circulation of $57.21. Considerably less than half of the total stock is metallic money, and a part of this latter circulates in a representative form as certificates. The following table shows the growth of the total monetary stock and money in circulation since 1900: Total Monetary Stock and Money in Circulation (In millions) Year Total Stock Money in Circulation Year Total Stock Money in Circulation 1901 $2,438 $2,175 1911 $3,556 $3,214' 1902 2,563 2,249 1912 3,649 3,285 1903 2,685 2,368 1913 3,620 3,364 1904 2,804 2,519 1914 3,738 3.402 1905 2,883 2,588 1915 3,989 3,569 1906 3.071 2,737 1916 4,483 4,024 1907 3.116 2,773 1917 5,408 4,764 1908 3.379 3,038 1918 6,741 5,379 1909 3.406 3,106 1919 7,519 5,766 1910 3.420 3,102 1920 7,895 6,088 There have been wide fluctuations in the volume of money in circulation at different periods; and over long periods there has ^ The Federal Reserve Bulletin in. its current issues gives a different figure for the amount held by federal reserve banks and agents, as, for example, for the date under consideration. July I, 1920, $2,021 million. The subtraction of this sum, together with the $485 million held by the government, leaves $5,381 million in circulation. This results in a per capita circulation of $50.19, as compared with $57-2i in the Treasury statement. H BANKING AND CREDIT [11 been an increase not only in the total amount but also in propor- tion to the population. This is seen in the following table : Increase in Per Capita Circulation since 1880 Amount Percentage Gain Percentage Gain July I (Millions) in Ten Years Per Capita in Ten Years 1880 I9734 $19.41 1890 1,429-3 47 22.82 16 1900 2,055.2 44 26.93 17 1910 3,102.4 57 34-33 29 1920 6,087.6 96 57-21 65 Most marked was the increase after 191 5. In that year the per capita circulation was $35.44. In the next five years the per capita gain was between $4 and $5 annually. 4. Gold Coinage. — Although gold constitutes an important part of the total monetary stock, ranging from two-fifths to more than half during the past ten years, it is rarely seen in circulation. A part is held by the Treasury in trust to secure the more con- venient gold certificates and as a reserve to protect the legal tender notes, and a much larger portion is in the vaults of the federal reserve banks, kept as reserve against their deposit and note obligations, and as a gold settlement fund for clearing house purposes. As reserves, gold accomplishes a greater amount of exchange service than if employed as an active circulating me- dium. Only a small portion of the total gold stock is to be found outside of the Treasury and the federal reserve banks. The monetary standard is gold and the gold dollar (its equiva- lent, but not coined) is the standard unit of value. Gold bullion may be coined without any limitations when presented at the mint. Gold coin is legal tender at its face value for all debts, when not below the standard weight and limit of tolerance pre- II] STOCK GP MONEY 15 scribed by law; and when below standard and limit of tolerance it is legal tender in proportion to its weight. Gold is now coined into quarter-eagles ($2.50), half-eagles ($5), eagles ($10), and double-eagles ($20). During limited periods $1 pieces (1849- 1889; 1902-1905) and $3 pieces (1854-1889) were coined, but the small size of such coins made them unacceptable for circulation. 5. Gold Dollar and Mint Price of Gold.— The weight of the gold dollar (not now coined) is 25.8 grains, of which nine-tenths, or 23.22 grains, is pure gold. The difference in weight is made up of copper alloy in order to give hardness to the coin. The weight of a new gold eagle or double-eagle must not vary more than half a grain from the standard weight fixed by law, and that of the smaller gold coins must not vary more than a quarter of a grain. This allowable variation is called "tolerance of the mint." The tolerance in fineness cannot exceed more than i one- thousandth. Coins are subject to loss in weight owing to abrasion; and after a circulation of twenty years and, at a ratable proportion of any period less than twenty years, the law permits a deviation from the standard weight of 1/2 per cent without diminishing the legal tender value of coins. If the loss be more than that, the coins are legal tender in proportion to their actual weight. The follow- ing table shows the standard weights and limits of deviation of gold coins (20 years old) : Standard and Least Current Weight of Gold Coins Denomination Standard Weight in Grains (Nine-tenths fine) Per Cent Abrasion in Grains (1/2 Per Cent) Least Current Weight in Grains Double-eagle .... Eagle 516.0 258.0 129.0 64-5 2.58' 1.29 0.64 0.32 51342 256.71 Half -eagle Quarter-eagle .... 128.36 64.18 l6 BANKING AND CREDIT [11 The mint price of an ounce of pure or fine gold is $20.67183 and of standard gold, $18.60465. These two values are deter- mined by dividing the number of grains in a troy ounce by the number of grains of gold in the standard gold dollar, thus: 480 -7- 23.22 = 20.67183 and 480-7- 25.8 = 18.60465 The mint price of gold is simply a quantity relationship between gold in the form of bullion and gold in the form of coins, and represents the number of dollars that physically can be made from an ounce of metal. Obviously this ratio is bound to remain fixed so long as the coinage laws are unchanged. The factors determining the mint price of gold are thus essentially different from those determining the price of wheat or other commodities. The price of wheat does not mean the number of bushels of wheat that a given quantity will command in the market but, instead, the amount of a second article, and in particular the monetary medium. 6. Coinage Charges. — The government mints receive and immediately pay for all gold bullion of standard fineness which may be presented. No charge or seigniorage is made for this exchange. If the gold be below the standard of fineness, a charge is made for parting (the separation from silver) or refining (the elimination of base metal). The rates of these charges are prescribed by the Director of the Mint and vary from 1/2 cent per ounce to 4 cents per ounce, according to the purity of the bullion. Deposits, however, containing 800 thousandths or more of base metal are declined, and no charge is made for bullion con- taining 9.92 thousandths of gold and upward. A charge of 2 1/2 cents per ounce for the copper alloy is also made, the amount to 11] - STOCK OF MONEY I? be calculated as one-ninth of the fine weight of the gold. ^ Accord- ing to the convenience of the mint, the bullion so received may be converted into coin or carried as gold bullion in the general fund of the Treasury or in the reserve of the Treasury against certifi- cates or legal tender notes. The provision allowing bullion to be carried against gold certificates dates only from 191 1; prior to that date all bullion was carried in the general fund. Gold coin will be delivered to any applicant by the Treasury for gold certificates, United States notes, treasury notes of 1890, or federal reserve notes, the consignee paying the transportation charges. Foreign gold coins which come into this country are generally melted into bars and subsequently coined into United States coins. Although a law was enacted in 19 11 permitting the Treasury Department to carry a certain amount of foreign gold coin in its reserve fund against which gold certificates may be issued, im- porters of foreign coin frequently do not find it profitable to dis- pose of the gold to the Treasury, for when the foreign coins are presented there is a heavy deduction for tolerance, abrasion, or light-weight coins. Importers of coin therefore may prefer to turn the coin into the assay office where they get more as bullion. For the convenience of exporters and manufacturers, gold is made up into bars. Commercial gold bars range in fineness frorq 990 to 999 thousandths fine, the weight and fineness being stamped on each bar. The mint exchanges fine gold bars for gold coin in lots of not less than $5,000 in value. The bars range in value as follows: $100, $2oo-$30o, $soo-$6oo, and $5,000. As the loss by abrasion of coins is to be considered, exporters of gold generally prefer the use of bars. For the work of refining, assaying, and coinage, the govern- ment operates several mints. There are coinage mints at Phila- ' See Problem i, Appendix A, for example of calculation. i8 BANKING AND CREDIT [11 delphia, San Francisco, and Denver; mints at New Orleans and Carson City conducted as assay of&ces; and assay of&ces at New York, Seattle, Boise, Helena, Salt Lake City, and Deadwood; these latter are bullion purchasing agencies for the mints. Re- fineries are operated at New York, San Francisco, and Denver institutions. 7. Gold Stock.— The United States holds a very considerable part of the world stock of gold available for money. In the year before the outbreak of the Great War nearly one-quarter (23 per cent) was credited to this country, and during the war period the gold money stock of the United States further increased. As the world production of gold fell off and gold imports were large, the proportion held by the United States in 1920 was swollen to about a third of the total world stock. The ten countries holding the largest amounts of gold in 191 8 were:' Gold Holdings of Several Countries Country Amount (Millions) Per Capita United States $3,165* 720 664 539 439 ■ 391 322 278 234 131 $30.14 15.61 16.73 7-95 21.39 6.99 3990 42.22 6.41 16.21 Great Britain France Germany Spain Japan Netherlands Italy Canada * Between 1918 and 1921 the share of the United States slightly decreased. 3 Report of the Director of the Mint, igiQ, p. 282. 11] STOCK OF MONEY 19 The possession of a large fraction of the world's gold mone- tary stock does not necessarily imply that a country is in a superior financial position. As will be subsequently seen, gold is the basis of credit money, and if the credit instruments and in- stitutions be wisely organized, a small amount of gold may be as effective as a larger amount in supporting the financial operations of a nation. Spain in 1918, it will be observed, had more gold per capita than Great Britain or Japan. The significance of this stock of gold in terms of physical measurement is of interest. A cubic foot of gold is worth $363,180. If the world's gold monetary stock be estimated at $9 billion it would occupy a space of 24,781 cubic feet. This represents a room about 50 feet square and 10 feet in height. 8. Production of Gold. — The total production of gold since 1492 is estimated (191 9) at $17,765 million (859 miUion fine ounces) . A considerable amount of gold goes into the industrial arts and some has been lost or worn out. The following table shows the world's production since 1492 -^ World Production of Gold since 1492 Period Value I 493- I 600 $501,640,000 1601-1700 606,315,000 1701-1800 1,262,805,000 1801-1900 7.695.570.000 1901-1919 7.698,934.000 Total $17,765,264,000 As much gold was mined in the first twenty years ot this century as in the previous one hundred years. Since 1900 the annual value of the gold product of the world and of the United States is estimated as follows :' ■• Report of the Director of the Mint, 1920, p. 294. 5 statistical Abstract of United States, 1920, pp. 800, 822. 20 BANKING AND CREDIT [11 Annual Gold Production since 1900 (In millions) Year World U. S. Year World U. S. 1901 $261 $79 1911 $462 $97 1902 297 80 1912 466 93 1903 328 74 1913 460 88 1904 347 80 1914 439 95 1905 380 88 1915 469 lOI 1906 403 94 1916 454 93 1907 413 90 1917 419 84 1908 443 95 1918 384 69 1909 454 TOO 1919 365 60 1910 455 96 1920 325 50 For several years, 1909-1916, the annual product was over $450 million. Disturbances caused by war and the increased cost of labor and supplies entering into mining caused a d ecline , showing a production in 1920 of $325 million, a decrease of nearly one- third. The annual production from our own mines, including Alaska, is about one-fifth of the total world's supply. The gain which the United States has made in gold stock in the past few years has been largely due to imports, as seen in the following table: Imports and Exports or Gold, 1901-1920 (In millions) Exports Imports Excess of Years Exports over Imports Imports over Exports 1901-1905 1906-1910 1911-1915 1916-1920 $322.9 372.5 415-9 1,282.9 $316.8 446.4 429-9 2,101.1 $6.1 $73-9 14.0 818.2 n 1 STOCK OP MONEY 21 In a period of rising prices no relief can be given to the gold- mining industry by increasing the mint price of gold. It is under- stood, of course, that the country will depart in no way from its. gold standard. Suppose that the mint price were increased from approximately $20 to $40 per ounce. The gold content of the dollar and hence its purchasing power would be halved. Prices would be thus doubled but the purchasing power of gold per fixed unit, as an ounce, would not be changed, so that the net effect would be nil. 9. Proposals to Encourage Gold Mining. — Although an enormous mass of gold has been mined in the past hundred years as compared with previous centuries, and the annual world pro- duction during the past twenty-five years has been far greater than during the period of the notable discoveries in California and Australia in the middle of the nineteenth century, the present decline in the annual yield is regarded by some as a serious danger. A decrease naturally affects adversely those engaged in the gold- mining industry. Apart from this it is held to be a matter of public concern, since gold is the standard of value, is the final basis of credit, and is in universal demand for banking reserves. Indebtedness, both public and private, is legally payable in gold coin of the present weight and fineness. New countries in the past half-century have changed from a silver to a gold standard, thus increasing the strain. There has been also a worldwide increased use of gold in the industrial arts. The world production in 1919, due largely to rising costs, was less than in any year since 1904. Production in the United States declined from $101 million in 1915 to $50 million in 1920, while the industrial con- sumption increased. For jewelry, gold leaf, gold plate, and for purposes of ornament and decoration it is estimated that the world is now using more than three times as much gold as was produced from the mines of the world in 1840. There is no law in the United States, as exists in most coun- 22 BANKING AND CREDIT [ H tries, against the melting of coin for industrial use. Manu- facturers in other countries therefore, who would be obliged to pay a premium in order to divert gold from their own mints, may- find it more profitable to buy gold coin in this country. To pro- tect our gold stock and also to encourage gold mining, it has been proposed that gold-miners be paid a premium of $io for every fine ounce produced, and that an excise duty of an equal amount be laid on the use or sale of gold in the United States for other than monetary purposes. Under this arrangement it is claimed that the tax would yield sufficient revenue to pay the premiums granted as a mining subsidy.'' Such proposals, however, have received but little support. With the readjustment of industry and technical improvements in the extraction of gold it is prob- able that the gold product will increase in the near future. 10. Silver Dollars. — Until 1873 the coinage of silver dollars like that of gold coins was unrestricted, but in the coinage act of that year this privilege was omitted. Silver dollars had pre- viously disappeared from use, since silver as bullion was worth more than the mint offered at the prevailing bimetallic ratio. But about the same time a sudden drop took place in the value of silver, due to new supplies in the United States and the sale of silver by Germany, which adopted a single gold standard. Prices of commodities were also falling, and farmers, particularly in the West, claimed that this was due to a contraction of the currency. Asaresultof this agitation the Bland Act (1878-1890) was passed, authorizing the purchase of a limited amount of silver to be coined into dollars; and the Sherman Act (1890-1893) increased this amount. Only indirectly, however, did the purchases under the latter statute result in the coinage of dollars: the purchases of silver were made by the issue of treasury notes, the bullion being held for coinage if needed for the redemption of the notes. ' See Our Vanishing Gold Reserve, a pamphlet published by the American Mininc Congress, 1919, Wasbmgton. """t II ] STOCK OF MONEY 23 Shortly after the Gold Standard Act of 1900 these treasury notes were retired (less than $2 million now outstanding) and the bullion previously purchased coined into dollars and subsidiary silver coins. When this was accomplished the coinage of silver dollars ceased (1904). Silver dollars are legal tender to any amount. The weight of the coin is 412 1/2 grains, nine- tenths fine, or 371 1/4 grains of pure silver. The bullion value of a silver dollar is determined by dividing the product of 371.25, multiplied by the market price of silver per ounce, by 480 (the number of grains in a troy ounce) . Thus if the market quotation for silver is 68 1/8 cents per ounce: 371.2 5 X 68 1/8 -' = 52.7 cents 480 Except for a few months in 1919 and 1920 the bullion value of a silver dollar since 1873 has been less than a dollar in gold, and during the ten years subsequent to 1893 its bullion value was less than 50 cents. In 1902 it fell to $0,367; in other words, a dollar in gold would buy 1,011.16 grains of pure silver, as compared with 371 1/4 grains of silver if it had not depreciated in value. As the Treasury bought the silver, both under the Bland Act of 1878 and Sherman Act of 1890, at its bullion value, a large amount of seigniorage or profit was made. During the entire period, 1878- 1904, this amounted to $1 18 million on a coinage of $570 million. During the period of the recent war the value of silver rose, and an act (the Pittman Act) was passed April 23, 191 8, authoriz- ing the government to melt and sell as bullion $350 miUion of silver dollars'' at a price to be determined by the Treasury, but not less than $1 per ounce of silver i ,000 fine. Under the author- ity of this act about 208 miUion fine ounces were sold to the British government for use in India. As a result the stock of silver dollars decreased. The decrease, however, will not be permanent, for the Pittman Act provides that domestic silver be repurchased to ^ Federal Reserve Bulletin, 1918, Vol. IV, p. 3PS. 24 BANKING AND CREDIT [ II replace the dollars melted, at a fixed price of |i per ounce. In 1920 the mint service began the purchase of silver, and in the following year its coinage into silver dollars, to replace those melted down under the Pittman Act. The price of foreign silver fell in 1920 to much less than $1 an ounce, but because of the preference given to domestic silver for the needs of the mint, the price of the latter is approximately $1 and will remain so until the replacement has been made. 11. Subsidiary Silver. — Until 1853, the coinage of subsidiary silver coins (half-dollars, quarter-dollars, dimes, and half-dimes) was free; the coins were proportionate in weight to the silver dollar and they were legal tender in any amount. In 1853, owing to the rising value of silver in the silver bullion market which led to the melting of coins, the weight of the coins was reduced — the half-dollar from 206.25 grains to 192.9 grains, and the quarters and dimes proportionately. By this change it was unprofitable to melt the coins. In coinage the tolerance in weight permitted is 1.5 grains and the deviation in fineness, 3 thousandths. Sub- sidiary silver is now legal tender for payments up to 1 1 o. Its coin- age is not free but the mint purchases silver in the open market and mints coins in denominations according to public demand. Upon deposit of other funds, the Treasury ships the coins to the applicant, the consignee paying transportation charges. 12. Minor Coins. — The current minor coins are the i cent bronze, made of 95 per cent copper and 5 per cent tin and zinc, and the 5 cent nickel, made of 75 per cent copper and 25 per cent nickel. The outstanding minor coinage is approximately $87 million. Though of considerable amount, it is not included in the ofiicial statements of the stock of money in the United States. These coins are legal tender up to 25 cents in any one payment. They are shipped by the mint upon application, the consignee paying the cost of transportation. II] STOCK OP MONEY 25 13. Gold and Silver Certificates. — Gold and silver certificates do not add to the total stock of money. They circulate in place of coin which to an equal amount is held in trust by the Treasury. They are simply "warehouse receipts," used as a convenient substitute for the heavier coin. Their use also saves loss by abrasion of coins. Gold certificates are issued, upon deposit of gold coin, bullion, and foreign coin, in denominations ranging from $10 to $10,000. The larger denominations are of special advantage in making bank settlements. In the past few years, due to the development of the federal reserve banking system, there has been a marked decline in the amount of gold certificates. At the close of 1916 there were $1,224 million in circulation. With the absorption of gold by the federal reserve bank, gold was used for security of the new federal reserve notes which began to be freely issued in 191 7. As a result the supply of gold certificates in four years decreased by more than half. Although gold certificates represent 100 per cent of gold specifically lodged with the Treasury for their re- demption, they were not made legal tender until December 24, 1919. Silver certificates are issued in denominations between $1 and $100 upon deposit of silver dollars. Silver certificates are not a legal tender, but are receivable for all public dues and taxes. 14. United States Notes. — ^Aside from the gold and silver certificates and treasury notes of 1890, there are four varieties of paper currency in circulation: United States notes, national bank notes, federal reserve notes, and federal reserve bank notes. The United States notes, sometimes called "greenbacks" or "legal tenders, " are an inheritance of the Civil War. Since 1878 the amount outstanding has been $346,681,016. The notes are legal tender in payment of all debts, public and private, except duties on imports and interest on the public debt. These excep- tions, which have little practical significance now, were introduced 26 BANKING AND CREDIT [II into the original law in order to make certain that the government had a gold fund from custom duties and to reassure the buyers of bonds that their interest would not be paid in depreciated currency. Notes are issued in denominations of from $i to $i ,000, but the larger part are in the smaller denominations of $1, $2, and $5 . Against these notes there is a gold reserve of $1 50 million, or about 45 per cent. The power of Congress to make paper currency legal tender was early contested in the courts. At first the Supreme Court decided adversely, but later the decision was reversed and their constitutionality affirmed. It is frequently proposed that these notes be retired, on the ground that the government should not in normal times give sanction to the circulation of promissory notes having a legal tender quality. In opposition, however, it is urged that as these notes are mostly in small denominations serving as pocket money, if retired, bills of other forms would be needed. Moreover, fund? raised by taxation would have to be provided for their redemption. 15. National Bank Notes. — These notes also have their origin in the legislation of the Civil War period. Hitherto notes were issued by hundreds of state banks. Many of these were sound and their credit good. Failures, however, were frequent and in some of the states the protection given to holders of notes issued was inadequate. Counterfeiting also was easy when there was a great variety of notes. But more powerful than any other reason was the desire to stimulate the purchase of government bonds, by the establishment of a national banking system, whereby institutions were granted the privilege of note issue based upon the deposit of government bonds . In order to force banks desiring the privilege of note issue into the national system, a heavy tax was placed on the notes of all state banks. The issue of national bank notes, notwithstanding the recent establishment of the federal reserve banking system with note-issuing powers, has continued to the present time, and these notes constitute an im- II] STOCK OF MONEY 27 portant part of the circulating medium. The principal fact to observe here is that the issue of these notes is inelastic, being de- termined by the deposit of certain classes of government bonds which are limited in volume and which must be previously pur- chased at the market price. The Federal Reserve Act plans for the gradual retirement of these notes, but the demands of recent war financiering have de- layed the carrying out of this intent and it seems probable that the national banking currency will remain a part of the circulating medium. The amount in circulation January 1, 192 1, was $708 million, as compared with the maximum in 1915 of $785 million. National bank notes are not a legal tender but are receivable by the government for all public dues except duties on imports. Moreover, each national bank must receive the notes of all other national banks at par. 16. Federal Reserve Notes. — The federal reserve notes con- stitute by far the largest part of the paper currency at the present time, amounting in 1920 to more than two-thirds of the total paper currency. These notes are issued through the twelve federal reserve banks, secured by certain classes of commercial paper, bills of exchange, acceptances, gold or gold certificates. Inasmuch as the volume of commercial paper and bills of ex- change changes with the fluctuation in business enterprise, the note-issuing power is elastic. 17. Federal Reserve Bank Notes. — The federal reserve bank notes constitute but a slight portion of the currency. Under the Federal Reserve Act of 19 13 the federal reserve banks were given authority to issue federal reserve bank notes secured by United States bonds, which they purchased from national banks in ac- cordance with a plan of ultimate retirement of national bank notes. It was not intended that the notes should play a perma- nent part in the currency system. By subsequent amendments 28 BANKING AND CREDIT [11 they were also issued upon the pledge of United States certifi- cates of indebtedness, or i-year gold notes; and in 1918 their issue was further extended to take the place of silver certificates called in from circulation when silver dollars were melted and sold as bullion under the Pittman Act. 18. Amounts of Different Kinds of Money. — From the fore- going description it will be seen that a great variety of monetary instruments has been used at different periods. This is more clearly shown in the table on page 29. This table may be further condensed to show: (i) gold, in- cluding gold certificates; (2) silver, including silver certificates; (3) government promissory notes, including United States notes, treasury notes of 1890, and currency certificates; (4) national bank notes, including federal reserve bank notes; (5) federal reserve notes; and (6) subsidiary silver coins. (See page 30.) 19. Credit Forms of Money. — The value of all the forms of money listed in the above tables, except gold and gold certificates, depends in some degree upon credit. The United States notes are promises of the government and are supported by its credit, reinforced by a partial gold reserve ; the national bank notes and federal reserve bank notes are secured by government obligations which are simply promises of the government to pay to the holders of the bonds at some designated date the debt due; and the federal reserve notes are secured by commercial paper (notes and bills of exchange) , also backed up by a partial gold reserve. The position of the silver dollar is not so clear. It is technically stand- ard money, but its bullion value is less than its face value. The Gold Standard Act of 1900, however, pledges the government to maintain "all forms of money issued or coined by the United States" at a parity with gold. 20. Changes in Composition of Monetary Medium. — The table on page 29 shows that there have been marked changes in 11] STOCK OP MONEY 29 I o 00 00 o H > < H W o O I-! n <: n M i-l -< CS ro rv) rt w ■* 00 q> ro ■^ N 6\ N ^6 4 ui t^ ^ uox^-BinoJiQ UI ,(t9UOp^ l^^oj^ ro di tn N di t^ t* W »« -O 00 a "^ 0^ w 10 H; sa;o]s[ sAjas.a^ I^JapsjI ■ ■ ■ ■ d d> ■ ■ ■ ■ 00 w ^ i 1 i n 2 s3iojs[ j[UBa: aAJOsa-a l^japajj CO ..... CS M : : : : : *^ sa:^o^ ^luBg ibuoi^b^^ ■^0 M r^ -rf H t^ H d po 10 -d rO 00 00 00 Oi 00 068I 'S3^0is[ XJnSB3JX : : ^ i> cigi 'sa^BDijiiiaQ ADuaJJtiQ s^:^OJS[ "S Tl r;. 00 00 ro w w N w ro fo ro PO ro (*3 ro PO ro 10 ufOO '^•I'BiPIsqTig •no (NO ro ro 0(5 rt xd to (i N '^ to t^ ro to m t*» H M M ^ sa^^BoyjlJaO JaAng 00 to «o ro to r^ 00 00 pj 0(j W 0. t- 00 1- -; f? c^ ■^ d vd to N 4 ■^ (N to t— PC d sa^t-Bogi^ao pioQ o() r^ 00 00 1- 00 d d w N d W ro t- 0> w M 00 q ro sa^BoijT:^iaO Aq pajaAOQ ■^ %o^ uoxnn'a P"^ "PO PPO !> ro 00 0\ H M to 4 d d d a N t- H 0. 0> fO N n to to 00 *-> to 00 Ol M M (N 00 00 0. 0\ 0\ Ol ^ (U I, - H ■; d 4) ■S S I ^» I y ft la, §|82 §•£2-3 * >,-^c 3 > c O Pi O M Hi PP < H o w w o o u w o O c Q C § i 1 fo di 10 M di 1^ IS CO &I 00 r^ ** "jp '-^ in re r*3 T ^ ^ CO ■^ 10 di M -* 10 ir- M "o 10 ^ H M W _ o ■S E ^1 ro PJ in 1 ^0 o> 00 H Vt M ro National Bank Notes and Federal Reserve Bank Notes ^(3 t- t^ 17 fy, M M « W W 1 a ^ \0 '-' t-. •+ 00 r^ M d ro in "^ ro 00 00 00 0. fn w (*3 r- 00 6^ U. S. Notes, Cur- rency Certificates and Treasury Notes of 1890 p d di >n n w H M S < Os r- 10 in N t^ T fn 00 ^ CO N PO 0> fO f^ ro r*) fj f*3 fj ro f) Silver Includ- ing Silver Certificates N -4 PO »^ in rj- cq (M M M G B < Ov ■^ q ro in rn ■^ « -d N f^ in r- m -^ m W ro '^ m m w Is 55 ^1 q fo m Ov n ■4 in di ■^ d N CO ro ^ T W < t^ w »9 t^ <> 0> ro in H ro w dv ro M o> -0 (N w m 00 ro m 00 Oi M M N 00 00 0, o< 0. Oi 11] STOCK OF MONEY 3 1 the composition of the monetary medium. Government credit notes have diminished to a small proportion; silver is of slight importance; bank notes based upon bonds, though increasingly large in amount, are a smaller percentage of the total; and gold in circulation declined from 44.9 per cent in 1910 to 20.2 per cent in 1920. The new form of credit money, federal reserve notes in 1920, constitutes more than half the circulation. It must not, however, be assupied , that the monetary system is necessarily weakened by this change, for back of the federal reserve notes is an enormous mass of gold. In the table on page 29 this is merged in the last column, "Money in the Treasury," which includes gold held by federal reserve banks and agents as reserve against federal reserve notes. Without this impounded gold the circula- tion of federal reserve notes would hardly be possible. To a very considerable extent the gold certificates have been retired, as seen in the decrease between 1915 and 1920, and the gold thus with- drawn from the Treasury is now held by the federal reserve banks to support the issue of credit notes which these institutions are making. 21. Redemption of Moneys. — The Treasury Department is continuously engaged in the exchange of moneys and in redeem- ing notes and the issue of new ones, because the old notes are worn out, or notes of different denominations are desired, or other forms of money are in demand. United States notes and gold certificates are redeemable in gold coin, treasury notes of 1890 in gold coin or silver dollars, silver certificates in silver dollars, national bank notes in lawful money, and federal reserve notes in gold or lawful money. Silver dollars, being standard, are not redeemable, but may be exchanged for gold according to Treasury practice. Subsidiary silver and minor coin in multiples of $20 may be redeemed in lawful money. During the crop movement in the latter part of the year notes of large denominations are sent in for redemption in order to secure small bills, while in the 32 BANKING AND CREDIT [ II first half of the year large bills are in greater, demand. The aver- age cost for the issue of each note of paper money, including the making, issue, and redemption, is about i 1/2 cents (1.526). Paper currency in all its different forms, when unfit for circula- tion — if not mutilated so that less than three-fifths of the original bill remains — is redeemable at the face value of the note. If less than three-fifths but more than two-fifths remains, the note will be redeemed at half its face value, but the pj-esentation of any fragment will secure redemption of full face value, if accompanied by satisfactory affidavits as to the destruction of the missing por- tions. Reimbursement in no case is made for currency totally destroyed. Mutilated and light gold coins are not redeemable at their face value, but can be sold as bullion. Light silver coins, however, are generally redeemable at their face value. Banks are constantly on the alert to detect counterfeit money and very little remains long in circulation. When discovered, the loss falls on the customer who deposited it; the note is stamped " Counterfeit " and turned over to the Secret Service Department of the government. Raised money is more frequent than counter- feit. As banks sort bills by denominations, and each denomina- tion bears a different engraving, a raised note is easily detected. References Moulton, H. G. Principles of Money and Banking. Coinage rules and regulations of the United States, abstract from General Instructions and Regulations in Relation to the Transaction of Business at the Mints and Assay Offices of the United States, Part I, pp. 81-85. Muhleman, M. L. Monetary Banking Systems. Different kinds of money, pp. 12-38; summary of legislation and court decisions in regard to legal tender, pp. 39-45; table showing characteristics of the different forms of money current (1908), p. 46. A valuable reference book with precise information at date of publication, 1908. United States. Bureau of Foreign and Domestic Commerce. Statistical Abstract (Annual). II ] STOCK OF MONEY 33 United States. Bureau of the Mint. Annual Reports of the Director. Statistics of gold production, also reproduced in the Statistical Abstract. Treasury Department. Annual Report of the Secretary on the State of the Finances. Treasury Department. Circulation Statement. Statistics of stock of money and money in circulation, and gold production, published monthly. These are compiled in tables running over a period in the Annual Report but more conveniently presented in the Statistical Abstract. Westerfield, R. B. Banking Principles and Practice. A standard recent description and discussion on coinage. Vol. I, pp. 18-34. Note: Problems 1-7, with solutions, in Appendix A of this volume should be consulted. CHAPTER III COMMERCIAL CREDIT INSTRUMENTS 1. The Use of Commercial Credit Instruments. — The conduct of modern business has made indispensable the use of certain credit instruments which serve as media of exchange. They make possible the purchasing of merchandise on deferred payments, facilitate the borrowing of money to meet current operating needs, and, in general, play a large part in the financial operations of commercial transactions. Settlements may be effected be- tween one person and another by a bill of exchange in its variety of forms, such as a check, a draft, or an acceptance ; by a promis- sory note; by a postal, express, telegraphic, or bank money-order; or by a certificate of deposit. Commercial credit instruments are to be distinguished from investment credit instruments: the former come into existence largely in the borrowing of working capital and the financing of merchandise sales on credit; the latter are chiefly stocks, bonds, and short-term notes, whose function is to provide a medium for securing funds for fixed capital requirements. Commercial credit instruments are also to be differentiated from commercial credit documents as bills of lading or warehouse receipts; the former are payable in money while the latter serve principally as evidence of title to or rights in goods. 2. Definition of Bill of Exchange. — The term "bill of ex- change" is used in a broad sense to refer to a written order to pay money, when drawn in proper form. According to the Uni - form Negotiable Instruments Law a bill of exchange is defined as "an unconditional order in writing addressed by one person to another, signed by the person giving it (called drawer) requiring 34 Ill 1 COMMERCIAL CREDIT INSTRUMENTS 35 the person to whom it is addressed (called drawee) to pay on demand or at a fixed or determinable future time a sum certain in money to order or to bearer." This definition contains a brief statement of the requirements to which an instrument must conform if it is to be a negotiable bill. A written order to pay money which fails to comply with all of these conditions cannot properly be called a bill of exchange, but it is not correct to assume that any precise formula of words or special phraseology is neces- sary to constitute a legally valid bill. No. 101 ^ Boston, Mass., Jan. 16, 19 22 I Sixty days . g ^^^ stght p^y j^ j^e order of — 04 -s -5 Seventh National Bank 9 -- l3 0«e hundred.o!,nd "^'.iriti-Jive Dollars u — § — m Value received and 'iharge the same to the account of §« 2 To A.B. Curtis '"'J S D.E. Foster a ill 01 Form I. Bill of Exchange Drawn at 6o Days A specimen bill of exchange is given in Form i. The three parties to this instrument are: D. E. Foster, the drawer; A. B. Curtis, the drawee ; Seventh National Bank, the payee. In the specimen given omission of the last clause, "Value received and charge the same to the account of, " would have no legal effect on the instrument, at least in those states where the Uniform Negotiable Instruments Law is in force. Checks are merely a special class of bills of exchange. The term "draft, " while having no fixed legal or commercial signifi- cance, is generally used synonymously with "bill of exchange." Discussion of documentary bills, sight bills, and time bills, bills under a bank credit, sight bills drawn on a foreign country, and various other types of drafts will be taken up shortly. 36 BANKING AND CREDIT [III 3. Parties to a Bill of Exchange. — First, may be considered briefly the legal relations of the three parties to a bill of exchange : the drawer, the drawee, and the payee. The drawer, or the party who makes out the order, directs the drawee to pay a specified sum of money. However, the mere written order of the drawer does not make the bill binding upon the drawee, even if the latter owes the drawer the sum of money called for in the instrument. The drawee does not become legally bound to the holder or payee until he has taken formal action to adopt the bill as his own obligation, which act is known as the "acceptance." According to the Uniform Negotiable Instruments Law, acceptance consists in the drawee's giving his written assent to the order of the drawer. This is accomplished ordinarily by writing or stamping the word "Accepted" with the date and his signature (generally written across the face of the bill on the left-hand end of the paper) . The word "acceptance" is used in commercial practice to designate three different things: (i) the act of the drawee in assuming the obligation contained in the instrument by giving his written assent to the order of the drawer ; (2) the written words added to the bill; and (3) the bill itself after acceptance. The word "acceptance" is the most commonly used term for an ac- cepted bill. In the specimen of a 60 days' bill already shown (Form i) A. B. Curtis is the acceptor and the bill is known as A. B. Curtis' acceptance. The payee is the person (individual, bank, firm, or corpora- tion) to whom the drawer has ordered the payment of money to be made. This person may be either the original payee named in the instrument or some party to whom the original payee has transferred the bill. When the drawee makes payment on the bill to the payee, he discharges his debt to the drawer by the sum he has so paid. It is evident that he cancels his obligation, not by direct payment to his original creditor but by a payment to a third party named in the original creditor's written order. In the specimen 60 days' sight bill, the clause, "Pay to the Ill ] COMMERCIAL CREDIT INSTRUMENTS 37 order of the Seventh National Bank, " has the same legal signi- ficance as " Pay to the Seventh National Bank or order." When a drawer makes out a bill payable to a bank it is customary for the bank either to buy the bill for a sum of present cash somewhat less than the face value of the instrument, or to receive it "for col- lection." A bill of exchange may be drawn to the order of the drawer instead of a third person, payable to "myself" or "ourselves." This is a convenient form if at the time the instrument is drawn it is not certain to whom it is to be sold or transferred . To become negotiable it must be indorsed by the drawer, who can make it payable to anyone he wishes. 4. Classes of Bills. — Bills of exchange may be classified in three different ways: 1. As to their maturity. 2. As to whether or not they bear accompanying documents to serve as collateral security. 3. As to their uses. Bills drawn at sight or on demand are payable immediately upon presentation to the drawee and are known as "sight" bills or "demand" bills. When bills are so drawn it is evident that there is no occasion for acceptance by the drawee, for the reason that if the drawee is willing to treat a sight bill as his obligation it is his duty to make payment at once. By payment he takes immediate possession of it and consequently there is no purpose served in writing "Accepted" upon it. There are one or two exceptions to this statement. The certification of a check by a drawee bank constitutes an acceptance of a demand draft and thus gives the holder of it a special security; and sight sterling drafts drawn on British importers and payable at a bank are first presented to drawees for acceptance. Time bills may be drawn payable a specified number of days 38 BANKING AND CREDIT [ III after date or after sight or demand. In the latter case the time of acceptance is the date of sight or demand, from which the date of maturity is determined, and therefore immediate presentment for acceptance is necessary in order to insure the maturity of the instrument at as early a date as possible. Bills that are drawn payable at 30 days and under are called "short " bills, while those that run for a longer period are known as "long" bills. With respect to the second classification, bills bearing accom- panying documents to serve as collateral security are known as "documentary" bills, while those with no documents attached are called "clean" bills. Such documents include bills of lading, insurance policies or certificates, and commercial invoices. In the case of foreign drafts they may also include consular invoices, certificates of origin, certificates of inspection, and similar papers, according to the character and destination of the shipment. 5. The Uses of Bills of Exchange — Commercial. — Finally with reference to their uses, bills of exchange may be drawn to make immediate transference of bank funds from one person to another or to withdraw such funds, as in the use of a check; to facilitate the purchase of some commodity either by a bank acceptance when the bank is acceptor or by a trade acceptance when the debtor is the acceptor; to enable banks to raise funds by issuing "finance" bills; or to provide a means whereby a creditor can bring pressure upon a slow debtor to discharge his obligations. The ordinary trade acceptance (Form 2) is created when, for example, the seller of merchandise draws a draft on the pur- chaser for the amount of the invoice and the purchaser accepts the draft. The purchaser, however, may make arrangements with his bank whereby the bill is drawn on the bank and is ac- cepted by it for his account instead of by the purchaser himself. When accepted, such a bill becomes a bank acceptance (Form 3). The Federal Reserve Board has defined a bank acceptance as "a Ill ] COMMERCIAL CREDIT INSTRUMENTS 39 draft or bill of exchange of which the acceptor is a bank or trust company, or a firm, person, company or corporation engaged in the business of granting bankers' acceptance credits." Bank acceptances are used to a large extent in financing foreign trade and domestic transactions involving not only the No. 5(5p Boston, Mass., September sj, 192/ $14,1^0.63 Ninety days... after sight pay to order of ...Ourselves Fourteen thousand one hundred fifty and 63/100 . . . Dollars. The obligation of the acceptor hereof arises out of the purchase of goods from the drawer. To i?. ^ . Powers &f Company Boston, Mass. H. C. Jackson Form 2. Trade Acceptance more important staple commodities but also many other kinds of merchandise, such as automobile tires of special make. Bank acceptances offer a means of investment in which the credit risk No. 130 Yokohama, Japan, January 10, 192/ Ninety days... after sight pay to the order of ...Ourselves Eighty- five thousand and two hundred... Dollars $8^,200.00 Drawn under . . .Eighth National Bank Letter of Credit '§'36587 dated December 16, 1919 Value received and charge the same to the account of To Eighth National Bank Boston, Mass. O. Y. Kioto & Company Form 3. Bank Acceptance is practically eliminated, for the reason that direct responsibility for their payment rests on banking institutions whose credit is generally well known. .For a long period acceptances have occu- pied a very important position in the foreign commerce of all 40 BANKING AND CREDIT [ III countries, including the United States. However, in the domestic commerce of the United States acceptances during the past half- century have not played any large part, as they have in Europe. Under the administration of the federal reserve system an effort is being made to give them a wider use. 6. Finance Bill. — The term "finance bill" is comparatively recent and designates long drafts drawn by bankers or stock exchange houses upon foreign banking or accepting houses for the purpose of raising funds in the country in which they are drawn. The effect of drawing finance bills is to utilize the foreign money market in financing some domestic undertaking. For example, suppose that the Atlas National Bank of New York has arranged with a London bank, by pledging securities at an acceptable New York depository (although the credit may have been extended without collateral requirements) for the drawing of a go days' sight bill on London. The New York bank is now in a position either to sell in the local market a 90 days' sight bill for the face of the credit or to forward the 90 days' sight bill to London with instructions that the draft be discounted and the proceeds be placed to its credit. Against this credit the New York bank may sell a demand draft. Which of the two plans the New York bank will follow depends upon the exchange rates on London existing at that time. In either case, however, neither the New York bank nor its London correspondent will have to put up any funds at the start. The London discount market provides the funds until the maturity of the draft, when the London correspondent looks to the New York bank for the necessary cover to meet the draft plus a small commission. Finance bills are commonly drawn for three purposes: (i) to take advantage of the situation when interest rates are higher at home than abroad; (2) to anticipate an expected fall in foreign exchange rates; or (3) to raise funds regardless of interest or ex- change rates. Ill ] COMMERCIAL CREDIT INSTRUMENTS 4I 7. Dunning Medium. — By no means uncommon in domestic transactions is the use of a draft for dunning a slow debtor who persistently refuses payment of an overdue account. The credi- tor by drawing a bill upon the debtor forces the latter either to pay or to disclose his refusal to some local bank to which the draft has been given for collection and with which the debtor may very likely wish to maintain his credit standing. 8. Checks. — A check is a written order for money, payable on demand, and drawn on a bank by a depositor, its cashier, or another bank. It does not have to be in any prescribed form, though in modern practice there is a uniform style. A common type is shown in Form 4. The drawer, or maker, is D. E. Fisher; No. 49 Boston, April 5, 1922 HUB NATIONAL BANK Pay to the order of . . .A..B. Curtis $4rh. .. Four ^ Dollars D. E. Fisher Form 4. Bank Check the drawee is the Hub National Bank; the payee is A. B. Curtis. The bank or drawee will not honor or make payment on this check, except at its peril, until the check has been indorsed by the payee. During the latter part of the seventeenth century merchants in England frequently deposited their money for safe-keeping with goldsmiths who had special facihties for taking care of valu- ables. It then became a practice for merchants to issue orders upon the goldsmiths when desiring to make payment; and the issue of these demands or orders marks the origin of the check system in England. One of these old checks drawn on a gold- smith, issued in 1675, reads as follows: 42 BANKING AND CREDIT [III Mr. Thomas ffowles. I desire to pay unto Mr. Samuell Howard or order upon receipt hereof the sume of nine pounds thirteene shillings and sixe pence and place it to the account of Yr servant, Edmond Warcupp 14 Augt, 167s £9 = 13 = 6 For Mr. Thomas ffowles, Gouldsmith, at his shop betweene the two Temple gates, Fleetestreete. On the back : Reed in full of this bill the sume of nine pounds thirteen shillings sixpence. Saml. Howard Private bankers extended the practice until by 1 780 it became general. London banks other than the Bank of England then began to discontinue their note issue. Instead of receiving a roll of notes the bank's customer obtained a book of order forms pay- able to bearer on demand and the bank undertook to honor such orders so long as it had assets of the drawer on hand. These order forms were issued payable to bearer and on demand in imitation of the notes which they were intended to replace. Just as the promissory notes bore registered serial numbers for ready verification, when the note was presented for payment, so these books of forms were similarly numbered. The practice of placing serial numbers upon these instruments as a check or means of identification is the explanation offered by some writers as to the derivation of the modern word "check."' 9. Drawing of Checks. — In writing a check good practice demands that it be dated, but this is not legally necessary; its validity and negotiability are not affected by the fact that it bears no date. If the instrument is not dated the holder has ■ F. Tillyard, Banking and Negotiable Instruments, p. 3. Ill ] COMMERCIAL CREDIT INSTRUMENTS 43 prima facie authority to fill in the date. It can be dated on a Sunday, as it is not in itself a contract. The date is usually that of its issuance, although legally it may be dated back or dated ahead. However, a check is not payable before its date. Checks are frequently postdated, especially by those whose deposit is insufi&cient to pay the check at the time of its delivery. Post- dated checks of this kind have often been held to be valid by the courts, provided the postdating is not done for a fraudulent pur- pose.^ To be negotiable, checks must be made payable "to bearer" or " to the order of." In drawing a check to oneself it is better practice to make it payable to the order of "cash" than to make itpayable to "bearer." In either case itis the custom of banks to insist that the check be indorsed by the payee but not by the maker. It is probable, however, that the bank does not have the legal right to insist upon indorsement, provided the person pre- senting the check is satisfactorily identified. Where the sum payable is expressed in words and also in figures, and there is discrepancy between the two, the sum de- noted by the words is the sum payable; but if the words are am- biguous or uncertain,ref erence may be had to the figures to fix the amount. ' 10. Presentation of Checks. — A check should be promptly presented. If it is not, a drawer may be discharged from liability to the extent of the loss caused by the delay. If, for example, the bank failed after there had been opportunity for presentation of the check, the payee would lose and could not recover from the drawer. A local check should be presented before the close of banking hours on the next business day following the date of issue. In order to charge the drawer of a check with liability, the check must be presented for pa)anent within a reasonable ' J. E. Brady, The Law of Bank Checks, p. 23. 3 Uniform Negotiable Instruments Law. 44 BANKING AND CREDIT [ III time after its issue, and in determining what is a reasonable time there must be taken into account the nature of the instrument, the usage of trade or business, and the facts of the particular case. If the check bears a date considerably previous to the time of presentation it is known as a "stale " check and probably will be carefully scrutinized. How long before a check is considered stale is not a definite and fixed matter. A check a month old has been decided not to be stale, but one 5 months old has been so treated. The teller must decide this question after a consideration of all the facts. An indirect routing of a check is liable to result in a loss to the owner thereof. This is illustrated by a case which arose in Ala- bama. A check drawn on a bank located at Greenville, Alabama, was received by the payee in Philadelphia on December 1 2 after banking hours and deposited the next day in a local bank for collection. This bank, instead of sending the check directly to a person or bank at the place where the drawee bank was located, which would have made it possible to present the check on or before December 17, sent the check to a bank in South Carolina, which forwarded it to another bank in Montgomery, Alabama, by which it was sent to a person in Greenville, Alabama, by whom it was presented to the drawee on December 10, one day after the drawee had failed. There was no proof to show that the manner of collection adopted by the Philadelphia bank was based upon custom, or any previous dealings between the parties. In an action by the payee of the check against the drawer, to recover the price of the goods for which the check was given, judgment was given for the defendant, because of the undue delay in pre- sentment. '' II. Responsibility of Drawee Bank. — The drawer of the check is responsible for carelessness in making the check. Legally it may be written with pencil, but this leads to errors and fraud. In writing the sum it is customary to begin at the left-hand margin in order to lessen opportunity for raising the amount. A ■■ J. E. Brady, The Law of Bank Checks, p. 102. lit] COMMERCIAL CREDIT INSTRUMENTS 45 bank in paying a forged check is responsible, for it is assumed to be familiar with signatures of depositors. If a check which has been properly made out is raised and then cashed, the loss may fall upon the bank. If, however, the drawer of a check leaves a blank which admits of opportunity for alteration, he may be held negligent. A holder (payee) of a check has no legal rights upon the bank upon which it is drawn, although the drawer has funds on deposit. The drawer can claim payment, but not the payee. If the check is not paid, the payee can sue the drawer. ^ Although the payee cannot compel the bank to honor the check, the bank is under obligation to the depositor to protect his reputation. A refusal to pay a check properly drawn and presented, if there be sufficient funds on deposit, would injure the depositor's credit and give cause for action against the bank. A bank, however, is under no obligation to make a partial payment up to the amount which may be on deposit, when the check is in excess. 12. Certified Check. — A certified check is a check which has written upon it an acknowledgment by the bank that the drawer of the check has sufficient funds on deposit to pay it. It is prac- tically equivalent to a bank note so far as the issuing bank is concerned. The acknowledgment is made by writing across the face of the check the word " Good, " "Accepted, " or "Certified, " and the name of the bank official assigned by the bank for this duty. Certified checks are commonly used by persons when their ordinary personal checks would not be readily accepted. In most banks the cashier generally certifies checks. Some banks prefer not to certify checks but to take up the check and issue a cashier's check against it, inasmuch as there is less opportunity for a banker's check to be subsequently tampered with if it should fall into the hands of a fraudulent person. s In a few states the payee may bring action against the bank on the theory that draw- ing a check is an assignment to a payee. 46 BANKING AND CREDIT [ III Certification constitutes a contract between the holder and the bank; the amount of the check is set apart out of the drawer's deposit for the purpose of paying the check. In legal contem- plation and effect a certified check is thus a certificate of deposit issued by the certifying bank. 13. Cashier's Check. — ^A cashier's check is a check drawn by a bank against itself, and usually signed by its cashier, payable when presented at the bank drawing the same. Such a check is commonly used by a person whose own check would not be so readily accepted as the check of some known bank. A cashier's check may be used by a person not having a bank accoimt and therefore unable to draw a check of his own. A slight charge may be made for the accommodation. 14. Stop Payment of Check. — A notice to stop payment of a check, to be effective, must, of course, be received by the bank before the check has been presented or certified. It is not unusual for a bank to require that stop orders be written. A telegram directing that the payment of a check be stopped may be acted upon by a bank at least to the extent of delaying the payment until further inquiry can be made. However, a bank is not legally bound to accept an unauthenticated telegram as a requirement for refusing payment. 15. Promissory Notes. — Whereas a bill of exchange is an order, a promissory note is a promise to pay money on the part of the one who writes it. A promissory note is an unconditional promise in writing made by one person to another, signed by the maker, engaging to pay on demand, or at a fixed or determinable future time a sum certain in money to order or to bearer. To the note as shown in Form 5, there may or may not be added an interest clause such as "With interest at 6 per cent per annum." Occasionally promissory notes bear an interest clause Ill ] COMMERCIAL CREDIT INSTRUMENTS 47 in which the rate is not specified, the rate implied being the legal rate of interest in the state of the promisor. In the absence of an $750.00 Boston, Mass., July 10, 192J Sixty days after date, / promise to pay to the order of A. B. Curtis $750 Value received. D. E. Foster Form 5. Promissory Note interest clause the full sum due upon the above note at its matur- ity is $750. When a note is drawn to the maker's own order it is not complete until indorsed by him. If A. B. Curtis wishes to sell this note before maturity he indorses it by writing his name across the back. This act trans- fers the right to receive payment; it also adds the implied promise that the indorser will pay the note if the maker refuses. If the indorsement is made in blank, that is, by writing simply the name (without "pay to the order of"), the note can be transferred from one person to another without further indorsement. Each additional indorsement, however, adds to the security. If the holder of a note wishes to transfer or assign it with distinct dis- avowal of responsibility, and this is satisfactory to the person receiving it, he may add to his indorsement the words, "Without recourse." The order of liability on a promissory note is: (i) drawer or maker, (2) first indorser, (3) second indorser, etc.* An indorser can collect, if possible, from those who indorsed above him, but not from those below. The holder of the note can proceed against any one or all of the indorsers. 16. Single- and Double-Name Paper. — If a note bears simply the name of the maker for its security it is called "single-name" ' With respect to one another, indorsers are liable prima facie in the order in which they indorse, but evidence is admissible to show that they may have agreed otherwise. 48 BANKING AND CREDIT ,[III paper; if indorsed by another it is "two-name " paper. A manu- facturer, for example, wishing to obtain the use of $5,000 may give his own note to a bank and on that personal security borrow funds. The note thus given is single-name paper. Or he might take the note of a jobber to whom he had sold goods for $5,000, indorse it, and obtain funds from a bank. This note then be- comes two-name paper. A considerable portion of the paper dis- counted by banks in the United States is double-name paper, and some hold that this paper is safest, partly because it bears two names, and partly because it arises, presumably, from an actual commercial transaction in which there has been a sale of goods and consequently clear evidence of value behind the note which ultimately will liquidate the obligation. On the other hand the note of a strong business house reputed to be solvent is often as acceptable to a bank, even if there be no immediate evidence in the making of the note that a particular sale has been made. The specimen note shown in Form 5 might have originated in the sale of $750 worth of goods by Curtis to Foster on 60 days' time. The chief advantage to Curtis of the note, as distinguished from a book account charge against Foster, is its superiority as a means of obtaining cash immediately. Curtis may sell the note to his bankfor perhaps$742.5o ($750 discounted at 6 per cent), or he may pledge it for a direct loan against his own note. A second and more important source of short-time promissory notes is the straight loan, by which is meant a direct advance of money, or the right to draw money, based upon a promise that the sum will be returned with interest in the future. A high per- centage of the direct short-term loans in this country are made by banks to their clients in all lines of business. Discussion of the subject of loans and incidental points is reserved for another chapter. 17. Accommodation Paper. — ^Accommodation paper is a bill of exchange or a promissory note to which the acceptor, maker, Ill] COMMERCIAL CREDIT INSTRUMENTS 49 drawer, or indorser has signed his name, without receiving value, for the purpose of obHging by the loan of his credit some other person who is to pay the note or bill at maturity. Any individual who lends his name to commercial paper is, of course, held for its payment, no matter what may be his intention in the begiiming or his private understanding with the accommodated person. Accommodation paper is looked upon by banks with more or less suspicion . There is no value received and it is not self -liquidating in the sense of being based on a merchandise transaction. i8. Money-Orders. — Money-orders are issued bypost-ofl&ces, express companies, telegraph companies, and banks, and are used for remitting funds of small amounts. A postal money- order is a government order issued at one office and payable at another. The maximum amount for which a single postal order may be issued in the United States is $ioo. When a larger sum is to be sent, additional orders must be obtained. International money-orders make it possible for sums, usually not exceeding $ioo, to be remitted cheaply to the principal countries of the world. The fees charged by the different issuing agencies are substantially the same. For postal money-orders the rates range from 3 cents, when the amount is $2.50 or less, to 30 cents for $100. A bank money-order is an order for the payment of money issued by a bank and payable at certain other designated banks in different parts of the country. The fees charged for bank money-orders are approximately the same as for postal and express money-orders. Bankers' limited checks are used com- monly for remitting small sums of money to any part of the world. Indicated on the face are certain fixed limits in various currencies. For amounts in excess of the sums stated it is cheaper and more convenient to purchase drafts. The bank postal re- mittance system is considered in a subsequent section. Telegraphic money-orders are telegrams of telegraph or ex- 50 BANKING AND CREDIT [III press companies ordering the payment of money at some other designated place. Remittance of funds by telegraph is common in foreign trade, and foreign exchange markets have daily quota- tions giving the telegraphic or cable transfer rates on the principal commercial centers of the world. The remittance of funds by money-order is mostly a matter of bookkeeping on the part of the agency issuing the order. No money is transferred from one place to another; a certain sum is received at one place and an equivalent sum paid at another place. 19. Bank Postal Remittance. — The term " bank postal remit- tance" refers to a special class of transactions utilized chiefly to meet the requirements of European immigrants to the United States, who wish to send money to the old country, and to facili- tate the transfer of funds to places where banking facilities are somewhat limited. The class of persons to whom immigrants usually send money would experience inconvenience in getting an ordinary banker's check or draft cashed. The postal remittance system may be compared to the money- order system in this country. The American bank, in return for dollars received from the remitter, notifies its foreign correspon- dent bank to pay the equivalent in the local currency, as deter- mined by the rate of exchange prevailing when the order is taken, to a specified person in that country. The foreign bank then either buys a postal money-order or puts the actual currency in an envelope and sends it to the beneficiary through the mails. The foreign bank charges the remitting bank's account and usually deducts its own charges, if any, from the face amount of the remittance. Banks in this country which do not carry accounts abroad invariably sell foreign checks and postal remittances under the protection of the large New York banks which maintain connec- tions throi^hout the world. When the purchaser pays for the Ill J COMMERCIAL CREDIT INSTRUMENTS 51 postal remittance he is given a receipt to be retained by himself and also a memorandum, containing explanations in about a dozen languages, which he is to mail to the person who is to re- ceive the money. This memorandum is in no way a draft or order but is simply a statement of advice, the order to pay having been forwarded by the bank direct to its correspondent abroad. 20. Circular Notes. — Circular notes (often written in French) are sometimes issued by banks and tourist agencies. They are similar to travelers' checks in form and use, and are issued for round sums of a given currency (dollars, francs, pounds sterling, etc.) . They are payable at the amount for which they are issued, without deduction in the countries which use that currency. In places where the local money differs from that specified on the circular notes, the equivalent of the amount is paid at the ex- change rate when cashed. At present (1922) there is very little difference between a circular note and a travelers' check, because banks, on account of the unsettled conditions of foreign exchanges, have generally ceased the practice of issuing travelers' checks payable at fixed rates in foreign currencies. 21. Travelers' Checks. — A travelers' check (Form 6) is in effect a circular note made out by a bank, express company, or tourist agency to the order of the traveler as payee. For con- venience they are made out in small sums and are available not only for foreign but for domestic travel. The checks are for rela- tively small amounts and are generally accepted by railroad companies, large stores, tourist agencies, and hotels without imposing on the traveler the burden of cashing them at a bank. They are issued in series or packages in varied denominations, generally from |io to $200, each bearing the signature of the bearer written in at the time of purchase and each being counter- signed by the bearer when presented for payment . Until recently on each check there was indicated opposite its value in United 52 BANKING AND CREDIT [HI Z U ui X o 00 cc -J Ul > < oe I- o '^ ^ w ^v, s# +J ?, M < B o >> >, O g m Ph 'S'O £ <^ tJ O rt t. HW O :^ S5 O >j u ,C o^ mpd o '^ ^ B , S O U > H o o il rt a r/l H Vh rt ■J (U < C n, z ni o i^ b S U 6 o g O Si Si o Ill ] COMMERCIAL CREDIT INSTRUMENTS 53 States money the cash equivalent in Enghsh, French, Italian, German, or other foreign money. Thus if the traveler were in Italy and had a $20 check he would know without asking that it was worth 102 hre and 50 centesimos. At present (1922) Ameri- can banks are issuing travelers' checks payable not in fixed equiv- alents of foreign currency but at the rate at the time of encash- ment for sight drafts on New York. While the original plan for making payments was satisfactory under normal conditions, the disorganization of the foreign exchanges brought about by the war has rendered it in most cases unsuitable for the needs of the traveler today. Travelers' checks generally offer a much more satisfactory means of carrying funds than do drafts. The latter must be cashed in a single lump sum which may be somewhat larger than the traveler wishes to carry on his person, and which may be a decided disadvantage if a little later a journey is made into another country where a different currency is in use. Under the standard terms in the United States these checks are sold for their face value in dollars plus a commission of 3/4 per cent, or 75 cents per $100 worth, with a minimum commission of 75 cents. 22. Certificates of Deposit. — By depositing a sum of money in a bank a person may, if he wishes, receive a certificate of de- posit instead of a credit to a regular checking account. A certifi- cate of deposit is both a receipt and a promissory note and may be drawn payable to any person whom the depositor may name. The certificate may be either negotiable or non-negotiable and may be made payable on demand or after a definite time. The demand certificate is used principally for the purpose of guaran- teeing payment to a creditor and also as an old method followed by some banks in transferring cash to distant points. In many respects a demand certificate is similar to a certified check or a bank draft. The time certificate usually yields a fair rate of interest and 54 BANKING AND CREDIT [ III offers the depositor a return on any temporary idle money that he is willing to turn over to the bank. For example, suppose Mr. A has |io,5oo to lend for 6 months. He can buy commercial paper, a corporate short-term note, etc., of that maturity. But he cannot judge the soundness of these investments. He goes, therefore, to a bank (any large bank) and buys (for that is what the transaction virtually amounts to) a 6 months' certificate (Form 7) yielding, to be sure, a lower rate than the investments alluded to above would. The bank prefers to issue the certificate / $10,500 Boston, Mass Mar. EIGHTH NATIONAL 15, l<)22 BANK No. 1672 Charles T. Adams . . . . has deposited . . .ten thousand and five .... hundred Payable Dollars to the order of . himself on the return of this certificate properly indorsed . . six months after date, with interest at 4 per cent George F per annum. Tompkins Cashier. Form 7. Certificate of Deposit rather than open a time deposit account, simply because it in- volves less bookkeeping and other clerical work. Mr. A is to leave the funds with the bank only for 6 months and the bank therefore does not consider it worth while to enter his name on the deposit ledger and go through the formalities incident to the opening of a new account. 23. Commercial Paper. — "Commercial paper" is a term employed more or less loosely ; in its broadest sense it includes all forms of credit instruments that arise from business operations. As generally used in the money market it may be defined as promissory notes issued by business concerns for the purpose of Ill ] COMMERCIAL CREDIT INSTRUMENTS 55 carrying on commerce and sold by the makers in the open market. This, it will be noted, rather rigidly limits the character of the paper included in the category to strictly direct obligations of the makers. Bankers' acceptances are definitely excluded, and trade acceptances are often listed either separately or as bills receivable. Comtnercial paper is sometimes called "purchased" paper as distinguished from discount paper of the bank's own customers. Commercial paper, as defined by the Federal Reserve Board regulations, is given a much broader interpretation and includes notes, drafts, and bills of exchange, which arise from deahngs in merchandise as distinguished from loans made for the purpose of trading in stocks and bonds. Commercial paper, eligible for rediscount at a federal reserve bank, must be a note, draft, or bill of exchange the proceeds of which have been used or are to be used in producing, purchasing, carrying, or marketing goods (goods, wares, merchandise, or agricultural products, including livestock) in one or more of the steps of the process of production, manufacture, or distribution. It must not be a note, draft, or bill of exchange the proceeds of which have been used or are to be used for permanent or fixed investments of any kind, such as land, buildings, or machinery, or for investments of a purely specu- lative character. Notes or bills with the proceeds of which bonds and notes of the United States have been purchased are eligible. The term is also appHed without any qualifying adjective to promissory notes and bills. Paper or commercial paper is further distinguished as agricultural paper, arising from the sale of agricultural products, and mill paper, which in New England refers to promissory notes and bills of textile mills. Similarly in the Northwest, notes and bills secured by grain held in eleva- tors are known as "elevator" paper. Such paper is also called "trade" paper. 24. Commodity Paper.— Commodity paper, within the mean- ing of the Federal Reserve Act, is restricted to notes, drafts, bills 56 BANKING AND CREDIT [ III of exchange, or trade acceptances accompanied and secured by shipping documents or by a warehouse, terminal, or other similar receipt covering approved and readily marketable, non-perish- able staples properly insured. " Staples " include manufactured goods as well as raw materials, provided the goods are non-perish- able and have a wide market. This is held to include ccftton yarns and flour. Commodity paper comprises not only paper originating with the producer, but also paper of merchants and others when the commodity is not being used for speculative or purely investment purposes. Potatoes, properly graded , packed, and stored in weather-proof and responsible warehouses, as evi- denced by its receipt, constitute a non-perishable staple. 25. Volume of Credit Instruments. — It is impossible to deter- mine the total amount of credit instruments outstanding at any one time. We know the amount of coin which has been minted and the amount of government and bank paper money which has been issued, but only estimates with a probable wide margin of error can be made of the outstanding volume of checks, promis- sory notes, bills of exchange, and the other miscellaneous variety of credit instruments which society has devised. Several inves- tigations, however, have been made to measure the proportionate use of credit instruments in exchange transactions in the United States, based on an analysis of the receipts of banking institu- tions. For example, an analysis of the receipts of 152 banks lor six consecutive days in 187 1 showed that 88 per cent was in checks, drafts, and commercial bills. Ten years later, in 188 1, a similar inquiry based on the receipts of over 2,000 banks for a single day gave the following results : Per Cent Checks, drafts, and bills 91-85 Clearing-house certificates 2.24 Paper money 4.36 Gold coin i .38 Silver coin .17 Ill 1 COMMERCIAL CREDIT INSTRUMENTS 57 The returns varied for different parts of the country. In New York City the proportion of credit instruments ran as high as 98.7 per cent, while in some of the states it was as low as 65 per cent. Subsequent investigations gave substantially the same results . The last and most exhaustive inquiry was made in 1 909 . ' It was then concluded "that a large proportion of the business of the country, even the retail trade, is done by means of credit instruments. While it is probably true that wage-earners, as a class, do not commonly use checks, it is also true that a great many do. Moreover, the use of checks is common among people who derive their income from other sources, even though it be not larger than the well-paid laborer. We are justified, therefore, in concluding that 50 or 60 per cent of the retail trade of the country is settled in this way."* Over 90 per cent of the whole- sale trade of the country is done with checks and other credit instruments ; of weekly pay-rolls reported by the banks 70 per cent was in checks; and finally "we may therefore safely accept an average of 80 to 85 per cent as the probable percentage of business of this country done by check." References Cleveland, F. A. Funds and Their Uses. Promissory notes, pp. 111-128; checks, pp. 55-66. Holdsworth, J. T. Money and Banking, pp. 1 14-1 16, 120-124. Moulton, H. G. Financial Organization of Society, pp. 162-169. Principles of Money and Banking. Part II, pp. 32-37. McMaster, J. S. McMaster's Irregular and Regular Commercial Paper. Contains a collection of forms showing notes, checks, drafts, in- dorsements, etc., with textual explanation. Tillyard, F. Banking and Negotiable Instruments. An English book containing in the appendix, 40 pages of forms of checks, bills of exchange, letters of credit, and shipping documents. 7 Made by the Comptroller of the Currency for the National Monetary Commission, under the editorial supervision of David Kinley. ' The Use of Credit Instruments in Payments in the United States, by David Kinley (Report of National Monetary Commission), p. 199- CHAPTER IV- COMMERCIAL CREDIT DOCUMENTS 1. Bills of Lading. — By "commercial credit documents" is here meant bills of lading, warehouse receipts, trust receipts, and numerous other forms which serve principally as evidences of title to or rights in goods. It is the purpose of this chapter to point out the salient features of the more important of these documents. A bill of lading is a document containing a written acknowl- edgment by a railroad, steamship company, or other carrier, specifying the receipt of goods for transportation. Besides being the final receipt from the carrier, the bill of lading is, in effect, a contract between the carrier and the shipper. It is customarily drawn up by the shipper on forms which the carrier supplies and which are signed by the latter after the receipt of the goods in the case of a railroad company, or after delivery of the dock receipt and the shipper's manifest in the case of a shipment abroad. Bills of lading are the most important of the shipping papers and are used extensively as collateral in connection with drafts and bills of exchange . The only thing that makes a bill of lading valu- able to buy or to use as collateral is the fact that the carrier will hold the goods until the bill itself is surrendered, except possi- bly in the case of a " straight" bill of lading. 2. Straight and Order Bills of Lading. — A straight bill of lading states that the merchandise is consigned or destined to a specified person. It is non-negotiable and therefore is not the proper form for use as collateral. An " order" bill of lading states that the merchandise is consigned or destined to the order of any person named in the bill, and is therefore negotiable. Such a 58 IV] COMMERCIAL CREDIT DOCUMENTS 59 bill will make the merchandise deliverable to the order of the shipper himself, to the order of the buyer, or to the order of some bank which has agreed to finance the shipment through the pur- chase of the shipper's draft or through the issue of a commercial letter of credit. Bills of lading drawn to the seller's order are used most generally when a draft is to be attached . The seller indorses it in blank and then delivers it to his bank as security for the bill of exchange. With practically no exceptions banks discounting drafts se- cured by bills of lading insist upon order bills of lading. When a draft is accompanied by a straight bill of lading the bank as a rule receives the item only for collection and does not credit the customer's account until funds have been received through the correspondent bank. 3. Ocean Bill of Lading. — Ocean bills of lading, unlike rail- road bills, vary in phraseology, due in part to the business cus- toms of the country under whose flag the vessel sails, and in part to the laws of the countries between which the steamer runs. Different bills of lading, for example (although issued by the same steamship company), are required for shipments to South America and those destined to England or France. Particularly in foreign trade it is not customary for the ocean bill of lading to be drawn in the consignee's name (straight) unless special arrangements have been made with the shipper, or unless advance payment has been made or security furnished before the shipment. The plan for effecting financial settlements most commonly employed in foreign commerce involves drafts or bills of exchange, to which are attached such documents as the ocean bill of lading, the shipper's invoice, and marine insurance poli- cies. The number of copies of the bill of lading required vary according to the nature of the transaction. They are usually issued in sets and some are made negotiable and others non- negotiable. Banks purchasing drafts require two or more nego' i- 6o BANKING AND CREDIT I IV able copies and insist upon possession of all other negotiable copies. Non-negotiable copies are necessary for the shipper, the carrier, and the consignee for filing, and by foreign consuls to comply with the provisions of the law. 4. Through Bills of Lading.— " Through" bills of lading, also called "export" bills of lading, are used where an exporter at an inland point wishes to bill his goods from point of shipment to the foreign point of delivery, port or interior. By a through bill the exporter avoids the necessity of obtaining a railroad bill of lading to cover the goods to the port of shipment, and then an ocean bill to the foreign port of destination. The export bill of lading, is, in effect, a triple contract embracing three things: (i) trans- portation by rail or water to port of shipment; (2) transportation by sea; (3) transportation from foreign port of entry to inland destination. 5. Transaction Illustrating Use of Bill of Lading. — In order to understand the use of a bill of lading as collateral in a domestic transaction let us suppose that Buyer and Company of Syracuse has purchased a bill of goods from Seller and Company of Boston, subject to a sight draft. Upon receipt of the goods the railroad company signs the bill of lading (Form 8) made out by Seller and Company. The bill of lading with the invoice (Form 9) is then attached to a draft (Form 10) drawn in favor either of Seller and Company or of its Boston bank and turned over to the latter . The Boston bank forwards the draft with the bill of lading to its correspondent in Syracuse, who presents the draft to Buyer and Company for payment. Upon payment of the draft Buyer and Company obtains the bill of lading and thus is in a position to secure the merchandise from the railroad company. As soon as the Boston bank has received notice that the draft has been paid, it advances the proceeds of the draft to Seller and Company, although the latter may possibly obtain immediate use of the IV] COMMERCIAL CREDIT DOCUMENTS 6i nnUoitn BUI of I.iA1d| Oometol tfl OetoDct 10, IBSO Boston 8e Albany Railroad Shipper* Wn. 11 .1 Ogenti Wo 38 N. V. C R. R. CO.. LU9BI ORDER BILL OF LAOmQ-ORICINAL RECEIVED, subject to tho ctusi6catioDi uid t&rlf[e ia elTect od the ilnto al mue of this OrigiDal BUI of Lading, Sfliaions-JJaaas -Ociahax,. _i9» - SQ ller . a.nd ■ CompEUiy the proporly described bclon, ID apparent nxid order, except u noted nd condition of contnnta of packagL's unknown), marked, coniisncd and dnatincd na indicated below, which said Company agnxt (contents and condition of contnnta of packagL's unknown), marked, coniisncd and dnatincd oa indicated below, which said Company agrc<» to carry to ila usual ploco of delivery at euid dcatinatioD, if on its rood, otncnviso to deliver to another carrier on tho route to i.iid dcsUnalinn. Itia mutually agreed, oa to each earner of all or any of snid tiropcrty over nil or uny portion of said routo to dcitinatj'nn andnslo each parly al any timaintcrc8t«d in all or any of Huid prnporty, that every scrvi en to l>o performed hereunder ahull \>o Bubjeet to all tho conditions, whnther printiid or written, liercia contained (Including conuitiana on bock hereof) and which urn agreed to by tho abippcr and accepted for hiiniK-liF and hU Basigna. Th*Byrr*nd«r of thia Original ORO ER Bill at Lading ^ravarly Indaraad ahall b* raqulratf baforatha dallvary of Iha prop- . . . . ^ by thla bill or lading will not ba pr ^ ... g orglvan In writing by tha ahlppar. 27t« EaU of Freight fn m CenUVtrlOO V». " IFSpKUl IV "ill IP It M IF Rule H 4Ui IT ii °S" of. 4" &. i VI .. (MiJl AiUim— Nol Consigned to ORDER OF Sal Tar n.n<\ nn>Tipfl.Tiy Deatination, SyzaCUBB^ Notify Euyflx....an4..Conq?an.y^... At Syi:a,0Ufl.fl. ., Route. E»„&._A. .; ..ILJCC*. .state of-HflIlt..JfflX]£ County of- gSfl Harrlflftn R'r.. -State of-Nft-ffJCorlJCounty of-. One (1) Ca s a LeatherjMahos any.31de_a Two (5)n\inri l aa Laathar ^ DESCRIPTION OF ARTICLESAND SPECIAL MARKS Ma'^f« 'Syracuse ~ If cbargt^ are to be E repaid, write or stamp ere, "To be Prepaid." Received}. to apply ID prepayment of the charj^ on the property described 'hereon. AfBI er Ctdikr, ^ft7r.' Agent ..a..Y,S Prr j/.r:./.V...-, (tu. BID sllsdint Is IS bf dssvi b, tb* aUnw sod iSBl . rO 00 O -^ W . GO CO CO '-■ Loan and Trust Companies On t-^ vD 0* r>. vo 00 00 O M \0 tH ro O'sl -1 MM CO (N 0\ t-i ON l-l O ON ■ (N ^ M ■ IN CD s "O lo r-^ i-H o y^ I^ On lO oo r^ lO ON O Tf O »o 00 C to r^ O ro N CO O O ^ On -^ -- 1^ •^ M3 lO 1-*^ t:J- lO i-T i-T oT ---" CO fliH w 00 o to o o n i>- lo CO "^ r--. lO CO CO \o t^ lO I>- ■^ ON 0>dTb«p.k. -I Ud br Hid BuL J^ .1 tl» cdiot Ihncf (FILL IN ALL BLANKS USING "NONE" WHERE NECESSARY) ASSETS UABIUTIES CuhoDhududbbub $ Note* PkT-U* aoNcmd $ Duo williin « din *.■■... .Z £££^ To oSan, Anck..^ PuidiM Hotel Parablo 10 onlrelkd a nbwEux UBMU » MuelMdlM (how »>lutd) * Tr.d.Ac«.pteneN ) p^» p..^.l T lotenatoBoodi A,t»^mAk $ PiMiiloaforFMlonlTMM « LKalniannco— CuhHiirBuki»lu(* $ StetouidOlliarTam « TOTAL CURRENT LI ABILITIES.... $ Bosdad Dobt $ Fl, TVi„l,.»Ji^ f Frvaftnnrrt T . Mortfaga* OB Rokl Eitelo $ ...... Und S CbaltelMorUf- » A]10lliorLiabllitla*(itnnitt) $ CuduJ „ $ BuUdtan J Furalhir. Mid Fiituro. S 9«"pl». 9 TOTAL » TOTAL S ^~ ^~ Valuo of nwrcIiaiidlM pnnliaiad for nozt Mhoq'i biulnoia and not indudad la abon aiMla or liabilit{«« $^. CM&vtnlLJibilitia: Fiiilf ii i4nHi ii !'NiitaR«MmlJ^TmifeAaMptanf«.BilRmt;fn'ATTf|tamTt.*-'™'*H Detaili..- ., - ..^ _ _ FEDERAL RESERVE BANK OF BOSTON Staluaal Fans Form 16. (a) Borrower's Statement (face) 214 BANKING AND CREDIT [XV An Uf ol ibeiboKUMti ptcdtul « uUfBcd? - An iii|> of die mbovc EaliXlies iteandl AawuDt ol tbon iccounU u>d nola ncdvable pul due oi doubdul t.. Dileol Inircnlorj^ Anouol ol Foe la«naoc > Od mcnluBdiie, $ Nd S«lci, liU'Eml ;cu> Ciou PfoGl, lul Gical jeuJ NnF^ob, lul bed yai7 - „ AffilUbd ceocenu (Ntoe ud lacaliaa)} , - II putncnlup, wkea Joo h Unniiule} AreihcK taj tab pending igijiut^rouT .. ■ ExpUnatioD of maf ilan in tbii ibUmaDt mmj ba mada below Form l6. (b) Borrower's Statement (reverse) Forms of this kind are furnished by the Federal^ Reserve Bank of Boston upon request of member banks which may wish them for customers. and the value of an independent appraisal of assets is liable to be considerably exaggerated, the reverse may be true. It is estimated that 90 per cent of the statements certified by public accountants are balance sheet audits. '' Although the other specific requirements of well-prepared credit statements vary somewhat under different conditions, the statement form of the Federal Reserve Bank of Boston shown in Form 16 illustrates the kind of information that banks desire. 4 Federal Reserve Bulletin, April i, 1917. p. 370. XV] THE CREDIT STATEMENT 215 6. No Fixed Rules of Interpretation. — In analyzing a credit statement there are no fixed rules to be followed or infallible tests to be applied. This is due in a large measure to the fact that each merchant or manufacturer has his own system of accounting and his own method of inventorying. When he prepares a credit statement for his bank or note-broker he starts generally with the ledger trial balance, which probably contains several hundred accounts, and condenses it into a few items for the statement. Very often the bank will find it necessary to make allowance for depreciation or shrinkage in value in order to determine the amount of assets actually available for the payment of current debts. Moreover, it may be desirable to have accurate informa- tion concerning obligations on account of contracts and agree- ments that do not appear on the conventional form of balance sheet. These obligations which are common to most business concerns arise from the purchase of raw materials or the sale of finished goods for delivery at some future date at fixed prices. In the case of specialties or luxuries subject to wide variations in prices, or on a fluctuating market for staple commodities, a firm's obligations of this character may cause serious embarrassment. But of no less importance is the consideration of unfilled orders or customers' contracts which have been canceled. In times of falling prices or business uncertainty, cancellation of contracts becomes a serious problem for manufacturers. Although in some instances manufacturers insist upon the terms of their contracts with buyers and refuse to submit to cancellations, in the majority of cases such losses are unavoidable. In general there are four good reasons why manufacturers do not as a rule take legal action against buyers who have canceled orders for goods. First of all, if the manufacturer values the good- will of his customer and is counting on future business with him he probably will not con- sider it wise to force him to take the merchandise. In the second place, the buyer might not be able to market the goods, and, consequently, if compelled to accept them he might be forced into 2l6 BANKING AND CREDIT [XV bankruptcy or placed in a position where he could not pay for them. Again, if the seller insists upon his legal rights the buyer may resort to technicalities and return the merchandise because of "defective" material or workmanship. Finally, legal procedure in such cases is long and expensive and is a matter which most business houses endeavor to avoid. 7. Business Conditions and Customs Affecting Credit. — In judging a financial statement the credit man will find indispens- able a knowledge of trade customs, such as buying and selling methods, discounts, datings, and manner of extending credit. As a general thing the best class of commercial paper is issued by concerns dealing in the necessities of life and commodities having a wide and active market, and not such as have utility of a transi- tory character and are subject to the whims of fashion. The fed- eral reserve banks look with particular favor on paper based upon readily marketable staples. By "readily marketable staples" is meant all raw products, such as cotton, grain and other foodstuffs, ores, and common chemicals, which enjoy a broad market and are thoroughly standardized and fairly non-perishable. No doubt there are some lines of manufactured goods which are sufficiently standardized as to methods of production, styles, uses, customs, and other factors, and for which there exists a broad enough market to warrant their inclusion in a list of readily marketable staples. It is hoped that the Federal Reserve Board in the near future will issue a list of staples which it considers readily market- able at all times and under all conditions. Usually the business of the borrower is subject to those influ- ences that affect allied and associated industries. For instance, the market for plumbing supplies is dependent on building opera- tions, the market for dyes is affected greatly by the activity in the textile and leather trades, and the demand for cement is influenced by the amount of road construction. Comparative statements covering a period of years which in- XV] THE CREDIT STATEMENT 217 eludes a business depression as well as a business expansion are much more significant than data for any single year. It is also desirable to obtain figures for similar concerns in the same section and possibly different sections of the country. = In examining a credit statement, banks usually first transcribe the data to a columnar sheet where comparative results for a number of years can be studied and trends in different directions can be noted. 8. Character of Quick Assets. — ^Jobbers and wholesale mer- chants stand between the original producers and the retailers, and this fact has a bearing upon the character of the former's quick assets. For example, accounts receivable of a jobber or a wholesale merchant are mostly due from retail merchants, and are more easily collected than open accounts in the retail trade. To a large extent also, the merchandise is in unbroken packages and is readily salable in the event of liquidation. The accounts receivable of a retail merchant are largely due from individuals and allowance must be made for loss in the process of collection. Because the merchandise consists of a widely distributed variety of articles and finished goods with a relatively narrow market, considerable difficulty may be met in realizing upon these assets should it become necessary. For the reasons given, the margin of quick assets of a retail merchant should be larger than in the case of a wholesaler. This is not to be considered a reflection upon the retail merchant's paper but simply an established principle of credit. Manufacturers' statements according to a well-recognized practice should have sufficient capital furnished by the stock- holders to cover the investment in plant, machinery, and equip- ment less the bonded or mortgage debt. The current borrowings will be represented by raw material, finished and unfinished goods, and current manufacturing expenses. In the business depression s Writings of Alexander Wall and publications of Robert Morris Associates contain information on this point. 2l8 BANKING AND CREDIT I XV of 1920 and 1921 many manufacturers quickly found themselves in the unfortunate position of having a small margin, if any, of quick assets over quick liabilities, although their fixed assets were often large. The seasonal requirements in many lines differ greatly. For instance, department stores have two fairly well-defined seasons and a well-conducted business can borrow and run out of debt twice a year. This is likewise true of many concerns selling to department stores. Shoe manufacturers should be in a position to carry liberal cash balances between seasons. Other lines, such as the fur business, liquidate by the end of December and tire manufacturers by June. The lumber manufacturer requires a year to get his cut ready for market, and consequently loans to finance his operations run fairly steady throughout the year. Such considerations as have been mentioned are of material significance because the indebtedness arising from the loan de- pends for liquidation on the convertibility, use, or operation of the property against which the loan is incurred. References Ettinger, R. P., and Golieb, D. E. Credits and Collections. Treating of the construction and analysis of the credit statement; illustrated with blank forms. See especially pp. 186-250. Kniffin, W. H. The Business Man and His Bank. How to prepare a statement, pp. 140-149. Commercial Paper. Discussion of the fundamental points for consideration in the analysis of credit statements in general, pp. 15-48. The Practical Work of a Bank. Deals with the essentials in granting credit, the moral risk, the requirements of a good credit statement, and the significance of important items in the statement. Analyzes four typical statements; PP- 373-502- Langston, L. H. Practical Bank Operation. Describes operations of the credit department of a bank, including sources of information, relations with borrower and determination of a line of credit, pp. 229-257. XV 1 THE CREDIT STATEMENT 219 Phillips, C. A. Bank Credit. Bank borrowers' statement, pp. 161-213; investigating a credit risk, pp. 214-223. Stockwell, H. G. Net Worth and the Balance Sheet. Presents a precise and elementary discussion of financial statements. See especially pp. 13-195. Westerfield, R. B. Banking Principles and Practice. Deals with the work of the credit department of a bank, including sources of information and interviews with borrowers, Vol. IV, pp. 93S-9SS- Willis, H. P., and Edwards, G. W. Banking and Business. Deals with sources of credit information and determination of line of credit; discusses some of the principal items in the borrower's statement; pp. 112-122. Almost any standard book on accounting deals with the analysis of financial statements. See especially: Cole, W. M. Accounts, Their Construction and Interpretation. Interpretation of balance sheets, pp. 104-109. Hatfield, H. R. Modern Accounting, pp. 35-69. Paton, W. A., and Stevenson, R. A. Principles of Accounting, pp. 545-598- CHAPTER XVI ANALYSIS RATIOS I. The Use of Ratios in Analysis. — The specific tests that may be applied by a bank to a credit statement rendered by an appUcant for a loan are of two kinds : quantitative and qualitative. By qualitative tests are meant the examination of the nature and inherent soundness of each item appearing on the prospective borrower's statement. Some discussion of this is given in the following chapter. Quantitative tests involve a determination of certain ratios such as the following, which will be discussed in sequence : Current assets to current liabilities. Inventory to cost of sales (merchandise turnover). Merchandise to receivables. Net worth to fixed assets. Sales to merchandise. Sales to receivables. Sales to net worth. Total debt to net worth. Sales to fixed assets. For the banker or note-broker, quantitative tests are the more practicable, and of the various ratios used the first, or the current ratio, is by far the most common. As a general thing the banker or note-broker, after satisfying himself as to the moral risk of his chent, accepts the accuracy of the figures appearing on the credit statement and concerns himself principally with the ratio of current assets to current liabilities. Although the use of the current ratio as a measure of the financial standing of a business firm is more or less justified by experience, this measure may XVI] ANALYSIS RATIOS 221 prove very unsatisfactory in certain cases and if employed, as it is frequently, as the acid test of a statement may do injustice to both the credit-grantor and the prospective customer. Excellent work has been done in the development of the technique of credit analysis by Alexander Wall and organizations Hke the Robert Morris Associates. Mr. Wall's ratio-averages include such items as the rapidity of turnover, relationship of debt to net worth, ratios for different industries and for different sections, etc. Although the future of credit analysis will probably witness pro- gress in the direction outlined by Mr. Wall, to date there are very few bankers who have found occasion to make practical use of these new ideas. 2. Ratio of Current Assets to Current Liabilities. — The terms "current" or "quick," when used in connection with assets and liabilities, refer to cash items or those that will take the form of cash or its equivalent within a comparatively short time (ordi- narily a year) , and distinguish such assets and liabilities from those of a permanent or fixed character. To the banker who is inter- ested most of all in the firm's ability to meet its current obliga- tions, this part of the statement is of primary importance. In the case of a mercantile company bankers ordinarily expect a satisfactory statement to show at least a 2 to i condition, or in other words, $2 of quick assets to discharge $1 of quick liabilities. This 2 to I ratio, or 50 per cent rule, is not an absolute standard but simply a working guide. The reasoning behind this rule is that whereas 100 per cent of the current liabilities will require pajTiient it is not safe to count on more than 50 per cent of the current assets being converted into cash within the same period when the liabilities will fall due. Concerns which have quick assets of an exceptionally liquid character may not require so large a ratio. For instance, the business of a packing house is such that the buying of raw materi- als can be curtailed at any time, with the result that a large part of 222 BANKING AND CREDIT [ XVI the assets can be quickly converted into cash. When a statement does not show a margin of current assets over current liabilities, one can be justified in concluding that part of the borrowed money is being used for the purchase of equipment or other fixed assets, or for the payment of debts contracted for fixed assets. In some cases, however, the situation may be due to recent large shrink- ages in inventory values. Under these conditions a conservative banker or note-broker will use great care in purchasing the paper. It is felt by some bankers that the use of the trade acceptance will interfere with the so-called "50 per cent" rule. In many countries depositors are given two Hues of credit, one hne of credit based on trade acceptances and the other line on inventories. The banker examines the trade acceptances offered and if they are satisfactory, agrees to take a large proportion of such paper received by the depositor. The banker then carefully considers the character of the inventory and its status with respect to the outstanding liabilities and grants a line of credit based on these facts. The line is liberal if the inventory consists of staple prod- ucts, and restricted if the inventory is made up of products that are not readily salable. Many foreign bankers claim that this is a more scientific way of extending credit than the American method of granting "50 per cent"; and, moreover, it is pointed out that the loan is based on two specific items in the depositor's statement — first, the trade acceptances, which represent the best form of accounts receivable, are discounted, and second, money is loaned on the depositor's inventory considered in relation to his liabilities. Under this system the funds advanced by the banker are very seldom used for the purchase of machinery and equipment, addi- tions to buildings, and for acquiring other fixed assets — a thing which sometimes happens under our system where the banker does not make a close inquiry as to the exact purpose for which the money is to be used. Banks in this country commonly grant lumber dealers a XVI ] ANALYSIS RATIOS 223 separate line on the customers' paper, and discounting this does not affect the line given to them on their straight paper, that is, their own promissory notes. This is also true of acceptances. A first-class concern presenting acceptances from highly rated cus- tomers may be accomrnodated practically without limit, provided the bank has the money and sees no need of contracting its loans. 3. Merchandise Turnover. — In the retail trade the poUcy of concentrating purchases with a few high-grade houses, buying often and turning stock frequently, is desirable because it means fewer creditors and a smaller stock of shopworn and unsalable goods. It is better for a retail establishment to have as credi- tors a few strong wholesale houses which have a real interest in the retailer's success than to have many small creditors who are apt to cause embarrassment in time of financial stringency. For the purpose of illustrating the significance of "turnover" in the analysis of a credit statement, the following balance sheet and statements of fact are of value : Central Shoe Store Boston, Mass., December 31, 1921 Assets Merchandise inventory $91,500 Fixtures 6,200 Accounts receivable 5,400 Cash 1,300 Total assets $104,400 Liabilities Accounts payable for merchandise ($8,500 past due) $33,50o Trade acceptances (due in 30 days) 12,000 Borrowed from individuals on notes ' 18,500 Total liabilities $64,000 Proprietor's net worth 40,400 Total liabilities and net worth $104,400 224 BANKING AND CREDIT [XVI Sales for year ended December 31, 192 1 jf 116,800 Purchase price of goods sold $92,000 Clerk hire 2,250 Rent 15.500 Expense 3>ooo 112,750 Net profit before personal withdrawals ., $4i050 Personal withdrawals 3.6oo Net profit after personal withdrawals $45° Average merchandise inventory for year at cost I92, 800 Analysis of this statement shows that the purchase price of the goods sold during the year amounts to $92,000 and that the average merchandise inventory for the year is $92,800. Ob- viously the merchant has turned his stock only once during the year. If the turnover were between two and three, as it probably should be, the proprietor would carry a stock of merchandise of approximately $30,000 instead of $92,800 and would be able to liquidate at once almost his entire indebtedness. As it is, the monthly receipts are in the neighborhood of $9,700. From this figure must be subtracted the monthly charge for clerk hire, rent, and expense, of approximately $1,700, and there is left $8,000 (before allowing f or.personal withdrawals) , which simply means that it will require the receipts of about 8 months to pay the debts. The number of times that stock is turned over each year has a significant relation to the time within which commercial paper should mature. If the yearly turnover in a certain mercantile establishment is 4, it means that on an average 3 months are required to sell a particular lot of goods. Therefore, since com- mercial paper depends for its liquidation upon the convertibility of the merchandise back of it, the paper of this firm ordinarily should run for not more than 90 days. In many cases turnover is misunderstood. For instance, a merchant carrying a stock of $10,000 and doing an annual busi- ness of $ 100,000 is apt to be misled with the idea that he has turned XVI ] ANALYSIS RATIOS 225 his stock 10 times. The error in the calculation is due to the fact that the turnover has been figured on sales, whereas the stock is based on cost. Turnover may be figured correctly according to either of twomethods: one involves a calculation with the cost of stock and the cost of gross sales; the other on the basis of value of stock figured at sales price together with total sales. If we assume that in the case above mentioned the merchant has realized a net profit of 33}^ per cent, he has turned his stock 6.67 times and not 10 times, as might be at first believed. The following illustrations are self-explanatory : Based on cost; Cost of average merchandise inventory $10,000.00 Cost of sales ($100,000 less 33 1/3% profit) 66,666.67 Turnover 6.67 times Based on sales price: . Sales price of $10,000 average merchandise inventory . . . $15,000.00 Total sales 100,000.00 Turnover 6.67 times 4. Ratio of Merchandise to Receivables. — This ratio is ob- tained by dividing the total merchandise inventory by the sum of the accounts and bills (notes) receivable. The resulting figure is an index of the dollars of receivables there are for every dollar of merchandise on hand. It is the general practice to carry mer- chandise on the balance sheet at cost or market, whichever is the lower. Accounts and bills receivable, however, represent selling price. The sale of merchandise therefore tends to increase the current ratio in favor of current assets . A comparison of the ratio of receivables to merchandise for different periods will indicate whether or not current assets include a greater proportion of profits as a result of conversion of merchandise into receivables. If this proportion be greater it might be contended that the cur- rent ratio should show an increase if the same financial strength is to be maintained. No doubt this theory has some merit, but, IS 226 BANKING AND CREDIT [XVI particularly in a period of depression, the fact that a concern is able to market some considerable part of its merchandise at a profit is more important than the ratio of merchandise to receiv- ables. The following examples containing two comparative statements which differ only in that $50,000 of merchandise in (a) has been converted into $75,000 of receivables and $25,000 of surplus or profit in (b) will illustrate the point : The X Y Z Company (a) (b) Before Conversion After Conversion Assets of Merchandise of Merchandise Cash $60,000 $60,000 Receivables 100,000 175,000 Merchandise 250,000 200,000 Current assets $410,000 $435,000 Plant and equipment 600,000 600,000 Other assets 90,000 90,000 Total assets $1,100,000 $1,125,000 Liabilities Notes payable $125,000 $125,000 Trade acceptances 15,000 15,000 Accounts payable 45,000 45,000 Accrued taxes, wages, etc 20,000 20,000 Current liabilities $205,000 $205,000 Bonded debt 100,000 100,000 Total debt $305,000 $305,000 Capital stock 500,000 500,000 Surplus 295,000 320,000 Total liabilities $1,100,000 $1,125,000 410,000 435,000 Current ratio = 200 per cent =212 per cent 205,000 205,000 Whereas the current ratio in (a) is 200 per cent it has been increased to 212 per cent in (b) solely as the result of $50,000 XVI] ANALYSIS RATIOS " 227 worth of merchandise being sold for $75,000, the $25,000 profit being carried in the surplus account. 5. Ratio of Net Worth to Fixed Assets. — To obtain this ratio net worth is divided by the total fixed or capital assets. The resulting figure indicates the proportion of the stockholders' or the proprietors' investment in plant and equipment or other fixed assets. Ratio of net worth ' to fixed assets also serves to measure plant expansion. The net worth of a concern may show a large increase during a certain year as a result of profitable business. What is done with these profits, however, is of considerable im- portance to the bank negotiating the loan. If all the increase is turned back into buildings and equipment, there is taking place a conversion of liquid into fixed capital, and this would be shown in a falling ratio of net worth to fixed assets. There is also the dan- ger that the profits which went into plant development may have been only apparent or book profits gained through the increasing prices of raw material rather than realized profits from the sale of manufactured goods. Too rapid expansion of plant is most likely to occur in a period of rising prices and, unless the undue development is checked, there usually results at a later period idle capital and increased overhead expense. 6. Ratio of Sales to Merchandise. — This ratio is the result of dividing the net sales for the year by the total merchandise in- ventory at the beginning of the year. It shows the dollars of sales for every dollar tied up in inventory. Although a low ratio of sales to merchandise may be the result.of large purchases in anti- cipation of higher prices, it is more likely to indicate a consider- able stock of unsalable goods. When this and the following ratio (section 7) are compared year by year, light is thrown on signifi- cant changes in the liquidity of the assets or in the current ratio. ^ In the case of a corporation net worth is equal to the total sum of the capital stock, surplus, undivided profits, and reserves of the nature of surplus. Net worth of a partnership is represented by the partners' capital and drawing accounts. Net worth of a single proprie- tor is represented by his capital account. 228 BANKING AND CREDIT [ XVI The ratio of sales to merchandise is not as significant as turnover and differs only, when compared year by year with the latter, inasmuch as mark-up and cost of doing business have been in- cluded . These last two items may fluctuate in different years and consequently make this ratio of little value. 7. Ratio of Sales to Receivables. — To obtain this ratio net sales for the year are divided by the total of the accounts and bills receivable at the beginning of the year. The resulting ratio indi- cates the dollars of sales per year for every dollar of receivables carried on the books. This may be a test of the efficiency of the credit and collections departments, though general business conditions would affect the situation. As the ratio increases, the length of the collection period decreases. The shorter the credit terms and the closer collections are made, the less chance there will be for loss through bad debts or slowness on account of busi- ness depressions ; that is, the larger the sales in proportion to the receivables, the greater will be the liquidity of those receivables. 8. Ratio of Sales to Net Worth. — This ratio is the result of dividing net sales by the net worth at the beginning of the period covered by the sales. It indicates the dollars of sales for every dollar of invested capital of stockholders, partners, or other pro- prietors. A business may be doing too much or too little business in proportion to the funds invested in it. If the capital invest- ment is being turned over very slowly this may be an indication of decay in the business structure. On the other hand, a very high ratio would probably indicate an overexpansion of business operations. A ratio of this kind is principally of value in compar- ing conditions in the same concern for different periods and in supplementing other existing information. 9. Ratio of Total Debt to Net Worth. — By dividing the total debt by the net worth a ratio is found which serves to throw light XVI] ANALYSIS RATIOS 229 on the proportion that exists between the funds loaned to the concern and the capital invested by the stockholders, partners, or other proprietors. As the proportion of total debt increases, the concern becomes more dependent upon the decisions of its creditors, particularly in times when there are urgent financial problems. Moreover, an increased ratio of debt to net worth makes it necessary for creditors to place greater reliance on the moral risk of the personnel. Generally speaking, an unduly high ratio will cause the conservative credit man to investigate the risk rather closely. 10. Ratio of Sales to Fixed Assets. — This ratio is the result of dividing the net sales by the total fixed assets at the beginning of the year. It indicates the dollars of net sales for each dollar invested in plant and equipment and other non-current assets and therefore throws light upon the rapidity with which the fixed capital is being turned over. Ratio of net sales to fixed assets is more significant when used to supplement ratio of net worth to fixed assets (see section 5). If the ratio of net worth to fixed assets and the ratio of net sales to fixed assets are both decreasing, or if they are below normal, the conditions can probably be ex- plained by : (i) plant development which is going on more rapidly in proportion than increase in net worth, and by (2) failure of sales to keep pace with growth in capital investments in plant and equipment. In a situation of this sort the immediate need would seem to be increased production rather than plant expan- sion. 1 1 . Judgment in Interpretation of Ratios. — The proper use of ratios in analyzing credit statements requires good Judgment for the reason that not infrequently the divisor or dividend is a fluctuating figure and may^be at a high or low point when the balance sheet is issued. Many banks request information as to when stocks of merchandise are at their highest point, when 230 BANKING AND CREDIT [XVI at the minimum, when current liabilities are greatest, and other similar data. Many concerns show a surprisingly different statement in July than in January with reference to the various ratios. This is so much so that banks are trying to educate their customers to make inventory statements twice a year. Concerns which are heavy borrowers often furnish their bank with a state- ment each month, estimating their merchandise by adding to the previous inventory purchases and deducting sales less estimated profit, or by means of a perpetual inventory. References Wall, A. Analytical Credits. This presents an analysis which attempts to apply to a particular business the law of averages derived from studying the ratios of many establishments grouped as to industry and location. Illustrated with blank forms, pp. 92-232. — — Bankers' Credit Manual, pp. 57-135. Note : See also references at the end of Chapter XV. Each of the books mentioned contains data dealing with the ratio of quick assets to current liabilities. CHAPTER XVII INDIVIDUAL ITEMS OF A CREDIT STATEMENT 1. Current Assets. — In the previous chapter there were pre- sented the broader considerations involved and the more impor- tant specific tests to be applied in the analysis of a credit statement. It was also pointed out that the banker or note-broker who has satisfied himself as to the moral responsibility of the applicant for a loan does not as a rule question the mathematical accuracy of the figures in the statement. The chief purpose of this chapter is to bring out the significance of the individual items comprising a credit statement so that a more thorough understanding of the whole may be obtained. Current assets will be considered first. 2. Cash. — Although from the viewpoint of the stockholder of a corporation a small cash balance or even possibly a bank over- draft may be more desirable than a large idle cash fund, neverthe- less the banker who is extending credit is interested in seeing the cash account large enough to provide for current operations. Many business establishments are conducted at times on so close a margin that any error in calculation leads to financial difficulties, as for instance, the inability to meet a note or the pay-roll when a remittance from a customer has been unex- pectedly delayed. It is possible that a concern expects to make large cash payments within a few days after rendering its state- ment and therefore it is desirable to know whether or not such are anticipated. Just what the immediate cash requirements of a firm are, varies in different lines of industry. Concerns handling merchandise on a strict consignment basis do not have the same cash problems as the ordinary mercantile establishment for the reason that pay- 231 232 BANKING AND CREDIT [XVII ment for the merchandise is not required until it is sold. Firms also that are engaged in selling goods, such as musical instru- ments, that involve a relatively small expense for clerk hire and other sales costs, can operate with a comparatively small amount of cash. Finally, what the low level of the cash account should be depends to a very great extent on the character of the other quick assets and the relation of all of them to the firm's liabiKties. Obviously the more liquid the other quick assets, the more readily it will be possible to convert them into cash and with this greater potential power of convertibility the less actual cash is needed. Most commercial banks, when making loans, require their customers to keep on deposit a minimum average balance of 20 per cent of the amount of the loans, and are not inclined to extend credit thereafter unless this informal understanding has been observed. It is highly advisable for the lending bank to be informed as to whether the cash account contains any unusual items, such as expense vouchers or lOU's of officers of the company or time certificates of deposit which have been used as collateral against existing loans. In the case of statements audited by high-class firms of public accountants it can usually be assumed that atten- tion will be called to items of this character. Ordinarily the cash item can be verified very easily by a bank making a direct loan, as it is in a position to demand from the borrower a list oi his depositories and also the amount of loans with other banks, if any. These figures can be checked by communicating with the other bank creditors. 3. Notes Receivable (Bills Receivable). — It is desirable in a carefully prepared credit statement to show the notes receivable account in detail, so as to indicate among other things: (i) notes from customers obtained only in the regular course of business; (2) notes from affiliated concerns; (3) notes from ofiicials and employees; (4) notes receivable which have been discounted at XVII ] ITEMS OF A CREDIT STATEMENT 233 the bank; (5) notes receivable past due; and (6) description of collateral if any. The notes receivable, also commonly called "bills receivable," should not ordinarily be a large item. A large amount of notes receivable from customers indicates that many of the customers are not of high grade, for example, retail dealers who are short of ready cash and have been obliged to give their promises to pay for merchandise. Sometimes a large item for notes receivable reflects unfavorable business conditions in the company's locality. When the notes receivable represent promises to pay by ofEcfers and employees of subsidiary or affiliated companies, the amount of such notes should be withdrawn from quick assets in the ab- sence of good reasons to the contrary. In other words, notes receivable should be restricted to paper that represents actual sales of merchandise. Notes receivable which have been discounted at the bank constitute a contingent liability on the basis of the company's indorsement, and indication of this fact should be made on the statement. One good method of accomplishing this purpose is to show on the one side of the balance sheet under the general heading of notes and accounts receivable the item, "Notes re- ceivable discounted or sold with indorsement or guaranty"; and on the other side to show under the general heading of secured liabilities the item, "Notes receivable discounted or sold with indorsement or guaranty {contra)." Both items will appear ex- actly the same in amount. Another method of securing some- what the same results is to reduce the notes receivable account by the amount of those discounted and to call attention to the contingent liabiKty in a footnote appended to the balance sheet. When notes receivable are secured by collateral such as stocks and bonds or real estate, it is usually an indication that the company does not feel certain about being able to collect the item promptly. Notes receivable that represent overdue or un- collectible accounts are doubtful assets because there is very 234 BANKING AND CREDIT [XVII little reason why a concern should take a customer's note in settlement of an account that is good. In certain Hnes of business the item, notes receivable, should be very small indeed due to trade custom, and if it is large a careful investigation is desirable. For instance, in the case of firms deaHng in plumbing suppKes, wholesale dry goods houses, department stores and retail estabHshments in general, the stand- ard form of credit is the open book account. Wholesalers, how- ever, are gradually supplanting some of their open accounts with trade acceptances. 4. Accounts Receivable. — Accounts receivable are simply book accounts, sometimes called "open" accounts, with the cus- tomers of the concern. An analysis of this item calls first of all for a knowledge as to whether the terms of sale allow the cus- tomers 30 or 60 days or some other period within which to make payment. By dividing the total yearly sales by the amount of the accounts receivable it is possible to determine with reasonable accuracy whether or not collections are being promptly made. For example, suppose that the terms of sale of a certain house average approximately 45 days and that the accounts receivable amount to $80,000 and sales total $650,000. In this case the sales are about eight times as large as the accounts receivable which means that outstanding accounts are not more than ij^ months' sales, and indicates that customers are meeting their obligations promptly. If a firm is selling on 30 days' credit and has on its books one-third of the year's sales, it is evident that the collec- tion methods or class of the customers are not of the best. Forty- five days' sales would reflect a much better and quite satisfactory condition. Accounts receivable are generally listed as accounts not due and accounts past due. Accounts receivable as a whole are some- times divided into good and doubtful, though the latter are almost always found in the past-due list. The character of outstanding XVII ] ITEMS OP A CREDIT STATEMENT 235 balances should be carefully investigated, because it not infre- quently happens that while a customer may be making regular payments on his account, old items which have been in dispute for a considerable period of time are being held in abeyance. Sums due on open account from directors, ofl&cers, or em- ployees of the company are not of the same character as trade accounts and should not be included under current assets. This applies also in the case of deposits as security, guaranties, and other special items not directly connected with sales. Balances due on account from subsidiary or affihated concerns, which may be operating as branches in the case of distributors, or as producers in the case of manufacturers, must not be included in the same item as customers' accounts, even if arising as a result of trading transactions. Frequently subsidiary and af&Hated companies' accounts represent the actual working capital or funds advanced by the parent organization, and although such ac- counts may be liquidated from time to time, they are more or less of a fixed character and should preferably be excluded from quick assets. Where branch distributors or manufacturing plants are not separately incorporated, no indebtedness of any kind with the main office should appear as an asset. The merchandise, cash, or advances that may have been made to the branch are simply subdivisions of the resources of the company as a whole and should be treated as such in the balance sheet. Trade discounts (and also so-called "cash discounts," if ex- ceeding I per cent) and freights allowed by the concern are important matters for consideration. If such items have been in- cluded in accounts receivable, although it is not the general prac- tice to handle trade discounts in this manner, a reserve to offset them should be listed under current liabilities (or, what is equiva- lent, be shown as a deduction under quick assets) . Cash discounts in practice are seldom deducted from receivables and amount in some lines to 5 per cent. It is also necessary to obtain information regarding customers' claims for rebates, allowances because of 236 BANKING AND CREDIT XVII defective material, and reductions in prices, in order to determine whether sufficient provision has been made for these items in the statement. No matter how promptly the customers of a company may meet their obligations, it is usually necessary to provide for a certain percentage of doubtful or uncollectible accounts. This is accomplished by setting up a reserve for bad debts which is shown on the balance sheet, preferably on the assets side, as a deduction from accounts receivable, or else on the liabilities side as a separate item. Normal loss will determine the extent to which it is necessary to provide for bad or doubtful accounts, and this is a matter which naturally varies in different lines of business. In some cases a reserve equal to i per cent of accounts receivable may prove adequate, whereas in other cases 3 per cent may be insufficient. As an evidence of the fact that bad debts are ordinarily just as unavoidable as many other expenses in a concern doing business on open account, a well-known sales manager has been quoted as stating that he would "fire " a credit manager who suc- ceeded in reducing bad debts to zero, implying, of course, that such a policy would be so strict as to drive away many customers. Inquiry must be made as to whether any of the accounts receivable have been hypothecated or assigned, and if so the balance sheet should indicate the fact. Numerous private bankers and other houses, and to some extent regular commercial bankers, make it a business to loan to concerns on their accounts receivable, or more exactly to purchase these debts, particularly in the case of manufacturers and wholesalers. Accounts can be assigned openly by notifying the customers, or arrangements can be made so that customers do not know that their accounts have been sold. When accounts receivable have been assigned or pledged, they are no longer an asset and should not be classed as such. Moreover, until they have been settled they remain a contingent liability for their ultimate payment and therefore XVII] ITEMS OP A CREDIT STATEMENT 237 this fact should be shown on the balance sheet either as an ap- pended note or under the general heading of secured liabilities bearing the caption, "Customers' accounts discounted or as- signed {contra)." 5. Merchandise. — Merchandise, including in the term fin- ished product, goods in process, and raw material, often con- stitutes the major portion of current assets and is the most difficult of them to appraise correctly. It has become the cus- tom to insist that merchandise be inventoried either at cost or at market price, whichever is the lower. The purpose of this policy is to prevent the inflation of the assets by the recording of profits before they are actually realized through the sale of the goods. When the market price is below cost some credit men and ac- counting firms are of the opinion that cost less the usual profit should be the inventory figure, that is, if an article has been pur- chased for $1 to sell at a 20 per cent profit (figured on selling price) and the retail market price falls to $1, the proper inventory figure would be 80 cents. Deduction of the profit is to be justified principally because of the further shrinkage in value due to selling and administrative expenses properly chargeable against gross profits from merchandise. Continuing on this point one writer states : When we consider, however, the next economic step in manu- facture and distribution, the book account, or the bills receivable, we do not find that this cost proposition exists. We do not hear it argued that the accounts and bills receivable should be carried on the statement at cost; and there is a large question as to whether or not such a plan would be feasible, equitable, or even possible. We are then confronted with the fact that, in the cur- rent assets, we have merchandise figured at cost, and receivables at cost plus. It seems very evident that if at any time any manu- facturer or merchant billed out his entire inventory, transforming it into receivables, there would be a considerable increase in the total amount of the current assets, which would not make neces- 238 BANKING AND CREDIT [ XVII sary any increase in the current debt, as has the cost of manufac- ture. It might be a mere bookkeeping transaction, accomplished easily and injecting into the current assets an amount equivalent at the very least to the entire expected profits on the transaction. ' The above discussion of billing out the whole inventory to make a profit seems overtechnical. If it be legitimate, well and good; no harm has been done. If it were done to deceive, it would be a fraudulent transaction. Careful outside investigation of the borrower's character would show, no doubt, that the moral risk was not first class. The proper basis of an inventory appraisal is largely a matter of opinion, but whatever method is followed should be clearly indicated somewhere in the credit statement or the accompanying data. Particularly in a period of falling commodity prices a statement should indicate whether cost or present values were used in figuring the inventory and also the depreciation that has taken place from the time the statement was made. In the business depression of 1920 and 192 1 many concerns got into financial difficulties largely on account of unusual shrink- age in inventory values and greatly diminished sales coupled with heavy debts. However, even in times of active business the merchandise account is very often a comparatively slow asset, particularly in the case of a manufacturing concern. The raw material must be put through the various factory operations, the finished goods must be sold, and finally 30 or 60 days' credit must be extended before cash is collected. Since it is not feasible in most audited statements for the ac- cotmtants to supervise personally the taking of the inventory or to make an independent appraisal, much reliance must be placed on the integrity of the borrower to furnish an honest inventory. Besides the matters mentioned, however, there are a number of other points to be observed in examining the merchandise ac- ' Alexander Wall, "Study of Credit Barometrics, " Federal Reserve Bulletin, March i, 1919, pp. 229-243. XVII ] ITEMS OF A CREDIT STATEMENT 239 count and they may be stated as given below. In most of these cases, to be sure, the persop. who is analyzing a credit statement must place reliance on the accuracy of the public accountant who has made the audit, or else on the integrity of the company itself. 1 . In a business where the average gross profit remains fairly constant it is possible to obtain a dependable check upon the inventory, provided the inventory figure for the beginning of the fiscal period is correct. The so-called "gross-profit " test consists of adding to the previous inventory the purchases and deducting the sales at cost. The percentage of gross profit is also compared with that of previous years and in the case of a business which operated on a fairly constant rate of gross profit, any discrepancy will usually be due to errors in stock-taking. Suppose, for in- stance, that the net sales of a company amounted in 1920 to $640,000 and the cost price of the goods sold was $520,000. The gross profit would be $120,000, or 18.8 per cent.^ Also let us as- sume that after the closing of the books in 192 1 the following data are shown: Net sates $780,000 Opening inventorj'' 100,000 Purchases (net) 800,000 Closing inventory 300,000 From these figures we would arrive at a gross profit of $180,000 or about 23.1 per cent.^ If this increase in percentage of gross profits of 4.3 per cent can be explained by business conditions, then probable accuracy of the inventory has been estabhshed by the test. But had there been reported a closing inventory of $100,000, a loss of $20,000, or 2.5 per cent, would result. The change of 21.3 per cent would suggest that something was wrong, and if unexplained by the increased costs of material, labor, and overhead, the conclusion might be drawn that the closing inven- tory figure was inaccurate. 2. Where the basis of inventorying is the company's own " Sales, and not cost, used as basis of computing profit in this instance. 240 BANKING AND CREDIT [ XVII manufacturing cost, it should be ascertained whether such cost includes any overhead charge for interest. It is customary for cost accountants to exclude interest from inventory figures even if it has been included in factory overhead. In short it is the general policy to exclude interest, selling expenses, and adminis- trative expenses from inventory prices. 3. Trade discounts should be deducted from inventory prices, but it is not customary to deduct cash discounts. 4. When goods consigned to others are included they should be valued on the same basis as other merchandise, and proper allowance should be made for loss, damage, or expenses of possible subsequent return. 5. In the event of an abnormally large merchandise account it is desirable to ascertain the reason in order to be sure that there has been no serious error in stock-taking. Large quantities of stock on hand may be the result of business foresight in buying in a low market, or lack of business foresight. In some cases an unusually large inventory is necessary because of the concern's distance from its source of supply. Seasonal conditions, such as the Christmas holidays, may also affect the inventories. 6. Import duties and freight charges are considered proper additions to the cost price of goods, but no other items should be added except under special circumstances. 7. If a company has discontinued during the year the manu- facture or sale of any of its products, the inventories of such items should be carefully scrutinized. 8. It should be ascertained that nothing has been included that has been sold and billed and is simply awaiting shipment. 9. Sometimes errors are made in not including under Habili- ties unpaid invoices for merchandise received at or just previous to the time of inventorying. 10. If a company has taken steps to increase the selHng price of its goods, obviously the inventory has a higher potential value than before. XVII 1 ITEMS OP A CREDIT STATEMENT 24 1 11. The inventory and gross sales may have an important connection and should be compared. Some merchants prefer to accumulate a large stock of old goods rather than to dispose of them below cost. If the turnover has been abnormally small it may be due to a poor stock of goods. 12. Particularly important is the matter of insurance on mer- chandise as well as on the plant and equipment. In this connec- tion it is well to explain briefly the so-called "80 per cent rule" which is widely in force in the insurance business and which i^ not generally understood. If the insured does not carry insurance to the amount of 80 per cent of the value of the property, in the event of loss or damage he can only recover such proportion as the amount of the insurance carried bears to the 80 per cent which he should have carried (and consequently becomes a coinsurer for any deficiency). For example, if the property is worth $10,000 and $6,000 insurance is carried, in case of a loss of $3,000 the insured could recover only three-fourths of the loss, or $2,250. The reasonableness of the 80 per cent clause can be illustrated. If one owner who pays a premium on $6,000 has a loss of $3,000 and recovers in full and another pays a premium on $8,000 and suffers a similar loss, the burden has been unequal. 6. Acceptances Held. — When companies sell their merchan- dise on an acceptance basis, the acceptances are, of course, avail- able for discount by bankers, or for disposal in the open market. This obviates to a large extent the necessity of a company's bor- rowing on its own note. The discount or sale of such acceptances, unless "without recourse," constitutes a contingent liabiUty. Acceptances, both bankers' and trade, are treated at length in a separate chapter. 7. Current Liabilities. — The liabilities in which the buyer of commercial paper is most concerned are: (i) notes payable (bills payable), (2) accounts payable, (3) acceptances, (4) reserve for 242 BANKING AND CREDIT [XVII income and excess profits taxes, (5) other current liabilities, (6) bonded indebtedness that will mature within the year, and (7) contingent liabilities. 8. Notes Payable (Bills Payable). — Notes and bills payable are used synonymously and include notes given for purchase of merchandise, notes sold to banks, notes sold in the open market, and notes payable to stockholders, directors, ofificers, friends, and relatives. Often notes are also given for equipment, are made payable in instalments, and are secured by a chattel lien on the equipment. Notes of this character are not a liability to be in- cluded in the statement unhss the property which they represent is Usted as an asset, in which event the two corresponding items should be treated as contingent assets and contingent liabilities. What is regarded as a sound credit principle in one line of business may not apply at all in another. The giving of notes for merchandise is still customary in some trades' and is not regarded as a sign of weakness, as in the raw silk industry, with tobacco- packers, with manufacturers of agricultural implements, and with jobbers in sparsely populated sections of the country. In most lines of staple commodities, however, it is not the practice to issue notes, and their appearance is immediately a danger signal indicating that the company is short of working capital. Generally speaking, a concern should not have two forms of paper outstanding at the same time. If merchandise purchases are settled by note or by acceptances and the concern negotiates a loan at the bank on its single-name paper, a bad impression is created because the loan at the bank implies cash payments for the merchandise. Similarly, if notes are sold on the market for the purpose of taking cash discounts, the persons from whom the goods have been purchased should not be given notes or acceptances. If the borrower's statement shows an odd amount for notes 3 Meredith Wood, " Credit Danger Signals, " Bankers Magazine, June 1920. XVII ] ITEMS OF A CREDIT STATEMENT 243 payable it is almost certain that the item contains notes of the firm given for purchases. When single-name paper is submitted to a bank for discount or is sold in the open market, it is issued in round amounts and therefore the presence of odd cents is indica- tive of the existence of other kinds of paper. Sometimes, however, this odd amount is due to the fact that the company has accepted deposits of money from directors, officers, friends, or relatives in return for its notes and has credited the notes payable item with the interest accumulations. A further explanation of this odd amount might be the practice of some companies of deducting the unearned interest charge on their discounted notes. Still another reason might be the fact that the firm has included its commit- ments through the acceptance by its banks of drafts drawn under commercial letters of credit. In general, where a company has borrowed on notes from its stockholders, directors, or officers, or from friends and relatives, it is very apt to experience internal friction and financial embar- rassment in the event of trouble. Sometimes loans of this char- acter are used as the means by which control of management is secured. Naturally, if a stockholder, director, officer, or a friend has made large loans to a company in return for its promissory note, he will be able to exert considerable influence over the busi- ness and possibly by threatening to demand payment may be able to secure control of affairs. Unless it is sufficiently certain that a company's indebtedness of this kind has been definitely subordi- nated to the general creditors and is fixed in the business for a specific period, such an item should not be considered a slow liability. Deposit accounts with the firm present a somewhat similar disadvantage. If they are large they may prove a source of danger to creditors other than the depositors, unless withdrawals are restricted. These depositors are usually persons who have associations with the company and are first to know of its financial troubles and to protect themselves by withdrawing their funds. 244 BANKING AND CREDIT [ XVII Another danger signal is flashed when a concern is obliged to settle for its minor bills by giving its note. An incident illustrat- ing the ever-alert credit sense of one of our well-known American bankers is pertinent at this point. This banker had been purchasing at frequent intervals for his institution the commercial paper of a large and supposedly pros- perous trade house, regarding it as a prime banking investment. The latest maturity of the company's note had been properly liquidated several months before, and the local broker had offered him a substantial amount of the concern's paper again, which he now held under option, and was considering buying. Quite acci- dentally he happened to run across something which many other men would have passed over without very much thought, in view of the company's generally strong and well-established rep- utation: he found that one of his depositors, who had been sell- ing the concern in question in small amounts, had received quite unexpectedly the company's note for a small bill amounting to two or three hundred dollars. The banker learned of this and immediately sent the paper back to the broker. "We loan no concern which has to pay for its minor bills by giving its note, " he said. It was simply a slight bit of warning, the single flash of a red flag, which his keen credit sense detected at once. Eight months later the company in question closed its doors and failed.'' Commercial paper should never be issued for financing of permanent or fixed assets. Plant, machinery, and equipment should represent contributed capital and funds received from the issue of bonds and other long-term obligations. It is not the function of a commercial bank to finance investments of this kind. The scope of its activities is confined for very good and obvious reasons to short-time loans of a liquid character. When possible a credit statement should classify the notes payable so as to indicate those which were given directly to the banks of the company and those which were sold in the open market. The former are not so much a source of concern as the latter, because it is more probable that they can be renewed with- ■< Meredith Wood, "Credit Danger Signals," Bankers Magazine, June 1920, p. 833. XVII ] ITEMS OP A CREDIT STATEMENT 245 out difficulty in case of necessity. Their existence limits the firm's borrowing capacity, however, and places it in a less favor- able position to ask for assistance from its bank if the occasion arises. Inquiry should be made in a study of the notes payable item to learn whether any collateral has been pledged with them. If collateral has been furnished with some of the notes but not with others, a considerable source of danger may exist for the unse- cured creditors. Notes payable may be given directly for merchandise or they may be substituted later for accounts payable. Notes of this latter character are apt to indicate that merchandise discounts have been neglected and a large volume of such notes given for goods bought some time previously expresses at once an unhealthy condition. The term "renewal" when used in connection with com- mercial loans often gives rise to erroneous opinions. For the purpose of financing current transactions it is customary for merchants and others to borrow funds from banks on notes. When a note matures it is not imusual for a new one to be given in its place and this is commonly called a "renewal." However, if the merchandise bought from the proceeds of the original note has been disposed of in the trade of the merchant and the new note is for the purpose of making further purchases, the new note is not strictly speaking a renewal but represents in jeality a new loan. So long as the bank is not furnishing funds for fixed capital, there is no reason why it should not continue making these new loans at the expiration of the old ones. An examination of the borrower's credit statement showing for comparative periods the margin of quick assets, the sales and purchases of merchandise will indicate the quality of the note, which is the real test. 9. Accounts Payable. — This term represents purchases on open credit charged on the books of the sellers against the buyer 246 BANKING AND CREDIT [XVII and to be settled on stated terms. Comparatively speaking, the amount of accounts payable outstanding should never be large. A well-managed concern will borrow money at its bank in order to obtain cash discounts for prompt settlements. If a man whose credit is good can borrow money at 6 per cent per year, it is poor finance to borrow money at 2 per cent for 20 days or 36 per cent per year, as he is doing when he is offered 2 per cent discount in 10 days but pays net in 30 days. A large accounts payable item is, therefore, a warning to the analyst that the concern is probably neglecting its merchandise discounts. Assuming that the terms on which the concern buys merchandise are 2 per cent discount if settled in 10 days, if the unpaid bills represent 10 days' purchases they would not be excessive. If a company issues notes to its creditors or to its bank, the amount of accounts payable should be particularly small. In some statements the accounts payable item includes only ac- counts in process of audit, often barely a day's purchases, which is an excellent sign of good management. If the statement has not been audited by public accountants, care should be taken to learn whether debts for all goods received on the last day of the fiscal period, and also for any merchandise that was in transit and belonged to the concern on that date, are included as liabilities, and the corresponding assets included in the inventories. Concerns often hold up entries at the end of the year and do not include considerable amounts of merchandise in transit. Apropos of this point a credit man with a well-known mercantile agency tells of a company whpse audited statement showed an increase in merchandise from $300,000 to $400,000 with a similar increase in debts and largely for this reason was refused a loan at its bank. 10. Acceptances Given. — This item includes trade and bank acceptances. For the purpose of making the statement as explicit as possible acceptances should be shown separately from notes XVII ] ITEMS OF A CREDIT STATEMENT 247 and bills payable. As already stated in the section dealing with notes payable, a concern should not issue acceptances and another form of paper at the same time. While the use of acceptances is as yet decidedly limited, it is anticipated that as business men become more accustomed to this kind of paper it will be more generally used. A more complete discussion of acceptances is presented in a separate chapter. II. Reserves. — The term "reserve" in a financial statement is used commonly in three different senses. It may indicate an offset or valuation account as reserve for depreciation ; it may be of the nature of surplus, as sinking fund reserve or reserve for additions and betterments ; or it may represent accrued liabilities as taxes and wages. Reserves for depreciation usually represent the estimated depreciation of one or more of the fixed assets from which they must be deducted to determine their real book value. Reserves for bad or doubtful accounts are another important class of valuation reserves and must be offset against accounts receivable to obtain the estimated value of the latter. There is a tendency at present to list valuation reserves on the resource side of the balance sheet where they are shown as subtractions from the corresponding assets. As a further step in simpHfying the balance sheet terminology and technique, many statements use the term "allowance" instead of reserve. Reserves of the nature of surplus are less common than the other kinds of reserve, and when they occur they usually can be recognized. They can be considered simply as surplus items for special purposes, and do not come under current assets or liabilities. Until the government has materially reduced the income and corporation taxes, the statement of every borrower should show a provision for this liability. As the tax is specifically based upon the net profits of a particular period, although payable some months thereafter, the tax accrues throughout the specified 248 BANKING AND CREDIT XVII period and should be properly indicated on the balance sheet. Very often this reserve will amount to hundreds of thousands of dollars, and since it is a quick liability that will have to be paid within a comparatively short period of time, it is essential that it be carried on the statement. If a concern has a large federal tax bill to meet and fails to give some evidence on its statement of the impending obligation, it is probably because the statement indicates a rather weak current ratio. One writer describes the statement of a house offering its paper in the open market which appeared to show obviousty this condition of affairs. Its current ratio for 1918 had been much more favorable than for 1919, a substantial reserve amounting to about $300,000 having been carried in the 1918 figures. As no reserve at all appeared on the 191 9 statement it was natural to assume that the concern had decided that by simply omitting this item altogether its absence would perhaps be overlooked and the ratio would benefit accordingly. But a concern which finds it expedient to practice such a method should realize that this very fact of attempted concealment will often injure it much more than telling the plain truth. 12. Other Current Liabilities. — Ordinarily the current lia- bilities that have just been described include all the important ones from the point of view of the bank analyst , Most balance sheets include other minor items in addition to those given and in some cases it may be desirable to examine them in detail. The more important of these remaining items include: accrued Ha- bilities on account of interest, wages, traveling expenses and commissions, legal expenses, and incidental operating charges. However, it is not within the province of this book to take up individually each of these accounting details, and moreover a satisfactory treatment of them will be found in almost any standard book on accounting, to which the reader is referred for detailed information. XVII ] ITEMS OF A CREDIT STATEMENT 249 13. Bonded Indebtedness that Will Mature within the Year. — Ordinarily the bank analyst is not interested in the outstanding bonds and other long-term obligations of a company. When, however, such obligations are to mature within the current year they become of the same general character as an ordinary current liability. It is entirely possible that the statement of a concern will show a not unsatisfactory risk from the point of view of the bank, even if the relation between its total assets and total lia- biHties is such that the net worth is practically zero. If the bulk of the liabilities are represented by bonds that do not mature for a period of years, their existence will be no great source of dan- ger to creditors holding short-term notes and other obligations maturing in the meantime. Of course if the concern's financial standing is such that the interest obligations on bonds cannot be met, the situation of the general creditors will be entirely different. Merchandise is not infrequently sold by concerns to customers whose financial standing indicates a larger amount of bonds out- standing than justified by present assets but which do not ma- ture within the period of payment specified in the sale. To be sure, there is a considerable amount of risk in dealing with con- cerns of this character for the reason that other symptoms are quite likely to appear on closer examination. 14. Contingent Liabilities. — The most common form of con- tingent liabilities is that brought about through the practice of indorsing and discounting notes receivable and acceptances, which feature has already been discussed in the section dealing with notes receivable . Other forms of contingent liabilities may be found in connection with the indorsement of outside paper, and the financing of subsidiary companies. Arrangements with sub- sidiary companies often involve indorsdment of current borrow- ings, guaranty of merchandise obligations, and the guaranty of their fimded debts. A contingent liability sometimes arises out of leases and contracts and other activities peculiar to some lines 250 BANKING AND CREDIT [XVII of business, the existence of which may be recognized when met. Contracts to accept the deUvery of goods forwarded before the date of the credit statement may call for the payment of large sums of money within a short time. In the case of raw materials for a manufacturer this might be a perfectly good reason for seek- ing a temporary loan pending production and sale, but for a merchant whose statement shows a large stock of goods on hand it might indicate a real liability impending with assets of a doubt- ful character to offset it. A properly prepared audited statement would indicate whether such purchase orders stood for stock in excess of the current and reasonable prospective demand. Where the contingent liability has been brought about through the fi- nancing of subsidiary companies, it may be necessary to inquire into the financial conditions of the latter organizations. It is not unusual for a subsidiary company to prove to be a burden instead of a source of profit for the parent organization. IS- Capital Assets and Capital Liabilities. — Although the ability of a company to show on its statements a substantial excess of current assets over current liabilities is the most essen- tial thing for the purpose of the bank analyst, nevertheless it must be borne in mind that concerning any set of figures it is necessary to view them as a whole rather than to compare only one or two groups and to rest the entire decision on the results of the showing made by these few. By confining the analysis to only one phase of credit some very important danger signals may be completely overlooked. One point of special significance, particularly since the war, is the relative size of the company's plants compared to its net worth. During the war the enormous increases in volume of business stimulated plants to increase their size rapidly in order to keep up with the large amount of orders which they received. Rising prices, continued demand, and expectation of increasingly large profits spurred many concerns to invest all their available XVII ] ITEMS OF A CREDIT STATEMENT 251 liquid capital in additional expenditures for plant and equipment. Naturally a cessation in demand and a falling off in prices left the companies in question with the greater portion of their assets completely tied up in machinery and buildings, and with a com- paratively small net working capital . While an addition to a plant may outwardly be a sign of prosperity and an increased volume of business, the real situation may be quite the opposite. Instead of large orders and growing sales there may take place a gradual deflation of an already unwarranted demand, with the result that the concern is left stranded, overextended in capital assets, and lacking the requisite amount of required funds to carry it along. In some lines of trade, as in cotton mills, fixed assets have a greater liquidating value than is the case in many other manufac- turing industries. The machinery and equipment in a cotton mill are for the most part standardized. Moreover, a large part of it can be moved without great difficulty. Second-hand machinery is frequently purchased and moved from one mill to another. These things tend to cause the fixed assets to have a greater po- tential power of liquidation. However, it must be remembered that a bank always wishes, if possible, to avoid the necessity of attaching property or forcing the sale of it in order to insure a claim. Measures of this kind are a last resort; hence in looking upon the borrowing company as a self-liquidating account the bank analyst can consider only the quick assets in the shape of cash, bills receivable, accounts receivable, merchandise, etc., of primary significance. 16. Income Sheet (Profit and Loss Account, Revenues and Expenses, etc.). — A bank will frequently find it possible to judge a concern's standing much more accurately by consideration of its sales and expenses of doing business in coimection with its state- ment of assets and liabilities. In the case of a partnership the income sheet or profit and loss statement will often reveal the 252 BANKING AND CREDIT [ XVII fact that the members of the firm are making too heavy with- drawals for personal expenses. The income sheet shows whether or not the firm is keeping track of the cost of running the business and also whether or not it is making a profit. Not infrequently a credit risk is rated primarily upon whether the prospective borrower is going ahead with a profit or falling backward with a loss. It is the conventional practice for the income sheet to start with the item, sales. Sales includes all merchandise (that is, what- ever goods the firm is manufacturing Or marketing, and does not include sales of its fixed assets or investments), whether cash, on open accoimt, or for notes or acceptances during the fiscal period under consideration. Sales should only include valid transactions which legally transfer to the purchaser the title to the merchan- dise. Goods shipped on consignment or on approval should not appear in the statement as regular sales, but, of course, should be properly included in the inventories. When it is customary to allow trade discounts, either the amount of such discounts should be excluded from sales, or there should be provision for showing it as a deduction or an offset under some such caption as "trade discount on sales." 17. Importance of Sales Returns. — In some lines of business the item of sales returns is an important one. An examination of this account will determine just what percentage of the sales are returned and whether this undesirable feature is increasing or decreasing. Where possible a statement should separate cash sales from sales on credit. This information is of value when de- termining the relation between the customers' unpaid accounts and the total charge sales for the period. To be more concrete, suppose the annual sales on credit on open account were $900,000 and that the average term of credit granted is 30 days, and that the current assets show $150,000 under accounts receivable. If it were known that the firm's monthly sales were fairly uniform XVII ] ITEMS OF A CREDIT STATEMENT 253 and that no extraordinarily large sales had been made recently, it would be reasonable to infer that either the firm's collection methods were lax, or else that accounts receivable included some bad and doubtful items. Assuming that under normal conditions there will be an appreciable number of customers who will dis- count their bills, a firm that is selling goods on 30 days' credit should be able to prevent its accounts receivable from exceeding 2 months' sales. 18. Comparison of Sales and Inventory, — For the purpose of testing the efficiency of the management it is desirable to compare the total sales and the final inventory. In making this compari- son, however, consideration must be given to the nature of the goods or more particularly to the time required to replenish stock. If the total sales of a manufacturing concern amount to $1,500,- 000 and the final inventory shows a balance of $600,000, it would seem fairly conclusive that there is too much money tied up in stock-in-trade. The conclusion would be more certain if it were found that the manufacturing operations required on the average about 3 weeks. If the gross profit on sales for the fiscal period in question was substantially the same as for the preceding periods, the probability of inventory inflation would not be great. On the other hand, it is quite possible that the inventory includes some dead stock and goods out of style, or goods for which there is no profitable market. Moreover, the concern may have overestimated its requirements for raw materials or may have manufactured more heavily than subsequent sales justified. Before arriving at final conclusions, however, it is necessary to obtain further facts and to examine them in the light of market conditions. During a period of rising prices and keen business activity the purchase of large quantities of raw materials to anticipate future needs may prove to be a prudent and highly profitable transaction. But when the market begins to sag, the situation becomes reversed 254 BANKING AND CREDIT [ XVtl and companies which have large stocks of merchandise may be required to register in their expense accounts millions of dollars because of shrinkage on inventory values. Refeeences Ettinger, R. P., and Golieb, D. E. Credits and Collections. Construction and analysis of the credit statement, pp. 186-250. Illustrated with blank forms. Westerfield, R. B. Banking Principles and Practice. The work of the credit department of a bank, including sources of information and interviews with borrowers. Vol. IV, pp. 935-955. Nature of a financial statement and the significance of its main items. Vol. IV, pp. 956-968. Willis, H. P., and Edwards, G. W. Banking and Business. Principal items in the borrower's statement; sources of credit in- formation and determination of line of credit, pp. 11 2-1 22. Any standard book on accounting deals with the items of a balance sheet and profit and loss statement. See especially: Cole, W. M. Accounts, Their Construction and Interpretation. Interpretation of balance sheets, pp. 104-109. Hatfield, H. R. Modern Accounting, pp. 35-69. Paton, W. A., and Stevenson, R. A. Principles of Accounting, pp. 545- 598. Note: See Appendix A, Problem 20. CHAPTER XVIII ANALYSIS OF TYPICAL CREDIT STATEMENTS In this chapter a number of typical credit statements are given, with an analysis of each. The first, that of the Cotton Mill Corporation, is dated September i, 19 — , and is as follows: Cotton Mill Corporation September i, 19 — Assets Current: Cash $1 18,364.43 Accounts receivable 50, 1 1 5.38 Notes receivable 1,663.21 Inventories: Cotton 121,667.70 Finished goods 123,525.64 Stock in process, supplies and waste 216,747.59 $632,083.95 Fixed Assets : Real estate $50>465.37 Buildings and fixtures 637,076.71 Machinery 830,501.12 $1,518,043.20 Less: Reserve for depreciation 405,142.21 1,112,900.99 Total assets $1,744,984.94 Liabilities Current: Accounts payable $238,096.48 Notes payable •' 630,695.30 Accrued : Labor 13.213-80 Taxes — domestic 6,934.92 Employees' deposits and uncalled-for wages 4,266.03 $893,206.53 Reserve for federal taxes 21,500.00 Capital stock , $1,000,000.00 Less: Impairment i69,72i-59 830,278.41 Total habilities , $1,744,984.94 Sales $305,160.00 Net loss 15,650.00 255 256 BANKING AND CRE;DIT [ XVIII This statement indicates such a poor financial condition that the concern could hardly expect to obtain a bank loan. Current assets are less than current liabilities, and in order to show a current ratio of 2 to i it would be necessary to treble current assets. It seems evident that collections are slow, since the re- ceivables represent an amount in excess of 2 months' average sales. Notes payable alone are almost equal to total current assets, and the latter includes raw material and stock in process, which probably cannot be liquidated before the maturity of the notes. Not only has the surplus account disappeared but there is an impairment of the capital investment; that is, the equity of the stockholders in the business is less than the face value of the capital stock. Finally, during the year the company did not earn enough to pay operating expenses and suffered a loss of $15,650. It would appear from all these facts that bankruptcy cannot be far off unless the stockholders contribute more working capital or provision is made for funding some of the current debts. First Metal Products Company Comparative Balance Sheets on December 31, 1919, 1920, 1921 A ssets i9'9 1920 1921 Capital assets: Land and buildings $75,000.00 $75,000.00 $75,000.00 Machinery and equipment .. . 23,849.14 24,139.85 25,412.26 Furniture and fixtures 5,624.36 5,879.63 6,283.22 Good-will 40,000.00 40,000.00 40,000.00 Total $144,473.50 $145,019.48 $146,695.48 Working and trading assets: Materials and supplies $27,349.23 $28,172.40 $17,275.19 Finished goods 15,763.88 22,587.15 32,260.55 Total $43,113.11 $50,759-55 $49,53574 XVIII ] ANALYSIS OF TYPICAL CREDIT STATEMENTS 257 Assets 1919 1920 1921 Current assets: Cash $18,429.60 $10,010.18 $5,073.49 Notes receivable 9,323.22 8,275.31 8,052.50 Accounts receivable 20,641.73 27,153.71 23,910.13 Total $48,394.55 $45,439.20 $37,036.12 Prepaid expenses: Insurance $800.00 $1,200.00 $1,500.00 Advertising 1,300.00 2,100.00 Total ■. . $800.00 $2,500.00 $3,600.00 Total assets $236,781.16 $243,718.23 $236,867.34 Liabilities 1919 Capital liabilities: Capital stock outstanding. . . $125,000.00 Mortgage on land and build- ings 40,000.00 Total $165,000.00 Current liabilities: Accounts payable $8,015.72 Notes payable 5,000.00 Accruals 3,264.20 Total $16,279.92 Reserves: Depreciation of buildings .... $ 1 0,45 1 . 75 Depreciation of machinery and equipment 6,204.79 Depreciation of furniture and fixtures 1,160.66 Total $17,817.20 Profit and loss surplus $37,684.04 Total capital, liabihties, reserves, and surplus $236, 78 1 . 1 6 Net sales $143,259.04 Net profits 31.925-75 Dividends j 25,000.00 17 1920 192 1 $125,000.00 $125,000.00 40,000.00 40,000.00 $165,000.00 $165,000.00 $14,059.87 $19,399-77 15,000.00 17,000.00 4.I73-24 2,431-50 fe3-233-ii $38,831.27 $12,701.75 ?i4.95i-75 7,806.34 9.293-72 1,748.62 2.241.35 $22,256.71 $26,486.82 $23,228.41 $6,549-25 $243,718.23 $236,867.34 $115,047.31 $108,955.49 10,544-37 8,320.84 25,000.00 25,000.00 258 BANKING AND CREDIT [XVIII The comparative financial statement of the First Metal Products Company indicates that the company is in a very un- satisfactory condition, if not one of practical insolvency. The current ratio has decreased materially in the last three years, and on December 30, 192 1 , the current assets are less than the current liabilities. However, in all justice to the company it should be noted that inventories of materials and finished goods are not carried under current assets, as is the common practice. If such were done the current ratio might seem at first sight satisfactory, but further examination is necessary to throw light on the char- acter and quality of the quick assets. The cash balance in 1921 is much too small for the needs of the business. The ratio of receivables to sales has increased so rapidly that in 192 1 there are between 3 and 4 months' average sales not collected. This not only implies poorer collection methods but also arouses the suspicion that many of the accounts are bad or doubtful. It would appear from the heavy inventory of finished goods, which doubled from 1919 to 1921, while sales decreased, that greater difficulty is being experienced in marketing them and that the company is unwisely tying up large amounts of capital in slow- moving merchandise. Finally at a time when the company is in serious need of cash there has been maintained a high dividend rate. In order to de- clare this dividend it has been necessary to draw upon the surplus created in former years and diminish it to almost one-sixth of its amount in 1919. Colonial Underwear Manufacturers November 30, 19 — Assets Liabilities Cash $308,165.16 Bills payable to banks )f685,ooo.oc Bills receivable 12,500.00 Bills payable to in- Accounts receivable . . 463,705.03 dividuals 10,500.00 Stock on hand and in Accounts payable for process 566,816.96 mdse 571246.57 XVIII ] ANALYSIS OF TYPICAL CREDIT STATEMENTS 259 Investments in affili- Accounts payable to ated companies .... 99,300.00 individuals 60,983.57 Real estate 650,019.64 42,000.00 46,646.22 Machinery and Reserve for taxes .... fixtures 809,787.01 Reserve for deprecia- tion 733.499-85 Capital stock 600,000.00 Surplus 674-417-59 $2,910,293.80 12,910,293.80 Sales $4,520,492.00 Net profits 121,194.00 Dividends 51,000.00 Allowance for depreciation 70, 194.00 No contingent liabilities. This statement, while showing a fair margin of current assets to protect creditors, indicates that the business is being operated to a considerable degree on the temporary investment of the creditors. For example, the item, bills payable, is greater than capital stock and is more than one-half as large as capital stock and surplus combined. The current ratio is i 1/2 to i, or some- what less than a 2 to i condition which bankers expect a good statement to reveal. The merchandise condition is favorable, there being only slightly over one month's goods on hand, al- though it is apparent the ctocern is doing too much business for the capital employed. The item, investments in affiliated companies, represents controlling interests in several firms, and it would be advis- able to request a consolidated statement so that an analysis of the whole might be made. The profits show a satisfactory earning ability but it would seem to be a good policy to accumu- late the profits instead of paying out large dividends. It would also be advisable to capitalize par t of the surplus and reserve funds which are too large for the capital now invested. Collections apparently are satisfactory, as receivables show outstanding ac- counts representing not more than i or 2 months' average sales. 26o BANKING AND CREDIT [XVIII Statement for information of banks and other clients of R. P. Ross & Co., who may be interested in buying the four months' NOTES OF the Stanley Manufacturing Company R. P. ROSS & CO. Note-Brokers 1 8 Tenth Avenue Boston, Mass. 14 Exchange Place Members New York and New York City Boston Stock Exchanges 220 South LaSalle St. Chicago The facts and information herein, although not guaranteed by us, have been obtained from sources which we believe to be reliable and are given without any responsibility on our part. Confidential Stanley Manufacturing Company Boston, Mass. December 31, 1921 Assets Cash $1,498,359.63 Accounts and notes receivable 2,270,938.02 Merchandise and material on hand 6,941,108.12 Company's stock held for sale to employees 34,129.86 Supplies, prepaid interest, and insurance 150,582.87 $10,895,118.50 Plants, water powers, warehouses and lands .^. 10.495,728.83 $21,390,847.33 Liabilities Capital stock, common $8,000,000.00 Capital stock, preferred 4,000,000.00 All debts 1,221,478.32 Reserve for United States income tax payable following year 750 000.00 Reserve for inventory depreciation 1,200,000.00 Surplus funds 6,219,369.01 $21,390,847.33 (Signed) Stanley Manufacturing Company By Charles A. Russell, Treasurer XVIII ] ANALYSIS OF TYPICAL CREDIT STATEMENTS 261 Springfield, Mass. February 9, 1922. Incorporated in Massachusetts. Manufacture twine, bagging, etc. Plants at Springfield, Mass.; Boston, Mass.; and Savannah, Ga. During year ended December 31, 1921, spent $1,878,784 on addition to plant. Charged to depreciation $512,486. Sales $21,000,000. Bank with: National Shawmut Bank Boston Bank of America New York National Bank of Commerce Springfield Merchants National Bank Springfield State National Bank Springfield Savannah Union Bank Savannah The foregoing statement of the Stanley Manufacturing Com- pany, which has recently sold to its note-brokers, R. P. Ross and Company, $4,000,000 of 4 months' notes bearing 6 per cent interest, indicates that this firm is in an excellent financial posi- tion and reveals a source of strength which commends the paper to prospective buyiers as being of the highest grade. The partic- ular points of merit in this company's paper are as follows : 1 . The ratio of current assets to current liabilities is approxi- mately 10 to I. 2. The cash account is ample and is more than sufficient to meet any immediate obligations. 3. R. P. Ross and Company state that the company is a seasonal borrower and sells its notes once a year for the purpose of financing the purchase of raw materials. When the finished goods have been sold and the proceeds received the notes are liquidated. This fact makes its paper more desirable than the offerings of a company which has some paper outstanding at all times. 4. The ratio of accounts and notes receivable to sales is small, indicating that the company's collection methods are satisfactory. 5. The ratio of merchandise and material on hand to sales would not seem to indicate an excessive inventory. Allowing for the profit there is about a 3 months' supply of goods on hand. 262 BANKING AND CREDIT [ XVIII 6. Reference to statements for previous years also shows good credit conditions. 7 . Most important of all is the moral risk. Trade references, which have been investigated by R. P. Ross and Company, and the company's past record, give evidence of the high character and integrity of its personnel. References KnifEn, W. H. Commercial Paper. Analyzes in detail 3 5 typical credit statements, pp. 90-1 59. Note: See Appendix A, Problems 21-24. CHAPTER XIX SECURITY AND OTHER INVESTMENTS OF COMMERCIAL BANKS 1. Security Holdings of Banks. — In addition to making short-term loans and discounts many commercial banks invest in securities, generally bonds. These may be regarded as long- time loans; but as their date of maturity is distant their liquida- tion into cash is not contemplated unless the bank is in urgent need of funds. Their current value is also subject to fluctuations, depending upon stock market operations, possible changes in the market rate of interest, and more than all upon the fortunes of the companies whose securities are bought. Funds so in- vested are withdrawn from immediate mercantile and manu- facturing needs in the marketing of goods, and throught he securi- ties are directed to construction or development of plant, as in the construction of railroads, public utilities, municipal enter- prises, factories, etc., or to the financial needs of governmental bodies. This business is more generally undertaken by bond houses, sometimes designated as investment bankers (whose function is to distribute securities to investors) as distinguished from commercial bankers. Although this distinction is recog- nized, commercial banks at times find it advantageous to invest a part of their funds in long-time securities. Particularly is this the case when there is a slackening in the demand for short-term loans. Rather than hold funds idle, the banks purchase bonds which will yield an income. 2. Classes of Securities. — Securities generally appear in the balance sheet of a national bank vuider four headings : 263 264 BANKING AND CREDIT [XIX 1. United States government securities, including the older issues of bonds, Liberty bonds. Victory notes, United States certificates of indebtedness. 2. Stock of federal reserve bank. 3. Other bonds, securities, etc. (other than stocks). 4. Stocks other than federal reserve bank stock. Investments in securities by national banks in 1920 (June 30) are shown in the following table. Figures for loans and total resources are also given for purposes of comparison: Millions United States government securities owned $2,269.6 Stock of federal reserve banks 65.3 Other bonds, securities, etc 1,802.2 Stocks other than federal reserve bank stock 49.4 Total securities $4,186.5 Loans and discounts 12,396.9 Total resources 22, 196.7 The securities may be further classified:^ Millions United States bonds other than Liberty bonds $815.4 Liberty loan bonds and Victory notes 1,454-1 Total United States obligations $2,269.5 State, county or other municipal bonds 338.4 Railroad bonds 416.4 Other public service corporation bonds 283.1 All other bonds (domestic) 309.8 Claims, warrants, judgments, etc 67.7 Collateral trust and other corporation notes issued for i to 3 years 145-9 Foreign government bonds 180.0 Other foreign bonds and securities 61.0 Stocks, federal reserve banks 65.3 Stocks, all other 49.4 Total securities of all classes $4, 186.5 Formerly national banks were obliged to own a certain amount of government bonds and pledge them with the Treasury ^ Report of the Comptroller of the Currency, 1920, Vol. I, p. 159. XIX] INVESTMENTS OP COMMERCIAL BANKS 265 as a condition for organizing under a federal charter, but in 191 7 (Act of June 21) this condition was repealed. National banks, however, must own certain issues of these bonds in order to issue circulating notes ; and they also hold and pledge them with the Treasury in order to receive federal deposits. Of the $2,270 million United States obligations, held by national banks, about one- third was owned and deposited to secure circulation. Dur- ing the financial operations of the war, the banks played a large part in underwriting the loans and the purchase of Liberty bonds, Victory notes, war savings and thrift stamps, and United States certificates of deposit,and the banks still hold a very considerable amount of government obligations then purchased, in addition to the older issues held as a basis for national bank notes. The investment in federal reserve bank stock is compulsory. Each member bank of the system (a national bank must be a member) is required to subscribe 6 per cent of its own capital and surplus to the capital stock of a federal reserve bank. As yet only half (or 3 per cent) has been called for. "Other bonds" represent state, county, or municipal bonds; railroad bonds; other public service bonds; foreign bonds; mis- cellaneous bonds ; claims, warrants, etc. ; judgments and collateral trust and other corporation notes. Holdings of this character in 1920 amounted to about one-seventh of loans and discounts. In 1880, the ratio was i to 20; in 1890, i to 16; in 1900, i to 7; and in 1910, i to 6. The marked change in this ratio took place between 1890 and 1900 when there was an enormous amount of financing in the organization of large corporations in which many banks took an active part. Some classes of bonds are used by banks as a pledge to secure state and municipal deposits and also to secure acceptances of foreign banks. 3. Policy as to Amount of Securities.— It is sometimes stated that investments in securities may properly equal the sum of 266 BANKING AND CREDIT [XIX capital stock, surplus, and undivided profits; in other words, that it is appropriate that a bank should apply the funds belong- ing to stockholders to fixed and permanent investments, and base its current operations upon deposits which may be ofifered and loans which may be sought. If this rule be applied for national banks as a whole, it will be noted that in 1920 investments in securities are much in excess of capital (including surplus and undivided profits). The holdings of securities amounted to $4,187 million and capital to $2,622 million. This large excess of security investments was due to the liberal purchases by banks of government obligations during the war. In 1915, before such demands were made upon the banks, security holdings amounted to $2,038 million and capital to $2,079 million. Individual banks, however, vary greatly in their policy with regard to investing in securities. For example, one bank may have over $2,000,000 of securities, and capital of $300,000; while another has securities, amounting to $350,000, and capital of $225,000. The loans of the two banks are approximately the same. It is evident that the first bank finds it more profitable to invest its funds in long-term securities, while the second uses its funds in short-term loans which are quickly liquidated. This may indicate that business is dull where the first bank is located and that consequently there is no demand for commercial loans ; or it may mean that the bank is using its resources in industrial promotions. Of even more significance are the figures for se- curity holdings when compared over a series of years. If these amounts increase with no increase in capital or in loans, it in- dicates that the bank is turning from commercial to financial banking. 4. Objections to Large Security Holdings. — As to the wisdom of using bank funds in security investments to the extent which is now common, opinions differ. On the one hand, it is said that XIX] INVESTMENTS OF COMMERCIAL BANKS 267 there is no difference between a bond and a note, except in time of maturity. Investments in sound securities which can be con- verted into cash serve as a secondary reserve in case of need. There are times when the demand for loans is hght, so that a bank cannot employ its resources profitably. The low rates of money in 1903 and 1904 are in particular cited as reasons for large in- vestments in those years. A bank in buying bonds loans to a railroad or government as it does to an individual on a note. The growth of corporations makes it necessary for them to borrow, but corporate financing demands a different form of credit obliga- tion than that used by individuals or partnerships. If banks were prohibited from loaning to corporations by purchase of bonds, corporations in selling bonds would be obliged to borrow from private individuals alone, but these in turn, in order to make advances, would borrow from banks, so that indirectly the net results would be the same. When business establishments were small, local credit was sought for; with the consolidation of scattered units into the large corporation or trust, local financing was abandoned and credit demands were met by issues of securities. On the other hand, it is urged that banks by loaning to cor- porations on long loans, even though they be salable, are neg- lecting commercial business, which requires short-time loans. The function of a bank is to facilitate commerce and not to operate as a finance company. The latter introduces a speculative ele- ment into banking, by making the banks a powerful factor in ths stock market. Through temporary investments in bonds a bank may be tempted into promotion of new securities which have unstable value. Moreover, if a panic occurs good securities can- not be sold except at a loss, thus crippling the bank at a time when it should be able to support credit. This critical attitude may be illustrated by an extract from a report made to the National Monetary Commission in 191 1 by Professor J. H. Hollander: 268 BANKING AND CREDIT [ XIX From whatever point of view regarded this apparent necessity under which American banks now labor of tying up large parts of their loanable funds in stock-exchange securities is unfortunate. It offers an unhealthy stimulus to corporate financiering by supplying a temporary and fictitious market for investment securities. It invites speculative gains and losses by the fluctua- tion in market price in the interval between purchase and liquida- tion. It curtails mercantile accommodation by the bank's re- luctance to liquidate such securities in a declining market, and it injects an additional element of risk into banking stability in the temptation to invest in less seasoned and more productive bonds. ^ 5. Investment in Silocks. — As a rule the amount of corpora- tion stocks which a national bank holds is small. Stock is of a more speculative character than bonds. A stock does not have maturity, while a bond is ordinarily a promise to pay with a definite period to run. Under a ruling of the Comptroller of the Currency, a national bank is not permitted to invest in a stock except when taken in payment of debt, and then may hold it only for a limited time. During the war permission was granted to invest not exceeding 10 per cent of the bank's capital and surplus in any domestic corporation eiagaged in foreign financial operations necessary to facilitate the export of commodities. 6. Banking House and Equipment. — Other items of invest- ment appearing among resources are "Banking house," "Furni- ture and fixtures," and "Other real estate owned." The first two are self-explanatory. A national bank is not permitted by law to invest in real estate, except as may be necessary to carry on its business. It may, however, if permission be granted by the Comptroller of the Currency, own a building larger than is needed for its own requirements and rent the remainder. The object of the law is to prevent investment in property which is not readily salable. The item, "Other real estate owned," is not ' Bank Loans and Stock Exchange Speculation, p. i8. XIX] INVESTMENTS OF COMMERCIAL BANKS 269 a contradiction of this principle. It refers to real estate acquired in the settlement of loans which debtors have not paid. The bank, however, is under obligation to dispose of such holdings within a limited period. References \ Westerfield, R. B. Banking Principles and Practice. Vol. IV, pp. 1022- 1028. CHAPTER XX CASH HOLDINGS AND RESERVE OF A COMMERCIAL BANK I. Need of a Reserve. — Reserve has a special technical signifi- cance in American banking practice, since both state and federal statutes require banks to maintain a reserve against deposits. The nature of the reserve has varied; it may consist of cash in the bank's own vault ; or a part may be cash and a part in the keeping of other banks; or the entire amount may be represented by bal- ances with other banks. A bank may also be required to keep a reserve against its note issues as well as against its deposits. All of these methods have been in operation at one time or another in American banking history. A distinction is to be made between cash and reserve. Cash is actual money which the bank holds in its vault, while reserve may include balances with other banks which can be drawn upon immediately to reinforce cash. A bank needs to hold cash for three purposes : 1. To meet the demands of depositors who wish actual money. 2. To redeem bank notes, if presented. 3. To pay to borrowers who wish immediate cash instead of credit as a deposit account. Few national bank notes, however, are presented for redemp- tion at the bank's own counter, as their security is never in doubt, so that the need of money in hand for this purpose may be dis- regarded. Few borrowers take any large amount of actual cash and the strain from this demand is small. The principal impor- tance of a cash reserve is to meet the demands of depositors who 270 XX ] COMMERCIAL BANK RESERVES 27 1 need cash and to make payment for current operating expenses. Depositors do not all draw checks simultaneously. Inasmuch as a bank is constantly receiving checks drawn against other banks which tend to counterbalance the amounts drawn against it, ex- perience shows that it is safe to carry on its operations with but a small amount of cash. 2. Reserve of National Banks under Old Law. — In order to understand the present law governing the character and amount of reserves required of national banks, it is desirable to describe briefly the older reserve system in operation before 19 14. Until that year national banks were required to keep reserves in lawful money as follows : 1. Country banks, 15 per cent, of which three-fifths might be deposited in a bank in a reserve city. 2. Reserve city banks, 25 per cent, of which one-half might be deposited in a bank in a central reserve city (New York, Chicago, St. Louis). 3. Central reserve city banks, 25 per cent in their own vaults. A central reserve city must have a population of 200,000; and a reserve city 25,000 (previous to 1903, 50,000). Not all cities, however, which can satisfy the population requirements are made central reserve cities or reserve cities. There are but three central reserve cities — New York, Chicago, and St. Louis — and about 60 reserve cities. All banks outside of the central reserve cities and reserve cities are called "country" banks. Lawful money included gold and silver coins, gold and silver certificates, legal tender notes, and clearing-house certificates (see Chapter XXI) issued against coin or legal tender. Banks were also permitted to include in this reserve the 5 per cent re- demption fund deposited with the Treasurer of the United States. A bank might, therefore, carry part of its reserve in its own vaults, and a part with other banks which, to that extent, acted as their agents. 272 BANKING AND CREDIT [XX 3. Reserve Requirements Illustrated.— Under this reserve system (treating the note redemption fund in the United States Treasury as in the bank's vault), deposits of $10 miUion in country or non-reserve city banks, would call for a cash reserve to be kept in their own vaults of but $600,000. They would carry and count as reserve $900,000 on deposit with reserve city banks. These reserve city banks would be required, to protect the deposits of the country banks, to have in their vaults cash to the amount of only $112,500, and might deposit $112,500 in central reserve cities, who, in turn, would have to have on hand 25 per cent, or but $28,125 in cash. This may be summarized in the form of a table : Cash Reserve on Deposits of $10,000,000 in Country Banks Amount of Deposits Cash Reserve in Vaults Deposited with Reserve Agents Coiintrv banks $10,000,000 900,000 112,500 $11,012,500 $600,000 112,500 28,125 $900,000 Reserve city banks (amount as above deposited by countrv banks) 112,500 Central reserve city banks (amount as above de- posited by reserve city banks) Total $740,625 $1,012,500 Per cent of total deposits . . . Per cent of deposits in coun- 63/4 72/5 91/5 10 1/8 Amount of cash outside original country banks $140,625, or 1.4 per cent. It will thus be seen that the country bank was obUged to keep 6 per cent on hand in cash, and of the country bank's reserve deposits the city banks kept i .4 per cent on hand in cash. There might therefore be but 7.4 per cent of cash, or $740,625 held XX ] COMMERCIAL BANK RESERVES 273 unloaned anywhere against this deposit of $10 million in the country banks. ' Under this system any city which had a population of 25,000 could become a reserve city on the appUcation of three-fourths of the national banks in that city. To become a central reserve city a population of 200,000 was required. There were nearly 50 reserve cities (only one, Boston, in New England), and only three central reserve cities — New York, Chicago, and St. Louis. Other cities might have qualified as central reserve cities but did not seek this distinction, as it would have obliged all national banks in such city to increase their cash reserves to 25 per cent. Although any national bank in a reserve city might act as a reserve agent upon permission of the Comptroller of the Cur- rency, this service was concentrated in the hands of but a few banks. In New York six banks held three-quarters of the re- serves for country banks, and in Boston the same proportion was held by two banks. Country banks availed themselves of the privilege of keeping a part of their reserve in reserve cities for two reasons: (i) be- cause the reserve banks paid a small rate of interest, generally 2 per cent on the balances deposited, so that the reserve was not altogether profitless; and (2) country banks must keep funds in a bank in a large commercial city in order to oblige their cus- tomers who wish to buy exchange to make pajnnents in these centers. 4. Reserve under the Federal Reserve Law. — Under the old law all cash which a national bank held might be counted as part of its reserve. The federal reserve law, enacted in 1913 (amended June 21, 191 7), changed this. A distinction is made between cash and reserve. The reserve is kept in the form of credits with a federal reserve bank. Cash in bank no longer constitutes part of the reserve, but simply serves the purpose of till money. ^ Report of the Comptroller of the Currency, 1907, p. 72. 18 274 BANKING AND CREDIT I XX The new law requires every member bank in the federal reserve system to maintain in a federal reserve bank a deposit known as "reserve balance" or "due from federal reserve bank," to secure the member bank's liability to its own depositors. The propor- tion of such reserve varies, as under the old law, depending upon whether the institution be a country bank, is in a reserve city, or in a central reserve city. The ratios are 7, 10, and 13 per cent respectively against demand deposits, and 3 per cent against time deposits for all institutions, without regard to their location. Under the former system the cash holdings of banks were scat- tered and, particularly in times of emergency, could not be made effective when there was the greatest strain ; under the new sys- tem the cash reserve is held by the federal reserve banks to secure their liabilities to the member banks and is thus centralized in 12 large reservoirs. The significance of this will be further explained in a subsequent chapter. A " country " bank needs less reserve than a bank in a city of metropolitan size, for the withdrawals of cash are likely to be less. There is a greater probability that checking accounts will be settled simply by transfer of credits within the bank; and withdrawals for settlement with other banks are less likely to be urgent. The variations in reserve requirements according to whether a bank be "country," in a reserve city, or in a central reserve city, with the new reserve rules of the federal reserve law are not altogether logical. Formerly it was clearly necessary that a reserve city bank should hold a larger reserve than a country bank, as it might hold the reserves of country banks which could be called for at any time the latter found advantageous. The amount of such withdrawals could not be calculated with as great precision as the withdrawals of cash by individual depositors. Now, however, no national bank keeps the reserves of other banks and consequently this protection is no longer needed. The federal reserve system inherits the classification of the old system with the result that a bank in a city as large as Providence, XX] COMMERCIAL BANK RESERVES 275 Rhode Island, with a population of 237,595 (1920) holds a reserve of but 7 per cent, while a bank in a reserve city, as Peoria, Illinois, with a population of 76,121, is obliged to hold 10 per cent. In so far, however, as banks hold funds of banks in other cities to meet the demand for domestic exchange, the need of variations in reserve requirements is justified. In addition to the reserve carried with the federal reserve banks, the banks hold cash in their own vaults. This may be regarded as till money needed to meet the current day-to-day demand of customers for actual cash. The amount thus re- quired is determined by experience rather than by law, and is much less than is generally supposed; in 1920 it was less than 5 per cent of all deposits.^ 5. Amount of Reserve Held. — The following table shows the amount of deposits, the reserve required, the amount held by federal reserve banks, and the per cent of actual reserve to de- posits, for national banks in the several groups, September 12, 1919:^ Reserve Position of Naiional Banks, September 12, 1919 (Amounts in thousands) Locality Deposits Reserve Required Held by Federal Reserve Banks Per Cent of Deposits Central reserve cities: New York $2,586,604 629,184 160,342 3,604,661 5,293,481 $336,259 81,794 20,844 360,466 370,842 $362,743 82,450 19.932 365.920 398,488 14.02 13.10 10. IS 7.53 All banks $12,274,272 $1,170,205 $1,229,533 10.02 ^ Report of Comptroller of Currency, 1920, Vol. I, p. iis- 3 Report of Comptroller of Currency. 1919, Vol. II, pp. 224-229. 276 BANKING AND CREDIT [XX Taking the country as a whole, the reserves of national banks were $59 milUon in excess of the legal requirement. The amount of reserve which a bank has in proportion to its liabilities is not necessarily a measure of its strength. Idle money in the vaults of the bank is not earning anything. A bank's profits come from its loans and investments. A well-managed bank therefore seeks to invest all its funds beyond what is needed to meet current demand, maintain public confidence, and satisfy legal requirements as to reserves. It is the quality of the loan account, by far the largest item among the resources, which in the last analysis determines whether the depositor is amply protected. 6. Relation of Reserve to Loans and Deposits. — The amount of reserve bears an intimate relation not only to deposits but also to loans, for, as seen in the chapter on deposits, loans and deposits are in great measure complements of each other. Disregarding, for the moment, the provisions of the Federal Reserve Act pro- viding for the holding of the reserve as a credit balance by the federal reserve banks, instead of allowing it to rest in the vaults of the individual banks, this relationship of loans, deposits, and reserve may be illustrated as follows : There is but a single bank in a given community and this has a capital of $100,000. The balance sheet reads : I Cash. $100,000 Capital $100,000 It is now assumed that there are 100 customers of the bank, all of whom are depositors. It is also assumed that the bank is re- quired to keep a certain cash reserve against its deposits, say, 10 per cent. The clients of the bank deposit $10,000 in cash, an average of $100 each. The balance sheet then reads: Cash $110,000 Capital $100,000 Deposits 10,000 $110,000 $110,000 XX ] COMMERCIAL BANK RESERVES 277 One of the customers, A, of the bank now applies for a loan. If he wishes cash, the bank can loan $109,000 without impairing the reserve protection of deposits. Omitting all calculations of interest or discount and the item, undivided profits, the balance sheet will read: 3 Loans $109,000 Capital $100,000 Cash 1,000 Deposits 10,000 $110,000 $110,000 What becomes of the cash loaned out? On the assumption that this is a self-contained community, that there is no other bank into which the cash can flow, and that the cash will not be transferred to any other community, it is obvious that it will not be long before it flows back to the bank. Some of the other 99 customers of the bank will receive it and deposit it in the bank. If it be assumed that the community already has all the pocket and till money needed in ordinary every-day exchange, all this cash, $109,000, will reappear at the bank in deposits. The balance sheet will then read : 4 Loans $109,000 Capital $100,000 Cash 1 10,000 Deposits 1 19,000 $219,000 $219,000 But the borrower may not take out his loan in cash; he may receive a credit as a deposit and the statement will read : 5 Loans $109,000 Capital $100,000 Cash , 1 10,000 Deposits 1 19,000 $219,000 $219,000 This is the same statement as No. 4. The borrower now proceeds to make payments in checks, drawing against his de- 278 BANKING AND CREDIT [XX posits. His checks are received by other business men in the town and are by them deposited. A's deposit is decreased, but B's and C's deposits are increased by the same amount, and there will be no change in the balance sheet, even if A checks out all of his own deposit. Can the bank make further loans and if so, to what extent? B may now apply for a cash loan. The bank, as before, must keep a cash reserve of lo per cent on its deposits of $119,000, or $1 1 ,900. The bank can thus loan $98,100, and the balance sheet reads : 6 Loans $207,100 Capital $100,000 Cash II ,900 Deposits 1 19,000 $219,000 $219,000 Again the cash is passed from hand to hand and within no long period is again deposited. The statement then appears : 7 Loans $207,100 Capital $100,000 Cash 110,000 Deposits 217,100 $317,100 $3i7>ioo Or, if borrower B does not take cash but a deposit credit, the statement will at once appear as in No. 7. This process can be continued until deposits reach $1,100,000, or ten times the cash reserve. Deposits in these transactions are due, not to any increase in cash, but to loans which have been advanced upon satisfactory collateral. In brief, if there were a single bank with which all the people of the business community did their banking, and if the cash reserve against deposits should be set at various times at 5, 10, and 16 2/3 per cent, the amount by which the bank could expand its loans for each additional dollar of cash deposited would be $19, $9, and $5, respectively.'' On the other hand, where several ■* The dollar deposited will, of course, require its own reserve. XX] COMMERCIAL BANK RESERVES 279 banks are established in the community there is no possibility of any one being able to expand its loans ten times for each cash deposit and maintain cash reserves of 10 per cent. This is because of the cash withdrawals and the necessity for settling unfavorable clearing-house balances. However, for the banking system as a whole the possibility of expanding loans and deposits is quite the same as already described where a single bank for the community has been assumed. 7. Relation of Reserve to Loans and Deposits for Individual Banks. — If there are several banks in a community, involving withdrawals of cash from one to another, each bank must retain a larger reserve than the foregoing analysis would imply. As- sume that in a certain community there are a number of banks and that they handle all the local business; also assume that each time a loan or discount is made, 80 per cent is withdrawn by check, the 20 per cent being left on deposit; and in addition that the banks are required to keep cash reserves of 10 per cent against deposit liabilities. In order to simplify the illustration it is also assumed that the 80 per cent cash withdrawal from bank W is paid to individual depositors of bank X, etc. The cash withdrawal from one bank thus becomes an additional cash deposit for the next bank which extends loans and discounts as before and in turn is subject to a similar percentage of cash withdrawals. The accompanying table starts with the receipt by bank W of $10,000 cash deposits. On the basis of this cash the bank de- cides to extend its loans and discounts to a point where the resulting net additional deposits, after allowing for a cash with- drawal of 80 per cent of the proceeds of these loans and discounts, leaves the bank with the necessary cash reserve of 10 per cent. The amount by which deposits created by loans and discounts may be expanded on the basis of a certain amount of additional cash can be determined either by a mathematical equation or by process of trial and error. For purposes of simplifying the illus- 28o BANKING AND CREDIT [XX tratioa the latter plan has been chosen and a reserve of slightly- less than lo per cent is maintained. It is thus found that ba.nk W can expand its loans approximately $i i ,000 on the basis of the receipt of $10,000 cash deposits. After cash withdrawals have been made the net additional cash leaves a reserve of 9.836 per cent, or slightly less than the required 10 per cent. The actual possible expansion of loans, therefore, under the conditions given would be slightly less than $11,000. The cash withdrawal of $8,800 from bank W becomes an additional cash deposit for bank X, which goes through the same operations. Table Showing Relation of Reserve to Loans and Deposits for Individual Banks (a) (b) (c) (d) Ce) (f) (g) (h) Bank Additional Cash Deposits Additional Deposits Created by Loans and Discounts Cash With- drawal 80 Per Cent of Column (c) Net Additional Depos-its Created by Loans and Discounts Columns (c)-(d) Net Additional Cash Columns (b)-(d) Total Net Additional Deposits Columns (b) + (c)- (d) Percentage of Cash Reserve, or Ratio of Column (0 to (g) w X Y Z Sio.ooo.oo 8,800.00 7,744-00 6,814.72 |l 1,000.00 9,680.00 8,si8.40 7.496.19 $8,800.00 7,744-00 6,814.72 5,996.95 12,200.00 1,936.00 1.70368 1,499.24 3l,200.00 1,056.00 929.28 817.77 Sl2,200.00 10,736.00 9,447.68 8,313.96 9.836 9.836 9.836 9.836 It will be observed from the table that each bank on the basis of a given cash deposit is able to increase its loans no per cent of the sum so received, while the resulting deposits, after the with- drawal of 80 per cent of the loans, are approximately 1 20 per cent of the cash deposits. To be more exact, column (g) in each case is 22 per cent greater than column (b), assuming a percentage of cash reserve, column (h), of 9.836 instead of 10. If the tabulation were carried out for other banks, column XX] COMMERCIAL BANK RESERVES 28 1 (g), Net Additional Deposits, would continue to show a con- stantly decreasing figure for each successive bank and the total of this column would be the amount by which all banks in the aggregate could expand their deposits arising from loans. This total is $101,667, or slightly more than 10 times the original addi- tional cash deposit of $10,000 in bank W. If a reserve of exactly 10 per cent instead of 9.836 per cent had been maintained, the total expansion would be precisely $100,000 for the banking sys- tem as a whole, as it was for the single bank which we assumed did all the business (page 278). 8. Export and Import of Gold. — One further observation should be made. If the original cash deposit of $10,000 in bank W has resulted from withdrawals from some other bank in the same country, thereds no new basis for expansion of loans for the banking system as a whole. But if this cash represents gold, imported or mined in the country, expansion for banks in the aggregate would be possible. ' Suppose, for example, that all national banks held $884 mil- lion of cash reserve, the law requiring a 10 per cent legal reserve against $8,840 million of deposits; $1 of cash supports $10 of deposits. If cash were reduced by $50 million withdrawal through export of gold, the ratio of cash reserve against deposits would be below the legal limit. The only way to retain the legal equilibrium between cash and deposits would be to reduce the loans, thus decreasing the deposits. If $884 million cash be re- duced to I834 milHon, the new reserve could support only $8,834 million of deposits, and it would consequently be necessary to reduce loans by $500 million. The decrease in loans does not of itself increase cash, but it reduces the amount of deposits. So, too, an influx of gold will increase the loaning power of banks many times the amount of the gold, if the loans are taken in the form of deposit accounts. s See note at end of chapter. 282 BANKING AND CREDIT [ XX The illustration given above presupposes the exportation or importation of gold. If the transfer of $50 million were made within the country, there would be no change in the loaning power of all banks, for the withdrawal from one bank would reappear as cash in another bank. It would then perform the same service as in the bank from which it was transferred, so that theoretically there would be no change in the total loans and deposits of all banks. Withdrawal of cash (gold) by export, or its gain by import, therefore, has far more important consequences than domestic losses or gains of cash which do not affect the total volume of cash within the country. 9. Procedure in Maintenance of a Reserve. — If a bank has a reserve which is near the legal limit, it must decline to make fur- ther loans even if there were an informal agrejment that a con- siderable part of the loan were to be left on deposit and not with- drawn in cash. Although there is no penalty imposed upon a bank when its reserve is less than the legal ratio, it is under pressure by the Comptroller of the Currency to restore its reserve as quickly as possible, and the National Banking Act forbids the bank to make further loans or to declare a dividend until the deficit is made good. There are various methods by which a bank can increase its reserve, but generally it is effected by decreasing its loans rather than by the sale of securities or increase of cash through deposits. It has been explained that deposits are largely due to loans and do not bring actual cash into a bank. To increase deposits through loans obviously increases the amount which must be held in reserve and places the bank in a still more pre- carious condition; the payment of outstanding loans will increase cash or, if paid by checks drawn on the bank itself, reduce de- posits, in either case increasing the ratio of cash reserve to deposits. In contracting its loans a bank in normal condition, and even XX] COMMERCIAL BANK RESERVES 283 in periods of emergency, rarely takes the position of refusing to loan, especially to its long-established clients. Such refusal would create irritation and be destructive of the good-will which is so large an asset in successful banking. Borrowing, however, is discouraged by an advance in the discount or loaning rates; and as a portion of the bank's loans, particularly in the larger cities,, are demand loans, this advance will lead to immediate payment by some borrowers and tend to lessen the strain which other borrowers might exert. As time loans are constantly maturing, the bank is thus enabled to maintain its reserve above the danger point. On the other hand, if there is surplus cash the bank will lower its discount rate so as to attract borrowers and thus keep its funds profitably employed. It is thus through its loaning department that the bank adjusts its reserve. With the establishment of the federal reserve banking sys- tem the maintenance of the reserve of the individual bank has been made much easier. The member bank may not only trans- fer cash to the federal reserve bank but also rediscount some of its commercial paper with the federal reserve bank and obtain a credit in return. Through these credits the bank is able to meet demands which would otherwise reduce its reserve. The significance of these changes in reserve methods is discussed in subsequent chapters. 10. Computation of Reserve of a Member Bank. — Under present procedure the reserve of all banks and trust companies which are members of the federal reserve system are maintained in a federal reserve bank. Using the balance sheet shown on pages 138-140, the computation is made as follows: Demand Deposits 1. Deposits, other than United States government and bank deposits, payable within 30 days j!i ,546, 145.47 (33) Less: "our checks"( 17 d, a) 60,944.83 $1,485,200.64 $62,829.70 (30) 24,829.81 (28) 78,846.55 16,482.26 (34) (31) 284 BANKING AND CREDIT [XX Due to Banks 2. Balance due to all banks other than federal reserve bank*. . . 3. Balance due to federal reserve bank — deferred credits 4. Cashier's, secretary's, or treas- urer's checks on own bank outstanding 5. Certified checks outstanding . . . Total due to banks (items 2, 3, 4, and 5) $182,988:32 Less: Deductions from Bank Deposits 6. Balances due from banks other than federal reserve bank and $39,7I3-I7 (13b) foreign banks 1,838.93 (H) 7. Items with federal reserve bank in process of collection 8. Exchanges for clearing house 9. Checks on other banks in same place 1,648.91 (16) Total deductions from bank deposits (items 6, 7, 8, and 9) $43,201.01 10. Net balance due to bankst $139,787.31 11. Total demand deposits (items i and 10) $1,624,987.95 Time Deposits 12. Savings accounts (subject to not less than 30 days' notice before payment) 13. Certificates of deposit (subject to not less than 30 days' notice before payment) 14. Other deposits payable only after 30 days 15. Postal savings deposits $7,893.25 (41) 16. Total time deposits (items 12, 13, 14, 15) 17,893-25 ♦"Balances due to all banks other than federal reserve bank" (item 2. demand de- posits) should include balances due to foreign banks. t Should the aggregate "due from banks" (items 6, 7, S. 9) exceed the aggregate "due to banks" (items 2,3,4,5) both amounts must be omitted from the calculation. XX] COMMERCIAL BANK RESERVES 285 Reserve Required Demand deposits: Banks in central reserve cities, 13% of item II Banks in other reserve cities, 10% of item II Banks outside reserve and central reserve cities, 7% of item II $113,749.15 Time deposits: All banks 3% of item 16 236.79 Total reserve to be maintained with federal reserve bank $1 13,985.94 Reference to item 1 1 of resources in the balance sheet shows that the bank has as lawful reserve with the federal reserve bank $168,016.50, which is in excess of the legal requirement. In computing the reserve certain deductions from deposits are allowed. The bank not only holds the deposits of other banks but it has deposits in other banks. If the latter (not in- cluding the deposit in the federal reserve bank) is less than the former, that amount may be subtracted in order to determine the net amount of bank deposits for which the bank is obliged to maintain a reserve. The amount "due to banks" includes not only items 28 and 30 in the balance sheet, but also certified checks (31) and cashier's checks (34), listed among liabilities as "certi- ficates of deposit." From the amount "due to banks" are subtracted items 13(b), "due from banks," and 14(a), "our checks." The item of "our checks," $60,944.83, is regarded as a cash item. These checks are held as cash each night, owing to the fact that the ledgers close at noon each day and the checks do not go on to the individual accounts on the ledgers until the following day. These checks have been actually paid and are held in cash as above stated, and are thus deductible from deposits. 286 BANKING AND CREDIT 1 XX Note: Professor Chester A. Phillips in a recent notable volume on "Bank Credit" has made a clear mathematical exposition of the limita- tions which restrict individual banks operating in a group when each is subject to demand from the others. If there be but one bank or if all banks be amalgamated in one system, the net deposit of a given amount of cash, c, against which there must be held a reserve-deposit ratio of R, would enable the bank to lend in addition to outstanding loans: - (c - Re) R c - Re R c(i~R) —^ "The deposit arising from the cash, c, would itself call for a reserve equal to Re, leaving c— i?c as reserve for deposits arising from additional loans" (P- 39)- If the reserve ratio be lo per cent and the cash deposit f loo, the equa- tion would be solved as follows: I $90 — ($100 — Sio) or — = $900, answer .10 .10 A distinction is made between primary deposits and derivative deposits : "A primary deposit is one that arises from the actual lodgment in a bank of cash or its readily convertible equivalent, such as checks or drafts drawn on other banks, but not made in anticipation of the payment of a loan. By a derivative deposit is meant one which arises directly from a loan or which is accumulated by a borrower in anticipation of the repayment of a loan." A primary deposit is fairly stable; a derivative deposit is "ex- tremely variable in magnitude." "A derivative deposit is superimposed upon the primary balance and, at the initial date of the relative loan, rises at once to a high point, falls away during the early period of the loan, then as the loan-maturity approaches rises more or less gradually to a peak and, when the loan is paid, drops precipitately to the initial and basic level" (pp. 40-41)- Dr. Phillips presents the following formula for the determination of the amount that any given individual bank in a system can add to its item of loans and discounts on the basis of additional reserve deposited with the bank. Abbreviations are used for the following terms: XX] COMMERCIAL BANK RESERVES 287 c = additional cash or reserve. Ci = overflow cash, i.e., what a bank tends to lose as the result of making the additional loans. X = loan expansion resulting from additional cash. r — ratio of cash or reserve to deposits. k = ratio of derivative deposits to loans. Since (i — k) is equal to the percentage of loans checked against by borrowers, it follows that: Ci = (i — k)x "Since the lending banker will make his loans of such an amount that the cash left in the bank after the overflow cash has been paid out will be equal to the reserve required for: (i) the original cash deposit, and (2) the derivative deposits arising from the loans, {re + rkx) would equal the cash which the banker would have to retain as reserve, c being the amount of the cash deposit and kx being the amount of the derivative deposits, and r being the reserve-deposits ratio. If {re + rkx) is retained by the bank, the amount of overflow cash, Cj, may be found by subtracting {re + krx) fromc. Hence: Ci = c — {re -\- krx) or c — re — krx Since e^ is also equal to (z —k)x, [i — k) X = c — re — krx Transposing: krx -{- {i — k) x = e — re or {kr -\-l— k)x = e — re . e — re and or kr -\- 1 — k e {I -r) kr + I — k The above formula may be applied to a concrete case as follows : cash equals fi.ooo; reserve-deposits ratio equals .10 per cent; and derivative deposit-loan ratio equals 20 per cent. e = $1,000 r = .10 k = .20 1,000 (i — .10) 900 X = ; = -— or 11,097.56 .02 -|- I — .20 .82 288 BANKING AND CREDIT [ XX If checks drawn by borrowers are in favor of depositors of the drawers' bank, there will be no corresponding loss of cash by the bank and to that extent the formula calls for qualification (p. 57). References Davenport, H. J. The Economics of Enterprise, pp. 260-266. Holdsworth, J. T. Money and Banking. Changes made by federal reserve system, pp. 421-428. Phillips, C. A., Bank Credit, pp. 32—76. Westerfield, R. B. Banking Principles and Practice. Vol. II, pp. 387- 399- Willis, H. P. American Banking, pp. 152-176. and Edwards, G. W. Banking and Business, pp. 350-364. ' CHAPTER XXI THE CLEARING HOUSE I. Purposes of a Clearing House. — A bank holds among its resources a liumber of items which represent credit claims in process of settlement and conversion into cash. Among these are to be noted : Items with federal reserve banks in process of collection. Exchanges for clearing house. Checks on other banks in the same place. Outside checks and other cash items. For the settlement of many of these claims the ingenious mechanism of a clearing house is used. The operations of a clearing house are based on a simple arrangement maintained by an association of banks for the pur- pose of facilitating the daily exchange of checks and drafts and settlement of balances. In the development of this primary purpose new ideas have been gradually added with the result that in recent years the clearing house has possessed efficient machinery for providing united action among the members in all matters affecting their mutual welfare and in questions of busi- ness stability and public interest. In the United States the use of a clearing house for banks was first advocated in 1831 by Albert Gallatin, a banker, and at one time Secretary of the Treasury. Some twenty years later the principal New York banks, recognizing the necessity of a more convenient arrangement for exchanging their checks and notes, organized a clearing-house association with approximately fifty members. Thereafter the organization of other clearing houses in this country followed rapidly. 19 289 290 BANKING AND CREDIT [XXI 2. Mechanism of a Clearing House. — The most important feature of a clearing house is the plan and not the organization or the building and its equipment. For the sake of simplicity the plan may be illustrated by supposing that three banks have formed a clearing-house association. Each day the clearing house receives from bank A checks drawn on B and C ; from B checks drawn on A and C; and from C checks drawn on A and B. On a certain day A presents checks on B for a total of $10,000 and on C $15,000; B presents checks on A $8,000 and on C $12,000; C presents checks on A $9,000 and B $15,000. These figures can be shown in tabular form : Table Showing Bank Clearings and Balances Bank Total Checks of Each Bank Against Other Banks Total Checks by Other Banks Against It Net Balance in Favor of Each Bank Net Balance Against Each Bank A B C $25,000 20,000 24,000 $17,000 25,000 27,000 $8,000 $5,000 3,000 Totals $69,000 $69,000 $8,000 $8,000 It is evident that there is a net balance of $8,000 due to A and net balances of $5,000 and $3,000 due from B and C. Inas- much as the clearing house is simply a go-between for the three banks and is not engaged in a banking business itself, there should be neither a balance against it nor in its favor at the end of day. According to the practice of making clearings, banks B and C, against which there are net balances, wUl settle first by providing the clearing house with the necessary funds, or $8,000 in all. The clearing house will then pay A the net balance due it, amounting to $8,000, and will thus complete the clearance operations with a zero balance, as is proper. XXI] THE CLEARING HOUSE 29 1 To give some idea of the enormous volume of checks handled by clearing houses it is estimated that 750,000 checks pass daily through the New York Clearing House. The figure for Boston is placed at 100,000 to 200,000. The clearing-house mechanism economizes the use of money. Since the establishment of the clearing house in New York in 1854 there have been only two years in which over 9 per cent of the claims to be settled had to be paid by the actual transfer of money, and in eleven years the figure was less than 4 per cent. Before the establishment of the federal reserve system the method of settling balances varied in different cities, although it was universal to require banks which had balances against them at the clearing house to make settlement first and then for payment to be made by the clearing house to the other banks. Settlements were made either on a cash basis or on some other basis. When cash was the basis the balances were usually paid in gold coin or legal tender notes. When cash was not the basis of settlement there were a number of methods in vogue, such as : 1. Drafts on other cities. 2. Clearing-house manager's check on debtor banks given to creditor banks. 3. Borrowing and loaning balances with or without interest. 4. Clearing-house certificates. 5. Clearing-house loan certificates. Of these different methods the most common was clearing- house certificates. In most cities each member of the clearing house had on deposit in the vaults of the clearing house, or some bank agreed upon as a depository, gold coin, silver certificates or legal tender notes, for which clearing-house certificates in large denominations were issued. These certificates saved the actual handling of the gold, but could be used only in settling balances 292 BANKING AND CREDIT [ XXI between the members. Another important advantage in the use of clearing-house certificates consists of the greatly diminished risk of transferring funds. In the case of a messenger carrying them being robbed, no loss would be occasioned because they can- not be cashed by an individual and are good only for settling bal- ances between banks. In times of financial disturbance or panic, clearing-house loan certificates were issued on the basis of ac- ceptable collateral security and thus enabled banks to meet their obligations at the clearing house without drawing on their cash funds. 3. Settling Clearing-House Balances under Federal Reserve System. — The method of settling clearing-house balances under the federal reserve system is a relatively simple matter. When member banks were required (after June 21, 1917) to keep their entire legal reserves on deposit at the federal reserve bank in their district, the process of settling the net balances from clearing- house operations became practically a matter of bookkeeping by which transfers are made between the different deposit accounts. For instance, in Boston the bank balances at the clearing house are settled as follows: The debit banks, all being members of the federal reserve system, draw their checks on the federal reserve bank to the order of the Boston Clearing House, which checks are deposited in the federal reserve bank to the credit of the manager of the clearing house. His checks are then drawn in favor of the credit banks for the entire balance, which, of course, settles the business of the day. 4. Clearings for Banks Not Members of the Clearing House. — Especially in the larger cities, all banks do not find it advantage- ous to become members of the clearing house. However, this does not put any hardship on non-member banks for the reason that most of them clear through banks (including the federal reserve banks) which are members. For instance, in a certain XXI] THE CLEARING HOUSE 293 city the Ninth Trust Company clears through the Tenth National Bank. Every day the checks which are received by the Ninth Trust Company are sent to the Tenth National Bank, which presents them together with its own items at the clearing house. Similarly when other banks in the city receive checks drawn against the Ninth Trust Company, they present them through the clearings to the Tenth National Bank. Thus if on a certain day the Tenth National Bank sent $45,000 of checks to the clear- ing house for the Ninth Trust Company and received from the clearing house $40,000 of checks drawn against the Ninth Trust Company, the latter would have as a result of the day's transac- tions a favorable balance of $5,000 and this sum would be placed to the credit of its deposit account with the Tenth National Bank. In like maimer if the balance of the Ninth Trust Company should be unfavorable by the same amount, $5,000 would be de- ducted from the deposit account which the Ninth Trust Company has with the Tenth National Bank. In cities where the federal reserve bank is a member of the clearing house it acts as the clearing agent for many banks. In Boston, for instance, the federal reserve bank, which is a mem- ber of the local clearing house, acts as clearing agent for many of the trust companies which are not members of the clearing house, or which do not clear through other banks 5. Checks Traded Directly between Banks. — Particularly in the larger cities many checks are exchanged directly between banks before and after the actual city clearings, which usually begin at about 10 A.M. and are finished at about 10:30 a.m. The object of this direct exchanging is to relieve congestion of work in the banks and at the clearing house. For purpose of clearing-house records, however, checks which are handled in this way are included in the totals of the daily clearings. It has been the custom in Boston for a number of years for the larger banks to meet at 9 o'clock and exchange checks. No settlement is made 294 BANKING AND CREDIT [ XXI at that hour, but the totals of the checks so exchanged are in- cluded in the regular clearing at lo o'clock. 6. Domestic Exchange. — The term "domestic exchange" ordinarily refers to drafts on out-of-town banks located in the United States. Before the establishment of the federal reserve collection system domestic exchange rates were an important factor in the settlement of transactions between business men in one section of the country and those in another. These rates were subject to much the same influences as those affecting the foreign exchanges. For example, during the summer and early fall funds flow from east to west to finance crop movements. This creates an increased demand in New York and other eastern cities for drafts on Chicago; or, what amounts to the same thing, there is an increased supply of New York exchange in Chicago. Consequently, before the operation of the federal reserve system exchange on Chicago during the late summer and early autumn was normally at a premium, while New York ex- change in Chicago was quoted at a corresponding discount. Naturally the premium or discount was small because it could not be greater than the cost of shipping currency, ordinarily not more than 50 cents per $1,000 between Chicago and New York. As indicated elsewhere, premiums and discounts on domestic exchange are now almost a thing of the past on account of the establishment of the federal reserve collection system. A few banks, particularly in sparsely settled sections, have not joined the system and obtain revenue by charges for the collection of checks and drafts. 7. Federal Reserve Collection System. — A bank's out-of- town items whi(;h require collection include checks (individual and bank), drafts, acceptances, bonds, and coupons. In order to facihtate the collection of these items each federal reserve bank is required to exercise the functions of a national clearing XXI ] THE CLEARING HOUSE 295 house for its members. No member bank is required to use it; and members may still keep accounts with correspondents and make their collections through the latter as formerly. Member banks, however, must remit or receive at par all checks drawn on them and presented at their own counters. The action of the Federal Reserve Board in organizing a national clearing-house system caused considerable opposition to develop, largely because it warred against established customs in the matter of charges for collection and exchange and thereby interfered with an important source of profit to country banks in particular. The opposition to those provisions which require the federal reserve banks to receive from their member banks, at par, checks and drafts payable on presentation and prescribe that no remittance charge for such checks shall be made against the federal reserve banks was for some time especially intense and sustained in districts Nos. 6, 9, and 10. This opposition, however, has gradually become less intense and will, it is be- lieved, disappear entirely within a reasonable time after all the banks in the country are placed on the par list. At present more than 95 per cent of the banks of the United States are on the par list. 8. Operation of System. — The federal reserve collection sys- tem is thus composed not only of member banks, but also of all non-member banks which have indicated their willingness to accept at par checks drawn on or presented to them. As an ex- ample of the operation of the federal reserve collection system let us consider the methods used by the Federal Reserve Bank of Boston, first in the handling of checks, and second in the handhng of other items. The Federal Reserve Bank of Boston will receive from mem- ber banks checks drawn on all national banks in the United States, and such checks on state banks and trust companies as can be collected without payment of exchange. In order to 296 BANKING AND CREDIT [ XXI facilitate collection it is required that checks deposited by mem- ber banks be sorted into separate cash letters as follows: (i) Boston checks, (2) New England checks, (3) other district checks. Checks drawn on banks and trust companies located in Boston are collected through the Boston Clearing House Asso- ciation of which the federal reserve bank is a member. Checks drawn on banks and trust companies in the First Federal Re- serve District, outside of Boston, are forwarded direct to such banks, which are required to remit immediately to the Federal Reserve Bank of Boston. Checks drawn on member and non- member banks in other reserve districts are dispatched for col- lection to the federal reserve bank (or its branch) in the district where they are payable. 9. Collection of Time Items. — In addition to handling checks for member banks the Federal Reserve Bank of Boston will re- ceive for collection and credit promissory notes; time, sight, and demand drafts with or without securities, bills of lading, or other documents attached; orders on savings banks; maturing bonds and coupons; checks previously protested; and any other forms of collection items. A Boston bank is expected to effect its own collection of time items payable at other Boston banks or trust companies. United States coupons are redeemable at the federal reserve bank, which acts as fiscal agent of the United States. There is no charge by the federal reserve bank for this collection service rendered to its members except: (i) a charge of 15 cents for each item returned unpaid, and (2) any exchange charge or fee imposed by the collecting or paying agent. In making the collection the federal reserve bank may, at its dis- cretion, send any item direct to the bank which is to make pay- ment, or where it is payable, or it may send the item to an agent with like authority for such direct sending. The bank or agent to which the item has been sent is then required to remit promptly. XXI] THE CLEARING HOUSE 297 The present collection system, particularly in the case of checks, has remedied the three principal disadvantages of previous systems. These disadvantages were : 1. In order to avoid exchange charges there were frequent circuitous routings of checks which caused delays in presentation of checks. 2. Exchange charges were inequitably borne. The interior country banks by charging exchange for collecting checks made large profits, whereas eastern banks by accepting country items at par made no profit. 3. Collection of checks was expensive because the exchange charges were often excessive. 10. Gold Settlement Fund. — For the purpose of effecting with as little delay and cost as possible settlements between the 12 federal reserve banks and their branches there has been es- tablished in the Treasury Department a gold settlement fund. By this means title to funds in one district can be transferred to another without the actual movement of money, and the old practice of shifting funds for crop-moving purposes is abolished. The heavy movement of government funds in connection with Liberty bonds and Treasury certificates of indebtedness affect to a large extent the gold settlement fund operations. Each reserve bank is required to keep in this fund with the Treasury of the United States a balance of not less than $1,000,- 000 and this was accomplished by shipments of gold to Washing- ton. The first withdrawal was made July 14, 1915, when the Federal Reserve Bank of Chicago sent a telegram filed at 10.30 A.M. At 2.30 P.M. the same day the Assistant Treasurer of the United States at Chicago was ready to make pajrment of $2,000,000 as requested. The great value of this method of clearings and transfers is further indicated by its economies. For the year 1919 the total expense of operation, including the entire cost of the leased wires 298 BANKING AND CREDIT [ XXI and salaries of accountants, was approximately $250,000. This represents the basic cost of effecting the domestic changes be- tween the 12 federal reserve districts. The extent of the saving may be appreciated from the fact that a charge of 10 cents per $100, if generally imposed, would have involved an expense to the commerce of the country of $73,984,252. II. Significance of Clearing-House Figures. — For the pur- pose of comparing business activity for different periods or for different sections of the country, statisticians sometimes employ clearing-house figures. Such use of these figures, however, for long periods, is open to serious criticism unless proper allowance is made for varying conditions. The large number of banking consolidations in recent years has tended to make the number and amount of clearing-house items smaller than what they would have otherwise been. The more banks there are in a com- munity, the more checks will be presented at the clearing house, because each bank will very likely have received during the day checks on every other bank. On the other hand, if several of these banks combine, checks that previously would have gone through the clearing house will now be handled by transfer en- tries on the books of the consolidated institution. In short, if in a certain community it were possible to combine all of the in- dividual banks into a single institution a clearing house would not be necessary. Notwithstanding these defects, bank clearings are frequently used as an index of the volume of business. It is customary, however, to distinguish between the clearings of banks in New York City and those in outside cities. Clearings in New York are affected by stock-exchange transactions which represent activity in the field of speculation rather than industrial and commercial enterprise. This may be illustrated by the follow- ing table which shows the clearings in New York and outside New York over a series of years : XXI ] THE CLEARING HOUSE 299 Bank Clearings in New York and in Other Cities New York Clearings Outside New York Year Amount (Billions) Increase or Decrease (Per Cent) Amount (Billions) Increase or Decrease (Per Cent) 1910 1911 1912 1913 1914 1915 1916 1917 1918 1919 $97,275 92,373 100,744 94,634 83,019 110,564 159,581 177,405 178,533 235,803 - 6.1 - 5-0 + 91 - 6.1 - 12.3 + 33-2 + 44-4 + 11.5 + 0.6 + 32.0 $66,821 67,857 73,209 75,181 72,227 77,253 102,275 129,540 153,821 181,717 + 7-3 + 1.6 + 7-9 + 2.7 - 3-9 + 7-0 + 324 + 26.7 + 18.7 + 18.1 It will be observed that the fluctuations in the New York clearings have been more violent than in other cities. In 1913 and 1 9 14 the number of shares sold on the New York Stock Ex- change was less than half as many as dealt in ordinarily. Nat- urally the volume of clearings is affected by higher prices and consequently the large gains shown in the more recent years are not due simply to the increased number of business operations calling for payment by checks, but also to the higher prices. References Dunbar, C. F. Theory and History of Banking. A mathematical explanation of operation, pp. 57-58. Fiske, A. K. The Modern Bank. pp. 30-33, 76-87. Harris, R. S. Practical Banking, pp. 161-177. Holdsworth, J. T. Money and Banking, pp. 212-225. KniflBn, W. H. Practical Work of a Bank. pp. 145-163. Moulton, H. G. Financial Organization of Society, pp. 457-468. Principles of Money and Banking. Part II, pp. 102-115. Phillips, C. A. Readings in Money and Banking. Largely historical, relating to development in United States and England, pp. 3SS-380. 300 BANKING AND CREDIT [ XXI Westerfield, R. B. Banking Principles and Practice. Vol. I, pp. 102- 104; Vol. Ill, pp. 651-671. White, H. Money and Banking. Copy for a proof sheet, pp. 216-223. Willis, H. P. American Banking, pp. 107-132. and Edwards, G. W. Banking and Business, pp. 236-240. CHAPTER XXII DEFECTS OF THE NATIONAL BANKING SYSTEM I. Inelastic Circulation. — To understand the changes which were introduced by the federal reserve banking law it is neces- sary to review some of the most salient characteristics of the national banking system. The National Banking Act of 1863 perpetuated the continuance of local independent banks, as con- trasted with a single large central bank with branches or sub- agencies. These banks had the right to issue circulation secured by bonds. In the chapter on national bank note circulation some of the reasons for fluctuations in the volume of these notes are given. Changes in the volume of national bank note currency — contraction and expansion by turns, during long periods — did not meet the more sensitive needs of business, with its periodic seasonal changes created by the movement of crops, fluctuations in commerce, activity in the securities markets, to say nothing of the strains arising during crises. The currency was yoked to the finances of the government, as reflected in the amount of its in- debtedness, rather than to current demands of industrial and commercial enterprise. Moreover, the technical regulations affecting the purchase and deposit of bonds and the issue or redemption of bank notes prevented a prompt response to the fluctuations of trade. In this respect the circulation lacked elasticity. Elasticity of circulation involves not only its possible expan- sion when there is demand for more currency, but also its con- traction when the demand is over. Contraction is as necessary as expansion; otherwise there will be inflation. Redemption of notes, resulting in contraction, was imperfect under the national 301 302 BANKING AND CREDIT [ XXII banking system. A national bank could not force the retirement of its notes, except through the redemption agency at Washing- ton or through the chance presentation of its notes at its own counter. Notes were rarely sent to the redemption agency unless they were cut or mutilated. Moreover, the law (1882) limited the amount of notes which could be withdrawn in any one month to $3,000,000.' Expansion might go on as long as bonds could be purchased and there was a profit in the oper- ation. Contraction, however, was hampered and could be accomplished only with delay. The situation was well described in a report of the National Monetary Commission:^ The sum of the whole matter is that under the existing system of bank notes based upon government bonds, normal and auto- matic expansion and contraction of the currency, in response to the needs of trade, is flatly impossible. The currency supply may be greatly enlarged in the dull midsummer months and sud- denly contracted when the active autumn business season begins. It may increase rapidly at a time when trade reaction has reduced to a minimum the necessities for even the existing bank-note supply, or it may be as rapidly reduced when large harvests, full employment of labor, and active hand-to-hand use of currency most need a larger circulating medium. Not only did bank note currency not respond to the needs of business, but frequently operated in the opposite direction. When business is active and there is general prosperity the price of bonds is likely to be high, thus retarding the increase in circu- lation. On the other hand, in a period of depression the price of bonds may decline, making it advantageous to the banks to purchase and thereby enlarge their note issues. 2. Scattering of the Reserves. — In the chapter on cash hold- ings and reserve of a commercial bank it was seen that under the ^ In 1907 this was increased to S9, 000,000. ' Alexander D. Noyes, History of the National-Bank Currency, published by the National Monetary Commission (1910), p. 20, XXII ] DEFECTS OF THE NATIONAL BANKING SYSTEM 303 original banking act reserves were scattered; a part of the re- serves were held in the bank's own vault and a part, except for banks in central reserve cities — New York, Chicago, and St. Louis — could be redeposited with agency banks in reserve cities or central reserve cities. A part of the reserve might thus be massed to a certain extent, but this massing or accumulation of reserves in centralized funds was not directed by the needs of commerce. A very considerable amount was attracted to the banks in the central reserve city, New York, where it found ready use in loans made to stock-brokers. As reserves held by banks for other banks were demand deposits, the New York reserve agents who handled these funds were obliged to be in a position to respond promptly to withdrawals by their client depositing banks. They therefore were disposed to loan on call, thus subjecting the stock-brokerage business to rapid and violent fluctuations in interest rates. In March, 1914, the New York banks held $836 million of the funds of outside banks, and an inquiry made in 1912 showed that loans to stock-brokerage banks at that time amounted to $240 million. 3. Immobility of Reserves. — Not only were the reserves scattered, although accompanied by a certain degree of central- ization in New York where they were devoted to a specialized business relating to the marketing of securities rather than the support of commercial undertakings, but they were rigid, or immobile. There was no authority or machinery whereby they could be promptly directed to relief when there was a special tension and demand for loans. In times of emergency it was difficult to call home the reserves which had been redeposited, without seriously affecting the value of the securities dealt in on the principal stock exchanges. Apart from the effects upon stock speculation, a sudden decline in the value of securities may 304 BANKING AND CREDIT [ XXII be disastrous, for these are used as collateral in borrowing by merchants and manufacturers.^ A banker (Warburg) wrote: If after a prolonged drought a thunderstorm threatens, what would be the consequence if the wise mayor of a town should at- tempt to meet the danger of fire by distributing the available water, giving each house owner one pailful? When the lightning strikes, the unfortunate householder wiU in vain fight the fire with his one pailful of water, while the other citizens will all fran- tically hold on to their own little supply, their only defense in the face of danger. The fire wUl spread and resistance will be impos- sible. If, however, instead of uselessly dividing the water, it had remained concentrated in one reservoir v/ith an effective system of pipes to direct it where it was wanted for short, energetic, and efiicient use, the town would have been safe. We have parallel conditions in our currency system, but, ridiculous as these may appear, our true condition is even more preposterous. For not only is the water uselessly distributed into 21,000 pails, but we are permitted to use the water only in small portions at a time, in proportion as the house burns down. If the structure consists of four floors, we must keep one-fourth of the contents of our pail for each floor. We must not try to extinguish the fire by freely using the water in the beginning. That would not be fair to the other floors. Let the fire spread and give each part of the house, as it burns, its equal and insufficient proportion of water. Pereat mundus, fiat justitia 1 * And Kemmerer illustrates the situation as "analogous to what would happen today if after drilling our American army to a high point of fighting efficiency, we should scatter the men in small units all over the United States to protect the country from a threatened invasion. Each community would be Jealous of its own squad of soldiers, but the invader would come and the efl&ciency of our well drilled soldiers would be practically nil."s 3 See page l88. 4 The Discount System in Europe, published by National Monetary Commissionf igio) P-33- " 5 E. W. Kemmerer, The A B C of the Federal Reserve System, p. 6. XXII ] DEFECTS OP THE NATIONAL BANKING SYSTEM 305 4. Acceptance Market Not Developed. — In other respects also the National Banking Act did not adequately meet the needs of business in the course of its rapid development. No authority- was given banks to accept domestic bills of exchange drawn by merchants, manufacturers, and others, for purchasing, carrying, and marketing goods. In the older countries of Europe a bank not only makes loans and discounts, but it undertakes to accept bills which may be drawn upon it, thus powerfully reinforcing its credit facilities. This practice was not recognized in the National Banking Act. There was fear that the privilege would be abused and would result in unsound banking; and, moreover, there was not the apparent need for this privilege, owing to the simpler methods of business in this country. With the development of foreign trade the advantage of acceptances became more and more apparent. 5. Lack of Rediscount Market.— Nor was there a rediscount market in the United States. By rediscounting, commercial paper which is held by one bank is sold to another bank. The National Banking Act did not prohibit this practice, but there was a general prejudice against it. The discounting of a note by a bank for its customer was regarded as a private arrangement, the knowledge of which should not extend to another bank. A business man who had credit could borrow from his individual bank, if the bank was able and willing to make loans, but the purchase of credit was to that extent restricted and personal. As a rule the borrower does not scatter his purchases of credit; his relationship in this respect is like that of a patient to his physician. It is intimate, confidential, and personal. Unless this personal relationship of credit can be supplemented by other devices, there will be great variations in the price of credit or rates of interest in different parts of the country, and indeed in different cities in the same section. This immobility of credit may be illustrated by comparing the factors which determine the 306 BANKING AND CREDIT [ XXII price of wheat with those which determine the price of money, the rate of interest. Wheat is grown on thousands of farms in widely different sections; there is, however, barring the differences due to the cost of transportation, but one price for wheat throughout the country. In other words, wheat can be mobilized and directed to any point where there is a deficiency. From the farm it goes to elevators along the lines of railroads; from there it is accumulated in terminal elevators and again redistributed to localities where demand is effective. The scattered supply is thus distributed and equalized in accordance with demand arising from thousands of scattered localities. But it is far different in the buying and selling of short-term credit, where a system of individualistic, independent banking is in operation. There may be a large amount of available credit in one section and a great demand in another which cannot easily be supplied. Some method must, therefore, be devised to mobilize credit, adjust supply to demand, and secure more uni- form rates of interest. Until the establishment of the federal reserve system little had been done in this direction. It was looked upon as a source of weakness on the part of a bank to apply to another bank for rediscount. Consequently the carry- ing of loans was not shifted from one bank to another. Banks in one section might hold large amounts of idle cash, while those elsewhere could not satisfy all the legitimate demand for com- mercial loans. Potential use of credit was thus wasted. 6. Disregard of Banking Defects. — There were thus three outstanding defects in the national banking system: (i) the scattering of the reserves; (2) the inelasticity of bank note circu- lation; and (3) the lack of a well-developed discount market. Little heed, however, was given to these shortcomings. Since the Civil War expert attention and effort had been largely di- rected to the establishment of a system of sound currency, by which all kinds of money should be maintained at a parity with XXII ] DEFECTS OP THE NATIONAL BANKING SYSTEM 307 gold. During the earlier part of this period the problem centered in the resumption of specie payments, by making government paper money, or greenbacks, equivalent to gold in current pay- ments; later discussion and legislation was devoted to the place of silver in the monetary system. The greenback question was settled by the Resumption Act of 1875 and its fulfilment in 1879; the silver issue was settled by the Gold Standard Act of 1900, whereby provision was made for the enlargement and mainte- nance of the underlying gold reserve of the Treasury. Engrossed by these efforts, the pubHc gave little attention to the need of banking reform and changes in the use of credit. There was an occasional note of warning and various plans were suggested by students of banking and business organization. None of these, however, seriously attracted the attention of Congress. 7. Panic of 1907 and Demand for Reform. — The defects of the banking system were re-emphasized by the panic of 1907. This, like all panics, came unexpectedly, and the disaster which followed awakened the public and Congress to the necessity of preventive and remedial measures. The National Monetary Commission, under the chairmanship of Senator Aldrich, was appointed to collect evidence and make a report. For immediate needs the Aldrich- Vreeland law was enacted (May 30, 1908). This provided for the issue of credit notes by individual banks upon deposit of other than government bonds, or through national currency associations upon pledge of com- mercial paper to be taxed at increasing rates depending upon the length of maturity of the paper. The Monetary Commission made an exhaustive investigation and submitted its report in 191 2. Seventeen defects in the existing banking system were noted . The chief among them were as follows : I. There was no provision for the mobilization and use of the scattered reserves of the banks. 308 BANKING AND CREDIT I XXII 2. Restrictions were placed upon use of reserves so that they could not be freely employed for loans in times of emergency. 3. The currency was inelastic. 4. Banks were without power to co-operate in times of stress. 5. Because of a lack of a broad established market for agricultural, industrial, and commercial paper, there was congestion of loanable funds in great centers ; this encouraged speculation. 6. There was lack of credit facilities in different parts of the country. The commission also prepared a plan for a central reserve in- stitution with extensive powers. But public sentiment was not prepared for so radical a change. The tradition of the misdeeds of the Second United States Bank was still current, there was an increasing fear of a money trust, the thousands of independent banks were suspicious of any additional supervising control, and partisan politics delayed reform. In 1913 the Democratic party came into power and, accord- ing to the position set forth in its campaign platform, promptly undertook the enactment of legislation. It, however, was tradi- tionally opposed to centralizing power in the hands of the banks. And yet no step in advance could be made without some degree of centralization. A compromise was therefore effected ; the findings of the Monetary Commission were revised and the Federal Reserve Act passed in 19 13. The following chapter will describe its principal provisions. References Agger, E. E. Organized Banking, pp. 215-240. Holdsworth, J. T. Money and Banking, pp. 344-374. Johnson, J. F. Money and Currency, pp. 368-374. Moulton, H. G. Financial Organization of Society, pp. 566-572. Phillips, C. A. Readings in Money and Banking, pp. 672-722. White, H. Money and Banking, pp. 401-410. CHAPTER XXIII ORGANIZATION OF FEDERAL RESERVE SYSTEM' I. Federal Reserve Districts. The Federal Reserve Act pro- vided for the establishment of not less than 8 nor more than 1 2 federal reserve banks in as many districts, bound together by an ingenious mechanism under the supervision of a Federal Reserve Board. This board is composed of seven members, five appointed by the President for terms of ten years each, and two, the Secretary of the Treasury and the Comptroller of the Cur- rency, serving ex officio. Two of the five members appointed by the President must be "experienced in banking or finance." The districts were to be "apportioned with due regard to the convenience and customary course of business." As the act, however, contemplated that the capital of these district banks be furnished by the member banks within the respective districts in proportion to their own individual capital, and as banks were not uniformly distributed throughout the country, the problem of districting was by no means easy. The Organization Com- mittee finally agreed upon 1 2 districts with federal reserve banks located at: (i) Boston, (2) New York, (3) Philadelphia, (4) Cleveland, (5) Richmond, (6) Atlanta, (7) Chicago, (8) St. Louis, (9) Minneapohs, (10) Kansas City, Missouri, (11) Dallas, and (12) San Francisco. The districts in which these banks are located are indicated in the accompanying map (Form 17). In order to remedy inconveniences arising from the creation of a district too large to be efficiently managed, a federal reserve bank may be required by the Federal Reserve Board to establish ^ For the sake of clearness, only the more salient features of the Federal Reserve Act are described in this chapter. Chapter XXIV presents additional data which enable the reader to understand more adequately the significant characteristics of this new legislation. 309 „ 310 BANKING AND CREDIT [ XXIII lU HI — O Hi I c t » J J " 5 * < <. ^ ^ ' IE c z «, _ u U < tE < O O ffi (D (D feSESS i±; bj o: c c a: c _| . _, Z Z (^ Ij of ^ 3 □ O Q — — - u u4 P tt! o a o XXIIl] ORGANIZATION OF FEDERAL RESERVE SYSTEM 3" branch ofi&ces within its district to be operated by boards of directors selected by the Federal Reserve Board and the federal reserve bank (Section 3). In 1920, 22 branches had been au- thorized. The principal services which these branches render are in expediting the receipt and shipment of currency and in the collection of checks and maturing notes, thus saving time in transportation in districts of wide area. All national banks, under penalty of forfeiture of charter, were obliged to assent to the provisions of the act and were thus forced to become member banks. 2. Capital. — The law requires that each federal reserve bank shall have a minimum capital of $4,000,000, subscribed in gold or gold certificates by the member banks (though provision is made for public subscription if not taken by banks) at the rate of 6 per cent of the capital and surplus of each member bank. Only half of this, however, is immediately payable, the remainder being subject to call by the Federal Reserve Board. Complete payment has not yet been enforced. In 1920 the paid-in capital of the several banks was as follows : Boston $ 7,718,000 New York 26,3761,000 Philadelphia 8,485,000 Cleveland 10,654,000 Richmond 5,269,000 Atlanta 4,053,000 Chicago . . '. 13,913,000 St. Louis 4,364,000 Minneapolis 3,457,000 Kansas City 4,456,000 Dallas 4,098,000 San Francisco 6,927,000 Total $99,770,000 It will be observed that there is a great inequality in the size of the banks, the New York bank having more than one-fourth 312 BANKING AND CREDIT [XXIII of the total capitalization. As all the banks are under the super- vision of the Federal Reserve Board, and must, if directed, co- operate as a unit, this inequality does not mean that one bank can dominate the others. 3. Management. — Each federal reserve bank is managed by nine directors divided into three classes of three each, known as classes A, B, and C. The directors in class A are chosen by and are representative of the member banks; the directors in class B, chosen also by the member banks, must be "actively engaged within their district in commerce, agriculture or some industrial pursuit" (Section 4); the directors in class C are selected by the Federal Reserve Board. The object of this classification is to secure a variety of in- terests in the management. Directors in class A represent the banks; those in class B, the public; and those in class C, the Federal Reserve Board. In order to protect the integrity of the management from partizan influences or the banker's prejudice, the law bars any member of Congress from appointment, or any officer or employee of any bank from serving in classes B and C. As a further safeguard, the Federal Reserve Board has advised (December 27, 1915) that no person holding political or public office or acting as a member of a political party committee shall serve as a director x)r officer of a federal reserve bank. To guard still further against the domination of big banks in the election of directors in classes A and B by the member banks, the institutions within each district are divided into three classes, banks in each class being as nearly as may be of similar capitalization. The smaller banks are in one group, the middle- sized banks in another, and the bigger banks in another. Each group elects one director for class A and one for class B. By this device it was intended to give the small banks an influence equal to that of large banks in the management. As Kemmerer states it: XXIII] ORGANIZATION OP FEDERAL RESERVE SYSTEM 313 The control of a federal reserve bank is as democratic as our democracy itself. " One bank, one vote" is the rule, and the vote of the First Bank of Jacksonville with its $25,000 capital counts as much as that of the National City Bank of New York with a capital and surplus 2,880 times as large. ^ One of the directors in class C, selected by the Federal Re- serve Board, is designated by the board as chairman and as "Federal Reserve Agent." He must be a person of "tested banking experience." As an adjunct to the administration of the federal reserve system is the Federal Advisory Council. The members of this council are chosen by the several federal reserve banks, one for each district. The council has power to confer with the Federal Reserve Board on general business conditions and to make recommendations in regard to discount rates, note issues, reserve conditions, and other questions affecting the reserve system. Through this agency it is expected that there may be a free opportunity to submit criticism and to propose amendments. 4. Discounting Functions. — The chief powers of these federal reserve banks are to discount the notes, drafts, and bills of ex- change of member banks; in other words, to advance credit to them upon the pledge of satisfactory security; to issue federal reserve notes; to receive deposits from member banks and the United States government; to purchase and sell in the open market bankers' acceptances; to deal in gold coin and bullion; to deal in government securities, including those of municipahties ; and to establish foreign agencies and correspondents. The ob- ject of these provisions is to provide a discount market, nation- wide in its scope, whereby the use of credit may be made more flexible. In addition, national banks were given wider powers, among which is the right to accept bills of exchange arising out of certain commercial transactions. ' E. W. Kemmerer, The A B C of the Federal Reserve System, p. 31. 314 BANKING AND CREDIT [XXIII The federal reserve banks widen the commercial credit market in three ways : 1 . By rediscounting for member banks, thus enabling these institutions to increase their own loaning facilities. 2. By open-market operations in the purchase and sale of acceptances, thus giving encouragement to a process of credit settlement, not as yet common in the United States. 3. By direct loans to member banks. A federal reserve bank may discount for any of its member banks any note, draft, or bill of exchange, provided: 1 . It has a maturity at the time of discount of not more than 90 days, exclusive of days of grace; but if drawn or issued for agricultural purposes or based on livestock it may have a maturity of not more than 6 months. 2 . It arose out of actual commercial transactions ; that is, it must be a note, draft, or bill of exchange which has been issued or drawn for agricultural, industrial, or commercial purposes, or the proceeds of which have been used or are to be used for such purposes. 3. It was not issued for carrying on trading in stocks, bonds, or other investment securities, except bonds and notes of the government of the United States. 4. The aggregate of notes, drafts, and bills bearing the signa- ture or indorsement of any one borrower rediscounted for any one member bank shall at no time exceed 10 per cent of the un- impaired capital and surplus of such bank; but this restriction shall not apply to the discount of bills of exchange, drawn in good faith against actually existing values. 5. It is indorsed by a member bank.^ The object of these statutory provisions regulating redis- count are with one exception — discounts on securities of the 3 See Federal Reserve Regulations, issued October, 1920, XXIII] ORGANIZATION OF FEDERAL RESERVE SYSTEM 315 government of the United States — to limit the privilege to opera- tions connected with the process of immediate production, manu- facture, and marketing of goods. With this in view the Federal Reserve Board carefully defines the various kinds of commercial paper, including: (i) promissory notes, (2) bills of exchange and trade acceptances, and (3) 6 months' agricultural paper; and for these different classes of paper each federal reserve bank deter- mines the rates of discount it will charge. A federal reserve bank may also discount for a member bank bankers' acceptances indorsed by at least one member bank and running for not more than 90 days, providing they grow out of transactions concerned with the importation and exportation of goods, or providing they grow out of the domestic shipment of goods, and shipping documents are attached. Of like purpose is the grant of power to purchase bills drawn by foreign bankers on member banks for the purpose of furnishing dollar exchange. 5. Control of Rediscounts. — It is not designed that a central rediscount bank, such as the federal reserve banks, shall furnish an inexhaustible supply of credits to member banks. Its primary purpose is to provide a fund from which individual or member banks can obtain loans in times of emergency. To make this principle effective, it is expected that the central reserve bank will charge a rate higher than the ordinary average rate charged by member banks to their customers. In order to check an excessive amount of credit advances, either by member banks to their individual clients, or by federal reserve banks to the member banks which may seek support through the privilege of rediscounts, it is presumed that the dis- trict banks will, if applications for rediscounts appear to be based upon speculation or unsound business conditions, increase their discount rates. The member banks consequently will have to pay a higher rate of interest for their rediscounts; and they in turn will be obliged to charge their customers higher rates. In 3l6 BANKING AND CREDIT [XXIII this way it is expected that the federal reserve banks will be able to exert an effective control over the discount market of the whole country. The operation of this principle in its most rigid form is well illustrated in England. The Bank of England fixes a rate of discount which it will charge, higher than the market rate. Naturally no banking institution will seek credit relief when com- pelled to pay a higher rate than it charges its own customers. By this action notice is given to the other banks that if they apply for discount it will be granted only on severe terms, and with this warning they generally stiffen their own rates. By this means the Bank of England exercises an effective control. These objects, of course, can only be accomplished in the United States when the larger part of the banking resources of the coun- try is brought within the scope of the federal reserve system. The primary purpose, however, of the discount rate of the re- serve banks is to protect the reserve position of the banks rather than to influence call and time rates of member banks. It was impossible to exercise this principle of control by the federal reserve banks effectively during the war on account of the necessities of government financing, and since the war the prin- ciple has been in a large degree inoperative. All banking insti- tutions were enlisted in placing the war loans in the hands of as many persons as possible, and to do this it was necessary to ex- tend credit to purchasers on pledge of the bonds. Terms for borrowing by member banks were made attractive, generally no greater than that of the bond, so that the loan carried itself. Member banks could make advances to their customers only on the assurance that the federal reserve banks would discount notes secured by their government obligations on terms which would involve no loss. "War paper" was discounted by the district banks for the member banks at preferential rates. Not only may a reserve bank rediscount the commercial paper presented by a member bank, but it may loan directly to XXIII] ORGANIZATION OF FEDERAL RESERVE SYSTEM 3 17 these banks. These loans, however, must have very short ma- turities, not exceeding 15 days, and the promissory note of the borrowing bank must be secured by commercial paper eligible for rediscount, or by government securities. 6. Open-Market Operations. — In addition to the foregoing dealings with banks, federal reserve banks may engage in cer- tain open-market operations, in the purchase of bills of exchange, trade acceptances, and bankers' acceptances of the kinds and maturities made eligible for rediscount^ with or without the in- dorsement of a member bank; that is, a federal reserve bank may take the initiative for employing its funds by purchasing in the open market certain kinds of short-term paper or credits. Until the passage of this act national banks could not accept time bills and this power was conferred upon state banks in only a few states. The Federal Reserve Act specifically grants this privi- lege and thus increases the use of the acceptance as an agency in mobilizing credit. At first the privilege was limited to credits advanced for the importation or exportation of goods, but later it was extended to credits for domestic trade. Not only may member banks deal in acceptances but the reserve banks can pur- chase them in the open market. In order to encourage the de- velopment of this credit instrument, and because of its high quality, the federal reserve banks have at times granted a more favorable rate of discount on it than that given for ordinary commercial paper. The privilege of granting acceptances may, however, be abused, for some banks regard the acceptance as a method of in- creasing their lending power beyond the limits imposed by sound banking principles. A limit therefore is set upon the volume of bills which an individual bank may accept. 7. Discount Rates of Federal Reserve Banks. — The federal reserve banks act independently, but under the approval of the 3l8 BANKING AND CREDIT [XXIIl Federal Reserve Board, in making their rates on the different classes of paper which they discount for member banks. The procedure is illustrated by the table on page 319, which shows rates, by banks and by character of paper, prevailing in March, 1921. For all bills discounted in October, 1920, the average maturity was 13 days. The New York reserve bank held bills with short- est maturities, 7 days on the average ; while the bills of the Minne- apolis and Kansas City reserve banks ran for approximately 40 days. 8. Holding of Reserves of Member Banks. — Among the enumerated powers of the federal reserve bank is the right to re- ceive deposits from a member bank. The new act makes these institutions the depositories of the reserves of all national banks and other banks joining the federal reserve system. Hitherto the reserves of national banks had been carried in their own vaults, or in part held by banks in reserve cities and central re- serve cities. This resulted, as already explained, in scattered reserves. The object of the new plan was to mass these reserves so as to make them more effective and also to divert their use into more strictly commercial purposes. Under the act (as amended June 21, 19 1 7), every member country bank keeps a reserve bal- ance with its federal reserve bank of 7 per cent on its demand deposits; a bank in a reserve city, of 10 per cent; and a bank in a central reserve city, of 13 per cent. On time deposits all classes of banks maintain a reserve of 3 per cent. Under these per- centages the amount of reserve which must be held is less than originally prevailed. The combination of reserves makes their use more economical; and, as individual banks can obtain funds by applying for rediscounts, it is not necessary to keep on hand large amounts for emergency. No longer do the member banks keep any reserves in their own vaults. The holdings of actual cash in their own vaults is de- XXIII] ORGANIZATION OF FEDERAL RESERVE SYSTEM 319 < m > W fA >-) < Q H fn Ch O W H -w^o t^'O r>»\o S CD tSv-'kS VOvo^OsO^D lOVO 10*0^ 53 +J -*-> E d m p (H w. S "S K h' SB S ^ T) n] +-* Sex: XI H r, ■a <1J a u y-* Pi c cam fe t^i^io^vo t^t^vo r^vo t^^ t^t^vOvOvO t--.r^vOvOvO r^^o \0 \0 lOVO^ »OVO lOvO^vOvO iravOOvOvO^'O^ lO'O^O'O O Tl fi liH ^ JS 1^ "O -71 > 2 -5^ ;3 ri tn O 2:} nJ w m2;£Spc;^OmSMQm s -J o 01 0< O O ■s X s s o -a :s s be d .S 3 Ph in o =a _ O 1" 6 u 8 t § ^ i § i-S^^ ,„ pi "I O 0) o 2 "S t, 6 6 ca' B 0) XI > g a o ft ' 01 "- J .20 • • CC Pi W rt D 3 Q < P 1-4 < P4 00 ■^ M C3 U 06 M t^ 0. ro 4 lO N f^; M-i 00 «o ■* \n ■* ■ w O CO -^ n (*) M "^ " ^ o £2 i^ "t & H Oi 00 ■^ 0. H W t-. ro <* r- -^ m ^ 00 H N H^ w q i3 « W <« M w N w" ci w" IN rt E-i "S " V. > -^ ■* ■* 0. t- .V. u a n « 00 t^ ^ sy fO q -q 00_ 00 00 ?: " w* „" M W l-t M M M 0 0\ 10 (N (^ rt m ^D 0\ 00 CO N T 01 q 0_ N N t^ q c?i M M •n' -t ■^ ■* ■^ -^ Q fl tn* nJ +j c 3 £ V. o n H Ol -tf \n n 00 n ^ Oi •H (O H ci e«' ro re re _^ -s ° s '3 £ 1- t* ro M r^ Oi t* M -* ^ M a o> Oi o> -* -T 10 i« >o 10 o ^«S a ■^ ■^ r; r* r* \0 00 g *^ H M M H M H w' < H M •3- fo « » QJ V ggs Is Jx oi y C o\ d £ a 0) at Oi >> "Il- now Ph Q g a " ls Is !5.s ss ss :ss SS 350 BANKING AND CREDIT [ XXV or transfer of credit between various sections of the country became in effect a single reservoir of credit. '' 7. " Free Gold." — In the table showing the reserves of the federal reserve banks the term "free gold" is used. This is the gold held in excess of what is required as reserves against net deposit and note liabiUties. This excess of free gold can be used as the basis of further reserve deposit credit or additional note circulation. During the first year of the federal reserve system the amount of free gold was very large as note circulation was small. With the increase in deposits and notes, more and more gold was needed for the reserves. At the beginning of 1919, the free gold of the 12 banks amounted to $550,000,000. At the close of the year it declined to $316,000,000. If it be assumed that for every $2 of increase in net deposits there is an increase of $3 in federal reserve notes, the last amount of free gold might have been converted into reserve gold to protect $332,540,000 of net deposits and $498,810,000 of reserve note circulation. = This represented the potential expansion at the close of 1919. If the district banks are able to accumulate a still larger part of the gold stock, a still further extension of note issues is possible without going below the normal reserve limits fixed by law. 8. Earnings and Dividends of Federal Reserve Banks. — The federal reserve banks are permitted to accumulate from their earnings a surplus equivalent to 100 per cent of the subscribed capital. After this surplus is accumulated and 6 per cent divi- dends paid on the stock, 90 per cent of the net profits must be paid to the government as a franchise tax, the remaining 10 per cent being added to the surplus. The earnings of the federal reserve banks are large. In 1919 the net earnings were $82,000,000, or 98 per cent on the paid-in ^ Sixth Annual Report of Federal Reserve Bank of New York, 1920, p. 13. 5 Federal Reserve Bulletin, February 1920, pp. 145-146. XXVI OTHER FEDERAL RESERVE BANK OPERATIONS 351 BOSTON 70 , 1 • > f / * 4 r ba 4 / m / r f r K MN AP JUL OCT NEW YOnK. PHILADELPHIA CLEVELAND JAN APR- JUL OCT CHICAGO -^^i;^ "f^?-^ 1(10 JAN APR JUL OCT KANSAS CITY 'ms. ^^-^'^i^i^ APR JUL OCT RICHMOND 40^^ --JaS « JAfi- APR JUL OCT ST. LOUIS J«<- APR- JUL OCT- DALLAS f L ^ ^D h V ^ \l\ "T V 1 V i. V AH APR JUL Oct ALL DISTRICTS TO " 50 M ta M ^ ^ « 10 AN APR UL oa eo ~ " ~ " ■ " " <^ « 1 ^ r i 1^ 30 s > W ^ ^ n jArf APR- JUL OCT ATLANTA JAN' APR JUL OCT- MINNEAPOLIS JAN- APft JUL OCT- SAN FRANCI5CO ls,P.\;^t-'^\^** Form 1 8. Charts of Reserve Percentages of Federal Reserve Banks (see page 348) 352 BANKING AND CREDIT [ XXV capital; and in 1920, $151,000,000, or nearly 161 per cent on the capital. In the latter year, 9 of the 1 2 district banks had reached a surplus of more than 100 per cent, thus establishing super- surplus accounts. These large earnings have aroused criticism from those who believe that the reserve banks, like public utili- ties, should be restricted to moderate profits. As the earnings are derived from the rediscounts made to member banks, these critics argue that the reserve banks should lower their discount rates and thus make it possible for borrowers of member banks to obtain loans at reduced rates. To do this, however, would run counter to the principles of sound centralized banking and result in inflation. The larger earnings of the reserve banks are due, not to ex- cessive rates of rediscount but to the large volume of busi- ness, calling for rediscounts, which the member banks transact. If the reserve banks discounted at more favorable rates, the member banks would be tempted to extend their loans and the volume of business would be still larger. Moreover, the reserve banks are able to make the large volume of rediscounts only through the issue of federal reserve notes. If rediscounts were increased, more notes would be issued, the currency would be increased, and the reserve banks would become involved in a continuous policy of inflation. The reserve banks retain only a small part of the earnings after the surplus is once established. Ninety per cent goes back to the federal Treasury, and the government is pledged to use this either for strengthening the gold reserve to protect the legal tender issues, or to purchase outstanding bonds. Thus the public gets back the profits which were created by borrowers. 9. The Balance Sheet of a Federal Reserve Bank. — The operations of a federal reserve bank may be more clearly under- stood by a consideration of a balance sheet. For this purpose that of the New York Federal Reserve Bank on December 30, XXV ] OTHER FEDERAL RESERVE BANK OPERATIONS 353 1920, is given. (Numbers are prefixed to the items for purpose of subsequent reference.) Balance Sheet of Federal Reserve Bank of New York, December 30, 1920 Resources Thousands 1 Gold and gold certificates : $135,046 2 Gold settlement fund. Federal Reserve Board 36,435 3 Gold with foreign agencies 1,211 4 Gold with federal reserve agents 254,575 5 Gold redemption fund 39,000 Total gold reserves $466,267 6 Legal tender notes, silver, etc 143,975 Total reserves $610,242 Bills discounted: 7 Secured by government war obligations 445,926 8 All other 458,313 9 Bills bought in open market 109,902 10 United States government bonds i ,468 1 1 United States Victory notes 50 12 United States certificates of indebtedness 59,692 Total earning assets $1,075,351 13 Bank premises 4,377 14 Uncollected items and other deductions from gross deposits 139,020 15 Five per cent redemption fund against federal reserve bank notes 2,766 16 All other resources i ,584 Total resources $1,833,340 Liabilities 17 Capital paid in $26,376 18 Surplus fund 51,308 19 Government deposits 2,260 20 Due to members — reserve account 693,474 21 Deferred availability items 94,273 22 Other deposits, including foreign government credits 11 ,284 Total gross deposits $801,291 23 Federal reserve notes in circulation 864,516 24 Federal reserve bank notes in circulation — net liability. . . 38,741 25 All other liabilities 51.108 Total liabilities $1,833,340 23 354 BANKING AND CREDIT [ XXV 10. Explanation of Items — Assets. — Gold is listed under several headings according to the special service it performs : 1. Gold and gold certificates. This is the gold set aside as a reserve against the deposits of member banks and federal reserve notes which have been issued to the bank. 2. Gold settlement fund, Federal Reserve Board. Instead of keeping all its gold in its vault, a part is kept by the Federal Reserve Board (de- posited, however, in the United States Treasury) in trust for the district bank to be used in making transfers to other federal reserve banks or to the United States Treasury. Such transfers may be large owing to the clearing house operations of the bank and its fiscal relationship to the government. This gold may be included in the reserve against deposits and federal reserve notes. 3. Gold with foreign agencies. Gold is also kept with agencies which have been established in foreign countries. By this means it is not neces- sary to make so frequent shipments in the settlement of foreign transac- tions. This also may be considered as part of the reserve. 4. Gold with federal reserve agents. This is the gold which has been deposited with federal reserve agents as collateral for federal reserve notes taken out. It wiU be noted that this is more than one-half of the total gold held, and, as already pointed out, indicates that a very considerable amount of the federal reserve notes has been issued in exchange for gold. This gold may also be considered as part of the reserve against notes. 5. Gold redemption fund. Each federal reserve bank must keep with the Treasurer of the United States a small amount of gold for the redemp- tion of its notes (Section 16, paragraph 4). This is included in the reserve against notes. The foregoing five items added together constitute the total gold re- serves to protect deposits of member banks and note liability. 6. Legal tender notes, silver, etc. In addition to gold the bank holds other forms of legal tender money. This may be counted as part of the reserve against deposits, but not against note issues. Item 6 added to the previous gold reserves makes the total reserves on hand. 7. Bills discounted, secured by government war obligations. These represent loans made to co-member banks. The item is a large amount due to the government's extensive financing. The Federal Reserve Act specifically authorizes a federal reserve bank to discount bills secured by col- lateral in the form of government securities as well as on commercial paper. XXV] OTHER FEDERAL RESERVE BANK OPERATIONS 355 8. All other bills discounted. This item refers to commercial paper of the classes admissible under the act, which the bank has discounted for member banks, and also includes biUs discounted for other federal reserve banks, and bankers' acceptances bought from other federal reserve banks with or without their indorsement. This item, together with No. 9 follow- ing, measures the extent to which the district banks are providing credit based on the ordinary transactions of business. 9. Bills bought in the open market. Bankers' acceptances are included in this item. 10. II, 12. United States government bonds. Victory notes, and certi- ficates of indebtedness. These represent the investment of the bank's funds in government securities, and, like No. 7, show the extent to which the bank is involved in government financing. The sum of the .bills dis- counted, bills bought, and government securities, makes up the earning assets of the bank from which it derives its profit. 13. Bank premises. This is self-explanatory, representing the value at which the ofiice and its equipment is carried upon the books of the bank. 14. Uncollected items and other deductions from gross deposits. This item refers to credits which are in process of collection, particularly through the clearing house operations of the bank. 15. Five per cent redemption fund against federal reserve bank notes. Just as national banks are required to keep with the Treasurer of the United States a fund of 5 per cent of the bond secured currency, so a fed- eral reserve bank which is taking out this form of currency, must maintain a redemption fund. 16. All other resources including miscellaneous, suspense, and adjust- ment accounts. 11. Liabilities. — On the liabilities side of the balance sheet the following items appear : 17. Capital paid in. This is the capital stock subscribed by the mem- ber banks of the district. 18. Surplus fund. Each federal reserve bank accumulates a surplus out of its earnings. 19. Government deposits. Thishasalready been explainedonpage 330. 20. Due to members — reserve account. This item refers to the de- posits which the member banks have made in accordance with the pro- vision that these institutions must keep their reserve against deposits with the federal reserve bank of their district. 356 BANKING AND CREDIT [ XXV 21. Deferred availability items. Each member bank must keep on deposit with its federal reserve bank a certain sum to provide for the settlement of adverse balances arising in clearing-house operations. It also includes favorable balances which member banks are credited with and which have not yet been withdrawn or transferred to the deposit reserve account. (No. 20.) 22. Other deposits, including foreign governments credits. Banks which are not member banks, as well as foreign governments and banks, may have deposits in the federal reserve bank. 23. Federal reserve notes in actual circulation. This represents the total amount of outstanding notes which has been issued by the Federal Reserve Board through the reserve agent to this particular bank. Any notes which the bank itself may hold not yet paid out are not included. 24. F'ederal reserve bank notes. These notes are explained on page 326. The sum given in the balance sheet is the amount which the New York bank has taken out less the cash which has been deposited with the Treasurer of the United States for their retirement. 25. All other liabilities. References Agger, E. E. Organized Banking, pp. 265-307. Federal Reserve Board. Annual Report. Contains not only reports of the board, but also the annual reports of the federal reserve agents of the twelve banks. The Seventh Annual Report covers operations for 1920. Federal Reserve Bulletin. Of first importance, issued monthly by the Federal Reserve Board. This appears in two editions; the first contains announcements, a review of business conditions and other general matter (price f 1.50) . The Final Edition includes detailed analyses, special articles, review of foreign banking and current statistics showing condition of federal reserve banks (price $4.00). Moulton, H. G. Financial Organization of Society. The war and the federal reserve system, pp. 624-646. Principles of Money and Banking. Part II. The practical workings of the system, pp. 282-287. Westerfield, R. B. Banking Principles and Practice. Note issues, Vol. Ill, pp. 350-373; earnings, pp. 260-262. CHAPTER XXVI ACCEPTANCES I. The Use of Bankers' Acceptances Illustrated. — A bankers' acceptance, within the meaning of the federal reserve regula- tions, is defined as a draft or bill of exchange of which the acceptor is a bank or trust company, or a firm, person, company, or cor- poration engaged in the business of granting bankers' acceptance credits. In order to illustrate the operation of bankers' ac- ceptances in domestic transactions, let us suppose that Buyer and Company of New York have purchased some goods from Seller and Company of St. Louis. Seller and Company demand immediate cash payment, but Buyer and Company, not having sufficient funds at their immediate disposal, apply to their bank in New York for assistance. Instead of following the old prac- tice of borrowing funds on a note, they arrange with their bank to authorize Seller and Company to draw a draft on the bank at, say, 60 days' sight. Having shipped the merchandise. Seller and Company proceed to draw the draft and then take it together with the shipping document to their bank in St. Louis, which receives the item for collection, and sends it to a New York cor- respondent, which in turn presents it to the drawee (Buyer and Company's bank) for acceptance. Whether or not the firm in New York is known by the firm in St. Louis makes very little dif- ference to the latter if it can produce a letter stating that the New York bank will accept its draft. This bank will accept the bill provided all necessary shipping documents conveying and secur- ing title of the merchandise to itself are attached. Upon ac- ceptance the bill becomes practically the same as a promissory note of the drawee and is given wide negotiabihty. The disposition of the draft will now depend upon instruc- 357 358 BANKING AND CREDIT [XXVT tions from the St. Louis bank. The latter will probably stipu- late either that the draft be held vuitil maturity for payment or that it be sold in the New York market, the proceeds being placed to the credit of the St. Louis bank; or it may require that the acceptance be returned to St. Louis. At the time of acceptance the drawee bank detaches and retains the shipping documents, the final disposition of which will depend upon the agreement between the bank and its customer. 2. No Cash Advanced by Accepting Bank. — It will be noticed that in the illustration the accepting bank did not advance any cash but simply loaned its credit. Of course, it will expect its client to provide the necessary funds before the expiration of 60 days to meet the draft at maturity. The turnover of the mer- chandise purchased by Buyer and Company will probably have supplied these funds and will have thus made the transac- tion self -liquidating. Although the accepting bank did not advance any cash, its credit risk was precisely as great as if a money loan based on the same collateral had been made to Buyer and Company. The bank became legally bound to pay the draft at maturity even if Buyer and Company did not provide the necessary funds before the expiration of 60 days. Whatever loss resulted from the default, if the collateral (shipping documents) had been sur- rendered or did not realize sufficient proceeds to cover the ac- ceptances, would be borne by the accepting bank. The bank will, of course, charge a commission for its risk and service. Although the rates for acceptance commissions vary, depending upon the time as well as the risk involved, the customary charges range from 1/4 to 3/8 per cent for every 90 days or from i to i 1/2 per cent per annum. 3. Shipping Documents. — Let us now return for a moment to the matter of the shipping documents retained by the drawee XXVI ] ACCEPTANCES 359 bank at the time of the acceptance of the draft. Buyer and Company will wish to obtain these documents for the purpose of getting the merchandise from the railroad company, which will demand the bill of lading before surrendering the shipment. In order to provide the greatest practicable security the most de- sirable thing for the bank to do would be to require its customer to store the goods in a public warehouse to be held there under the bank's control, properly insured, until Buyer and Company provided sufhcient funds to release them and meet the draft at the expiration of 60 days. To accomplish the transfer of the merchandise from the rail- road to the warehouse, it would have been necessary for the bank to surrender the shipping documents to its customer on a trust receipt, which would be temporarily accepted pending the de- livery of the warehouse receipt. However, the bank may, if it chooses, grant Buyer and Company more liberal terms by sur- rendering the documents to them without requiring any col- lateral security and the acceptance would comply with the Federal Reserve Act and be eligible for rediscount. 4. Diagrammatical Representation. — The diagram in Form 19 illustrates the financing of the shipment in the example con- sidered above. Each step is numbered in order and the explana- tion of the several steps is as follows : 1. Buyer and Company arrange with their New York bank (A) to open a 60 days' acceptance credit in favor of Seller and Company of St. Louis. 2. Buj'er and Company's New York bank (A) forwards to Seller and Company a domestic letter of credit authorizing drafts for not more than a specified sum, say, $65,000, when drawn at 60 days' sight and accom- panied by bill of lading and insurance certificates. 3. Having arranged shipping details and having provided for insurance. Seller and Company draw a draft on the New York bank (A) at 60 days' sight for the amount of the shipment, say, $64,898.50, and attach to it their own invoice, original bill of lading, and insurance certificates. The 36o BANKING AND CREDIT [XXVI draft with documents is then turned over by Seller and Company to their St. Louis bank (C) for collection. Instead of receiving the item for collection the St. Louis bank (C) might have purchased (discounted) it. If this were done the St. Louis bank (C) would immediately forward the item to its New York correspondent (B) Seller and Company St.LouiB Seller and Company's St.LouiB Bank BankC Buyer and Company New York (6a) Buyer and Company's New York Bank Bank A (6) New York Correspondent of St.Louis Bank BankB New York Discount House (Open Market) Form 19. Diagram Illustrating the Financing of a Shipment of Goods by Means of Bankers' Acceptances with instructions that the draft be presented for acceptance and then held until maturity for payment, or sold in the New York market, the proceeds being placed to the credit of the St. Louis bank, or returned to St. Louis. Many banks offer to market bills on behalf of their customers, the chief reason being that a bank actively engaged in acceptance business has better access to the discount market and closer familiarity with houses offering the best rate and having the widest distribution for bills than is possible for the individual merchant. 4. The St. Louis bank (C) forwards the draft with documents to its correspondent bank in New York (B). XXVI ] ACCEPTANCES 3^1 S- The New York correspondent (B) of the St. Louis bank presents the draft with documents to the drawee bank (A), that is, Buyer and Company's bank, for acceptance. 6. After having accepted the draft the drawee bank (A) retains the documents but returns the draft itself to presenting bank (B) , that is, the correspondent of the St. Louis bank. 6a. In accordance with customary arrangements the shipping docu- ments are released to Buyer and Company by their bank (A) under a trust receipt. Buyer and Company surrender the bill of lading to the rail- road company and obtain the goods. In some cases banks, upon delivery of bills of lading or other evidences of property held to secure payment of the bill, demand some sort of collateral to be held by the bank pending the removal from the warehouse or railroad and sale of merchandise described in the bill of lading. But if a customer is of undoubted credit standing and well known to the bank holding the documents, the use of a trust receipt or collateral is waived. 7. The New York bank (B), upon order from its St. Louis correspon- dent, sells the acceptance for the latter's account in the New York market. 5. Wide Use of Bankers' Acceptances. — Under the Federal Reserve Act the use of bankers' domestic acceptances is not re- stricted to transactions based on an actual sale and shipment of goods; banks are permitted to accept drafts secured by ware- house receipts or other documents conveying or securing title covering readily marketable staples. In different sections of the coimtry during the crop-moving periods there is a greater local demand for money than the immediate available supply in that region. At the same time there are, very likely, banks in other districts which have surplus funds awaiting investment. For the purpose of drawing upon these surplus funds and equalizing the interest rates between different sections of the country, the Federal Reserve Act provides a simple but effective means. Suppose a southern cotton-buyer has requested his bank in Dallas to help him finance some cotton which he has in storage awaiting shipment. Furthermore, assume that the Dallas bank has loaned all of its available money and therefore is not in a position to advance any funds to its client on the basis of his 362 BANKING AND CREDIT [ XXVI promissory note, receivables, or other paper. The bank may, however, loan the cotton-buyer its credit, that is, agree to accept drafts drawn upon it when they are secured by the proper ware- house receipts and insurance papers. Upon acceptance this instrument can be readily sold to bankers in other parts of the country who happen to have surplus funds at their disposal. Although bankers' acceptances occupy a prominent place in domestic transactions, they play a role of greater importance in financing imports and exports. Under the federal reserve regu- lations, bills drawn under a credit opened for the purpose of conducting or settling accounts resulting from a transaction or transactions involving the shipment of goods between the United States and any foreign coimtry or between the United States and any of its dependencies or insular possessions or between foreign countries, are eligible for rediscount. Any federal reserve bank may also acquire drafts or bills drawn by a bank or banker in a foreign country or dependency, or insular possession of the United States for the purpose of furnishing dollar exchange under prescribed conditions. The extensive use of bankers' acceptances in financing im- ports and exports is indicated by the large number of American branch banks and agencies which have been opened in foreign lands since the passage of the Federal Reserve Act. An idea of the importance of the dollar acceptance and "dollar exchange" is to be gained from a statement of Paul M. Warburg: There are outstanding today (June 10, 1919), drawn in almost every part of the globe, approximately $500,000,000 in American bankers' acceptances. But this is only the beginning. Some months ago I ventured the prediction that in the not too distant future we should live to see American bankers' acceptances reach the biUion dollar mark, and I have no hesitation in reaffirming the opinion. 6. Necessity of Bankers' Acceptances for a Discount Market. — Before the inauguration of the federal reserve system in 1914 XXVI ] ACCEPTANCES 363 our banking system lacked a standardized credit instrument and this made a broad discount market an impossibility. If we had no well-defined methods of grading cotton, dealings on the Cotton Exchange would be very limited if at all possible. The same holds true in the case of tobacco, grain, wool, and many other commodities. The bank acceptance is a credit instrument in which the element of risk has been reduced to a negligible factor because direct responsibility for its payment rests on bank- ing institutions whose standing is generally well known. In order to throw light upon the importance of bank acceptances in this cormection, it is helpful to consider rather briefly the prin- cipal functions and features of a discount market. The most important function of a discount market is to fur- nish a central reservoir of commercial credit by means of which individual banks may regulate their investment and cash posi- tion. A broad discount market operates as an equalizer of in- terest rates not only between different sections of the country but also between the United States and foreign countries. For instance, if banks in one district have surplus funds, their pur- chases of acceptances in the discount market will tend to raise interest rates in that district to the level in other districts. Simi- larly in the case of the United States and foreign countries, the purchase or sale of bills moves funds from countries where in- terest rates are low to those where interest rates are high. It is understood, of course, that to some extent inequalities will con- tinue to exist even within a country on account of lack of com- plete mobility of banking funds and minor differences in risk. A broad discount market also tends to stabilize gold move- ments between countries. In the past gold was frequently exported or imported when it was clearly foreseen that existing conditions were but temporary. By making it possible for banks to accumulate in their portfolios supplies of foreign bills and to sell them when the market conditions are favorable for making a profit, many uimecessary gold shipments can be prevented. 364 BANKING AND CREDIT [ XXVI The prevention of unnecessary gold movements and the de- velopment of a closer relation between interest rates here and abroad tends to produce greater stability of interest rates within the United States. This is mainly due to the fact that large reservoirs of credit are not subject to sudden movements in the same measure that smaller ones are. The component factors of a discount market are: 1. The banks that create the acceptance. 2. The banks and others who purchase and sell accept- ances. 3. The central bank of rediscount (in the United States the 1 2 federal reserve banks) . 4. Discount houses, brokers, and other middlemen. 7. Abuses of Bankers' Acceptances. — In discussing certain abuses of bankers' acceptances, Mr. Warburg has stated: With respect to bankers' acceptances, permit me to give you just a few illustrations: it is clear that the Federal Reserve Act when authorizing domestic acceptances contemplated two kinds of credits; one — acceptances secured by readily marketable staples — but not to be secured by any other kind of goods — and two, credits to finance the transportation of any kind of goods. In both cases the law prescribes that documents — warehouse receipts or biUs of lading, respectively — are to be attached when the acceptance is made. Power, however, is given to accepting banks to release documents in order to facilitate the handling of the goods. But you can readily see that abuse is possible by pre- senting documents at the time the acceptance is made and using these documents over again, after release, to secure another credit . You can easily imagine, moreover, how under the guise of financ- ing a domestic transportation lasting only a week or two, a 90-day credit might be secured, which thus might serve to carry articles other than readily marketable staples. It is evident, furthermore, how easily, by this method, these acceptances may be turned into unsecured transactions; and unsecured credits amounting in the aggregate to 20 per cent of the capital and surplus of a bank may XXVI ] ACCEPTANCES 365 thus be granted to one single party instead of 10 per cent as pro- vided as the limit for similar loans under the National Bank Act. Should the law be amended so as to prevent such abuses, or should the federal reserve banks and the accepting banks get together and adopt measures to stop bad practices of their own accord? I do not think there can be any doubt as to which would be the better course. ' 8. Trade Acceptances. — A tirade acceptance is a bill of ex- change drawn to order, having a definite maturity and payable in dollars in the United States, and bearing on its face or accom- panied by satisfactory evidence that it is drawn by the seller of the goods on the purchaser of such goods. Such evidence com- monly consists of a statement on or accompanying the acceptance to the following effect: "The obligation of the acceptor of this bill arises out of the purchase of goods from the drawer." For the purpose of illustrating the use of the trade acceptance let us assume that a New York firm called Buyer has purchased some goods from a St. Louis firm called Seller. In rendering an invoice for any single purchase that is reasonably la,rge in amount. Seller will send at the same time a trade acceptance form properly filled out. In cases where Buyer purchases several bills of small amount, Seller when rendering a monthly statement will accom- pany the same with a trade acceptance for the total amount. Upon receipt of the trade acceptance Buyer has the choice of either accepting it or paying the bill in cash. Should he choose the second plan he will deduct such cash dis- count as is allowed under the terms of transaction which have been previously agreed on. On the other hand, if Buyer follows the first method he will stamp across the face of the trade ac- ceptance the date and the words "Accepted, payable at — Bank," and then sign it and return it to Seller. Seller may then dispose of the acceptance in a number of ways. He may hold it ^ Acceptances in Our Domestic and International Commerce, pamphlet published by- American Acceptance Council, p. 23. 366 BANKING AND CREDIT [ XXVI in his portfolio until a few days before it becomes due, when he will turn it over to his bank for collection. If he does not retain the acceptance until then, he will probably use it for raising funds in the meantime by selling it with a number of other trade ac- ceptances to his banker or in the open market through brokers or dealers in commercial paper. Finally, as a third possible method, Seller may borrow from his bank on his single-name promissory note and use the acceptance as collateral. In reference to the place of payment of a trade acceptance the law specifies that it shall be the office of the acceptor (the buyer of the goods) unless a different place be designated on its face, such as the acceptor's bank, and this is the customary method. 9. Advantages of Trade Acceptances. — Trade acceptances offer many advantages to the banker and to the buyer and seller of the merchandise. The more important of these advantages may be summarized as follows : 1. Trade acceptances are usually self -liquidating because the acceptor receives certain merchandise out of which the trade acceptance has arisen and from the sale of these goods he expects to obtain the necessary funds to meet the obligation at maturity. 2. When a banker discounts a trade acceptance he receives two-name paper, which is generally safer than a single-name note. 3. When a banker discounts a trade acceptance he knows from looking at the face of the instrument what the credit was extended for, but in the case of a single-name note the borrower makes it out for a round sum and may either fail to state the pur- pose for which the proceeds are to be used or he may explain his object in only a general way. 4. The law providing against a loan to any one person of more than 10 per cent of the capital and surplus of a bank does not apply to trade acceptances. 5. Trade acceptances as paper for rediscounting are looked upon with particular favor by federal reserve banks, XXVI ] ACCEPTANCES 367 6. Secret assignments of book accounts for the purpose of raising cash present many objections. The use of trade accept- ances overcomes in a legitimate naimer all such disadvantages and leaves very little excuse for such practice. 7. Bankers to whom trade acceptances are presented for col- lection or for discount have an opportunity of gaining informa- tion in regard to the credit standing and character of those who have given acceptances. 8. When trade acceptances are generally used and open book accounts are less common, bankers will be in a position to keep in close touch with local credit conditions because practically all trade acceptances are forwarded for collection through banks. 9 . Whereas in the past bankers usually expected that a borrow- er's quick liabilities would not exceed 50 per cent of his quick assets, it is now felt that the introduction of the trade acceptance will make it advisable for the 50 per cent rule to be modified. 10. Discount companies, brokers and other concerns in the open market provide a ready means for disposing of such paper. 1 1 . The principal mission of the trade acceptance, however, is to liquify credit, improve merchandise turnover, and minimize credit losses. 10. Objections to Use of Trade Acceptances. — ^Although the foregoing arguments might seem to leave very little to be said on the other side of the case, nevertheless many practical objections have been raised which those who favor the use of trade accept- ances have been unable to answer satisfactorily. A number of organizations, including the Philadelphia Board of Trade and the Commercial Law League of America, have adopted resolu- tions opposing the use of trade acceptances. The opposing arguments may be summarized as follows:^ ^ See Trade Acceptances, Supporting and Opposing Arguments, pamphlet published by Chamber of Commerce of U. S. (1918, Washington). 368 BANKING AND CREDIT [ XXVI 1. Under existing commercial practice most trades in the United States have become habituated to the cash discount sys- tem whereby the seller allows the buyer to deduct a certain per- centage from the face of the invoice for payment within a given number of days. Buyers may be divided into three classes : First grade: Those who habitually discount. Second grade : Those who pay bills when due. Third grade : Those who are delinquent. Naturally, the first grade of buyers will pay cash and there- fore trade acceptances will be used for the most part when dis- counts are available only by an inferior credit risk or a poor business man. 2. Unless the seller has a monopoly or is in a position to prac- tically enforce his terms of sale, buyers who pay their bills promptly as they mature will ordinarily refuse to sign a trade acceptance, and, furthermore, will be antagonized by a request to do so. 3. "The cash discount system takes the burden of insuring credits from the seller and distributes it among thousands of banks where buyers borrow. It diminishes risks, because the local banker can estimate better than one at a distance the personal equation of the borrower and other elements that enter into the calculation." 4. Whenever a merchant takes a trade acceptance from his customer and discounts it at his bank, he must indorse it. To the extent of his liability as indorser the merchant is still carry- ing the account as before. It he adopts this plan generally, it means that he is an indorser for all of his customers and therefore contingently liable to the full extent of their purchases. 5. The open account system is more simple than a system which requires the handling of a piece of paper, and the indorse- ment of it, by the purchaser and seller of the goods and the lending bank. XXVI ] ACCEPTANCES 369 6. Under the "cash discount — open account — single-name paper" system, payments are made by the purchaser sending his remittance directly to the seller in the form of a check which may be cleared in most cases without a collection charge. Trade acceptances, however, are more difficult to collect than checks and banks usually make a charge for the service. In view of the objections that have been raised trade acceptances are not likely to gain rapid favor in many trades. The system of open accounts, with cash discount and single-name paper, has become so strongly established in our domestic commerce that the bur- den of proof will probably continue to weigh heavily on those who would replace this system with another. References Chamber of Commerce of the United States. Trade Acceptances, Sup- porting and Opposing Arguments. Commercial Paper and Bills of Exchange of the World. Bank acceptances, pp. 37-46. Holdsworth, J. T. Money and Banking. Briefly summarizes advantages of trade acceptances, pp. 110-114. Kniffin, W. H. The Business Man and His Bank. pp. 193-212. Mathewson, P. Acceptances, Trade and Bankers'. Gives a detailed description of procedure and argument for use of trade acceptances with illustrations of forms. Westerfield, R. B. Banking Principles and Practice. Vol. IV, pp. 999- 1020. Among the banks and trust companies who have published useful pam- phlets on acceptances are the Irving National Bank, N. Y.; National City Bank of New York; National Bank of Commerce in New York; American Exchange National Bank, N. Y.; Guaranty Trust Com- pany of New York, N. Y.; Mechanics and Metals National Bank, N. Y. Useful pamphlets have also been prepared by the American Acceptance Council, 111 Broadway, N. Y. This organization also publishes a monthly periodical^ Acceptance Bulletin. CHAPTER XXVII PRINCIPLES OF FOREIGN EXCHANGE I. Equilibrium of Exchange. — Changes of a fundamental character affecting our trade and financial relations with other countries were brought about by the war. Previous to 1914 the United States occupied the position of a borrowing nation on account of large foreign investments. The vast untouched re- sources of our country afforded opportunity for cheap production of foodstuffs and raw materials of which the European countries particularly were in need. In the earlier years of our develop- ment most of the immigration from Europe was from those countries which were highly advanced in industrial methods and which had large accumulations of capital. Under such circum- stances it was a natural outcome that capital should flow from Europe to the United States for investment, and that the income from this capital, unless reinvested here, should become a charge against us in the foreign exchanges. For some ten years preceding the war the average annual trade balance in favor of the United States on merchandise ac- count was approximately $500,000,000 and it was practically off- set by what is usually known as the "invisible account." That is to say, the United States and other nations, like individuals, are constantly buying from each other services as well as physical goods. To be more exact, the figures upon which the so-called favorable trade balance is based are taken from the ofi&cial re- ports of the Department of Commerce, which show the amount of commodities entered or cleared at our various ports. But these figures do not contain any of the invisible items of trade, such as interest and dividend payments upon American securities held abroad, commissions of foreign bankers, premiums on policies of 370 XXVII] PRINCIPLES OF FOREIGN EXCHANGE 371 foreign insurance companies, charges of foreign shipping against our merchants, expenses of American tourists abroad, remittances of immigrants to relatives in the old countries, etc. As a result of the war we have bought back most of the American securities which were held abroad, and the interest and dividends upon them hereafter will not be a large item for settlement in international exchanges. In the future the develop- ment of a large fleet of merchant ships will probably make it possible for us to carry a greater portion of the overseas trade. Moreover, private and governmental loans to Europe have suddenly changed our position from a debtor to a creditor nation. The question may be asked as to what effect the shifting of the balance of payments in the invisible account will have upon our foreign trade. It is obvious that a country's receipts and payments in international commerce must balance in the aggre- gate. Nothing changes hands except for some equivalent. A country which has borrowed capital abroad must not only pay for all the merchandise that it imports but must also meet its interest charges. Normally, therefore, a debtor nation exports more merchandise than it imports, and a lending nation imports more than it exports. The terms "unfavorable" and "favorable" trade balances are misleading. It is customary to say that the exchanges are in our favor when the dollar is at a premium as measured in other currencies, which is the same thing, of course, as the other cur- rencies being at a discount. The exchanges are in our favor in the sense that at the time under consideration we are exporting more than we are importing and that the dollar has arisen in value in the money markets of the world. They are in our favor for importing purposes, but they are not in our favor for export- ing purposes. When dollar drafts are at a premium American goods cost more to foreign buyers and consequently a premium on dollar exchange operates in the same way as a tariff barrier abroad. 372 BANKING AND CREDIT [ XXVII 2. Settlement of Foreign Balances. — As between individuals there are only three ways in which a financial settlement can be effected. They are: cash, trade, and credit. As between na- tions the situation is much the same. Just as cash plays a minor part as compared with checks and drafts in domestic business, gold, which is the cash of international transactions, is used for settling a relatively small amount of the world's foreign trade. Even if there had not been developed the machinery of bills of exchange and telegraphic transfers for settling international transactions, the use of gold would be limited for physical reasons. The total amount of gold in the world is relatively small when compared with the yearly volume of foreign trade of all nations. To be more exact, according to the report of the Director of the Mint for 1919, a conservative estimate of the world's gold mone- tary stock is $9 billion. The total imports and total exports of the principal countries of the world are probably about six times as great as the gold monetary stock, or considerably more than $50 billion. ' Essentially, foreign trade involves the exchange of goods and not money. Naturally, a nation cannot expect to increase its exports without reckoning with a corresponding growth in im- ports. To be sure, the extension of credit by the selling nations to the buying nations may postpone the operation of this prin- ciple of reciprocity, but ultimately the debt will be liquidated through goods and not gold. A brief consideration at this point of the major steps in the foreign banking operations required to finance purchases and sales of merchandise abroad will be helpful. If the London branch of the Associated Trust Company of Boston collects £50,000 which B in Leeds owes A in Boston for shoes, and the bank's main office here collects £50,000 which C in Boston owes D in Manchester for woolens, it is evident that the shipments of merchandise have effected an exchange without ' See latest Statistical Abstract of the United States. XXVII ] PRINCIPLES OF FOREIGN EXCHANGE 373 the transfer of any cash or the creation of any final debt. The Boston bank debits its London office for the value of the shoes and credits it for the value of the woolens. Similarly, the Lon- don bank debits its Boston office for the value of the woolens for which payment has been made to D, and credits it for the value of the shoes. The merchants in both countries have settled their transactions in full; the two branches of the banking house are square; and £100,000 in business has been consummated without requiring the use of a single coin. If the shoes had amounted to £60,000 instead of £50,000, the difference might have been made up by the Boston bank arranging to make payment for a local importer who had bought £10,000 of cutlery from a Sheffield dealer. Naturally, in actual practice it is not to be expected that pay- ments for merchandise imports will exactly match payments for exports. During and following the war the exports of the United States exceeded the imports, causing a heavy foreign credit bal- ance in our favor to be established. From time to time this balance was reduced by shipments of gold to this country and by our extension of large credits to foreign countries. It is not to be assumed, however, that this situation alters the truth of the undisputed economic principle of reciprocity. According to this principle the total value of the merchandise and services sold by any country to all other countries must in the long run equal the total value of the merchandise and services bought by that country from all others; and the price-determining forces in the world's markets automatically check the continued flow of money into or from any country. 3. What Foreign Exchange Is. — "Foreign exchange," as the term is commonly employed, covers in its broadest sense all the variety of monetary and credit instruments used in the settle- ment of international transactions. It includes bills of exchange, cable transfers, gold, silver, currency, international money-orders, 374 BANKING AND CREDIT [ XXVII international reply coupons, travelers' checks, stocks, bonds, bond coupons, and interest and dividend checks. Just as the check is the most common instrument for making domestic payments, the foreign bill of exchange is the principal medium for settling debts between the business men of one country and those of another. Foreign bills of exchange are similar to domestic drafts and are simply written orders drawn by one person upon a second and made payable to a third party, or possibly to the drawer himself. Below is an example of bill drawn by a merchant in the United States upon a London bank: £800 New York, N. Y., December 20, 1921. Sixty days after sight of this First of Exchange (Second of the same tenor and date unpaid) pay to the order of ourselves eight hundred pounds. For value received and charge to account of To London and Liverpool Bank, Ltd. Merchants Export Company London, E. C, England. Sherman Noyes No. 165 Treasurer 4. Classification of Foreign Bills of Exchange. — Foreign bills of exchange may be classified in a number of ways : 1. As to maturity: (a) Demand or sight bills or bankers' checks — payable im- mediately on presentation. (b) Short bills — payable within a month from time of accept- ance. (c) Long bills — payable after a month from time of acceptance. 2. As to whether drawn payable after sight or after date: (a) Drawn payable so many days after sight, that is, after acceptance. (b) Drawn payable so many days after date (not common in foreign exchange) . 3. As to domicile: (a) Sterling drafts, also called "sterling exchange" — payable in pounds in England. (b) Franc drafts — payable in francs in France. XXVII ] PRINCIPLES OF FOREIGN EXCHANGE 375 (c) Dollar drafts, also called "doUar exchange," or "dollar acceptances"— payable in dollars in United States. (d) Bills on other countries. 4. As to whether bearing collateral security or not : (a) Documentary bills — having attached bills of lading and other shipping papers. (b) Clean bills — with no documents attached. 5. As to parties to instrument: (a) Bankers' bills, bankers' drafts or bankers' checks— drawn by one bank against another. (b) Commercial bills — drawn by a merchant against another merchant or the latter's bank. 6. As to nature of transaction: (a) Grain bills. (b) Cotton bills. (c) Finance bills — drawn for purpose of borrowing funds in foreign money markets. 5. Foreign Exchange Markets. — International trade, like domestic trade, has created certain important money markets where the great bulk of exchange transactions are handled. By maintaining balances at these points banks in other parts of the world can sell drafts, or the right to draw them, to persons who wish to make payments abroad. In order to build up these balances with foreign correspond- ents, local banks must buy for remittance bills of exchange or other foreign items from customers or from other banks. Briefly, therefore, the foreign exchange transactions of a bank are for the most part connected with the hundred and one operations neces- sitated in the buying of commercial bills from one set of customers for foreign remittance, and the selling to another set of customers drafts drawn against the proceeds obtained abroad. Of impor- tance also are dealings of a bank to cover its position in the market so that speculative losses may be avoided. Before the war London, by occupying much the same posi- tion with respect to the commerce of the world as New York 376 BANKING AND CREDIT [XXVII holds in the trade of the United States, was the leading inter- national money market, and sterling exchange was looked upon as the international money par excellence. During recent years the wide fluctuations in sterling drafts have increased the element of risk involved in settlements through London and have caused dollar acceptances to enjoy greater favor than previously, particularly with American business houses. 6. Dollar Exchange. — Until after the passage of the Federal Reserve Act in 19 13 national banks were not permitted to accept time drafts drawn against them. It became the customary practice for exporters in other countries who were sending goods to the United States to draw their drafts against credits opened by American importers in London, Paris, or some -other foreign center. Occasionally, however, drafts were drawn on the Ameri- can importer himself, but unless the latter had an international reputation his acceptances did not find a ready discount market abroad and consequently were not a desirable form of settlement to the foreigner. At present member banks in the federal re- serve system are authorized to accept drafts drawn against them which have not more than 6 months' sight to run, resulting from transactions involving the importation or exportation of goods. The law also permits member banks to accept dollar drafts that are not connected with the specific shipment of merchandise, but which are drawn by banks or bankers^ for the purpose of trans- ferring funds for any legitimate object as required by the usages of trade in the countries of their origin. This provision enables American banks to make convenient arrangements to maintain balances abroad and foreign banks to do the same thing in the United States. Another factor contributing to the development of the use of dollar exchange is the authority granted to American banks to ' Individual merchants may not draw dollar exchange of this second class; the drawer must be a bank or banker. XXVII] PRINCIPLES OF FOREIGN EXCHANGE 377 establish foreign branches . Particularly, many of the large banks located at the seaboard have taken advantage of this provision and have opened branches in the principal foreign banking centers. 7. Par of Exchange. — To explain the movements of exchange rates in a simple manner was never an easy matter and the erratic fluctuations brought on by the war have not been conducive to greater simplicity of the task. A convenient rule-of-thumb to remember is that whenever the United States becomes indebted to another coimtry, whether it be for merchandise purchased or on account of freight, insurance, or other charges against us, a de- mand is created for foreign exchange in this country in order to transfer funds abroad, thus tending to cause the rates to advance. Similarly whenever a foreign country becomes indebted to us for any reason, funds must be transferred in our direction, thus in- creasing the supply of foreign exchange available for sale in the United States and therefore tending to cause the exchange rate to decline. The rates of exchange are in the first instance determined by the intrinsic relation of the monetary unit of one country with that of another country. For example, the gold sovereign con- tains 113.002 grains of pure gold, and is therefore 4.8665 times the amount of pure gold contained in the gold dollar, which is not coined but amoimts to i/io of the pure bullion contents of the $10 gold piece (232.2 grains). This relation .between the monetary units of two countries, which is found in the case of countries on a gold basis by comparing the pure bulUon contents of the imits in question, is called the "par of exchange." Just as $4.8665 is found to be the par of exchange between the United States and England, the par of exchange between the United States and France is $.1930, between the United States and Germany $.2382, etc. Between countries on a gold basis, par of exchange is invariable as long as the pure bullion contents 378 BANKING AND CREDIT I XXVII of the coins being compared remain unchanged, or, in other words, until one of the countries in question adopts a new coinage law. In the case where one country is on a silver basis and the other is on a gold basis, a momentary par of exchange is found by com- paring the market value of the pure bullion contents of the re- spective coins. Naturally, the par of exchange between the United States and China will be different when silver is quoted at 90 cents per ounce than when it is quoted at 75 cents an ounce. 8. Movements Above and Below Par. — If it cost nothing either in the way of transportation or interest charges to ship gold between two countries on a gold basis and there were a per- fectly free gold market at both ends (that is, if there were no restrictions on gold exports and the paper money in each country was convertible into gold), the rate of exchange would always be at par. Let us consider the exchange between the United States and England before the war. At that time England was not on an inconvertible paper basis as at present (1922) and it was pos- sible for a person holding a pound sterling note or demand draft to convert it immediately at face value into gold sovereigns. Furthermore, there were no governmental restrictions on export shipments of gold from that country. Under these conditions the holder of a sterling demand draft in the United States would not sell it for any sum less than the equivalent in United States money of the sum due in England after deducting the cost of sending the gold to this country, because with the British gold the American could obtain at the mint or in the market our money at the ratio of $4.8665 for i sovereign. Similarly, an importer in the United States who wished to remit funds to Great Britain would have the choice of shipping actual gold in case the exchange rate went far enough above par (before the war about 2 1/2 cents per sovereign) to make it profitable. The rates above and below par at which gold shipments take place XXVII ] PRINCIPLES OP FOREIGN EXCHANGE 379 are called the "upper" and "lower" gold points; they are not absolute but vary from time to time as shipping costs decrease or increase. 9. Effect of Depreciated Paper Money. — The stabilizing in- fluence on the exchange rates that was produced before the war by unrestricted gold shippients disappeared shortly after the outbreak of hostilities, when the principal European countries took measures to protect their gold reserves. Gold disappeared from circulation and these countries, by suspending the redemp- tion of paper money in gold coin, automatically changed from a gold to an inconvertible paper basis. In determining the rates of exchange between the United States and England or France or Italy, the original par of exchange in each case began to exert a smaller and smaller influence as these countries increased their issues of paper money and thus departed farther and farther from their gold bases. Paper money is a promise to pay on demand basic or stand- ard money. Basic or standard money in the United States and Europe is a piece of gold bearing the stamp of the issuing govern- ment. The stamp is primarily a certification of weight and fineness and has no other commercial significance; in international money transactions, gold exchanges according to its weight and fineness. So long as a nation keeps its promise to pay, on demand, gold for paper money the latter remains at parity with gold. When the promise is suspended, however, gold is driven out of circulation, prices in general are quoted in the paper money, and gold money commands a premium. If it is expected that gold payments will not be resumed in a short time, the premium will be large. Obviously the quantity of paper money outstanding will be an important factor influencing this situation. At any given time the value of such paper money is affected by every rumor which has to do with the credit of the issuing government. Thus during the Civil War the price of gold in terms of green- 380 BANKING AND CREDIT [XXVII backs rose and fell according to whether final victory seemed to favor the Union or Confederate armies. But, what is still more pertinent to the present problem, the price of gold and the price of sterling exchange moved very closely together in New York from 1862 to 1879, when greenbacks finally came to par with gold. Without the stabilizing influence of unrestricted gold ship- ments, exchange rates become speculative and may conceivably fluctuate within almost any limits. The rate or price at any time is determined, like the price of commodities, by the forces of supply and demand. But the character of the supply and demand depends not only upon the industrial and financial con- ditions of the countries under consideration, but it is also af- fected by all kinds of rumors, such as concerning plans for grant- ing large credits by the United States, internal difficulties, etc. All those things which tend to contribute toward the greater economic production of European countries will make possible larger exports by them, and thus, through increasing their credits in the foreign exchanges, will tend to bolster their exchange rates. Practically speaking, it is difficult to conceive how foreign ex- change rates on Europe can be brought back to par until it is evident that these countries will shortly resume specie payments and make their paper money redeemable in gold at 100 per cent face value. Otherwise, even if the unfavorable trade balances against European countries were corrected, their exchanges would still be depreciated to the extent that their currency is depre- ciated internally. Naturally, this necessitates greatly improved economic conditions — the restoration of the normal methods of international trade by which goods are used to pay for goods, and the resumption finally of specie payments. 10. "Pegging" Exchange.— It is not to be assumed that foreign exchange rates are determined solely by commercial and banking factors . This would be the practical situation if we were XXVII] PRINCIPLES OF FOREIGN EXCHANGE 381 living in a laissez-faire regime; but particularly since the war movements of gold, interest rates and exchange rates have been subject to influences outside the free operation of the law of sup- ply and , demand. Governments exerting their influences through central banks and other charmels adjust discotint rates, borrow funds, and buy and sell gold, silver, and securities in such manner as to affect very decidedly the foreign exchanges. During the latter part of the war the English, French, and Italian exchanges were "pegged," or fixed by agreement at a point somewhat below par, called the "war par." For instance, the rate of sterling exchange in the New York market was fixed by the British government at $4.76 7/16 from January, 1916, until March, 1919, by authorizing J. P. Morgan and Company to buy bills that might be offered in New York at that rate. When the plan was suspended a sharp decline in sterling followed. It was explained by some persons that by permitting British bills to decline to a point where remittances were made extremely costly to the English business man, purchases in the United States for import into Great Britain would be curtailed. This was bound to be a result; but whether it was the primary reason for the action taken, or whether some other motive was responsi- ble, the official "pegging" policy would under any circumstances have had to be abandoned sooner or later on account of the in- ability of the British government to continue indefinitely to furnish J. P. Morgan and Company with funds to meet its commitments. II. Spread in Rates. — Fundamentally, the spread in rates between drafts payable at different dates is a function of time and interest. As might be expected, demand drafts, which are payable immediately upon presentation to the debtor or drawee, will command a higher price than time bills, which need not be paid until a stated period of time has elapsed. But since the quickest way of remitting funds abroad is by cable, telegraphic 382 BANKING AND CREDIT [XXVII transfer rates will be higher in price than quotations for demand drafts. Raising and lowering of the discount and interest rates abroad have an important influence on the rates of foreign exchange in American financial centers. To illustrate the point, let us as- sume that an American exporter has requested his New York banker to purchase a 6o-day sterling bill on a London bank. The rate that the New York banker can offer for the bill will de- pend on the proceeds he expects to be able to realize from mailing the item to a London correspondent for discount and credit, and selling against this credit demand drafts in this country. Neces- sarily with a high London discount rate the proceeds of the 60- day bill, and consequently the sterling rate for it in New York, will be less than if the London discount charges were low. In the case of demand drafts the effect, if any, of a change in the London or other foreign discount rates is more limited but quite the opposite to that produced upon time bills. This is because higher interest rates abroad, if continued for any con- siderable period without a corresponding change in this country, will tend to cause American banks to loan more funds in foreign money markets and to withdraw less through the sale of demand drafts here. Not only will the supply of demand drafts thus be curtailed but there might be expected also in some cases an in- creased buying of demand drafts in this country for the purpose of remitting funds abroad to be loaned there. 12. Rate Adjustment. — If for any reason the rates should get "out-of-line," there are always persons ready to seize the oppor- tunity for profit, thus causing the situation to be adjusted. For instance, if the rate in New York for demand drafts on London at a certain time was relatively cheap as compared with the rate for cable transfers, a banker in this country could buy demand drafts for remittance to London and sell future cables against the prospective credit. Another operation of this XXVII 1 PRINCIPLES OP FOREIGN EXCHANGE 383 same general nature is the selling of demand drafts against long bills. To be more concrete, let us assume that a New York banker has purchased a 60-day sight bill for £10,000 drawn by an Ameri- can exporter against a bank credit opened in London by an Eng- lish importer. The New York banker will forward the draft immediately to London and may either instruct his correspond- ent to sell it in the discount market and place the proceeds to his credit or to hold it until maturity. If the instructions are that the draft is to be held for maturity, the New York banker can obviate the risk of exchange by either selling futures (demand or cables) or his own long bills of about the same maturity. If, on the other hand, he chooses the plan of having the bill discounted, he will be able to sell demand drafts at once against the proceeds. In order to show how this might result in the case mentioned, let us assume that the pertinent facts are as follows : London "arrival "3 discount rate for 60-day bills 6% English stamp charges 1/20% Rate for sterling demand drafts in New York $340 Calculation: 1. Amount of 60-day bill on London £10,000 2. Deduct discount (63 days' interest) at 6% 103. 1 1.3 3. Deduct English stamp charges 1/20% 5. 0.0 4. Proceeds in London £ 9,891. 8.9 5. ProceedsinNew York from sale of demand draft at $3.40 $33,630.89 It is evident from this calculation that, if the proceeds from discounting the 60-day bill of £10,000 and selling it by way of a demand draft amount to $33,630.89, the 60-day rate should be approximately $3,363 (33,630.89 -r- 10,000). Lack of consistency in the rates of these two classes of bills would, of course, cause bankers to buy the relatively cheaper and sell the relatively dearer until the situation was adjusted. 3 London "arrival" or "forward" discount rate means the rate at which a London correspondent bank will undertake to discount a bill or parcel of bills "to arrive," to use the bankers' phrase. The rate is quoted by telegraph in advance of the shipment of bills. 384 BANKING AND CREDIT [ XXVII References Agger, E. E. Organized Banking. International clearings and exchange, pp. 124-138. Brown, H. G. International Trade and Exchange, pp. 76-102. Dunbar, C. F. Theory and History of Banking, pp. io3-r3r. Eschar, F. Foreign Exchange Explained. Technical explanations as well as theoretical analyses. Holdsworth, J. T. Money and Banking. Contains forms, pp. 256-258. Moulton, H. G. Financial Organization of Society. Part II, pp. 107- 120. Phillips, C. A. Readings in Money and Banking. Domestic exchange, pp. 290-304; foreign exchange, pp. 305-354. Westerfield, R. B. Banking Principles and Practice. Comprehensive explanation of the elements of foreign exchange, Vol. V, pp. 1096-1173. Whitaker, A. C. Foreign Exchange. London money market, pp. 190-257; purchase of bills, how rates are determined, pp. 258-273; comprehensive discussion of arbitrage, PP- 397-428; specie shipments, pp. 517-575. Willis, H. P., and Edwards, G. W. Banking and Business, pp. 252-269. York, T. Foreign Exchange. Contains technical explanations as well as theoretical analyses. CHAPTER XXVIII THE PROCESS OF FOREIGN EXCHANGE 1. Foreign Transactions of a Bank. — The foreign transactions of a bank have to do principally with : 1 . The financing of merchandise imports and exports. 2. The financing of international sales and purchases of securities. 3. Interest and dividend remittances. 4. The borrowing and loaning of funds abroad. 5. The payment for international services rendered, such as freight and insurance or foreign travel. 6. The remittances by immigrants of funds to "the old country." 7. Dealings of a hedging or speculative character, as future sales, options, and puts and calls. A merchant has at his disposal a number of methods of financ- ing foreign shipments, and for convenience the principal ones may be enumerated as : 1 . Open credits. 2. Cash with order. 3. Cash against documents. 4. Drafts drawn under commercial letters of credit. 5. Drafts drawn directly on the importer. 2. Open Credits. — By the term "open credits" is meant the usual book accounts, under which plan the seller, trusting in the honesty and financial ability of his customer, allows him to ob- tain merchandise without a documentary acknowledgment of the obligation, such as a note or an accepted draft. 25 385 386 BANKING AND CREDIT [ XXVIII As far as credits and financing are concerned, the trade be- tween adjoining nations in Europe is handled in almost the same way as trade between the various states in this country. This fact has led to not a little difficulty for many American exporters selling their goods to European buyers who have not been accus- tomed to importing merchandise from overseas and who vigor- ously ob j ect to any other terms than "open credits . ' ' Merchants of the West Indies, Cuba, Mexico, and, in short, of all the Caribbean countries, have frequently requested "open credits" in dealing with foreign exporters. Partly as a consequence of the keen competition in these fields, and partly because so much of the trade consists of a direct exchange of imports and exports, a large amount of the business of American export commission houses with these countries is carried on through open credits. The use of open credits in international trade, particularly when it is overseas, has some advantages but many more disad- vantages. The advantages consist principally of eliminating the objections frequently made by foreign merchants to the purchase of goods that are subject to payment or acceptance of the draft attached to the shipping documents. These objections are usually based on three grounds: (i) unfamiliarity with this form of business; (2) that such terms are a reflection on the stand- ing and character of the purchaser; and (3) that the acceptor of a draft becomes legally bound to pay at a certain time, whether it is convenient or not. Much has been done and is being done to remove these difiiculties and to educate merchants in foreign trade to the fact that drafts and acceptances are the universal practice in all but a very small fraction of overseas commerce. The most convincing argument, of course, is the lower prices which the exporter can offer in case his firm through the sale of a draft may obtain immediate cash. Further, there may be pointed out the possibility of having the time of payment of drafts extended in case it is not convenient for them to be met when due. XXVIII] THE PROCESS OP FOREIGN EXCHANGE 387 While there are, no doubt, just as large, sound, or honest business firms abroad as at home, and although an occasional exporter will be found who will declare that his experience in extending open credits to foreign customers has proved satisfac- tory, the weight of evidence is against this method of conducting business. 3. Cash with Order. — A foreign importer is naturally reluc- tant to pay for his goods in advance. He may not know as much about the seller as the latter knows about him and he must be convinced that the seller is reliable before he will forward his money. The use of this method of financing shipments is de- cidedly limited, particularly in the case of an exporter who has just entered the field. The foreign merchant is mindful of in- stances of manufacturers abroad receiving, filing away, and for- getting his orders to which were attached bank drafts or money-orders. Other insolvent concerns have used funds remitted to them in advance and have failed before ship- ment was effected, with the result that the unfortunate for- eigners' money passed with the other assets into the hands of receivers. 4. Cash against Documents. — The term "cash against docu- ments" signifies that the importer will be required to make pay- ment before the shipping documents, and therefore the control of the merchandise, is surrendered to him. Although the pay- ment may be made at the point of origin, the port of export or import, or the place of destination, ordinarily the place of taking up the documents is within the exporter's country". The im- porter may provide for pajmient in a number of ways : He may remit a draft payable in the exporter's country to an agent who will thus be furnished with funds to take up the documents for him. He may induce a commission house, located near the ex- porter, to take up the documents for him, in which case there are 388 BANKING AND CREDIT [XXVIII several possible arrangements between himself and the commis- sion house. In the great majority of cases, however, an arrange- ment much more satisfactory than cash with order, and one which adequately protects both parties, is for the buyer to open a bank credit with a responsible bank in some convenient foreign exchange center. The bank which issues the credit may be located in the exporter's country, the importer's country, or in a third country. The institution which pays for the documents will reimburse itself in some appropriate and convenient manner at the expense of the importer's bank, and the latter will in turn collect payment from the importer himself. The bankers will of course receive commissions for their services. 5. Drafts Drawn: under Commercial Letters of Credit. — ^A commercial letter of credit is an authorization issued by a bank in favor of the seller and specifying the terms under which he may draw drafts on it for what he has sold. The letter of credit is addressed to the seller and it customarily begins with some such opening statement as, "You are hereby authorized to draw upon the ABC Bank under the following conditions." A bank credit serves chiefly to give assurance to the exporter that he will be able to sell his draft for cash at the time of shipment. Where the drawee bank and the bank which grants the credit are differ- ent institutions, there frequently arises what is called the "con- firmed credit." Without confirmation the exporter is in the beginning protected only by the engagement of the bank which has issued the letter of credit. In the case of a confirmed credit the drawee bank ratifies the original credit and agrees to accept the drafts of the exporter; the latter is thus given a right of action in contracts against this bank in case it should subsequently refuse to accept the instrument. After acceptance, however, a draft under an unconfirmed credit is just as good as one under a confirmed credit, because upon acceptance the drawee bank becomes fully and unconditionally bound to pay. XXVIII ] THE PROCESS OF FOREIGN EXCHANGE 389 A broad basis of classification of letters of credit rests on the right of the issuing bank to rescind its engagement to honor drafts diawn by the beneficiary. If the credit-issuing bank reserves the right to withdraw from the undertaking the document is styled a "revocable" letter of ciedit. The "irrevocable" letter of credit contains a definite engagement on the part of the issuing bank to honor drafts drawn by the beneficiary in accordance with the terms and conditions specified in the letter. This engagement may not be cancelled by the issuing bank prior to the expiration date without the consent of the beneficiary. The "irrevocable" letter of credit may be strengthened further by having the notify- ing bank in the same country as the exporter add its unqualified assurance that it will pay or accept the bills drawn by him even if the foreign bank should refuse to honor them. It is then called a "confirmed" export letter of credit. Expressing, therefore, both the definite undertaking of the issuer and also of the notifier, it is actually an "irrevocable-confirmed" letter of credit. Where the notifying bank does not add its guaranty, the credit is described as "unconfirmed," since the advising bank maintains that it is merely transmitting the information of the credit to the beneficiary without incurring liability for its continuance. Thus three classes of letters of credit may exist: (i) irrevocable by the issuer and confirmed by the adviser; (2) irrevocable by the issuer but unconfirmed by the adviser; (3) revocable by the issuer and also unconfirmed by the adviser.' Drafts under commercial letters 01 credit are usually drawn payable "at sight" or at 30, 60, or 90 days or some other period "after sight." "After sight" means after the day the drafts have been presented to the drawee for acceptance. Sight drafts, known also as "demand" drafts, must theoretically be pre- sented by the corresponding banker at the drawee's address immediately upon receipt and must then and there be paid. Credits in foreign trade are in the great majority of instances based upon the acceptances of time drafts. When the draft has been accepted it becomes the equivalent of a promissory note, but has the additional characteristic of containing on its face ' Federal Reserve Bulletin, February 192 1. 390 BANKING AND CREDIT [XXVIII evidence of an undisputed commercial transaction. With the delivery of the bills of lading, upon the acceptance of a time draft, the extension of actual credit begins. 6. Drafts Drawn Directly on the Importer. — ^The disadvan- tages of drafts drawn directly on the importer are summarized in the advantages possessed by drafts drawn under letters of credit. Obviously, if the exporter is willing to have his bank receive his bills for collection instead of discounting them at once and advancing him the proceeds, it will ordinarily be of less im- portance whether the bills are drawn on a bank or a merchant. In case the foreign merchant has an international reputation, his acceptances will find a ready market and the exporter who has drawn on him should experience no difficulty in getting the drafts discounted. Sometimes in foreign trade when the exporter is following the plan of drawing drafts directly on the importer, a credit document known as an "authority to purchase" is issued by a bank at the importer's request and expense for the benefit of the exporter. The purpose of this document is to give the exporter assurance that he will be able to sell his drafts to his local bank for cash at the time of shipment of the goods. The bank in the exporter's country acting as agent for the importer's bank will buy the exporter's drafts and will then forward them to the bank which issued the authority to purchase, at the same time charging the latter's account. 7. The Drawing of Drafts. — In the drawing ot international bills of exchange either the debtor or the creditor may take the initiative in effecting settlement. The debtor may purchase a bank draft and send it to the creditor, or the creditor may draw a draft upon the debtor, the debtor's bank, or the latter's corre- spondent. Where the debtor takes the initiative he buys from his local XXVIII ] THE PROCESS OF FOREIGN EXCHANGE 391 bank a draft on its foreign correspondent in the country to which the remittance is to be made. The debtor then sends this draft to the creditor, who cashes it or has it discounted at his own bank. The creditor's bank is willing to cash or discount the draft be- cause it is the obligation of a bank payable at a central point where the creditor's bank also keeps an accoimt. This method of settlement is not customary in regular commercial transactions and is restricted mostly to small purchases abroad by private individuals who are buying books or periodicals, etc. If the creditor takes the initiative, he draws a draft either on the debtor, the debtor's bank, or the latter's correspondent. Collection of such a draft may be made by the creditor through the agency of his local bank, which will send it to a foreign cor- respondent for payment. When the creditor takes the initiative, drafts are drawn for the most part on banks instead of directly on the debtor. Such drafts are drawn under what are known as "commercial letters of credit," which are issued by the debtor's bank or the latter's correspondent, authorizing the creditor to draw bills of exchange upon it under certain stipulated condi- tions. Generally speaking, merchants' drafts upon banks com- mand a better price in the market than drafts drawn directly upon foreign importers, principally for the reason that the drawee bank is usually better known than the foreign importer. 8. The Documentary Instructions. — Foreign bills of exchange, just as in the case of domestic bills, may be either "clean" or "documentary." A clean bill has no shipping papers or other bills attached to it to act as collateral security. Until accepted a clean bill is single-name paper. After acceptance it becomes double-name paper. A documentary bill is always secured by the papers which carry title to the merchandise, the sale of which the bill repre- sents. The bill of lading, the insurance certificate, consular invoice, and commercial invoice may be accompanied by a hypoth- 392 BANKING AND CREDIT [ XXVIII ecation certificate, specifically acknowledging the goods covered by the documents for the protection of the banker who discounts the bill. The hypothecation certificate may be an individual statement covering only the one shipment, or it may be a blanket certificate covering all current transactions between the exporter and the banker. The importer, who is the drawee of a docu- mentary bill, has the right in any event to receive the attached bill of lading and other shipping documents at the time when he makes payment. However, he may be treated more liberally. Shipping documents may be handed to him for his mere accept- ance of the draft. The disposition of these collateral documents is determined by the so-called documentary instructions. These instructions may be : 1. Documents for payment (D. P.) 2. Documents for acceptance (D.A.) 3. Documents for delivery (D.D.) Of the three types of instructions, "documents for payment" give to the holder the greatest security because he retains posses- sion of the collateral until payment has been made by the foreign importer. These are the usual instructions when a draft is drawn on a merchant. When the drawee is a bank, the terms are never ' ' documents for payment " but rather " documents for acceptance ' ' or "documents for delivery." A draft with a bill of lading attached with the instructions "documents for acceptance" is called in brief a "documentary acceptance bill," whereas if the instructions are "documents for payment " it is called a ' ' documentary payment bill . " When the drawee is a mercantile house of high standing the instructions accompanying the draft may be "documents for acceptance." In the case of American cotton exports, documentary acceptance bills were drawn in great numbers before the war upon English spinners. Drafts drawn with the instructions "documents for delivery" are exceptional. Instructions of this kind confer XXVIII J THE PROCESS OF FOREIGN EXCHANGE 393 authority upon the agent of the exporter to surrender the bill of lading and other shipping documents even before the accept- ance takes place. The documentary instructions are important matters for the exporter and the foreign importer, and also for negotiating bankers. Although the character of the instructions depends to a large extent upon the usages of the trade and the arrangement between the merchants, misunderstandings and disputes are frequently connected with this matter. If the drawer offers a bill for sale to a banker and the latter instructs that the terms be "documents for payment," it is necessary for the drawer to make arrangements with the foreign importers to permit him to accompany the bill with these instructions. Frequently, especially in the case of sterling exchange, time bills are drawn with the instructions "documents for payment." In such transactions the importer who pays the draft is en- titled to a rebate or discount. In England it is the practice for the importer to make payment under what is known as the "retirement rate of discount," also called "rebate rate of in- terest." This means that the importer when taking up his bill will be allowed a discount of 1/2 per cent above the advertised rate of interest for short deposits allowed by the leading London joint-stock banks, which is ordinarily i per cent below the Bank of England's official minimum discount rate. In the United States, where documentary payment bills have been rare, there has been developed no standard practice in this matter; the rate is left to private adjustment between the importer and the bank holding the bill. References Kniffin, W. H. The Business Man and His Bank. Contains forms, pp. 253-273. Langston, L. H. Practical Bank Operation. A technical presentation of the subject from the viewpoint of the banker. Vol. I, pp. 284-311; Vol. II, pp. 445-448^ 394 BANKING AND CREDIT [XXVIII Moulton, H. G. Financial Organizations of Society. Part II. Financing imports and exports, pp. 410-425. Shugrue, M. J. Problems in Foreign Exchange. Contains solutions, copies of exchange documents, and foreign exchange tables. Westerfield, R. B. Banking Principles and Practice. Deals principally with the operations of the foreign exchange departments of a bank. Vol. V, pp. 1200-1317. Whitaker, A. C. Foreign Exchange. Documentary trade biU and letters of credit, pp. 98-189. Willis, H. P., and Edwards, G. W. Banking and Business. Financing foreign trade, pp. 270-284. CHAPTER XXIX TYPICAL FOREIGN EXCHANGE TRANSACTIONS I. Financing an Export Shipment by Means of Dollar Ac- ceptances. — A Brazilian importer in Rio de Janeiro has placed an order with the Boston Leather Company for a shipment of patent leather amounting to $75,000 and has arranged with his local bank to finance the transaction on 90 days' credit. The Rio de Janeiro bank issues a commercial letter of credit on its banking correspondent in Boston, the Hubville National Bank, requesting the latter to accept 90-day sight drafts drawn by the Boston Leather Company under certain stipulated conditions, but not exceeding in total amount the sum of $75,000. When the Hubville National Bank has received these instruc- tions, which would ordinarily be in the form of a cable, it noti- fies the Boston Leather Company of the opening of the credit and states the terms and conditions. The Boston Leather Company now ships the goods and obtains from the steamship company ocean bills of lading. In accordance with the terms of the letter of credit the local firm also arranges for marine insurance on the cargo and secures from the underwriters necessary insurance coverage. Having taken care of all the shipping details the Boston Leather Company draws on the Hubville National Bank a 90- day sight draft for the amount of the shipment and attaches to it the shipping documents stipulated in the letter of credit, includ- ing the original commercial invoice, ocean bills of lading, consular invoices, and insurance certificates. If everything is in order the Hubville National Bank "accepts" the draft upon presen- tation. The Boston Leather Company may hold the acceptance until maturity and receive the full face of the draft, but in order 395 396 BANKING AND CREDIT [XXIX to obtain funds immediately it chooses to request the local bank to discount the draft. If the draft was drawn for exactly $75,000 and the discount rate on this class of bills was 6 per cent, the proceeds credited to the Boston Leather Company would be ^TSi^TS- The following calculation is explanatory: Amount of 90-day draft $75,000 Deduct discount, 90 days' interest at 6% 1,125 Proceeds $73,875 The documents are immediately forwarded by the Hubville National Bank to the Rio de Janeiro bank, which will be advised that a draft for the amount of the invoice has been accepted for its account against the credit issued. Upon the arrival at Rio de Janeiro the documents will be turned over to the Brazilian im- porter in accordance with the bank's customary arrangements, or as previously agreed between the bank and its customer. The Brazilian importer will then surrender the bill of lading to the steamship company, obtain the merchandise, and from the pro- ceeds of its sale get funds to pay his bank. At the maturity of the draft in New York the Rio de Janeiro bank will be required to deposit sufficient funds with the Hub- ville National Bank to enable the latter to meet its "acceptance " and obtain the customary or previously agreed upon acceptance commission. 2. Sterling Draft Sold for Future Delivery by an American Exporter. — In May a Milwaukee manufacturer accepts an order from an English concern for some special lathes amounting to £10,000 sterling for shipment to Manchester on or before the following October 20. Fearing that a depreciation in the sterling exchange rates in October might seriously diminish or wipe out his profits, the Milwaukee manufacturer arranges with his local bankers for sale to them for future delivery in October, drafts on the English concern's bank to the amount of £10,000 XXIX ] TYPICAL FOREIGN EXCHANGE TRANSACTIONS 397 at the rate of $4.22 per pound. At the rate of $4.22 per pound the Milwaukee manufacturer expects to be able to realize his es- timated profit from the sale of lathes. With the exchange thus definitely fixed he has protected himself from any loss that might result from sterling exchange falling in October below $4.22. To be sure, he has also eliminated the possibility of any specu- lative profit due to a rise in sterling rates. In October when the lathes are ready for shipment the Ameri- can exporter draws a draft on the English concern's bank and delivers it to the Milwaukee bankers to whom he sold the October exchange at $4.22 per pound. Whether the sterling exchange rate at that time is $4 or $4.50 does not matter because he will re- ceive for his £10,000, $42,200, on which he figured when he sold the future exchange. When the Milwaukee bankers bought the exchange for future delivery they could have protected themselves if they wished by hedging, either by selling their own long bills to fall due in London in October, or by selling in the local market sterling demand drafts for October delivery to American importers expecting to remit funds at that time. Under either of these two plans the obligation of the Milwaukee bankers will be the same. The latter alternative, however, involves no immediate money trans- action because the importers will not be required to make pay- ment to the bank until the sterling drafts are delivered to them in October. 3. Cotton Shipped on Consignment Financed by Dollar Ac- ceptances. — Johnson Brothers, cotton-buyers of Tulsa, Okla- homa, have made arrangements to ship 400 bales of cotton costing $100,000 on consignment to a broker in Paris for sale after arrival. In order to protect themselves from a possible loss on account of a drop in prices, Johnson Brothers immediately hedge by selling through their brokers futures at the New York Cotton Ex- change. The Prosperity Trust Company of New York is then 398 BANKING AND CREDIT [ XXIX requested to finance the shipment, which is to be sent by railroad from Tulsa to New York and from there by steamer to Paris. Having agreed to finance the transaction by means of a bank acceptance, the Prosperity Trust Company authorizes Johnson Brothers to draw upon it at 60 days' sight for 80 per cent of the purchase price of the cotton, that is $80,000, with the understand- ing that the railroad bills of lading covering the shipment are to be attached to the draft. After making the shipment at Tulsa, Johnson Brothers draw on the Prosperity Trust Company a 60-day sight bill and, having attached to it the railroad bills of lading, place it in the mail. Four or five days later the New York bank accepts the draft and following the instructions of the drawer sells it in the open market and credits the account of Johnson Brothers for the proceeds. Supposing that the discount rate for this class of bills is 6 1/2 per cent, the proceeds placed to the credit of Johnson Brothers would be $79,133-33 ■ Amount of 6o-day sight draft $80,000.00 Deduct discount, 60 days' interest at 6 1/2% 866.67 Proceeds $79ii33-33 The bank retains the railroad bills of lading and for addi- tional security requires Johnson Brothers to sign an " acceptance agreement" pledging the 400 bales of cotton as collateral and promising to provide the bank with sufficient funds to meet the acceptance at maturity. When the cotton arrives in New York the Prosperity Trust Company, already having arranged for cargo space, makes ship- ment to Paris and obtains the necessary ocean steamer bills of lading. As previously arranged between the bank and its cus- tomer, insurance on the cotton while in transit to Paris is to be provided for by Johnson Brothers and the policies are to be sent to the Prosperity Trust Company. These policies together with the ocean steamer bills of lading will be forwarded by the bank XXIX] TYPICAL FOREIGN EXCHANGE TRANSACTIONS 399 to its French correspondent. Instructions will be sent at the same time to the effect that on arrival the cotton is to be stored in a warehouse pending further advice. Johnson Brothers' French broker is notified of the arrival of cotton by the Paris bank and he immediately takes steps to dis- pose of the consignment in his local market. When the sale has been completed the Paris bank, acting upon instructions from its New York correspondent, will deliver the cotton to the buyer against payment in francs for the amount of the sale or against a written promise to pay within a specified number of days. On settlement of the transaction by the Paris cotton-buyer, the Prosperity Trust Company will be notified by its French correspondent that an amount specified has been collected and has been placed to the credit of the New York bank. The Pros- perity Trust Company will immediately convert the Paris credit into dollars at the market rate for cable transfers on Paris. The proceeds of the sum converted into dollars will be applied to pay- ment of Johnson Brothers' draft of $80,000 and the balance, after deducting the necessary commission charges, is placed to their credit. Not infrequently it happens that the American bank receives funds from abroad before the maturity of its acceptances. In such cases the banking practice is to allow the customer a rebate of interest until the maturity of the draft. 4. Financing an Importation of Gutta-Percha from Singapore with Sterling Exchange. — Lincoln Brothers of Boston have ar- ranged with the Hubville National Bank to have a 90 days' credit opened with the Middlesex Bank, Ltd., of London, in favor of the Oriental Export Company of Singapore against shipments of gutta-percha to Boston. After receiving the Boston bank's letter of credit authorizing drafts on the Middlesex Bank, Ltd., under certain stipulated conditions, the Oriental Export Com- pany, already having secured cargo space, makes shipment. At 400 BANKING AND CREDIT [XXIX the same time it draws on the London bank a 90-day sight bill for £50,000 and attaches to it: 1. Ocean steamer bill of lading 2. Consular invoice 3. Marine insurance policies 4. Commercial invoice The draft with documents attached will be sold by the Oriental Export Company to its local bank in Singapore at the market rate in the currency of the Straits Settlements (Straits dollars) for 90-day sight bills on London. Unless for some reason the terms of the credit have not been fulfilled and the draft is not accepted in London, the transaction is concluded so far as the Singapore exporters are concerned. The Singapore bank will now send the original shipping documents direct to the Boston bank so that no delay will be incurred by the American importers in obtaining the goods after arrival, and will forward the draft with duplicate shipping documents to its correspondent in London, who will present the bill to the Middlesex Bank, Ltd., for acceptance. If this bank is satisfied that all the terms of the letter of credit have been properly observed, it will accept the draft, retain the documents, but return the draft itself to the Singapore bank's correspondent. The latter will either hold the draft until maturity 93 days hence (90 days plus 3 days of grace) or sell it in the discount market, depending upon the instructions from Singapore. With the London discount rate on 90-day sight bills at 6 per cent and stamp charges at 1/20 per cent, the proceeds placed to the credit of the Singapore bank in London in case instructions call for the immediate sale of the bill, would be £49,210 I2S. 4d. This is arrived at as follows: I. Amount of 90-day sight draft £50,000 2., Deduct 93 days' discount at 6% 764. 7.8 3. Deduct stamp charges of i /20% 25. 0.0 4. Proceeds £49,210.12.4 XXIX ] TYPICAL FOREIGN EXCHANGE TRANSACTIONS 4OI The duplicate shipping document will be forwarded immedi- ately by the Middlesex Bank, Ltd., to the Boston bank in order to prevent any inconvenience that might be occasioned by the loss or delay in transit of the original documents. The Boston bank will also be notified at the same time by its London corre- spondent concerning the acceptance of the draft and will be expected to provide in London at its maturity £50,000 for cover. On the arrival of the gutta-percha in this country Lincoln Brothers will wish to obtain possession of it for manufacturing purposes, but since their bank holds the documents the cargo can- not be secured from the steamship company until the bill of lading has been surrendered. The Boston bank will want to retain some control over the goods and therefore let us assume the request of their customer to sign a trust receipt in return for the bill of lading. Although the form and terms of a trust receipt vary, in general this document specifies that the title to the goods remains with the bank and that they are being held in trust by the customer. Furthermore, the customer agrees to turn over to the bank cer- tain proceeds of the sale of the manufactured goods until the debt is settled. Moreover, the bank reserves the right to take possession of the goods at any time, although, should this action be considered necessary on account of such a matter as financial embarrassment of the customer, no little difficulty might be experienced in determining which of the goods were actually covered by the trust receipt. It is not customary, however, for a bank in this case to insist rigidly upon the terms of its contract unless there is danger that the customer will not be able to meet his obligations. There- fore, as a matter of practice, the Boston bank, while reserving the right to enforce the provisions of the trust receipt, will not expect Lincoln Brothers to make payment until it is necessary to remit to London to cover the draft, which will become due there 93 days from the date of its acceptance by the Middlesex Bank, 26 402 BANKING AND CREDIT * [ XXIX Ltd. The Boston bank will give its customer the choice of set- tling by means of a bankers' check on London, which would have to be purchased for mailing, let us say, lo days before the ma- turity of the bill in London, or of remitting by cable some 9 days later. Assuming that Lincoln Brothers choose the former plan and bankers' checks on London are selling at 3.46 3/4, they will send to the Boston bank their personal check for $173,375 (£50,000 times 3.46 3/4) plus a commission of, say, 3/4 per cent, amounting to $1,300.31, or a total of $174,675.31. 5. Remitting Funds to Calcutta for Purchasing Jute. — The Lancaster Bag Company of Brooklyn is planning to instruct its purchasing agent in Calcutta to buy for immediate ship- ment jute costing approximately 200,000 rupees. Before the war the Brooklyn firm provided its Calcutta agent with funds through purchasing rupees in London for remittance to India. To be more explicit, the Lancaster Bag Company followed the policy of buying sterling cables in the New York market to be used for remittance to a London correspondent who was in- structed to buy rupee cables for remittance to Calcutta. At this particular time its procedure is to make direct remittance in rupees from New York to Calcutta. This plan makes it pos- sible for the American importer to avoid the exchange risks due to fluctuations in the rates for the pound sterling. In other words, indirect remittance through London brought into the transaction an additional factor of instability, namely, the changing sterling-rupee rate, and mede it impossible to deter- mine at the time the amount of funds necessary to be for- warded to London in order to purchase the required amount of rupees. When the Lancaster Bag Company has decided to make re- mittance to its agent in India, it will arrange through its New York bank to have the necessary number of rupees forwarded to Calcutta. Upon settlement of the transaction with the local XXIX] TYPICAL FOREIGN EXCHANGE TRANSACTIONS 403 bank, the Lancaster Bag Company will be given a receipt with a statement that 200,000 rupees are to be telegraphed immediately to the Calcutta agent of the Brooklyn firm. If at this particular time the telegraphic transfer rate be- tween London and Calcutta is 25. 4J. and between New York and London $3.60, the Brooklyn concern should have bought the rupees at $.42. The following computation is self-explanatory: 1. £1 = 20s. = 2^od. 28 2. Cost of I rupee in London 2s. Ad. = 2M., or £ — 240 3. Cost of £1 or 2^od. in New York = $3.60 4. Therefore, — X $3.60 = $.42, cost of i rupee in New York 240 Proof: 1. Cost of Rs. 200,000 at $.42 =$84,000 2. If indirect remittance were made through London, $84,000 at $3.60 per pound would provide £23,333 1/3 in London. 28 3. £23,333 i/3at per rupee would provide Rs. 200,000 in Calcutta. 240 6. Finance Bills. — Finance bills are foreign drafts drawn for the purpose of making available the funds obtained in connection with a financial transaction, such as an issue of stocks or bonds; or a reorganization, a readjustment, or an underwriting. The term is also commonly applied to a long bill drawn by a banker in one country on a banker in another, generally against bal- ances or securities pledged for the latter's account.' The pur- pose of a finance bill of this latter class may be: (i) to anticipate a fall in foreign exchange rates, (2) to take advantage of higher interest rates in one country than in another, and (3) to raise funds regardless of the conditions of interest or exchanges. For instance, under normal conditions large exports of grain ^ Not all long bills drawn by bankers are finance bills. Often bankers draw long bills in connection with the purchases of commercial and other forms of exchange more or less as a part of the regular daily routine. 404 BANKING AND CREDIT [ XXIX and cotton in the autumn cause the rates on sterhng exchange to drop from previous higher levels in the summer months. About the middle of August a New York banker wishing to take ad- vantage of an expected drop in exchange rates arranges with his London correspondent for a 60 days' credit of £50,000 by pledg- ing securities for the latter's account at an acceptable New York trust company, although not infrequently in such cases a credit is extended without any collateral requirements. The New York banker immediately proceeds to draw a 60- day sight bill on London. He may realize on this bill at once by selling it in New York at the market rate for 60-day bills, or he may send it to London^ to be discounted and sell his own de- mand drafts against the proceeds of the credit thus obtained. If he follows the second plan, the New York banker will not be re- quired to wait until he has been informed that the bill has been accepted and discounted in London before selling the demand drafts. It is quite possible for the same steamer to carry the 60-day bill and the demand drafts. Of course, the proceeds cannot be foretold to the exact amount, but this is not vital, as the demand drafts would probably not be drawn for the exact amount of the proceeds. Any balance would be debited or credited to the New York bank's account in London. Let us assume that the New York banker chooses the second plan and that the pertinent facts are : 1. August 15 the rate for bankers' checks on London $4.88 2. London arrival discount rate on 60-day sight bills 4% 3. English stamp charges on 60-day sight bills 1/20% 4. London banker's commission 1/8 % 5. New York banker employs funds for 63 days at an average rate of 6% 6. Ten day before maturity of the London draft the New York banker remits with a demand draft purchased at I4.84 ' The London bank will quote a discount rate "to arrive," that is in advance, and the New York banker will thus know the exact amount of the demand exchange he can market. XXIX] TYPICAL FOREIGN EXCHANGE TRANSACTIONS 405 Computation: 1 . Amount of 60-day sight bill £50,000 2. Deduct London discount, 63 days' interest at 4% 345. 4. i 3. Deduct English stamp charges 1/20% 25. o. o 4. Proceeds in London £49,629.15.11 5. Sells demand draft in New York at $4.88 6. Proceeds of demand draft £49,629.15.11 at $4.88 $242,193.40 7. New York banker employs these funds for 63 days at an average interest rate of 6% earning 2,543.03 8. Total proceeds and interest $244,736.43 9. At end of 60 days New York banker buys a sterling de- mand draft for £50,062.10.0 (50,000 plus 1/8% com- mission) for remittance to London at $4.84 costing 242,302.50 10. New York banker's profit (8 minus 9) $2,433.93 It is evident that if the New York banker had been able to obtain the necessary cover for the original draft on his London correspondent at less than $4.84, he would have made an addi- tional profit, and that if the rate were much above $4.84, he would have incurred a loss. This brings into the transaction an ele- ment of risk which the New York banker may or may not wish to take. In case he wishes to avoid the risk he may hedge through buying exchange for future delivery instead of waiting until the time of remittance to make the purchase. In the illustration just given, whether the New York banker would choose to sell the 60-day sight bill outright in the New York market or follow the plan described would depend upon the quotations for demand and 60-day bills. If the rate for 60-day bills were more than $4.843868 it would be more profitable to dispose of his London credit by way of a 60-day bill. The fol- lowing computation is self-explanatory: 1. Amount of 60-day bill £50,000 2. Proceeds in New York from sale of bill at I4.843868 $242,193.40 3. Proceeds of demand draft in New York at $4.88, (line 6 in computation above) $242,193.40 406 BANKING AND CREDIT [ XXIX It will be observed that neither the New York banker nor his London correspondent were required to advance any money. The London correspondent did not loan any money but merely accepted the draft and was provided with the necessary fluids to meet it at maturity. The actual funds were supplied by the London discount market which in discounting the bill was pro- tected by the primary liability of the drawee bank and the secondary liability of the drawer. This very ready means of raising funds might seem to be open to serious objection because of the possibility of abuse, but as a matter of fact any such danger is carefully guarded against. It is the policy of the London dis- count market to keep informed as to the financial condition of both the drawer and acceptor. Higher discount rates and, if necessary, refusal to take the paper prove the most effective checks that can be devised by the discount market against any attempt to issue finance bills beyond reasonable limits. Finance bills perform two important economic functions. In transferring loanable funds from one market to another they tend to equalize interest rates in the different financial centers. In anticipating a drop in foreign exchange prices they tend to in- crease the supply of bills when prices are high and increase the demand for bills when prices are low and thus cause exchange rates to be more nearly uniform throughout the year. Since the war the lack of stability in the foreign exchange markets, together with higher interest rates abroad, have caused a marked decrease in the drawing of finance bills. 7. Arbitrage Transactions. — Arbitrage in foreign exchange may be described in simple language as the buying of drafts in one market at a low price and selling them in another market at a high price. Essentially, the operation is very similar to what happens when traders buy grain, cotton, or other commodities in one city for resale at a profit in another city. For instance, since sterling drafts are sold in all the money XXIX] TYPICAL FOREIGN EXCHANGE TRANSACTIONS 407 markets of the world it might be expected that there would be one rate between dollars and pounds in New York and another in San Francisco; or that the rate between dollars and pounds would differ as to whether the exchange were made directly on London or iiidirectly through the medium of French francs, Swiss francs, Italian lire, or Japanese yen. It is the purpose of the following illustration to explain how the forces of competi- tion tend to establish a parity in price quotations in the exchange markets throughout the world. Let us assume that at a certain time the cable rates between New York, London, and Paris are as follows: 1. New York rate on London $3-25 2. " " " " Paris 6.50 cents 3. London " " " 51 francs A foreign exchange trader in New York remits £10,000 by cable to his London correspondent with instructions that these funds be used for purchasing francs to be forwarded to a Paris corre- spondent. At $3.25 per pound, £10,000 would cost $32,500 and with this sum of English money the London correspondent would buy cables on Paris at the rate of 51 francs to the pound. £10,000 would, therefore, establish in Paris a credit of 510,000 francs in favor of the New York foreign exchange trader. The latter would then be in a position to sell New York exchange on Paris at the rate of 6.50 cents per franc and by selling 510,000 francs he would receive $33,150. But since he started with only $32,500 this rapid trading from New York to London, to Paris and back to New York again has yielded a profit of $650 less broker- age commissions and incidental expenses. In the illustration just given francs are cheaper in London than in New York. With the foreign exchange traders all over the world continually on the alert for such opportunities for profit there would be stimulated immediate buying of francs in London for sale in New York. These trading operations would 408 BANKING AND CREDIT [ XXIX tend to establish very quickly a parity in the foreign exchange quotations in New York, London, and Paris, that is, in this parti- cular instance bring about rates that would offer no opportimity to make a profit through the triangular transaction of buying francs in London, remitting them to Paris for credit, and selling drafts in New York against this credit. It is not difficult to understand why this condition could be created as a result of a change in any one, two, or each of the three rates. For in- stance, if we assume the New York rate on London to continue at $3.25 and the New York rate on Paris to remain at 6.50 cents, the London parity rate on Paris would be 50 francs per pound (3.25 -e- .065). Similarly, if we assume the London rate on Paris and the New York rate on Paris to remain unchanged, the New York parity rate on London would be $3-315 (51 X .065). Finally, if we assume the London rate on Paris and the New York rate on London to remain unchanged, the New York parity rate on Paris would be $.06176 (3.25 -¥■ 51). As a practical matter it is more reasonable to expect that a parity would be established as a result of interactions and changes in each of the markets rather than of a rise or fall of rates in only one market. The final effect would be the same in any event. References Exporters' Encyclopedia. Published yearly with monthly supplements. Technical information for the exporter and importer. Margraff, A. W. International Exchange. Technical banking features of foreign exchange. Also contains much illustrative problem material. Shugrue, M. J. Problems in Foreign Exchange. Contains illustrative problems with and without solutions. York, T. Foreign Exchange. Practical problems in foreign exchange, pp. 167-169. CHAPTER XXX THE NEW YORK MONEY MARKET I. Flow of Money. — Just as grain flows from the farms and the country elevators into the primary markets, such as Chicago, Duluth, and Kansas City, for subsequent distribution, so large quantities of money and credit instruments find their way to New York, the great money market of the United States. A money market is in reality principally a credit market. When interest rates are high it is commonly stated that "money is scarce," but strictly speaking credit has become difficult; the volume of money has probably remained substantially unchanged. Al- though the price of grain will usually vary slightly in different markets of the country, the spread cannot for any length of time be greater than an amount representing the transportation, in- surance and interest charges, and a small margin of profit, because when it exceeds this amount traders will be induced to buy in the cheaper and sell in the dearer place, thus correcting the situation. Interest, or the price for the use of money or credit, is subject to much the same influences and its rates tend to move in the same direction whether it be New York, Chicago, or Seattle. However, because money is loaned in the various markets under different conditions of risk and because its flow from one place to another must first overcome varying degrees of inertia, it is not surprising that the level of interest rates should be slightly higher at one point than at another. Wall Street, the financial center of New York, is intinaately coimected with the monetary reservoirs of other parts of the country, and in fact with those of the whole world. High interest rates open the conduits through which flow supplies of yellow metal from the Klondike and the Transvaal, domestic funds from 40# 4IO BANKING AND CREDIT [ XXX interior points, and foreign money from London, Paris, and Ber- lin. Similarly, lower interest rates tend to check and in many cases to reverse the flow of funds, thus bringing about a more even distribution of money in the world's financial centers. In studying the conditions affecting the money rates in the United States it is important, therefore, to examine the forces that are operative in the New York money market. The rate of interest which must be paid for borrowed money depends upon the supply and the demand for fimds. As in the case of practically all commodities bought and sold in a market, anticipated future demand and supply as well as present demand and supply are factors. This is true of commodities, as is seen in the variation of price for immediate delivery and price for future delivery. The price of cotton may be high for spot delivery and low for delivery in 3 months, if there be an expectation that future demand will diminish or that a large new crop is forthcoming. So it is with the price or interest of money. The money market is organized to meet these conditions and needs. There is conse- quently a demand or call money market and a time money mar- ket. As a rule there is a close relationship between the two, but at times there may be a marked difference. 2. New York Bank Statement. — In the New York money market certain evidence in regard to the supply of loanable money is furnished each week in the published statement of bank and trust company conditions simimarized by the New York Clearing House. From these it is possible to determine: (i) the amount of loans, discounts, and investments; (2) cash in vault; (3) reserve with legal depositories; (4) deposits, both de- mand and time; and (5) the surplus reserve, that is, the reserve in excess of legal requirements. This statement is published on Saturday. As not all of the banks are members of the federal reserve system, and as state banks which are not members are not subject to the same reserve requirements, the weekly statement is XXX] THE NEW YORK MONEY MARKET 41 1 in a composite form showing: (i) condition of member banks and trust companies, and (2) condition of non-member institutions. Knowing the reserve requirements for each of the two classes, it is possible to calculate the reserve position and surplus funds of the two classes combined. A further distinction is made between "actual" figures and "average" figures in the New York Clearing House statement. Actual figures are those for the close of business on Friday; average figures are obtained by taking the average of the figures for each day of the week. In normal weekly periods the average figures are the better index of banking conditions, as they take into account all of the operations of the week. If, however, there is a continuous movement in process, as in the piling-up of funds, or steady withdrawal of money, the actual figures, given for the last day of the period, are an aid in disclosing the extent of the movement. 3. New York Money Rates.^ — The above explanation may be illustrated by the table on page 41 2 showing,for a series of weeks in 192 1, the condition of New York banks' current rates on call money and commercial paper, and the discount rate of the New York Federal Reserve Bank. 4. Reserve in the Bank Statement. — Before the estabhshment of the federal reserve system, and more particularly before the transfer of all reserves of member banks to a federal reserve bank, the amoxmt of the surplus reserve of banks was generally re- garded as an index of the bank's ability to make additional loans and of the probable trend of rates of interest on money. This relationship, however, is no longer so evident. Under the new law a member bank establishes its reserve, not only by transfer- ring cash to the federal reserve banks but by borrowing from the federal reserve bank, either by loans on acceptable collateral or by rediscounts of commercial paper. The potential reserve is no 412 BANKING AND CREDIT [XXX On H fi § o i w m a M H fH W m" O o « .2 i-i H O <; <: pq M o Discount Rate of N. Y. Fed- eral Re- serve Bank (Per Cent) 01 M M »0W10X0»0101010»0 Time Moneyf Commer- cial Paper (Per Cent) -OO'O'O'O loioiovi 1 1 1 1 1 1 1 1 1 Tl- Tt N 0) 0) N ro ro w M I-I w Call Moneyf Rate tor Week End- ing on Date in Column I (Per Cent) -M'fqqqfO Surplus Reserve Average $7-8 7-7 20-1 8.6 II. 2 8.0 15.2 20.0 6.9 Surplus Reserve Actual ■<^ -^ o r^ q q m hh- -t &4o -^w dco 0**^0 wiorO'HOM(N»OT}- rOmt-QOlOMNCOt- II ooqconqqcowO t^OOQOt^OOQOChOO Net Time Deposits q>ocs(oqMi"^coi-. WHMWMWOJNN Wnqr;-qc?ir^ r^iocd dvTtH ■4m h wrooOMO'^WOO vOO'O'O'OnO r-oooo Loans, Discounts, Invest- ments, etc- (--■roiooqooiniMMw I>0\>0 m'o dirTM di fOfMOMNOOt-O-O rOOt^-+M00ionos M H N M W Ol 5i c (3 ts J3 tH !>, »w > tu i' <(i;Q XXX] THE NEW YORK MONEY MARKET 413 longer measured by the cash of member banks, but by the char- acter of the assets available for receiving credits at the federal reserve bank, and also by the ability of the federal reserve bank to grant such credits. From the pubUshed statements of the clearing house banks, it is impossible to determine the amount of assets which the member banks can pledge with the federal re- serve bank and thus convert into a reserve. The amount of "cash in vault," which might be transferred by a member bank to the federal reserve bank, though precisely stated, is small and may be disregarded as a potential influence in providing loaning facilities. The member bank may, however, by rediscoimting at the federal reserve bank suddenly increase its reserve by mil- lions of dollars, and for this reason the fluctuations in the surplus reserve may be due simply to bookkeeping operations between the member bank and the federal reserve bank. As a result the weekly statement of the New York Clearing House members, taken by itself, without comparison with other statements, has lost much of its significance. Not only must the member banks have acceptable assets to pledge with the federal reserve bank in order to increase its reserve, but the federal reserve bank must be in a position to grant the credit. This in turn depends upon the condition of the federal reserve bank. It, too, must maintain a reserve. The weekly statement of the New York Federal Reserve Bank must therefore be examined as well as that of the New York Clearing House members. According to law each of the twelve reserve banks is required to keep on hand a lawful money reserve of 35 per cent against deposits of member banks and 40 per cent against its own notes. Obviously, when the actual reserve closely approximates the lawful reserve the abiUty of the reserve banks to accommodate their members has approached its limit and the situation is apt to be acute. If, however, the reserve ratio is high or is on the increase any flurry in the rates of interest should cause no great alarm. 414 BANKING AND CREDIT [XXX 5. Factors Affecting the Money Market. — The condition of New York banks, as reflected in the weekly statements, is deter- mined and modified by a great variety of economic movements. The following may be mentioned as especially significant : 1. The volume of manufacturing, commercial, and mercan- tile business. 2. The volume of speculation and transactions in the New York Stock Exchange. 3. Flow of funds to and from the interior. 4. Financial transactions with the government, as pajrment of maturing indebtedness, purchase of goverimient securities, and payment of federal taxes. 5. Import or export of gold. 6. Issue of new securities. 7. Dividend and interest disbursements at the quarterly periods. The interplay of these movements affects the money market in any locality, but is much more marked in New York City, because financial operations are on so large a scale there. Experts endeavor to analyze the changes as reflected in the bank state- ments and, in the light of known current commercial and finan- cial transactions, to interpret and predict the probable course of the money market. 6. Course of Money Rates. — As a rule money rates in New York are higher in the last 3 months of the year than in the first 8 or 9 months, due to the seasonal demands for currency created by crop movements. Deposit funds are withdrawn from New York banks by banks in the West and South in order to afford accommodation in the purchase of grain and cotton which is being harvested and marketed. There is consequently a flow to the interior. As funds are withdrawn, money rates tend to stiffen. The following table shows the rates on 60-day time loans by months during the years 1910-1919: XXX] THE NEW YORK MONEY MARKET 415 M Hi o I? < o w ■ s < a I o VO P4 O Ph to o o l-l a H z o ;^ N -Sf \ ^ M ro TT ?f 1 ovp r- r* r- III n N W N ■^ •!? •ir •^ -^ -^ ^-^ --^ ^v. M H M f*5 ro ro m in >o -n 10 m «o in 10 10 00 ?? f N Tj- « --^ M ro 10 m ■O sC w w 10 -C vO 10 •* ■<+ C4 IN N ^ Tt w _^ W K. fO ro H ro H T f ■^ ■* o in 10 m o» « N w ^ ' ' 1 1 1 4 4 4 ■^ -^ --- --^ >-l M (S N _ro CO " -* n- TT m m 10 m ■^ ■^ 'q C4 ^T ■* ■* r* -3- ro 'it ifl N (JO ro ro (N 00 00 00 m ^ N N es ■3- ■* T ' ' M N --^ --^ --^ -^ -- •^ M M M M f> •* -* -JT ^f 71- »o 10 10 Oi -t ■* -* " (N T* N ■-< fO ro ro fO rj- TT ro fO (s fO ■* Tt TT tt ■t ■<* N ■* ■* N --^ --, -^ ■^ M fO ro >- M ro « ? ? ? ? f? 0. ' k 4 ' 41- ' i, it ^4^ -^ ---, --~ ^ -^ ro fO M ro H. CO 11 N N ro w ro ro ro Tf m m m '^ ■^ per cent. In favor of easy conditions, it is noted that the gold reserve of the New York Federal Reserve Bank continued to increase XXX 1 THE NEW YORK MONEY MARKET 419 and that new corporate securities were finding a ready market. New York banks continued to gain currency from the interior. There was a large expansion in loans and deposits. The former was attributed to dis- bursements on the third instalment of the income taxes, and the latter to payment by the government of Liberty bond interest. For the week of September 24, though rates had been irregular, on the whole greater ease prevailed. The New York Federal Reserve Bank lowered its discount rate to 5 per cent and its reserve ratio advanced to 84.1 per cent. As to the future: "Prominent bankers at this center do not fail to suggest that there is still a large volume of money tied up in so- called frozen credits, some of which will not be thawed out for some time longer. They offer the further suggestion that in spite of the relatively low rates for money now, it should not be assumed that tlie banks will loan large sums for speculation in stocks oi' commodities in the near future.'' In the week ending October i , the rate on call money rose to 6 per cent during one day, but in general there was little change in the money market. The statement of the condition of the New York banks, however, showed the elimination of the surplus reserve and a deficit of f 10.9 million. This was due principally to interest and dividend disbursements. Loans were increased $55 million and demand deposits nearly as much. Member banks reduced their borrowings at the federal reserve bank by f 3 7 . i million. "These changes, however, attracted only perfunctory notice as they are regarded as only bookkeeping transactions and almost certain to be read- justed in the course of another week." In commenting upon credit conditions for the month as a whole, the Monthly Review for October i, published by the Federal Reserve Agent of the New York Reserve Bank, observes: "The reduction of discount rates of the New York Reserve Bank on September 22 was a reflection of existing credit conditions in this Federal Reserve district. More particularly, it was a reflection of easier conditions in the money market. Evidences of the tendency toward lower rates for money included the sale on September 15 of $698,000,000 of Treasury certificates and notes at rates lower, for corresponding maturities, than at any time since March, 1920. . . . These lower rates of return on investments of complete security and the readiest sale are the best indices at this time of market rates for money." For the week ending October 8, it is noted in the Chronicle that the general trend of the money market is toward greater ease. Call money rates ranged from 4>^ to 5>^ per cent and mercantile paper rates were a shade easier. As anticipated in the previous week, the deficit in the re- 420 BANKING AND CREDIT [ XXX serve of member banks was extinguished by borrowings at the federal reserve bank. Reference is made to the large issues of new bonds, but notwithstanding this employment of funds "the prevailing opinion ap- pears to be that the money market will be easy for some time to come. As a matter of fact, no one can do much more than venture a guess, because of the many uncertainties in the general situation. If business should improve rapidly, as is forecast by some authorities, there would be a free demand for funds. This, coupled with requirements abroad, might bring about a fairly firm money market.'' For the week of October 15, call money rates were slightly firmer. This is attributed to preparation for government tiansactions and to interest and dividend payments by corporations. "Today the New York Federal Reserve Bank wUl pay to local depositories $1 25,000,000 on matur- ing Treasury certificates of indebtedness, and an additional $17,000,000 for interest on Liberty bonds. On the other hand the government wiU withdraw from local institutions $117,000,000. During the first half of next week it is assumed that the greater part of these funds will find their way back into regular channels." Notwithstanding the large increase in deposits, the reserve was increased by further borrowings at the reserve bank. In the week of October 22 the money market was "decidedly easier." The advance in the reserve ratio of the New York Federal Reserve Bank from 77 to 83 per cent "attracted special attention." "Borrowers on time found offerings freer." The combined statement of condition of banks again shows that the surplus reserve figure is regarded as of little significance. Demand deposits were increased $77,000,000 requiring a larger reserve. As the banks decreased their borrowings at the federal reserve bank there was a deficit in the reserves. A week later (ending October 29) call money rates were higher. The reason for this was not clear. " Little has been published to explain the higher tendency of all money. The withdrawals by the government have not been large," and financing for private corporations was not "particu- larly striking." 8. The New York Call Money Market.— Occasionally the rates on call money in New York City are very high, 15 or 20 per cent, or even higher. This may create distrust and alarm. Frequently such high rates are not a true index of the trend of the money market, but represent the charges made to belated bor- XXX] THE NEW YORK MONEY MARKET 42 1 rowers from the stock exchange who need funds at once to settle unexpected adverse balances. A call rate of 15 per cent on a given day does not mean that all borrowers on call paid that rate. The rate may have been applied to but a very few and for only a very short time. The high call money rate as a rule applies only for a single day, as the next day the loan is renewed at the re- newal rate, which is much lower. Exceptionally high rates are incident to stock-exchange operations which require daily settle- ments, and do not necessarily reflect the probable rates for time loans or discounts on commercial paper. Because of the wide- spread public misimderstanding of the significance of call money rates, the Senate in March, 1920, asked the Federal Reserve Board to report on the "cause and justification for usurious rates of interest on collateral call in the financial centers." According to the reply made by the Federal Reserve Board present practice may be summarized as follows:^ Collateral call loans, in the general acceptance of the term, are made chiefly in New York City, which is practically the only important call money market in this country. These loans are secured by the pledge of investment securities, i.e., stocks and bonds, generally those which are dealt in on the New York Stock Exchange. The loans are made for the most part to houses which are members of the stock exchange, and the money so borrowed constitutes a portion of the funds employed ordinarily in purchas- ing and carrying securities for their customers and sometimes for themselves. The bulk of call money is lent on the floor of the New York Stock Exchange at the "money post," where through various brokers loanable funds are offered and bids for funds are received. Most of the business is done between the hours of 12 noon and 2:45 p.m. 9. Sources of Call Money. — The principal supplies of money for collateral call loans are loanable funds of banks and bankers 3 Federal Reserve Bulletin, April 1920, pp. 368-372. 422 BANKING AND CREDIT [XXX located both in and outside of New York City, including foreign banks and agencies of foreign banks, and similarly the loanable fundu of firms, individuals, and corporations seeking temporary investment. In the matter of the supply or attraction of fimds to the call money market, there is generally a definite and well- understood obligation on the part of banks to accommodate first their own commercial clients, so that it is only the excess of loan- able funds which they may have from time to time that is avail- able for the collateral call money market, or for the purchase of commercial paper in the open market. This excess of loanable funds available for employment in the securities market varies, therefore , according to the commercial requirements of the country. The idea that when call money rates are high, say, at 25 to 30 per cent, all banks are investing in that manner and receiving abnormal rates is erroneous. In fact one of the reasons for the high call rates is that money is going largely to commercial bor- rowers, and the brokers for that reason are compelled to bid high for accommodation. 10. Former Place as Secondary Reserve. — Prior to the insti- tution of the federal reserve system, bankers, especially in reserve centers, were accustomed to look upon call loans as their principal secondary reserve, on the theory that inasmuch as those loans were payable on demand, the invested funds could always be promptly obtained on short notice to meet withdrawals of de- posits or for other use. Consequently there was available for col- lateral call loans a supply of funds sufficient for ordinary market requirements and at low rates, although at times the rates rose to high levels as the supply of funds diminished, or the demands increased. The traditional attitude of banks toward call loans as their chief secondary reserve has been greatly modified by two causes. The first resulted from the closing of the stock exchange at the outbreak of the European war in the summer of 1914, when it XXX ] THE NEW YORK MONEY MARKET 423 became practically impossible to realize on call loans secured by investment securities, which became, therefore, "frozen loans." This brought about a more or less permanent prejudice against dependence upon call loans as secondary reserves. The second and more important factor was the creation of the federal reserve system. Under the terms of the Federal Reserve Act provision is made for the rediscount of commercial paper, but the rediscount of loans for the purpose of carrying investment securities, other than United States government obligations, is excluded. Conse- quently in order to maintain maximum liquidity, with suitable provision for secondary reserves that can be immediately availed of, banks, including foreign agency banks, now invest a greater proportion of their resources in assets that can be realized upon at the federal reserve bank. Another changed factor in the present situation grows out of the fact that the war and post-war condi- tions have rendered unavailable supplies of money which for- merly came from foreign banks. II. War Regulation of Money Market. — During the latter part of the war, agencies of the government were employed to restrict the issue of new securities for purposes other than those which were deemed essential. Moreover, as the Treasury under- took to sell large amounts of certificates of indebtedness and Liberty bonds bearing low rates of interest, the question arose as to whether the competition of the general investment market might not prejudice the success of the government issues. In these circumstances, with full understanding on the part of the Treasury Department, the officers and members of the New York Stock Exchange undertook to limit transactions which would involve the increased use of money for other purposes, in con- sideration of which the principal banks of New York City en- deavored to provide a stable amount of money for the require- ments of the securities market. 424 BANKING AND CREDIT [ XXX After the armistice these restrictions were removed and ordi- nary market forces reasserted themselves. The issuance of new securities was resumed in unprecedented volume and consumed a vast amount of capital and credit when bank credit was already expanded by the necessity of carrying large amounts of govern- ment securities which the investment market was not prepared to absorb. 12. Renewal Rate on Call Loans. — The renewal rate, or the rate at which loans not called for payment bear interest until the following day, is regarded as the real barometer of market condi- tions, and its fluctuations throughout the longer periods indicate more significantly the relation between the supply and demand of loanable funds. The renewal rate is fixed about 1 1 -.^o a.m. each day by the president of the exchange after consulting with the money- brokers and certain officials, and is based upon the approximate rate for that day and the probable demand for money before the rate is set again. When money is scarce the renewal rate is sometimes set higher than the prevailing interest rates, partly for the purpose of attracting funds. Not infrequently it is found that the renewal rate has been placed too high, for very shortly new loans, which of course do not bear the renewal rate, are made at a lower figure. Interior bankers often complain about being dis- criminated against because their funds are not loaned by their New York correspondents at the highest rates for the day. Such complaints for the most part are not based on the facts of the case for several reasons. As a general rule the great bulk of the money loaned on call bears the renewal rate from day to day and only a very small proportion gets the high rates quoted. Late in the afternoon where the renewal rate for the day is possibly 6 or 8 per cent, the rate for new loans often goes to 12 or 15 per cent or even higher, largely because the banks' loanable funds for the day have been exhausted and no additional money is forthcoming. XXX 1 THE NEW YORK MONEY MARKET 425 13. Influence of Call Money Rates on Business. — The rates for call money do not determine and have not exerted an impor- tant influence on the rates for commercial borrowings. This is to be explained by the universal custom of banks to satisfy first the commercial needs of their customers. Banks feel an obliga- tion to customers but not to those who borrow in the open market on securities. Furthermore, as the resources of the banks mainly come from the commercial customers, their own self-interest compels a preference in favor of their commercial borrowers, since failure to grant reasonable accommodation would induce them to withdraw their deposits and so reduce the abihty of the banks to do business. An attempt to control the rates for call loans by the establish- ment of an arbitrary limit at a low level would be distinctly hazardous, for the reason that up to the point where the arbitrary rate would limit the supply of new money, speculation and ex- pansion might proceed unchecked and the natural elements of correction or regulation would hot obtain. In other words, high rates act as a deterrent to overspeculation and undue expansion of credit . What is more , high call money rates attract funds from interior points, and to fix arbitrarily the rates below their real competitive market level would simply mean a smaller amount of available funds for loans. Again, a supply of money avail- able at a fixed maximum might become exhausted and liquida- tion might suddenly become forced, because the demands for additional accommodation for the fulfilment of commitments already made could not be met. As an example of the effect of such liquidation upon dealers and merchants in commodities, the case might be cited of a commitment to purchase a round amount of cotton on a certain day. Many of the houses on the cotton exchange are also members of the stock exchange and frequently borrow very largely on the stock exchange to provide fimds against settling their transactions in cotton. If, therefore, an important cotton settlement is imminent, and borrowings on 426 BANKING AND CREDIT [ XXX securities could not be availed of, the cotton transaction could not be carried out and a drastic liquidation through sale either of securities or of the cotton might be required to avoid default. References The Commercial and Financial Chronicle (weekly). Gives current analyses and explanations of the money market; also contains editorial paragraphs and descriptions of the principal changes of the week. Federal Reserve Bulletin (monthly). Contains tables showing discount rates and interest rates in the various centers throughout the United States. Huebner, S. S. The Stock Market, pp. 295-305. Meeker, J. E. Work of the Stock Exchange. Chapter 8. Moulton, H. G. Financial Organization of Society. Call loans and stock-brokers, pp. 391-394. Pratt, S. S. The Work of Wall Street. Chapter 20. CHAPTER XXXI MONETARY PROBLEMS I. Controversies in Regard to Money and Banking. — Promi- nent among the many questions of economic interest which have aroused during the past century widespread public discussion in the United States, and at times violent partizan agitation, have been those relating to money and banking. In the first half of the last century banking policies occupied the center of the stage; in the latter part of the century the nature of the monetary me- dium and its volume. Early in the nineteenth century a struggle took place over the renewal of the charter of the First United States Bank. An attack was made on the ground that the bank was an undemocratic political institution, that it centralized the power of the federal government at the expense of state preroga- tives and local banks, and that the large holdings of capital by foreign stockholders menaced the independence of the United States. The Second United States Bank (1816-1836) had a stormy career. At the outset it had to contend with the rivalries of local banks; later in Jackson's administration the question of renewing its charter became a national issue. Again opposition was in- spired by the fear of a money monopoly. There were also con- tests in different states over questions of banking policy. On the one side was the effort in undeveloped communities lacking capi- tal to secure a larger command of credit. Frequently this led to the establishment of weak institutions, the overissue of notes, and reckless speculation. In opposition was the conservative desire to avoid these evils, and this was reinforced by a suspicion of money interests which might through banking institutions impose heavy burdens upon industry and agriculture. The early 427 428 BANKING AND CREDIT [ XXXI development of banking was thus constantly attended by dis- trust, bitter debate, and frequently by reversals of financial policy. After the Civil War public discussion was concerned with questions relating to money rather than with banking organiza- tion. In particular there was prolonged controversy over the issue of promissory notes or greenbacks by the government, and over the coinage of silver. As the legislation following these contests has left its impress upon our credit system, these topics require explanation. 2. Issue of Government Notes. — The Constitution is silent as to the power of Congress to authorize the issue of bills of credit or government non-interest promissory notes with no specific date of maturity. Experience with such notes, known as "con- tinental currency," during the Revolutionary period had been disastrous, and the convention which framed the Constitution decided to strike out a proposed clause conferring this power. Although the decision was adverse to positive authority, their issue is not specifically prohibited. Twenty -five years later when the government was in need of funds to carry on the war with England, issues of treasury notes were made. These were re- garded as emergency notes, in anticipation of revenue, and as soon as the war was over were quickly funded into long-term bonds. Of the five issues made at this time, four bore interest, and none were made legal tender. As nearly all the notes were in large denominations, they were not designed to go into general circula- tion to become a part of currency. At later periods Congress resorted to this financial expedient to secure funds when the Treasury was hard pressed, as during the years 183 7-1 843, occasioned by the panic of 1837 ; in the war with Mexico (1846) ; and in the panic of 1857. All of these notes bore interest and none of them were given a legal tender quality. XXXI] MONETARY PROBLEMS 429 3. Legal Tender Issues of Civil War. — As a result of the over- whelming financial demands made upon the Treasury during the Civil War, Congress not only authorized the issue of notes but swept aside all the restrictions which had been attached to pre- vious issues. It was argued that the government should not be dependent upon banks or loans; rather it should assert its power and dignity by the issue of its own notes : " To render the govern- ment financially more independent, it is necessary to make the United States notes a legal tender." This view prevailed, and Congress, by the act of February 25, 1862, authorized the issue of $150 million non-interest legal tender notes. Similar issues were authorized in July of the same year and in 1863, making in all $450 million. At first these notes could be converted into bonds, but this privilege was quickly rescinded. In 1865, at the close of the war, $433.1 million were outstanding in circulation. It is difficult to determine how far the issue of the greenbacks contributed to the derangement of prices and depreciation of the currency. Specie payments were suspended early in the war, and gold went to a premium. A considerable part of the government loans was in the form of short-term treasury notes (not legal tender) which circulated to some extent as money, and there was an expansion in local bank note issues. Each of these factors contributed to inflation. In 1862 the value of the paper dollar as measured in gold fell to 76 cents, in 1863 to 62 cents, and in 1864 to 39 cents. At the close of the war it was about 70 cents. When peace returned it was generally assumed that the green- back issues would be retired, but opposition quickly arose to any contraction of the currency. Some opposed because the redemp- tion of the notes would require additional tax burdens, and others because of the difl&culty in securing gold to be used for redemp- tion of the notes. These views were soon supplemented by the demand that the currency should be expanded instead of con- tracted. "Our currency, as well as everything else, must keep pace with our growth as a nation," declared a member of Congress. 430 BANKING AND CREDIT [ XXXI It was urged that contraction would reduce prices and that this would be injurious to business. Debts had been assumed on the basis of high prices, and it would be disastrous to force the debtors to pay in a dearer currency. Influenced by such arguments, only a small amount of contraction was effected — $44,000,000 being retired. In 1868 any further contraction was prohibited by Congress. 4. Constitutionality of Issues. — In the meantime the question of the constitutionality of legal tender notes was raised. In 1869 the Supreme Court decided adversely in a divided opinion, four to three. This decision created great dissatisfaction and a new case was brought before the court in 1 87 1 . The membership of the court was changed during the two intervening years by the appointment of two additional justices, and on this occasion the court sustained the constitutionality of the issue. "What we do assert is, that Congress has power to enact that the government's promises to pay money shall be, for the time being, equivalent in value to the representation of value determined by the coinage acts or to multiples thereof." A third decision a few years later justified the exercise of this sovereign power in times of peace as well as during an emergency created by war. It was not until 1875 that Congress took a decisive step to provide for a restoration of the depreciated currency to its value at par in gold; and resumption was finally achieved in 1879. By the act of 187s, it was intended that the greenback issues should be reduced to $300,000,000, but those who advocated inflation were strong enough in 1878 to enact legislation forbidding any further contraction of greenbacks. At that time there were $346,681,016 of these notes outstanding, and from that date the same amount has been carried as one of the liabilities of the Treasury. Occa- sionally it has been proposed that the notes be retired, and that the government free itself from any further responsibihty for the issue of bills of credit with the legal tender attribute. Time, how- XXXI] MONETARY PROBLEMS 431 ever, has confirmed their use, and as they form but a small portion of the currency and enjoy popular confidence; they are universally acceptable and are likely to remain in circulation for an indefinite period. 5. The Adoption of the Bimetallic System in 1792. — The first coinage act of 1792 established the bimetallic system with a mint ratio of I to 15 between gold and silver. Within a few years, however, gold was worth more in terms of silver than was recog- nized by the mint valuation, and consequently there was but little coinage of that metal. In 1834 that deviation was remedied by changing the mint ratio to approximately i to 16. This proved satisfactory for a few years, but after the gold discoveries in California and Australia, beginning about the middle of the cen- tury, gold fell in value. In other words, silver rose in value and was worth more in the bullion market than at the mint. Silver therefore was not coined. The stoppage of the coinage of silver dollars did not create any serious inconvenience, for the state banks were able to furnish notes in small denominations, which served the ordinary needs of retail trade and industry. The disappearance of the small silver coins in denominations of less than |i was, however, a more ser- ious matter, for banks did not issue notes in fractional parts of the dollar. To meet this difficulty. Congress lowered the weight of the subsidiary coins and thus made it unprofitable to melt the coins for sale as bullion. Silver dollars, however, went out of circulation and were unfamiliar to the generation living between 1850 and 1878. 6. Demonetization of Silver in 1873. — In 1873 the coinage laws were revised and in the act as finally passed no reference to the coinage of silver dollars was made. As these coins were not in circulation at the time, the omission did not attract attention. The discovery of new silver mines in Colorado quickly aroused 432 BANKING AND CREDIT [ XXXI inquiry, for the owners of the mines found that there was no provision for disposing of their product at the mint. Moreover, the bulUon value of silver was falling. Germany had recently changed from a bimetallic to a single gold standard, and to carry this out the German government sold a large amount of the dis- carded silver and this lowered the price. The mining interests of the West promptly demanded that silver be restored to coin- age and be remonetized. This demand was reinforced by other groups of inflationists who complained that the fall in commodity prices, accompanying the readjustment of industry after the Civil War, was occasioning great hardship. Particularly was this true of those who were in debt, as, for example, farmers in the purchase of land. All classes who favored a high level of prices joined together, not only to prevent the contraction of the green- backs, but also to re-establish the free coinage of silver. 7. Silver Purchase Acts. — The agitation became extremely bitter. The omission of silver dollars from the act of 1873 was declared to be. a premeditated plot which was planned by the creditor class, who profited by low prices. The " Crime of 1873" was denounced in heated campaign speeches. Congress went so far, in 1875, as to recognize the silver dollar as legal tender money, but made no provision for its coinage. Three years later silver won a partial victory. The Bland Act authorized the purchase and coinage of a limited amount of silver — at least $2,000,000 and not more than $4,000,000 per month. The new silver coins were not favored in the East ; individuals regarded them as cumbersome, and banks in some cities endeav- ored to cast discredit upon them by refusing to accept them in settling clearing-house balances. This was futile, for the coins were legal tender. In order to utilize the new coins as currency, Congress authorized the issue of silver certificates upon deposit of silver coins, and this form of representative money largely took the place of the coins in the northeastern section of the country. XXXI ] MONETARY PROBLEMS 433 The silver party still continued active; in 1890 it won another victory in the Sherman Act, which provided for the purchase of 54,000,000 ounces of silver annually. Instead of immediate coin- age, however, the Treasury was authorized to hold the silver bullion and issue treasury notes against this metal security. Only when the treasury notes were presented for redemption was --the silver to be coined into dollars. Success was short-lived; there was alarm over the ability of the government to maintain specie payments and the act was repealed in 1893. The advocates of silver did not accept this defeat. The fall of prices was world-wide and other nations were disturbed by popular discontent due to the unsettlement of values. Efforts were made to secure international bimetallism by common action of the more important commercial nations. While the free silver party welcomed support from any source, it insisted that this country should not wait for the consent of other nations. Rather it should proceed independently. No respect was given to the argument that, if the United States alone authorized the free coinage of silver at a ratio of i to 16 when the market ratio was I to 30, gold would disappear from circulation and that this coun- try would practically be placed upon a single silver standard. Contracts of indebtedness based upon a standard of gold would be disturbed if settlement could be made in a silver dollar worth only 50 cents in gold, and exchanges with countries which main- tained the gold standard would be subject to the continuous fluctuations in the relative value of the two metals. The presi- dential campaign of 1896 was waged upon this issue; the free silver party was defeated. Although there was an occasional renewal of interest in silver coinage, the movement had spent its force. There was a turn in the price level. Prices slowly began to rise, and the revival of industry in the closing years of the century destroyed the force of the arguments which had sustained the silver cause for so many years. 28 434 BANKING AND CREDIT f XXXI 8. Demand for Inflation. — In each of the two controversies which have been briefly described, it has been noted that the change in the price level was a powerful influence in provoking agitation. They both arose when the change was downward and the agitation was directed in favor of an expansion or inflation of the currency. The arguments rested upon the assumption that prices are determined by the volume of money. If there be a larger supply of money, prices will be higher ; if smaller, prices will be lower. In each case, however, the agitation was devoted to increasing the supply of a particular kind of money, regardless of the effects which this would have upon the monetary system as a whole. An increase in greenbacks would not necessarily increase the total mass of money, for both theory and experience show that if one form of money be increased in excess of public confidence, the other forms of money, in which there is general confidence and for which there is general acceptability, will tend to disappear from circulation. If greenbacks had been freely issued beyond the ability of the government to redeem them in gold, the monetary standard would no longer be gold, but government promissory notes. The result would be a paper standard. So, too, in the case of silver. If silver were freely coined and the public lost confidence in the ability of the government to redeem it in gold, gold would disappear from circulation. In each case gold would be valued more than the greenbacks or the silver; it would consequently be valued at a premium. It might remain in the country but it would be held simply as a commodity and its price determined like other commodities, by the current supply and demand. The advocates of greenbacks and of free silver paid little heed to such considerations; they were bent upon the increase of one particular kind of currency, irrespective of its influence upon the total volume. Q. Index Numbers. — Changes in prices are conveniently shown by the use of index numbers. An index number when XXXI] MONETARY PROBLEMS 435 applied to prices in its simplest form "is the price of a composite commodity unit, representing approximately the average price of commodities in general." ' Such a number for a given year by itself has little significance, but when compared with similar units for other years shows the changes which have taken place in the prices of commodities as a whole. Many methods have been decided for computing price index numbers, but the result- ant figures do not show great differences. The more common method is to select a given year or short period of years as a base, represented by loo, and calculate the figures for other years in percentages of the base year. For example, suppose that the following prices are given : Year Cattle (100 lb.) Cotton (lb.) Coal, Anthracite Chestnut (2,240 lb.) Steel, Structural (lb.) 1913 1917 1918 1919 1920 $8,507 12.560 17.625 16.869 15-381 $0,128 .261 .312 -351 .410 $5-313 5-933 6.693 8.304 9-551 $0,016 .062 -033 .027 -032 If the prices for 1913 be taken as the base for comparison, expressed as 100, and the prices for the succeeding years be com- puted in terms of percentages, the following table is derived : Year Cattle (100 lb.) Cotton (lb.) Coal, Anthracite Chestnut (2,240 lb.) Steel, Structural (lb.) 1913 1917 1918 1919 1920 lOO.O 147.6 207.2 198-3 180.8 lOO.O 203.9 243-8 274.2 320.3 100 .0 111.7 126.0 156.3 179-8 100. 387-5 206.3 168.8 200.0 ^ See references on the construction of index numbers at end of chapter. 436 BANKING AND CREDIT I XXXI In this form the series of prices for the desired commodities are more easily compared. A further step, however, can be advantageously taken; the four series may be averaged to show composite prices for each of the years: 1913 lOO.O 1917 212.7 1918 195-8 1919 199.4 1920 220.2 10, Index of United States Bureau of Statistics. — In the fore- going tables, only four articles are given, and each is considered of equal importance. Composite averages which are computed from such restricted data are likely to be distorted and do not express representative conditions. It is therefore desirable to include in the computation a large number of commodities and to weight them according to their relative importance, as deter- mined by the amounts consumed or marketed. For example, the United States Bureau of Labor Statistics in computing index numbers of wholesale prices includes over 300 articles and weighs the price of each article by the estimated quantity of the article marketed in the last census year. Not all, however, of the index numbers in current use present the comparisons in terms of relative numbers calculated in percentages. Bradstreet's index number, based upon about 100 articles, represents simply the sum of actual prices reduced to a per pound basis. Some of the bestknown index numbers use less than 50 series of quotations; that of the London Economist includes 44 articles, that of Sauerbeck 45, and the New York Annallist series 25. If the articles be wisely chosen, there is little variation between the index number based upon many commodities and that based upon a few. The table on the following page shows the changes in whole- sale prices between 1890 and 1920, according to the United States Bureau of Labor (1913 = 100) :^ ^ Monthly Labor Revicvi, Feb. J92i,p. 45. XXXI] MONETARY PROBLEMS 437 United States Bureau of Labor Index Number for Wholesale Prices Year Index Number Year Index Number 1890 81 1906 88 1891 82 1907 94 1892 76 1908 91 1893 77 1909 97 1894 69 1910 99 1895 70 1911 95 1896 66 1912 lOI 1897 67 1913 100 1898 69 1914 100 1899 74 1915 lOI 1900 80 1916 124 1901 79 1917 176, 1902 85 1918 196 1903 85 1919 212 1904 86 1920 243 1905 85 The bureau also publishes index numbers for retail prices of 22 articles of food for the years 1907-1920, as follows (1913 = 100) :^ United States Bureau of Labor Index Numbers for Retail Prices Year Index Number Year Index Number 1907 82 1914 102 1908 84 1915 lOI 1909 89- 1916 114 1910 93 1917 146 1911 92 1918 167 1912 98 1919 186 1913 100 1920 203 3 Monthly Labor Review, Feb. 1921, pp. 19-21. 438 BANKING AND CREDIT [ XXXI II. Effects of Fall in Price Levels. — Reference has been made to the fall of prices after the Civil War, continuing until nearly the end of the last century, and to the influence of this decline in arousing demand for inflation in the currency, either by an increase in government paper money or by the free coinage of silver. Beginning with 1897 there was an upward movement in prices, and during the recent war the advance was extreme. As early as 19 10 the advance had attracted wide public discussion and created what is popularly known as the "cost of living" problem. More recently, beginning with 1920, there has been a fall in prices. The effects of these opposing movements may be briefly summarized as follows. A fall in prices is especially disadvantageous to producers who have borrowed money at a higher level. The debt, including principal and interest, is a fixed overhead charge which must be met, though the selling price of goods falls. The creditor on the other hand gains by a fall in price, and in the organization of economic society as a whole it may be said that the loss of one class is offset by the gain of the other. If, however, a particular business is based largely upon borrowed capital, so that interest forms a large item in the cost of production, there is little com- pensation, to those engaged in that class of enterprise, from a fall in prices. This was the position of many farmers who pur- chased farms or farm equipment upon borrowed money at the close of the Civil War, and as a result many of this class supported the earlier proposals for inflation. A similar disadvantage is found in branches of business which are accustomed to carry large inventories of raw materials or finished goods. If prices fall, sales must be made at a loss. Moreover, in a falling market the demand for goods is hesitating, for each possible buyer is influenced by the consideration that by waiting he may be able to purchase the goods desired at a lower price. Falling prices thus place a burden upon debtors, may depress business, and if long continued may cause unemployment. XXXI] MONETARY PROBLEMS 439 Wages will undoubtedly be reduced, but the wage-earners do not necessarily suffer since they are compensated by the reduced cost of living. Current transactions can be adjusted to a new level without serious disturbance, but the settlement of contracts made in the past is far more difl&cult. 12. Influence of Rising Prices. — On the other hand, rising prices, which are advantageous to the producer, are a burden upon the consumer. If the consumer is at the same time a producer to an equal degree, his purchasing power is not changed, but if the rise be rapid it is difl&cult to make these adjustments promptly, so that the burden of an increasing cost of living will not be felt by a part of the community. The rise in prices places greater burdens upon investors and those who receive fixed salaries. Investors, however, though powerless to obtain relief until their investments mature, and though they must make sacrifices, are not as a class endangered, for the possession of an investment gives some protection. The salaried class will be at a disadvan- tage, for salaries do not quickly respond to changing conditions of economic life, but this group generally has a margin of com- pensation which it can sacrifice without immediate and serious distress. Wage-earners are more frequently in a position to secure a readjustment of compensation in proportion to the cost of liv- ing. The rise in prices stimulates business enterprise, for the manufacturer is protected to a certain degree against loss by the advance in the price of the raw materials which enter into the finished product, during the time which it takes to manufacture the goods; and the trader is likewise safeguarded because to the profit obtained by marketing is added the differential due to price increase. During the period of rising prices there is a greater disposition to assume the risk of indebtedness. High profits not only justify an expansion of business upon credit, but also beget carelessness in incurring debts. As long, however, as prices rise, danger does not appear imminent. 440 BANKING AND CREDIT [XXXI Many reasons have been given for the rise of prices beginning in 1915, and various plans have been proposed not only to check the rise but also to restore the pre-war level. Special causes which affect prices, as changes in cost of production, tariff duties and taxation, monopolies, trade union regulations, extravagance and speculation, lie outside of our subject matter, but the relation of the volume of money to prices requires a brief consideration in order to explain the question of inflation as it was developed dur- ing the war period. 13. Quantity Theory of Money. — Economists with few excep- tions agree that the quantity of money is an important factor in determining the general level of prices. This is known as the ' ' quantity theory of money. ' ' In the making of prices two factors are included: first, the volume of business transactions, and second, the supply of currency. If the supply of money and other forms of credit currency increases faster than the quantity of goods transferred in the market, prices will rise ; if the quantity of goods to be marketed increases faster than the circulating me- dium, prices will fall; and if both increase or decrease in the same proportion, prices will remain stationary. This principle may be illustrated by assuming that a sudden addition is made to the supply of money. If $100 million worth of gold be brought from the mines to the mints, the owners of this gold will be in possession of that amount of coin which will be spent in some form or other. A part will be expended for commodities and this will create an additional demand for these goods. Their price will tend to rise. Or if the mine-owners invest a part in securities, as of railroads or manufacturing corporations, the money will be used by these companies in the purchase of suppHes and equipment, and again there will be a tendency for such goods to rise in price. Labor and goods engaged in the proc- ess of mining have been converted into the money article, which is thereby effedtive for continuous exchange and valuation of articles. XXXI] MONETARY PROBLEMS 44 1 Or suppose that there are 100,000 workmen whose labor can be appHed either to agriculture for the production of wheat or in mining for the production of gold, and that before labor begins operations an ounce of gold is worth 20 bushels of wheat. If gold is $20 per ounce," the price of wheat is $1 per bushel. Let it also be assumed that labor is equally productive, whether in agricul- ture or in mining; that is, during a year a workman can produce, over and above the cost of production, either 1,000 bushels of wheat or 50 ounces of gold. If mining has been undertaken, there is an immediate market for the gold at the mint at a fixed price, viz., $20 per ounce, and it is at once converted into coin which has a purchasing power of $100 million. If there be no greater amount of wheat on hand at the end of the year, and there is nothing to purchase with the gold except wheat, it is obvious that the added purchasing power of $100,000,000 would greatly in- crease the demand for wheat. An owner of gold would give more than a twentieth of an ounce, or $1 of gold, for a bushel of wheat. The price of wheat would rise. On the other hand, if the labor had been directed to the grow- ing of wheat, 100 million bushels would be offered for sale. If there be no greater amount of gold at the end of the year than there was at the beginning, and there was nothing to exchange for the wheat except gold, it is obvious that the added offering of 100 million bushels of wheat would greatly increase the de- mand for gold. An owner of a bushel of wheat would give more than a bushel for a twentieth of an ounce of gold, or $1 . That is, the price of a bushel would be less than $1, or price falls. If 50,000 workmen are engaged in raising wheat and 50,000 in mining gold, the result would be 50 million bushels of wheat and 25,000 ounces of gold. The purchasing power of the gold is $50 million and the ratio of wheat to gold is exactly the same as at the beginning of the year. '' $20, rather than the actual mint price of gold, is assumed for convenience in calcula- tion. 442 BANKING AND CREDIT [XXXI In the foregoing illustration it has been assumed that there are only two commodities, wheat and gold. The same forces are operative if there be more than two commodities. Assume that 50,000 workmen mine gold, 25,000 raise wheat, and 25,000 manu- facture woolen cloth; also that before this new production, a bushel of wheat will exchange for a yard of cloth. Prices, there- fore, are: wheat, $1 per bushel; cloth, $1 per yard. At the end of the year there is a new supply of gold convert- ible into coin, $50 million. There is also an addition of 25 million bushels of wheat and 25 million yards of cloth. There is no change in the ratio between wheat and cloth, but there is a change in the ratio between gold and wheat, and equally so between gold and cloth. The possessors of gold may prefer to increase their holdings of cloth rather than of wheat. Purchasing power will be directed toward cloth more than toward wheat. The price of cloth will rise accordingly, and if purchasing power is not applied to wheat, the price of that commodity may not be affected. But it is probable that the possessors of cloth may desire a greater amount of wheat. With the gold obtained in exchange for cloth, they will apply their purchasing power upon wheat, and the price of wheat rises. The mere presence of gold does not change prices, but the use of gold is its influence upon purchasing power. 14. Credit Money and the Quantity Theory. — A similar effect is brought about if forms of credit money, as, for example, bank notes or deposit credits, are created. As money and credit instruments are identical in their power to effect exchanges, their use affects prices in an equal degree. Taussig states this position as follows: A purchase on credit has the same immediate effect in prices as a purchase with cash. If, in addition to a given number of pur- chasers offering money, there are as many more, whose credit is good, offering to buy on time, the effect on the seller is the same XXXI] MONETARY PROBLEMS 443 as if the entire number offered money. With a fixed supply of commodities, prices would double in either case. ^ The credit of banks or of business enterprise is transformed into a medium by which purchasing power is expressed. The increase in spending power is illustrated by the loans of national banks. In 1914 (June 30) these amounted to $6,430 million; in 1918 (November i) they were $10,097 niillion; and in 1920 (May 4), $12,289 million. In six years the banks were able to grant to borrowers facilities by which they could nearly double their purchasing power. This would constitute an important factor in increasing the demand for commodities and tend to raise prices. These loans were not necessarily made in actual money, but could be effected by deposit credits. If these new loans and deposit currency represented a corre- sponding increase in business transactions and consequently an increase in the amount of money work to be done, there would be no change in prices. If, however, they represented new acces- sions of money, as gold and bank notes, with a proportionately less amount of business transactions to be handled, the relation between the money supply and commodities would be changed and prices would rise. This was the ^ase. Large imports of gold meant a decrease of commodities in return for an increase of gold; large issues of federal reserve notes in exchange for government obligations meant a consumption and destruction of commodities in return for ultimate promises of the government. The govern- ment through the machinery of bond issues and the federal re- serve banks was a generous spender; its increased purchasing tended to raise prices; and this in turn enabled individuals who produced to increase their purchasing power. But there was not a corresponding increase in production or amount of commodities to be sold. Purchasing power outstripped the volume of business transactions to be handled. S p. W. Taussig, Principles of Economics, Vol. I, p. 427. 444 BANKING AND CREDIT [ XXXI In the application of the quantity theory of money, money is given a broad interpretation — it includes not only gold and silver coins, government promissory notes, and bank notes, but also deposit currency — it comprehends everything which performs the work of money. Consideration must also be given to the velocity of circulation — that is, the rapidity with which exchanges can be effected — and also to the volume of trade which gives rise to exchange transactions. As Walker states it: We should all agree that the value of money depended on the demand for and supply of money. In speaking of the demand for money, we should of course understand that the effective occa- sions for its use in exchange were meant, and consequently, we should have reference not merely to the amount of goods pur- chased, but also to the frequency with whichthose goods were to be exchanged in their passage from producer to consumer. Again, in speaking of the supply of money, it would be understood, almost without the necessity of explanation, that reference was had, not alone to the number of money pieces, but also, and conjointly with this, to the rapidity of their circulation. "The nimble six- pence does the work of the slow shilling."* It must not therefore be assumed that it is an easy matter to determine what prices will be, simply from a consideration of the volume of money. There is a continuous change in the volume of trade, in the velocity of circulation of money and credit, in the ratio between bank reserves and deposits, and in the volume of deposits. All that can be claimed, at the present stage of analysis of market and trade operations, is that over a long period of time the quantity of money determines the level of prices. During shorter periods there are many factors, whose influences are not as yet clearly understood, which enter into the determination of current prices. Particularly is this true of transition periods so characteristic of the business cycle today. ^ "The Value of Money," paper read before American Economic Association (1893). published in Discussions in Economics and Statistics, Vol. I, p. 196. XXXI ] MONETARY PROBLEMS 445 Professor Irving Fisher, one of the most recent and vigorous ad- vocates of the quantity theory, makes the following qualifications : We have seen, for instance, that a sudden change in the quan- tity of money and deposits will temporarily affect their velocities of circulation and the volume of trade. Reversely, seasonal changes in the volume of trade will affect the velocities of cir- culation, and even, if the currency system is elastic, the quantity of money and deposits. In brisk seasons, as when "money is needed to move the crops," the velocity of circulation is evi- dently greater than in dull seasons. Money is kept idle at one time to be used at another, and such seasonal variations in veloc- ity reduce materially the variations which otherwise would be necessary in the price level. In a similar way seasonal varia- tions in the price level are reduced by the alternate expansion and contraction of an elastic bank currency. In this case tem- porarily, and to an extent limited by the amount of legal tender currency, money or deposits or both may be said to adapt them- selves to the amount of trade. In these two ways, then, both the rise and fall of prices are mitigated. Therefore the "quan- tity theory" will not hold true strictly and absolutely during transition periods.^ 15. Relation of Prices and Volume of Currency Illustrated. — During the recent rapid rise of prices, there was a great increase in the volume of currency. Is there any causal relation between the two movements? The question may be illustrated by an analysis which Professor E. W. Kemmerer has made, represent- ing the growth of business (as indicated by 12 indices, e. g., production of pig iron, wheat, cotton, coal, freight tonnage, building, etc.), monetary circulation, deposit currency, and prices. ' Using index numbers in order to compare different economic movements, the changes which took place between 1910 and 1917 are presented as follows (the average of 1910-1914 = 100): ' The Purchasing Power of Money, p. l6l. ' "Inflation, " in American Economic Review, Vol. VIII Qune 1918), p. 247. 446 BANKING AND CREDIT [XXXI Table Showing Changes in Several Economic Factors, igics-igiy Year Growth of Monetary Bank Wholesale Business Circulation Deposits Prices 1910 93 95 90 99 1911 95 98 94 97 1912 102 100 102 101 1913 105 102 104 102 1914 104 106 no lOI 1915 108 III 118 102 1916 113 125 147 125 1917 127 148 , 174 178 From this table it can be computed that growth of business increased between 1913 and 1917, 21 per cent; monetary circula- tion 45 per cent; bank deposits 67 per cent; and prices 75 per cent. During the next two years, 1918-1919, the physical volume of trade declined, while there was a further increase in monetary circulation, bank deposits, and prices. If the volume of trade declined, it may be assumed that the volume of exchange trans- actions requiring the use of money declined. The need of money to do money work accordingly diminished. If at the same time the volume of money and bank credit increased and prices of practi- cally all commodities were higher, it is concluded that the cause was an increased supply of money rather than a scarcity of goods. 16. Equation of Exchange. — The operation of the quantity theory of money may be expressed by an algebraic formula. Professor Kemmerer states it as follows:' MR N prite. = money. = rapidity of circulation. = the amount of business or number of business transactions. P = P M R N ' E. W, Kemmerer, Money and Prices, p. is. XXXI] MONETARY PROBLEMS * 447 Professor Irving Fisher presents the equation of exchange in somewhat fuller form : MV + M'V = FT M represents the volume of money in circulation, exclusive of the amount in the United States Treasury and banks. V represents the velocity of its circulation, that is, the number of times that the money in circulation is turned over in a year. M represents the volume of bank deposits subject to check. V represents the velocity of circulation of M', that is, the activity of bank accounts. T represents the volume of trade, or the transactions effected by money and deposits. P represents the price level. In the above equation, therefore, MV, representing the prod- uct of the money in circulation multiplied by its velocity of circulation, expresses the total monetary circulation or the total expenditure of money per annum. In the same way M'V expresses the total deposit circulation, or the total expenditure by checks per annum. PT represents the total value of the goods bought, expressed as the product found by multiplying the price level by the volume of trade. From this equation, it is obvious that: „ MV+M'V' As V (velocity of money in circulation) is fairly constant, this means that the price level moves up or down according to the increase or decrease in money, to the change in deposits subject to check, and to the varying velocity of the deposit checks. The change in M'V is reflected in the fluctuations in bank clearings. The foregoing equations of Kemmerer and Fisher are in no sense a proof of the quantity theory of money. They are simply 448 BANKING AND CREDIT [ XXXI expressions of an identity. The equivalence of the two sides of an equation over a period of years neither demonstrates nor dis- proves the quantity theory. Statistical calculations have been made by Professor Fisher for the five factors, M, M' , V, V, and T for a series of years beginning with 1896, and the resultant values of P determined. A comparison of these values with the actual level of prices as determined by index numbers shows but slight differences. 17. Multiple or Tabular Standard of Value. — Various pro- posals have been made to remedy the disturbances caused by fluctuations in the price level. One of the earliest of these plans was the multiple or tabular standard of value, based upon the prices of commodities. By the use of such a standard a debtor would pay in money, not the sum which he originally borrowed, but a sum which would buy the same amount of goods as could have been purchased at the time the debt was contracted. The determination of these amounts would be effected through the preparation and publication of index numbers by some con- stituted authority, as the government; and the changes in index numbers would measure the money equivalent to be paid. Reference has been made to the fall of prices after the Civil War. Let it be assumed that the index number of articles selected for the multiple standard was 120 in 1870 and that a debt of $1,000 was incurred in that year, running for five years at 6 per cent interest. At the end of one year, when interest is due, the index number stands at 114. How much should the debtor pay and how much should the creditor receive, in order to remain on exactly the same economic footing as when the loan was made? The prices of commodities have fallen 5 per cent; obviously $57 will purchase as much as the $60 anticipated. The creditor is receiving a compensation, measured in purchasing power, which will give him the same purchasing power as he enjoyed when he made the loan. XXXI] MONETARY PROBLEMS 449 If the index number should rise to 126, economic equity, by the same reasoning, would demand that the debtor pay $63 in order that the creditor should not suffer any real loss in the in- come which he expected. In the table on page 43 7 it is seen that prices rose between 1896 and 1913, a period of 17 years, from 67 to 100. If an investor purchased in the former year at par a 4 per cent $1,000 bond, maturing in 1913, he would receive annually $40, and at maturity $1,000. As prices rose, the $40 which the investor received year by year would purchase a diminishing amount of articles, and in 1 91 3, the $i,coo received on pajmaent of the principal of the loan would purchase far less than in 1896. Not only did the in- terest payments yield less real income than had been anticipated, but the purchasing power of the principal when returned, was less by one- third. As yet proposals for the substitution of a standard other than gold have attracted but little interest. Index numbers are only approximations of the actual level of prices and their proper construction is still a matter of dispute, owing to technical difficulties in the selection of the articles, the variation of prices of the same article in different markets, and the uncertainty of the degree of weight to be given to the several commodities. Notwithstanding their defects, which make the compulsory acceptance of such a standard undesirable, the principle of a multiple standard has been used, apparently with advantage, by voluntary agreement. For example, certain employers pay their workmen wages which are periodically adjusted to prices as indicated by one of the current series of index numbers. 18. Stabilized Dollar. — The use of a multiple standard does not do away with price fluctuations; it is simply a device to mitigate the evils. In more recent years, attention has been directed to the possibility of preventing price fluctuations by changes in the money standard. For example. Professor Fisher 29 450 BANKING AND CREDIT I XXXI proposes that the weight of the gold dollar be varied so as to keep its purchasing power unvariable. ' ° "We now have a gold dollar of constant weight and varying' purchasing power. We need a dollar of constant purchasing power and therefore of varying weight." Professor Fisher would not abandon the gold standard, but simply change the weight of the gold dollar as prices rose or fell. Gold coins would be abolished and the government would hold all the physical gold, against which bullion certificates are to be issued. Thus an ounce of gold held by the government would support a varying number of dollar bullion certificates, according as prices changed. The degree of change in the weight of the gold dollar supporting the bullion certificate would be adjusted to the change of prices as determined by the index number of prices. If prices rise i per cent, i per cent more gold will be added to the dollar. As all gold circulated in the form of paper representa- tives, it would be possible to vary at will the weight of the gold dollar "without any annoyance or complexity as would arise from the existence of coins." The result would be a stabilized dollar. The plan has the merit of simplicity, but, like the use of a multiple standard, involves a radical change in the habits of the business world. It is not likely, therefore, that it will receive any large degree of support in the near future. It is desirable, however, that the unsatisfactory service of the present monetary standard be clearly recognized and that sympathetic consideration be given to all proposals that might diminish violent changes in the purchasing power of money. References The Quantity Theory of Money Carver, T. N. Principles of National Economy, pp. 385-388. Clay, H. Economics for the General Reader, pp. 198-203. '" This plan is fully described, and objections considered, in Irving Fisher, Stabiliz- ing the Dollar (1919). The author cites writings of others who have proposed similar plans. XXXI ] MONETARY PROBLEMS 45 1 Fetter, F. A. Modern Economic Problems, pp. 30-35. Gide, C. Political Economy, pp. 232-237. Laughlin, J. L. Principles of Money. Presents a detailed discussion of the theories of different writers. His position is adverse to the theory, pp. 225-334; Taussig, F. W. Principles of Economics. Vol. I. The theory is accepted if "rightly stated," pp. 236-242. Westerfield, R. B. Banking Principles and Practice. Vol. I, pp. 162-172 . Proceedings of the Meeting of the American Economic Associa- tion, held at St. Louis, Dec. 1910, published as supplement of the American Economic Review, Apr. 191 1, pp. 37-70, contains a paper by Professor Fisher, and criticism by other speakers. Much of this is reprinted in Phillips, C. A., Readings in Money and Banking, pp. 159-210. Index Numbers Mitchell, W. C. Index Numbers of Wholesale Prices in the United States and Foreign Countries. Secrist, H. Introduction to Statistical Methods, pp. 294—396. Johnson, J. F. Money and Currency, pp. 103—112. Taussig, F. W. Principles of Economics. Vol. I, pp. 290-296. Equation of Exchange Fisher, I. Purchasing Power of Money. Especially Chapter 12, pp. 276-318, where the author makes a fqll statement of his method and presents the results of his statis- tical calculations. Generous recognition is given to the work of Professor E. W. Kemmerer, Money and Credit Instruments in Their Relations to General Prices (1909) . Professor Fisher's analyses are also presented in the American Economic Review, Vol. I (1911), pp. 296-305; Vol II (1912), pp. 302-319; VoL III, pp. 196- 198; Vol. IV, p. 46s; Vol. V, pp. 407-413; Vol. VI, p. 457; Vol. VII, pp. 934-938; Vol. VIII, p. 871; Vol. IX, pp. 407-409; these continue the calculations of the equation through the year 1918. APPENDIX A PROBLEMS WITH SOLUTIONS In banking and credit, as in other branches of economics, a liberal use of illustrative problems serves, to promote effectively a thorough grasp of the subject. Not only is the student given a nucleus about which he can center his ideas gained in dealing with material of a more abstract nature, but he has the important satisfaction of knowing that he has accomplished some concrete and tangible part of his task. From the viewpoint of the teacher a well-selected problem should serve as a talking point or a text, from which he can expand and digress as much as he judges it to be desirable. Naturally many points are not susceptible of one definite answer but are more or less moot; not to bring this to the realization of the student is, of course, quite as bad as to leave him with merely very general impressions. Solutions have been furnished with some of these problems for two chief reasons; first, in order that they may serve as a guide in working out similar problems set by the instructor and, second, to save time for the reader or student who can master the point of the problem without obtaining an independent answer. For the purpose of providing the student with similar problems for independent solution, the instructor may easily vary the figures in the problems presented here in the Appendix as well as those scattered throughout the main part of the text. To aid the reader in solving the problems, interest tables will be found in Appendix C. I. A mining company sends to the United States Mint 10,000 ounces of gold, .950 fine. The mint charges 2 cents an ounce for removing the im- purities. The gold is coined into pieces of standard fineness. How much gold will the company receive in dollars, there being no charge for coining 453 454 APPENDIX except lyi cents per ounce for the copper alloy? The coining value of an ounce of pure gold is $20.67183. United States gold coins are 9/10 fine and i/io alloy. Solution i (basis value) : 10,000 ounces .950 fine = 9,500 ounces pure gold 9,500 ounces pure gold X $20.67183 = $196,382.39, value in coin 9,500 -j- 9 = 1,055.55 ounces of alloy 1.055-55 X $.02 1/2 = $26.39, charge for alloy 10,000 X $.02 = $200, charge for refining $200 + $26.39 = $226.39, total charges $196,382.39 — $226.39 = $196,156.00, net coin received Solution 2 (basis weight): I ounce troy weight = 480 grains Fine gold in $1 = 23.22 grains 9_,50o2l48o ^ ^^ ^ ^^^^_^3^ ^^ 23.22 $196,382.43 — $226.39 charges as above = $196,156.04, net coin received. Difference of $0.04 in answer is due to use of decimal fraction in Solution 1. 2. Suppose that the weight of the gold dollar is increased i percent. What will be the mint price of gold per fine ounce? Solution: Grains of fine gold in dollar at present 23.22 Add I % 0.2322 Grains if weight is increased i % 23.4522 Divide 480, the number of grains in an ounce of gold, by 23.4522 (times $1) and the result, $20.47, will be the mint price under the conditions given. 3. Suppose that the weight of the gold dollar is increased i per cent. What will be the par of exchange with England? Solution: Grains of fine gold in dollar if weight is increased i % . . . 23.4522 Grains of fine gold in a sovereign 1 13.0016 Dividing 113. 0016 by 23.4522 (times $1), the result, $4,818, is the par of exchange with England under the conditions given. PROBLEMS WITH SOLUTIONS 455 4. Suppose that the gold dollar is 11/12 fine, with no change in weight. What will be the mint price of gold per fine ounce? Solution: Present weight of gold dollar, 25.8 grains 11/12 X 25.8 = 23.65 grains of fin^e gold Divide 480, the number of grains in an ounce of gold, by 23.65 (times $1) and the result, $20.30, will be the mint price per fine ounce under the conditions given. 5. Suppose that the gold dollar is i i/i 2 fine with no change in weight . What will be the par of exchange with England? Solution: Grains of fine gold in dollar if 11/12 fine 23.65 Grains of fine gold in a sovereign 1x3.0016 Dividing 113.0016 by 23.65 (times $1), the result, $4,778, would be the par of exchange with England under the conditions given. 6. If a $20 gold piece is melted what will the gold bullion be worth? If $20 in silver dollars is melted what will the silver buUion be worth? Explain the reason for the difference. Assume that the gold and silver coins are full weight and have not been worn by circulation. Solution: (a) Grains of pure gold in a dollar, 23.22, and in JS20, 464.40 464.40 464.40 grains = ounces 480 ' '■ — X $20.67, mint price per fine ounce = $20 480 (The calculation does not work out exactly $20, which is the correct answer, as the mint price, $20.67, is not an exact figure but the price to the nearest cent.) (b) Weight of a standard silver dollar is 412.5 grains 9/10 fine; $20 in silver therefore contains 8,250 grains 9/10 fine. The price of silver like any other commodity is continually changing. At 60 cents per standard ounce, 8,250 grains is worth X $0.60 = $10.3x25, or each silver dollar will 480 have an intrinsic value of $0.515625. 456 APPENDIX (c) Gold is the monetary standard of the United States and has a free and unlimited coinage. Anyone may send gold buUion to the mint and after paying slight charges for assaying and refining, etc., will receive coins equal in weight to the metal sent. Gold bullion of a given weight and fineness, therefore, will command in the market a price equal to the number of gold doUars it wOl make if coined. The possibility of melting the coin into bullion or having the buUion coined causes an interchange- abUity and consequently an identical value for a given quantity of gold in the form of buUion or coin. It is assumed, of course, in the above statements that we are consider- ing the normal situation when the country is actually on a gold standard and has not temporarily suspended specie payments, as in the case of most European countries at present. Silver does not have free and unlimited coinage like gold; no individual may send silver bullion to the mint for coinage. From time to time sUver is purchased in the market by the government in competition with other buyers who desire it for industrial and other commercial purposes. In 1919 silver bullion reached an exceptionally high price and this was reflected in high exchange rates on silver standard countries. In order to stabilize such exchanges and more particularly those on the Far East, the Treasury released for foreign shipment some of the silver dollars it then held. At the same time Congress passed a law which provided for the subsequent purchase of an equivalent amount of silver bullion at $1 an ounce to replace these silver dollars which had been released by the Treasury. Aside from this artificial price , which wUl disappear when the total quantity of bullion provided for is purchased, the price of silver is determined in the same way as the price of any other commodity. Only by limiting the number of silver coins to the needs of the country can their value be kept equal to the value of gold coins. Obviously , when- ever the government purchases 50 cents' worth of silver and coins 4 quar- ters or 10 dimes it is making a profit of 50 cents. This source of profit, however, has decided limitations. Any attempt to carry it beyond the needs of the country would endanger our gold standard and bring about confusion in our monetary system. 7. A business house negotiates a loan at its bank by discounting a 60- day non-interest-bearing note for $10,000 received from a customer. The note is discounted at 7 per cent on the day it is received and the borrower agrees to maintain a deposit balance of about 20 per cent of the loan, or, say, $2,000. PROBLEMS WITH SOLUTIONS 457 (a) What is the real rate of interest paid by the borrower, assuming that the bank pays no interest on deposit balances? (b) Answer the same question assuming that the bank pays 2 per cent interest on the deposit balance which averages $2,000. Solution: (a) Face of 60-day note $10,000.00 Deduct interest at 7% for 60 days 116.67 Proceeds to credit of borrower $9,883.33 Deduct balance not withdrawn 2,000.00 Amount of loan actually used $71883.33 $116.67 - — = .0148, rate of interest for 60 days $7,883.33 .0148 X 6 = .0888, rate of interest for i year of 360 days (b) 7% discount on $10,000 for 60 days $1 16.67 Deduct 2% interest on $2,000 for 2 months 6.67 Net cost of funds borrowed $1 10.00 Amount of loan actually used $7,883.33 $110.00 = .014, rate of mterest for 60 days $7,883.33 .014 X 6 = .084, rate for I year of 360 days 8. On April i a merchant presents for discount at a bank a note dated the same day for $5,000 due in 60 days. The note bears interest at 6 per cent and the bank's rate of discount is 6 per cent. What will the note yield to the merchant? On May i the bank sells the above note to another bank at the same discount rate. What profit will the first bank make by the transaction? The second bank? Solution: April I Pace of note $5,000.00 Add interest for 60 days at 6% 50.00 Amount due on note at maturity $5,050.00 Deduct discount for 60 days at 6% 50.50 Proceeds received by merchant $4,999.50 458 APPENDIX May I Amount due on note at maturity $5,050.00 Deduct discount for 30 days at 6% 25.25 Proceeds received by first bank $5,024.75 Cost to first bank 4>999-5o Profit of first bank $25.25 Proceeds received at maturity by second bank $5,050.00 Cost to second bank 5,024.75 Profit of second bank $25.25 9. (a) If a bill is drawn to mature 3 months from August 25, when does it become due? (b) If a bill is drawn to mature 90 days from August 25, when does it become due? Solution:' (a) November 25, unless that date falls on Sunday or a holiday, in which case the due date would be the next business day following Novem- ber 25. (b) November 23, unless that date falls on Sunday or a holiday, in which case the due date would be the next business day following Novem- ber 23. 10. Find the net proceeds of a 90-day note for $1,200 dated September 1 2, bearing 5 per cent interest and discounted October 7 at 6 per cent. Solution: Face of note $1,200.00 Add 90 days' interest at 5% 15.00 Amount due at maturity $1,215.00 Due date 90 days from September 12 is December 11 Discounted October 7 for 65 days Discount for 65 days at 6% on $1,215 is 13.16 Net proceeds $1,201.84 11. On October 26 the Washburn Chemical Company of Boston sold to its bank a 60-day promissory note for $3,000, dated October 21 and bearing 7 per cent interest. The bank's discount rate was 7 per cent. What are the proceeds? PROBLEMS WITH SOLUTIONS 459 Solution: Face of 7% 6o-day note $3,000.00 Interest for 60 days at 7% 35-00 Amount due at end of 60 days $3,035.00 Discounted October 26 for 55 days at 7% • 32.46 Proceeds $3,002.54 12. In what time approximately will it take a given sum to double itself at compound interest at a given rate? For example, how long would it require $100 placed in a bank at 4 per cent, interest compounded quarterly, to amount to $200? Solution: The following approximation formula is convenient for obtaining results accurate to within less than a year: •693 , n = — + .35 t where n represents the number of periods (i year, J^ year, % year, etc.) and i represents the rate of interest for a period. Solving the above prob- lem we get : .693 M = h .35 = 69.65 periods of 1/4 years, or 17.4 years .01 If we divide 70 by the rate of interest the result is close enough for most practical purposes and the formula can be remembered more easily when thus simplified. 13. Many banks advertise the payment of interest on daily balances of checking accounts at a nominal rate, which is commonly 2 per cent. One method of computing the interest is to add together the balances for each day and allow a i day's interest on the total. For example, suppose that the bank's account with the ABC Company showed these facts: May Deposits Withdrawals Balance I $700 $... $700 2 400 200 900 3 900 4 750 500 1,150 5 360 400 1,110 6 900 700 1,310 460 Deposits Withdrawals Balance May 7 450 560 1,200 8 600 450 1,350 9 525 875 1,000 10 ... ... 1,000 11" 875 600 1,275 12 690 580 1,385 13 430 800 1,015 14 510 620 905 15 770 475 1,200 16 600 560 ' 1,240 17 ... ... 1,240 18 685 535 1,390 19 715 650 1,455 20 565 800 1,220 21 740 860 1,100 22 800 600 1,300 23 910 720 1,490 24 ... ... 1,490 25 760 810 1,440 26 450 625 1,265 27 950 700 1,515 28 1,000 650 1,865 29 540 890 1,515 30 760 950 1,325 31 •■• .•• 1,325 $17,435 $16,110 $38,575 One day's interest on $38,575 at 2 per cent per annum is $2. 11. 14. On January i, 1922, $300 is deposited in a savings bank which pays 4 per cent interest, compounded semiannually. What will the deposit amount to 10 years later? Solution: Refer in Appendix C to Table 3, "Compound Interest on fi." Since interest is to be compounded twice a year there will be 20 interest periods and the interest rate is 2 per cent per period. Therefore, if we take the figure in the table, opposite 20 periods and under 2 per cent, we find that f i deposited at 2 per cent interest per period will amount to $1.485947 at the end of 20 periods. Similarly $300 will amount to 300 X $i.485947j or $445-78. PROBLEMS WITH SOLUTIONS 461 15. A father wishes to set aside in a bank, at the birth of his son, a sum which will accumulate to $10,000 by the time the son reaches his majority. Assuming that the bank rate of interest is 4 per cent, compounded semi- annually, what is the sum required? Solution: Refer in Appendix C to Table 4, "The Present Worth of $1." Since interest is to be compounded semiannually there will be 42 interest periods in 21 years and the semiannual interest will be 2 per cent. Therefore, if we take the figure in the table, opposite 42 periods and under 2 per cent, we firid that $0.435304128, set aside and allowed to accumulate at 2 per cent semiannual interest, will amount to $1 at the end of 21 years. In order to accumulate $10,000 under the same conditions, it would be necessary therefore to set aside 10,000 times $0.435304128,' or $4,353,041. 16. A man puts $25 into a savings bank at the end of every month for 10 years. If the bank pays 4 per cent interest per year, compounded semi- annually, what will the savings amount to at the end of 10 years? Solution: Refer in Appendix C to Table 5, "The Amount of $i per Annum." Since interest is to be compounded semiannually, there will be 20 interest periods in 10 years and the semiannual interest will be 2 per cent. Therefore, if we take the figure in the table, opposite 20 periods and under 2 per cent, we find that $1 set aside each 6 months, at 2 per cent semiannual interest, will amount to $24.297370. $25 set aside each month, or $150 each 6 months, therefore amounts to 150 X $24.297370 or $3,644.61. 17. Banking transactions: Puritan National Bank Resources Loans and discounts $8,550,000 United States bonds i ,890,000 Other bonds and securities 1,015,000 Customers' liability account of acceptances 315,000 Stock in federal reserve bank 60,000 Banking house and vaults 160,000 Exchanges for the clearing house 300,000 Cash 285,000 Due from banks 700,000 Interest earned, not collected 30,000 $i3,305>ooo 462 APPENDIX Liabililies Capital $1,000,000 Surplus and undivided profits 1,540,000 Reserve for taxes and interest 45.0O0 Unearned discount 1 15,000 National bank notes outstanding <)(>i,92o,493, additional notes (i/io of new paper) $271,860,493, new total notes .40, (40% gold reserve) (i) $108,744,197, gold reserve against notes $116,515,000 .(T. D.) + 3591284,436, additional deposits (9/10 of new paper) $475,799,436, new total deposits ■35. (35% cash reserve) (2) $166,529,803, cash reserve against new total deposits Adding (i) and (2): $108,744,197 166,529,803 $275,274,000, total cash reserves 472 APPENDIX 26. Relation of gold to loans and discounts : " Yesterday there arrived in New York on the steamship 'Roumania' $9,100,000 in gold to be de- livered to the i8th National Bank." The i8th National Bank deposits all of this gold, with the Federal Reserve Bank of New York. (a) How much additional paper can the federal reserve bank now re- discount for its members, assuming that the latter leave the entire pro- ceeds of the rediscounts on deposit to the credit of their reserves? (b) How much additional loans can member banks make to their cus- tomers on the basis of the increase in reserves as a result of rediscounting paper at the federal reserve bank as described under (a) ? Solution: (a) Against balances due its member banks a federal re- serve bank must maintain a cash reserve of 35 per cent. Therefore, $9,100,000 in gold would enable th? Federal Reserve Bank of New York Ml to increase its deposits, that is, balances due member banks, — ■ '- '- or 35 per cent $26,000,000. Disregarding discount charges, the Federal Reserve Bank of New York can now rediscount for its members additional paper to the extent of $26,000,000 — $9,100,000 (the gold itself will constitute a part of the deposits), or $16,900,000. (b) The answer to this question will vary depending upon the location of the member banks. Those member banks which are located in New York City may increase their loans to such a point that the resulting de- mand deposits are covered by a 13 per cent reserve at the Federal Reserve Bank of New York. Banks located in Albany, Buffalo, and other reserve cities must maintain 10 per cent reserves, the ratio for country banks being 7 per cent. Against time deposits which are relatively small, member banks must maintain reserves of 3 per cent. For the sake of simplicity, if we take an average of 10 per cent for all member banks an increase in their reserves of $26,000,000 would enable them to increase their loans to cus- . $26,000,000 tomers to the extent of approximately or $260 000 000 or 10 per cent ' ' almost 30 times the original gold. This figure, of course, is a theoretical maximum, but it gives some idea of the relation of gold to inflation during and immediately following the war. 27. The Washburn Chemical Co. of Boston on October 15 presented at the Hub National Bank for collection trade acceptances as follows: (a) $10,000 drawn at 30 days after sight on Baker and Jones, Spring- field, Mass. (b) $8,000 drawn at 60 days after sight on Henry Allen, Providence. PROBLEMS WITH SOLUTIONS 473 (c) $15,000 drawn at 30 days after date October 15, on Garland Brothers, Woi caster. The Hub National Bank immediately forwards the drafts to its cor- respondents who present them to the drawees for acceptance; the corre- spondent banks then hold the acceptances until maturity for payment. On October 1 7 the Hub National Bank notifies the Washburn Chemical Company that its three drafts have been accepted as of October 16. On October 20 the Washburn Chemical Company arranges with the Hub National Bank to discount this paper at 7 per cent. What will be the total proceeds received by the Washburn Chemical Company? Solution: (a) Amount of acceptance, $10,000 Date accepted October 16 Due November 15 Discounted October 20, at 7% for 26 days: 6% on $10,000 for 30 days $50-00 Add 1/6 8.33 7% for 30 days $58-33 — of $58.33 iS50.55 30 ______ $10,000.00 —50-55 Proceeds of (a) $9,949-45 (b) Amount of acceptance, $8,000 Date accepted October 16 Due December 15 Discounted October 20 for 56 days at 7%: 6% for 60 days $80.00 Add 1/6 13-33 7% for 60 days $93-33 f^of$93-33 «87.ii 60 . $8,000.00 -87.11 Proceeds of (b) $7,912.89 474 APPENDIX (c) Amount of acceptance, $15,000 Date accepted October 16 Due November 14 Discounted October 20 for 25 days at 7%: 6% for 30 days $75-00 Add 1/6 12.50 7% for 30 days $87.50 — of $87.50 $72-92 $15,000.00 — 72.92, Proceeds of (c) $14,927.08 Proceeds of (b) 7.912.89 Proceeds of (a) 9i949-45 Total proceeds $32,789.42 28. On October i the Washburn Chemical Company of Boston bought a lot of goods amounting to $75,000 from a firm in Newark, New Jersey. According to the terms of the sale the buyer opens a 60 days' credit at the Hub National Bank in favor of the Newark firm. After having made shipment the Newark firm on October 21 draws a draft at 60 days after date on the Hub National Bank and attaches to it the bill of lading. The draft is accepted on October 22. On October 25 the Newark firm arranges with its local bank to discount the bank acceptance at 6>^ per cent. What are the proceeds? Solution: Amount of draft, $75,000 Date accepted October 22 Due December 20 Discounted October 25 for 56 days at 6 1/2%: 6% for 60 days $750.00 Add 1/12 62.50 6 1/2% for 60 days $812.50 1^ of $812.50. $758.33 $75,000.00 -758.33 Proceeds $74,241.67 PROBLEMS WITH SOLUTIONS 475 29. The following statements have been taken in part from the weekly foreign section of a financial publication. Supply in each of the blank spaces the word "advance" or "decline" with the necessary modifications as the case may require. (a) Leading European banks lowered their discount rates and ex- change . (b) There was a good supply of commercial bills, especially against cotton, and exchange . (c) Merchandise exports were large, but in the previous months bills had been drawn against future shipment of goods, and consequently exchange did not . (d) There was a belief that the Morgan syndicate would get a large part of the $50,000,000 new issue of New York City bonds to be placed abroad, and exchange . (e) American securities were sold in New York for European acount, and exchange . (f) A slight —- in exchange was caused by the placing abroad of some choice investment securities. (g) Exchange dealers sought to cover for contracts for future delivery of exchange made earlier in the year and which are now maturing; as a result, exchange . (h) Rates , mainly as the result of drawing against credit which had been established abroad through the previous sales of considerable blocks of railway stock. (i) Political unrest in Europe and the probable issue of government loans by France, led to a in exchange. (j) A severe monetary stringency in New York led to American banks drawing on their balances in European banks, and exchange . Answer: (a) Advanced (f) Decline (b) Declined (g) Advanced (c) Decline (h) Declined (d) Declined (i) Decline (e) Advanced (j) Declined 30. The Atlantic Export Company of Boston has sold some merchan- dise to a firm in Copenhagen. The latter's bank has arranged with its London correspondent for the acceptance of 90-day sight bills properly drawn and with the necessary documents attached to the amount of £3 ,000 . What are the proceeds which the Boston banker will pay the Atlantic 476 APPENDIX Export Company for their 90-day bill of £3,000 if the demand rates for bankers' checks on London are quoted at $4.40, the London discount rate for 90-day bills is 6 per cent, and the English stamp charges are 1/20 per cent of face of bill? Allow the Boston banker as a margin of profit yi cent per £. In England 365 days are always used as the basis of computing dis- count. On 30, 60, and 90-day sight bills, 3 days of grace are allowed. Solution: Basis £100 $440.00 Deduct discount, 93 days' interest, at 6% $6-73 Deduct English stamp charges at 1/20% 0.22 Deduct Boston banker's margin of profit, 1/4 cent per £ 0.25 Total deductions per £100 7.20 Proceeds per £100 $432.80 Rate per £ for 90-day bill 4.328 Proceeds from sale of 90-day bill for £3,000 $12,984.00 APPENDIX B PROBLEMS WITHOUT SOLUTIONS 31. A mining cpmpany sends to the United States Mint 12,000 ounces of gold .925 fine. The mint charges 2 cents an ounce for removing the impurities. The gold is coined in pieces of standard fineness. The only other charge that is made b, 2}4 cents per ounce for the copper alloy. How much gold will the company receive? 32. Suppose that the weight of the gold dollar is decreased i per cent. What will be the price of gold per fine ounce? 33. Suppose that the weight of the gold dollar is decreased i per cent. What will be the par of exchange with England? With France? 34. Suppose that the gold dollar is lo/ii fine, with no change in weight. What will be the mint price of gold per fine ounce? 35. Suppose that the gold dollar is lo/i i fine, with no change in weight. What will be the par of exchange with England? With France? 36. (a) If $150 of gold coin is melted what will the gold bullion be worth? (b) If $150 in silver dollars is melted what will the silver bullion be worth? Use latest market price for metal. Assume in each case that the gold and silver coins are full weight and have not been worn from circulation. (c) Answer the same question for silver assuming that money is in the form of subsidiary silver instead of dollar pieces. 37. A merchant negotiates a loan at his bank by discounting a 60-day non-interest-bearing note for $6,000 which has been received from a cus- tomer. The note is discounted at 6 per cent on the day it is received and the borrower agrees to maintain a deposit balance of 20 per cent of the loan, or, say, $1,200. (a) What is the real rate of interest paid by the borrower, assuming that the bank pays no interest on deposit balances? (b) Answer the same question, assuming that the bank pays 2 per cent interest on the deposit balance, which averages $1,200. 38. On June 15 a merchant presents for discount at his bank a note dated the same day for $7,000' due in 60 days. The note bears 7 per cent 477 478 APPENDIX interest and the bank's rate of discount is 7 per cent. What will the note yield to the merchant? On July 3 the bank sells the note to another bank on a 6 per cent dis- count basis. What profit will the first bank make by the transaction? The second bank? 39. (a) If a bill is drawn to mature 2 months from February 18, when does it become due? (b) If a bill is drawn to mature 60 days from February 18, when does it become due? 40. Find the net proceeds of a 60-day note for $800 dated July 21, bearing 6 per cent interest and discounted July 28 at 5}^ per cent. 41. On June 25 Dixon Brothers discounted at their bank a 90-day promissory note for $2,500, dated June 15 and bearing 6 per cent interest. The bank's discount rate is 6 per cent. What are the proceeds? 42. Determine the approximate time it will take for the following sums to double, triple, and quadruple themselves: $100 at 4 per cent interest, interest compounded semiannually. $300 at 5 per cent interest, interest compounded quarterly. $600 at s>^ per cent interest, interest compounded monthly. 43. On July I, 1922, $600 is deposited in a savings bank which pays 4}4 per cent interest, compounded semiannually. What will the deposit amount to 15 years later? 44. A father wishes to set aside in a bank, at the birth of his son, a sum which will accumulate to $7,500 by the time his son reaches his majority. Assuming that the bank rate of interest is 4 per cent, compounded semi- annually, what is the sum required? 45. A man puts $20 into a savings bank at the end of every month for IS years. If the bank pays 4 per cent interest, compounded semiannually, what will the savings amount to at the end of 15 years? 46. Make such changes in the statement of the Puritan National Bank, shown in Problem 17, as are necessitated by the following trans- actions: (a) $25,500 invested in stocks and bonds. (b) $1,000 cash received for dividends and interest on stocks and bonds. (c) $125,000 of new bills and notes discounted at an average rate of S per cent per annum and for an average time of 4 months. Those receiv- PROBLEMS WITHOUT SOLUTIONS 479 ing loans take $10,000 in notes of the bank, $5,000 in legal tender, and the remainder in the form of deposit accounts. (d) $3,500 in the notes of the bank are presented for redemption. (e) At the clearing house the bank presents checks on other banks to the amount of $250,000 and receives for settlement depositor's checks on itself for $325,000. (f) Bank sells at par a New York bank draft of $500 to a depositor who pays with his check. (g) Of the notes and bills discounted in (c), $20,000 are renewed for an average time of 3 months at a discount rate of 5 per cent per annum, the discount being paid by depositors drawing checks against their bank bal- ances, $45, 000 are paid at maturity in checks on other banks, and the remainder are settled by depositors drawing checks against their bank balances. 47. Point out, with a brief explanation in each case, which of the following transactions would affect and which would not affect the surplus in the statement of the Puritan National Bank shown in Problem 17: (a) Payment of salaries. (b) Putting a new wing on the building. (c) Payment of insurance on building. (d) Increasing legal reserve against deposits. (e) Declaring but not paying a cash dividend. (f) Writing off a worthless account. (g) Issuing additional stock at a 5 per cent premium. 48. Bank A advertises that during the past year its deposits increased 35 per cent. Bank B's deposits increased 6 per cent. Both of these in- stitutions are commercial banks. Do these facts throw any light on the comparative strength of the two banks? Explain. 49. From the following facts of a manufacturing concern determine in two different ways the merchandise turnover: Cost price of average merchandise inventory $90,000 Average selling profit (based on selling price) 40 per cent Total sales ?45o,ooo How long should the commercial paper of this concern run? Give reason. 50. The statements of a firm for two successive years show the follow- ing facts: 48o APPENDIX 1921 1922 Cash $15,000 $10,000 Receivables 95.0OO 60,000 Merchandise 190,000 180,000 Total current assets $300,000 $250,000 Accounts payable $50,000 $45.ooo Other current liabilities 100,000 80,000 Total current liabilities $150,000 $125,000 Assuming that the moral risk and other factors have remained un- changed, which of the two statements show the stronger position from the viewpoint of the lending banker? 51. Electric Manufacturing Company 1920 1922 Receivables $130,000 $180,000 Sales 400,000 850,000 Terms 30 days net 30 days net In which year, presumably, is the quality of the receivables the higher? Explain briefly. 52. The sales of a certain firm for the past year were $800,000 arid its terms were 5 per cent discount for payment within 10 days, 30 days net. What should be the average amount of receivables? Assuming that the firm has two main selling seasons, how large might the receivables become without indicating signs of weakness? Explain and point out what these signs of weakness are. 53. In working out this problem refer to the statements of the Indian National Bank and the Federal Reserve Bank of Boston shown in Problem 25. The Indian National Bank discounts at the federal reserve bank $6,500,000 of commercial paper. The discount rate is 5 per cent and the paper runs on the average 45 days. The Indian National Bank takes $100,600 of the proceeds in federal reserve notes and leaves the remainder on deposit. Calculate the necessary changes in the statements of the federal reserve bank and the member bank , including the federal reserve ratio. 54. The Federal Reserve Bank of New York receives $5,000,000 of gold deposits. (a) If member banks take all of their rediscounts in federal reserve notes how much additional paper can the reserve bank rediscount for its PROBLEMS WITHOUT SOLUTIONS 481 members, assuming that it does not borrow at other reserve banks? Make no allowance for discount charges. (b) Answer the same question, assuming that member banks leave all of their rediscounts on deposit. (c) Answer the same question, assuming that member banks take 1/20 of their rediscounts in federal reserve notes and leave the remainder on deposit. 55. "Yesterday there arrived in New York on the steamship 'City of Naples' $2,000,000 in gold to be delivered to the Hood National Bank." The Hood National Bank deposits all of this gold with the Federal Reserve Bank of New York. (a) How much additional paper can the federal reserve bank now re- discount for its members, assuming that the latter leave the entire pro- ceeds on deposit to the credit of their reserves? (b) How much additional loans can member banks make to their cus- tomers on the basis of the increase in reserves as a result of rediscounting paper as described under (a)? 56. On September 28, John Jones, of Boston, sold R. M. Smith of Worcester, machinery amounting to $2,480, less 20, 25, and 10 per cent. Terms: one-half, 60-day note with interest at 6 per cent; one-half on ac- count, 60 days. What was the amount of the note when received? On October 12 Jones discounted at the Tenth National Bank, at 6 per cent. Smith's note dated September 28, the bank giving credit for the proceeds. If the bank charges i/io per cent for collecting out-of-town paper, what was the amount bf the proceeds credited? 57. Explain the following operations: Adams and Company of Boston, dealers in dry goods, arrange with the Hub National Bank to accept a draft for $28,000 payable in 90 days from date of October i , the bank receiving yi per cent of the face of the accept- ance for the privilege of so doing. The bank was given satisfactory security. Adams and Company then sold the acceptance back to the Hub Na- tional Bank on the same day at 6 per cent discount, receiving the face of the draft less the discount, and this amount was placed to the credit of Adams and Company. On October 31 the Hub National Bank sold the acceptance to the Massachusetts National Bank at 5^ per cent discount. On November 30 the Massachusetts National Bank sold the acceptance to the Worcester National Bank at a discount of 5>^ per cent. How much profit did the Hub National Bank make, and how much the Massa- chusetts National Bank? 31 - • 482 APPENDIX 58. The following statements have been taken in part from the weekly foreign section of a financial publication. Supply in each of the blank spaces the word "advance" or "decline" with the necessary modifications as the case may require. (a) It was claimed in some quarters that the action of the Federal Reserve Board in urging curtailment of borrowing at the federal reserve banks had led to the unloading of a large volume of sterling bills by ex- porters who felt doubtful of their ability to carry these bills, thus causing exchange to . (b) In part, the rapid in sterling rates was due to hurried cover- ing of outstanding short contracts, induced by the altered financial out- look. (c) The in sterling was correctly interpreted as reflecting marked improvement in Great Britain's economic and financial position. (d) There were large additional arrivals of gold from London, and there were also reports of more consignments in prospect, but they had no effect in arresting the movement of exchange. (e) Offerings of commercial bills continued heavy, and there appeared to be an utter lack of buying power, and exchange consequently . (f) In explaining the in exchange on Argentina it was said that a large amount of merchandise had accumulated in the Buenos Aires Custom House and that Argentine consignees were declining to remove it, owing to extensive losses incurred on it through the in the American dollar. (g) During November silver declined steadily causing Far Eastern exchanges to . (h) Greek exchange as a result of intimations by the allied powers that no further financial aid would be extended to Greece in the event of King Constantine's return to the throne. (i) Leading European banks raised their discount rates and exchange APPENDIX C INTEREST TABLES' Interest tables showing interest on $i,ooo, 360-days-to-the- year basis and 365-days-to-the-year basis; also tables showing the amount of $1 at compound interest, the present worth of $1 due at some future period, and the amount of $1 set aside each period for a number of periods are given on the following pages. In the United States it is the common banking practice to compute interest and discount on the basis of 30 days to the month and 360 days to the year, with no days of grace. Federal reserve banks, however, use the 365-day method. For sterhng exchange calculations, interest and discount are figured on the basis of 365 days to the year, with 3 days of grace allowed on promissory notes and bills of exchange or drafts, except those drawn payable at sight, as in the case of bankers' checks. These tables are greatly condensed from similar ones used in banking practice and have been selected primarily to serve as an aid in the solution of problems presented in the appendices and elsewhere, or which the instructor may devise. ^ Adapted, from Montgomery Rollins, Interest Tables, through courtesy of the Financial Publishing Company, Boston. 483 484 APPENDIX Table i. — Interest Calculated on Basis of 360 Days Interest on Sl.ooo TO THE Year Day to I Month Days 4% 4 1/4% 4 1/2% 5% 5 1/2% 6% 6 1/2% 7% 7 1/2% $ $ $ $ $ « $ $ $ I O.IIII 0.1181 0.12S0 0.1389 0.1528 0-1667 0.1806 0.1944 0-2083 2 0.2222 0.2361 0.2500 0.2778 0.3056 0-3333 0.3611 0.3889 0.4167 3 0.3333 0.3542 0.3750 0.4167 0.4583 0.5000 0.5417 0.5833 0.6250 4 0.4444 0.4722 O.5OCO 0.5556 0.6111 0.6667 0.7222 0.7778 0.8333 S 0.SSS6 0.5903 0.6250 0.6944 0.7639 0.8333 0.9028 0.9722 1.0417 6 0.6667 0.7083 0.7500 0.8333 0.9167 1. 0000 1.0833 1. 1667 1.2500 7 0.7778 0.8264 0.8750 0.9722 1.0694 1. 1667 1.2639 1.3611 1.4583 8 0.8889 0.9444 1.0000 I. nil 1.2222 1.3333 1.4444 I.SS56 1.6667 9 1. 0000 1.062s 1. 1250 1.2500 1.3750 1.5000 1.6250 1.7500 1.8750 10 I. mi 1. 1806 1.2500 1.3889 1.5278 1.6667 1.8056 1-9444 2.0833 II 1.2222 1.2986 1.3750 1.5278 1.6806 1.8333 1.9861 2.1389 2.2917 12 1-3333 I.4167 1.5000 1.6667 1.8333 2.0000 2.1667 2.3333 2.5000 13 1.4444 1.5347 1.6250 1.8056 1.9861 2.1667 2-3472 2.5278 2.7083 14 1.SSS6 1.6528 1.7500 1.9444 2-1389 2.3333 2.5278 2.7222 2.9167 IS 1.6667 1.7708 1.8750 2.0833 2.2917 2.5000 2.7083 2.9167 3.1250 16 1.7778 1.8889 2.0000 2.2222 2.4444 2.6667 2.8889 3.1111 3-3333 17 I.888g 2.0069 2.1250 2.3611 2.5972 2.8333 3.0694 3-3055 35417 18 2.0000 2. 1250 2.2500 2.5000 2.7500 3-0000 3.2500 3-5000 3.7500 19 2. nil 2.2431 2.3750 2.6389 2.9028 3-1667 3.4306 3-6944 3.9583 20 2.2222 2.36II 2.5000 2.7778 3.0556 3-3333 3.6111 3-8889 4.1667 21 2.3333 2.4792 2.6250 2.9167 3.2083 3-5000 3.7917 4-0833 4.3750 22 2.4444 2.5972 2.7500 3.0556 3-3611 3-6667 3-9722 4.2778 4.5833 23 2.55S6 2.7153 2.8750 3.1944 3.5139 3.8333 4-1528 4.4722 4.7917 24 2.6667 2.8333 3-0000 3.3333 3.6667 4.0000 4-3333 4.6667 5.0000 2S 2.7778 2.9514 3.I2SO 3.4722 3.8194 4.1667 4-5139 4.8611 5.2083 26 2.8889 3.0694 3.2500 3-6111 3.9722 4.3333 4-6944 5.0555 5.4167 27 3.0000 3.1875 3-3750 3-7500 4-1250 4.5000 4-87SO 5. 2500 5-6250 28 3.IIII 3.3056 3.5000 3.8889 4-2778 4.6667 S-0556 5.4444 5-8333 29 3.2222 3.4236 3.6250 4.0278 4.4306 4.8333 5-2361 S-6389 6.0417 30 3.3333 3.5417 3.7500 4.1667 4-5833 5.0000 5-4167 5-8333 6.2500 INTEREST TABLES Table i (continued) Interest on Ji.ooo 485 I Month, I Day to 2 Months Days 4% 4 1/4% 4 1/2% 5% 5 1/2% 6% 6 1/2% 7% 7 1/2% { $ J $ $ $ $ S $ I 3 •444'! 3.6597 3.8750 4.3056 4.7361 5.1667 5.5972 6.0278 6.4583 2 3.5556 3.7778 4.0000 4.4444 4.8889 5.3333 5. 7778 6.2222 6.6667 3 3.6667 3.8958 4.1250 4-S833 5.0417 5. 5000 5.9583 6.4167 6.8750 4 3.7778 4.0139 4.2500 4-7222 5.1944 5.6667 6-1389 6.6ni 7.0833 S 3.8889 4.1319 4.3750 4-8611 5.3472 5. 8333 6.3194 6.80SS 7.2917 6 4.0000 4.2500 4.5000 S.oooo 5. 5000 6.0000 6.5000 7.0000 7.5000 7 4. nil 4.3681 4.6250 S.I389 5.6528 6.1667 6.6806 7.1944 7.7083 8 4.2222 4. J 861 4.7500 5. 2778 5.8056 6.3333 6.8611 7.3889 7.9167 9 4.3333 4.6042 4.8750 5.4167 5.9583 6-5000 7.0417 7.5833 8-I2S0 10 4.4444 4.7222 5.0000 5.5556 6. nil 6.6667 7-2222 7.7778 8-3333 II 4.SSS6 4.8403 5.1250 5.6944 6-2639 6.8333 7.4028 7.9722 8.S417 12 4.6667 4.9583 5. 2500 5.8333 6.4167 7.0000 7.5833 8.1666 8.7500 13 4.7778 5.0764 5. 3750 5.9722 6.5694 7.1667 7.7639 8.3611 8.9583 14 4.8889 5.1944 5.5000 6. nil 6.7222 7.3333 7.9444 8.5555 9-1667 IS S.oooo 5.3125 5.6250 6.250C 6.8750 7.S000 8. 1250 8.7500 9-3750 16 S-iiii S.4306 5.7500 6.3889 7.0278 7.6667 8.3056 8-9444 9-5833 17 5.2222 5.5486 5.8750 6.5278 7.1806 7.8333 8.4861 9-1389 9.7917 18 5-3333 5.6667 e.ooor 6.6667 7.3333 8.0000 8-6667 9-3333 10.0000 19 5.4444 5. 7847 6. 1250 6.80S6 7.4861 8.1667 8.8472 9-5278 10.2083 20 5.5556 5.9028 6.2500 6.9444 7.6380 8.3333 9-0278 9.7222 10.4167 21 5.6667 6.0208 6.3750 7.0833 7.7917 8-5000 9.2083 9.9166 10.6250 22 5.7778 6.1389 6.5000 7.2222 7.9444 8.6667 9-3889 lo.ini 10-8333 23 5.8889 6.2569 6.6250 7.3611 8.0972 8.8333 9.5694 10.3055 n.0417 24 6.0000 6.3750 6.7500 7.5000 8-2500 9.C000 9.7500 10.5000 11.2500 25 6. nil 6.4931 6.8750 7.6389 8-4028 9-1667 9.9306 10.6944 11.4583 26 6.2222 6.6111 7.0000 7.7778 8-5556 9-3333 lo-nii 10.8889 11.6667 27 6.3333 6.7292 7.1250 7.9167 8.7083 9-5000 10.2917 11.0833 11.8750 28 6.4444 6.8472 7.2500 8.0556 8.86n 9-6667 io.472i n-2778 12.0833 29 6.5556 6.9653 7-3750 8-1944 9.0139 9-8333 10-6528 11,4722 12.2917 30, 6.6667 7.0833 7.5000 8.3333 9.1667 10.0000 10.8333 11.6666 12.5000 486 APPENDIX Table i (continued) Interest on $1,000 2 Months, I Day to 3 Months Days 4% 4 1/4% 4 1/2% 5% 5 1/2% 6% 6 1/2% 7% 7 1/2% I $ 6.7778 $ 7.2014 $ 7.6250 $ 8.4722 $ 9.3194 $ 10.1667 $ 11.0139 $ II.86II $ 12.7083 2 3 6.8889 7.0000 7.3194 7.4375 7.7500 7.8750 8.61II 8.7500 9.4722 9.6250 10.3333 10.5000 I1.194-" 11.3750 12.0556 12.2500 12.9167 13.1250 4 5 7.1111 7.2222 7.5556 7.6736 8.0000 8.1250 8.8889 9.0278 9.7778 9.9306 10.6667 10.8333 11.5556 II. 7361 12.444/1 12.6389 13.3333 13-5417 6 7 7.3333 7.4444 7.7917 7.9097 8.2500 8.3750 9.1667 9.3056 10.0833 10.2361 11.0000 II. 1667 11.9167 12.0972 12.8333 13.0278 13-7500 13-9583 8 9 7.5556 7.6667 8.0278 8.1458 8.5000 8.6250 9.4444 9.5833 10.3889 10.5417 11.3333 11.5000 12.2778 12.4583 13.2222 13-4167 14,1667 14-3750 lO II 7.7778 7.8889 8.2639 8.3819 8.7500 8.8750 9.7222 9.861I 10.6944 10.8472 11.6667 11.8333 12.6389 12.8194 13.6111 13.8056 14-5833 14-7917 12 13 8.000c 8.1111 8.5000 8.6I8I 9.0000 9.1250 10.0000 10.1389 11.0000 II. 1528 12.0000 12.1667 13.0000 13-1806 14.0000 14.1944 15.0000 IS. 2083 Id IS 8.2222 8.3333 8.7361 8.8542 9.2500 9.3750 10.2778 10.4167 11.3056 11.4583 12.3333 12.5000 13.3611 13-5417 14.3889 14.5833 15.4167 15-6250 l6 17 8.4444 8.5556 8.9722 9.0903 9.5000 9.6250 10.5556 10.69^4 II.6III 11.7639 12.6667 12.8333 13-7222 13.9028 14.7778 14.9722 15-8333 16.0417 I8 19 8.6667 8.7778 9.2083 9.3264 9.7500 9.8750 10.8333 10.9722 II. 9167 12.0694 13.0000 13.1667 14.0833 14.2639 15.1667 1S.3611 16.2500 16.4583 20 21 8.8889 9.0000 9.4444 9.5625 10.0000 10.1250 II. nil II. 2500 12.2222 12.3750 13.3333 13.5000 14.4444 14.6250 15-SSS6 15-7500 15.6667 16,8750 22 23 9. nil 9.2222 9.6806 9.7986 10.2500 10.3750 11.3889 11.5278 12.5278 12.6806 13.6667 13.8333 14.8056 14.9861 15.9444 16.1389 17-0833 17-2917 24 25 9.3333 9.4444 9.9167 10.0347 10.5000 10.6250 11.6667 11.8056 12.8333 12.9861 14. 0000 14.1667 15.1667 IS. 3472 16.3333 16.5278 17.5000 17-7083 26 27 9-5556 9.6667 10.1528 10.2708 10.7500 10.8750 11.9444 12.0833 13.1389 13.2917 14-3333 14.5000 15.5278 15.7083 16,7222 16.9167 17-9167 18,1250 28 29 9.7778 9.8889 10.3889 10.5069 11.0000 II. 1250 12.2222 12.3611 13.4444 13.5972 14.6667 14-8333 15.8889 16.0694 17. nil 17-3056 18.3333 18.5417 30 10.0000 10.625c 11.2500 12.5000 13.7500 15.0000 16. 2500 17.5000 18.7500 INTEREST TABLES 487 Table 2 — Interest Interest on $i,ooo Calculated on Basis of 365 Days to the Year I Day to 31 Days Days 4% 4 1/4% 4 1/2% 5% 5 1/2% 6% 6 1/2% 7% 7 1/2% $ $ $ $ $ $ $ S $ I 0.1096 O.I 164 0.1233 0.1370 0.1507 0.1644 0.1781 o.igi8 0.2055 2 0.2192 0.2329 0,2466 0.2740 0.3014 0.3288 0.3562 0.3836 0.4IIO 3 0.3288 0.3493 0.3699 0.41 10 0.4521 0.4932 0.5342 0.5753 0.6164 4 0.4384 0.4658 0.4932 0.5479 0.6027 0.6575 0.7123 0.7671 0.8219 5 0.5479 0.5822 0.6164 0.6849 0.7534 0.8219 0.8904 0.9589 1.0274 6 0.6575 0.6986 0.7397 0.8219 0.9041 0.9863 1.0685 1.1507 1.2329 7 0.7671 0.8151 0.8630 0.9589 I.OS48 1.1507 1.2466 1.3425 1.4384 8 0.8767 0.9315 0.9863 1.0959 1.2055 1.3151 1.4247 ■1.5342 1.6438 9 0.9863 1.0479 1. 1096 1.2329 1-3562 1.4795 1.6027 1.7260 1.8493 10 1. 0959 1. 1644 1.2329 1.3699 1.5068 1.6438 1.7808 1.9178 2.0548 II 1.2055 1.2808 1.3562 1.5068 I.657S 1.8082 1.9589 2.1096 2.2603 12 1.3151 1.3973 1.479s 1.6438 1.8082 1.9726 2.1370 2.3014 2.4658 13 1.4247 1.S137 1.6027 1.7808 1.9589 2.1370 2.3151 2.4932 2.6712 14 1.5342 1. 6301 1.7260 1.917S 2.1096 2.301J 2.4931 2.6849 2.8767 IS 1.6438) 1.7466 1.8493 2. 0548 2.2603 2.4658 2.6712 2.8767 3.0822 16 1. 7534 1.8630 1.9726 2.I918 2.dlI0 2.6301 2.8493 3.0685 3.2877 17 1.8630 1.9795 2.09SQ 2.3288 2.5616 2.7945 3.0274 3.2603 3-4931 18 1.9726 2.0959 2.2192 2.46S8 2.7123 2.9589 3.2055 3-4521 3.6986 19 2.0822 2.2123 2.3425 2.6027 2.8630 3.1233 3-3836 3-6438 3.9041 20 2.1918 2.3288 2.4658 2.7397 3.0137 3.2877 3-5616 3-8356 4.1096 21 2.3014 2.4452 2.S890 2.8767 3.1644 3.4521 3-7397 4.0274 4-3151 22 2.4110 2.5616 2.7123 3-0137 3-315I 3-6164 3-9178 4.2192 4-5205 23 2.520s 2.6781 2.8356 3-ISO7 3-4658 3-7808 4-0959 4.4110 4.7260 24 2.6301 2.7945 2.9589 3.2877 3-6164 3-9452 4.2740 4.6027 4.931S 2S 2.7397 2.9110 3.0822 3-4247 3-7671 4.1096 4-4521 4-7945 5. 1370 26 2.8493 3.0274 3-2055 3.5616 3-9178 4.2740 4-6301 4-9863 5.342s 27 2.9589 3.1438 3.3288 3.6986 4.0685 4.4384 4.8082 5-1781 5.5479 28 3.0685 3.2603 3-4521 3.8356 4.2192 4.6027 4.9863 5-3699 5.7534 29 3.1781 3.3767 3-5753 3.9726 4.3699 4.7671 5.1644 5.5616 5.9589 30 3.2877 3-4931 3.6986 4.1096 4.52OS 4.9315 5.3425 5.7534 6.1644 31 3.3973 3.6096 3-8219 4.2466 4.6712 5.0959 5.5205 5.9452 6.3699 488 APPENDIX Table 2 (continued) b on $T,ooo 32 Days to 62 Days Days 4% t 1/4% t 1/2% 5% 5 1/2% 6% 6 1/2% 7% 7 1/2% 32 $ 3.5068 $ 3-7260 $ 3.9452 $ 4-3836 $ 4-8219 $ 5.2603 $ 5.6986 $ 6.1370 $ 6.5753 33 34 3-6164 3.7260 3-8425 3-9589 4-0685 4-1918 4-5205 4-6575 4-9726 5-1233 5.4247 5.5890 5.8767 6.0548 6.3288 6.5205 6.7808 6.9863 35 36 3.8356 3-9452 4-0753 4-1918 4-31SI 4.4384 4-794S 4-931S 5-2740 5-4247 5.7S34 5.9178 6.2329 6.4110 6.7123 6.9041 7-1918 7-3973 37 38 4.0548 4.1644 4-3082 4-424'' 4.5616 4.6849 5-0685 5-20SS 5-57S3 5.7260 6.0822 6.2466 6.5890 6.7671 7.0959 7-2877 7.6027 7.8082 39 40 4.2740 4.3836 4-5411 4-6575 4.8082 4.931s 5-3425 5-4795 5.8767 6.0274 6.4110 6.S753 6.9452 7.1233 7-4795 7.6712 8.0137 8.2192 41 42 4.4932 J. 6027 4-7740 4.8904 5.0548 5-I781 5-6164 5-7534 6.1781 6.3288 6.7397 6.9041 7.3014 7.4794 7-8630 8.0548 8.4247 8.6301 43 44 4.7123 4.8219 5.0068 5.1233 5-3014 S-4247 5.8904 6.0274 6.4795 6.6301 7.068s 7.2329 7.657s 7.8356 8.2466 8.4384 8.8356 g.0411 4S 46 4.9315 S.0411 5.2397 5.3562 5.5479 5.6712 6.1644 6.3014 6.7808 6.9315 7.3973 7.5616 8.0137 8.1918 8.6301 8.8219 9.2466 9.4521 47 48 5.1507 5.2603 5.4726 5.5890 5.794s 5.9178 6-4384 6-5753 7.0822 7.2329 7.7260 7.8904 8.3699 8-5479 9-0137 9.2055 9.6575 9.8630 49 SO 5.3699 5.4795 5.7055 5-8219 6.0411 6.1644 6.7123 6-8493 7.3836 7.5342 8.0548 8.2192 8.7260 8.9041 9.3973 9.5890 10.068s 10.2740 51 52 5. 5890 5.6986 5. 9384 6.0548 6-2877 6.4110 6.9863 7-1233 7.6849 7.8356 8.3836 8.5479 9.0822 9.2603 9.7808 9.9726 10.4794 10.6849 53 54 S.8082 S.9178 6-1712 6.2877 6.5342 6.6575 7.2603 7-3973 7.9863 8-1370 8.7123 8.8767 9.4384 9.6164 10.1644 10.3562 10.8904 11.0959 55 56 6.0274 6.1370 6.4041 6.5205 6.7808 6.9041 7-5342 7.6712 8-2877 84384 9.041 1 9.205s 9.7945 9.9726 10.5479 10-7397 11.3014 I1.S068 57 58 6.2466 6-3562 6.6370 6.7534 7.0274 7.1507 7.8082 7.9452 8.5890 8-7397 9.3695 9.5342 10.1507 10-3288 10.9315 II. 1233 11.7123 11.9178 59 60 6-4658 6.5753 6.8699 6.9863 7.2740 7.3973 8.0822 8.2192 8-8904 9-0411 9.698( 9.863< ) 10.5068 ) 10.684s II.3151 11-5068 12.1233 12.3288 61 62 6.684c 6.794. 7-1027 7.2192 7.5205 7.643S 8.3562 8.4932 9.1918 9-3425 10.027 10.191 % 10.863c 3 II. 041 ) ll.698e 11.890^ 12.5342 t 12-7397 INTEREST TABLES Table 2 (continued) 489 Interest on $i,ooo 63 Days to 93 Days Days 4% 4 1/4% 4 1/2% 5% 5 1/2% 6% 6 1/2% 7% 7 1/2% $ $ ; ; $ ; ; J $ 63 6.9041 7.3356 7.7671 8.6301 9.4932 10.3562 11.2192 12.0822 12.9452 64 7.0137 7.4521 7.8904 8.7671 9.6438 10.5205 11.3973 12.2740 13.1507 65 7.1233 7.5685 8.0137 8.9041 9.7945 10.6849 11.5753 12.4658 13.3562 66 7.2329 7.6849 8.1370 9.0411 9.9452 10.8493 11.7534 12.6575 13.5616 67 7.3425 7.8014 8.2603 9.1781 10.0959 11.0137 11.9315 12.8493 13.7671 68 7-4521 7.9178 8.3836 9.31S1 10.2466 II.1781 12.1096 13.0411 13.9726 69 7.S6l5 8.0342 8.5068 9.4521 10.3973 11.342s 12.2877 13.2329 14.1781 70 7.6712 8.1507 8.6301 9.5890 10.5479 11.5068 12.4657 13.4247 14.3836 71 7.7808 8.2671 8.7534 9.7260 10.6986 II.6712 12.6438 13.6164 14.5890 72 7.8904 8.3836 8.8767 9.8630 10.8493 11.8356 12.8219 13.8082 14.794s 73 8.0000 8.5000 9.0000 10.0000 11.0000 12.0000 13.0000 14.0000 15.0000 74 8.1096 8.6164 91233 10.1370 II. 1507 12.1644 13.1781 14.1918 15.2055 75 8.2192 8.7329 9.2466 10.2740 II. 3014 12.3288 13.3562 14.3836 15.4110 76 8.3288 8.8493 9.3699 10.4110 11.4521 12.4932 13.5342 14-5753 15.6164 77 8.4384 8.9657 9.4932 10.5479 11.6027 12.6575 13.7123 14-7671 158219 78 8.5479 9.0822 9.6164 10.6849 11.7534 12.8219 13.8904 14.9589 16.0274 79 8.657s 9.1986 9-7397 10.8219 11.9041 12.9863 14.0685 15-1507 16.2329 80 8.7671 9.3151 9.8630 10.9589 12.0548 I3.ISO7 14.2466 15-3425 16.4384 81 8.8767 9-43t5 9.9863 11.0959 12.2055 I3.3ISI 14.4247 15-5342 16.6438 82 8.9863 9-5479 10.1096 11.2329 12,3562 13.4795 14.6027 IS-7260 16.8493 83 9-0959 9-6644 10.2329 11.3699 12.5068 13.6438 14.7808 15-9178 17.0548 84 9.2055 9.7808 10.3562 11.5068 12.6575 13.8082 14.9589 16.1096 17.2603 85 9.31SI 9.8973 10.4795 11.6438 12.8082 13.9726 15.1370 16.3014 17.4657 86 9.4247 10.0137 10.6027 11.7808 12.9589 14.1370 15.3151 16.4932 17.6712 87 9.5342 10.1301 10.7260 11.9178 13 1096 14.3014 15.4931 16.6849 17.8767 88 9.6438 10.2466 10.8493 12.0548 13.2603 14.4658 15.6712 16.8767 IS.0822 89 9.7534 10.3630 10.9726 12.1918 13.4110 14.6301 15.8493 17.0685 18.2877 90 g.8630 10.4794 11.0959 12.3288 13.5616 14.794s 16.0274 17.2603 18.4931 91 9.9726 10.5959 11.2192 12.4658 13.7123 14.9589 16.2055 17.4521 18.6986 92 10.0822 10.7123 11.3425 12.6027 13.8630 15.1233 16.3836 17.6438 18.9041 93 10.1918 10.8288 11.4658 12.7397 14.0137 15.2877 16.5616 17.8356 19.1096 490 APPENDIX Table 3 — Amount of |i for Any Time from i to 45 Periods Interest compounded annually 45 years; semiannually 2 2>^ years; and quarterly for iiX years Periods 2% 2 1/2% 3% 3 1/2% 4% 1 1.020 000 I. 02s 000 1.030 000 1.03s 000 1.040 000 2 1. 040 400 1.050 62s 1.060 900 1.071 22s 1.081 600 3 1.061 208 1.076 891 1.092 727 1. 108 718 1.124 864 4 1.082 432 1.103 813 1.125 S09 1. 147 523 1.169 859 5 1. 104 08l 1. 131 408 1.159 274 1.187 686 1. 216 653 6 1. 126 162 1. 159 693 I-I94 052 1.229 255 1.26s 319 7 1.148 686 1. 188 685 I-229 874 1.272 279 1. 31s 932 8 1. 171 6S9 1. 218 403 1-266 770 1.316 809 1.368 569 9 1.195 093 1.248 863 1-304 773 1.362 897 1.423 312 10 1.218 994 1.280 085 1-343 916 1-410 599 I-480 244 11 1.243 374 1.312 087 1.384 234 • 1-459 970 1-539 454 12 1.268 242 1.344 889 1.42s 761 I-SIl 069 1-601 032 13 1.293 607 1.378 sii 1.468 534 1-563 956 I-665 074 14 1.319 479 1.412 974 1-512 590 1-618 695 1. 731 676 IS 1.34s 868 1.448 298 1-557 967 1-675 349 1.800 944 16 1.372 786 1.484 506 1.604 706 1-733 986 1.872 981 17 1.400 241 1.521 618 1.652 848 1.794 676 1-947 901 18 1.428 246 1-559 659 1.702 433 1.857 489 2.025 817 19 1.456 811 1.598 650 1.753 506 1.922 SOl 2-106 849 20 1.48s 947 1.638 616 1.806 111 1.989 789 2-191 123 21 1.51s 666 1.679 582 1.860 295 2.059 432 2.278 768 22 I.S4S 980 1.721 571 1. 916 103 2.131 512 2.369 919 23 1.576 899 1.764 611 1-973 587 2.206 115 2.464 716 24 1.608 437 1.808 726 2-032 794 2.283 329 2.563 304 2S 1.640 606 1.853 944 2-093 778 2.363 245 2.665 836 26 1.673 418 1.900 293 2.156 591 2.44s 959 2.772 470 27 1.706 887 1.947 800 2.221 289 2.531 567 2.883 369 28 1. 741 024 1-996 495 2.287 928 2.620 172 2.998 703 29 I.77S 84s 2.046 407 2.356 566 2. 711 878 3.118 652 30 I.811 362 2.097 568 2.427 263 2.806 794 3-243 398 31 1.847 S89 2.150 007 2.500 080 2.905 032 3-373 133 32 1.884 541 2-203 757 2.57s 083 3.006 708 3-508 059 33 1.922 231 2.258 851 2.652 335 3. Ill 942 3.648 381 34 i.g6o 676 2.315 322 2.731 905 3.220 860 3-794 3l6 35 1.999 890 2.373 205 2.813 863 3.333 590 3-946 089 36 2.039 887 2-432 535 2.898 278 3.450 266 4-103 933 37 2.080 685 2-493 349 2.985 227 3-571 025 4.268 090 38 2.122 299 2-555 682 3.074 784 3.696 oil 4-438 814 39 2.164 745 2-619 575 3.167 027 3.82s 372 4-616 366 40 2.208 040 2.685 064 3.262 038 3-959 260 4.801 021 41 2.252 201 2.752 190 3-359 899 4.097 834 4-993 062 42 2.297 24s 2.820 995 3.460 696 4.241 258 S-192 784 43 2.343 189 2.891 520 3.564 S17 4.389 7C2 5-400 495 44 2.390 053 2.963 808 3.671 452 4-543 342 S-616 515 45 2.437 854 3.037 903 3.781 596 4-702 359 S-841 176 INTEREST TABLES 491 Table 4 — Present Worth of $i Due at Any Time from i to 45 Periods Interest compounded annually 45 years; semiannually for 22^^ years; and quarterly for 11^ years Periods 2% 2 1/2% 3% 3 1/2% 4% I .980392157 •975609756 .970873786 .966183575 •961538462 2 .961168781 ■951814396 .942595909 .933S10700 •924556213 3 .942322335 .928599411 .915141659 .901942706 •888996359 4 ■923845426 •905950645 .888487048 .871442228 .854804191 5 .905730810 •883854288 •862608784 .841973167 .821927107 6 .887971382 .862296866 .837484257 .813500644 .790314526 7 .870560179 .841265235 .813091511 .785990961 .759917813 8 .853490371 .820746571 .789409234 •759411556 .730690205 9 •836755266 .800728362 ■766416732 ■733730972 .702586736 10 .820348300 .781198402 ■744093915 ■708918814 •675564169 ■ 11 .804263039 .762144782 .722421277 .684945714 .649580932 12 .788493176 ■7435SS88S •701379880 .661783298 .624597050 13 .77303252s .725420376 .680951340 .639404153 .600574086 '14 .757875025 .707727196 .661117806 .617781790 .577475083 IS .743014730 ■690465557 .641861947 .596890619 .555264503 16 .728445814 .673624934 .623166939 .576705912 •533908176 17 .714162562 .657195057 .605016446 .557203779 .513373246 18 .700159375 .641165909 .587394608 .538361140 .493628121 19 .686430760 .625527716 .570286027 .520155690 .474642424 20 .672971333 .610270943 .553675754 .502565884 .456386949 21 .659775817 .595386286 •537549276 ■485570903 .438833602 22 .646839036 .580864669 .521892501 .469150631 .421955387 23 .634155918 .566697238 .506691748 .453285634 .405726333 24 .621721488 .552875354 •491933736 .437957134 .390121474 25 .609530871 .539390589 •477605569 .423146989 .375116802 26 ■S97579285 .526234721 .463694727 .408837671 .360689233 27 .585862044 .513399728 .450189056 .395012242 .346816570 28 .574374553 .SO0877784 .437076753 .381654340 .333477471 29 .563112307 .488661252 •424346362 .36874815s .320651415 3C. .552070889 .476742685 .411986760 .356278411 .308318668 31 .541245970 .465114815 .399987145 ■344230348 .296460258 32 .530633304 ■453770551 •388337034 ■332589709 .285057940 33 .520228729 .442702977 •3770262/17 ■321342714 .274094173 34 .510028166 .431905343 .366044900 .310476052 .263552090 35 .500027613 .421371066 ■355383398 .299976862 .253415471 36 .490223150 .411093723 •345032425 •289832717 .243668722 37 .J80610932 .401067047 •334982937 ■ •280031610 •234296848 38 .471187188 .391284924 .325226152 .270561942 .225285431 39 .461948223 .381741389 •315753546 .261412505 .216620606 40 .452890415 .372430624 •306556841 .252572468 .208289045 41 .444010211 ■363346950 .297628001 .244031370 .200277928 42 .435304128 .354484829 .288959224 .235779102 .192574930 43 .426768753 .345838858 .280542936 •22780589s .185168202 4/1 .418400739 •337403764 .272371782 .220102314 .178046348 45 .410196803 .329174404 .264438624 .212659241 .171198412 _492 APPENDIX Table s — Amount of $i Set Aside Each Period eor i to 45 Periods Interest compounded annually 45 years; semiannually 22>^ years; and quarterly for 11 )4 years Periods 2% 21/2 % 3% 3 1/2 % 4% I I. 000 000 1. 000 000 1. 000 000 1. 000 000 1. 000 000 2 2.020 000 2.025 000 2-030 coo 2.03s 000 2.040 000 3 3.060 400 3-075 625 3.090 900 3.106 22s 3. 121 600 4 4. 121 608 4-IS2 516 4.183 627 4-214 943 4.246 464 5 5. 204 040 S-256 329 5.309 136 5-362 466 5.416 323 6 6.308 121 6.387 737 6.468 410 6-550 152 6.632 976 7 7.434 283 7.5^7 430 7.662 462 7.779 40 8 7.898 295 8 8.582 969 8.736 116 8.892 336 9-051 687 9.214 226 9 9.754 628 9-954 519 10-159 106 10.368 496 10.582 795 10 10.949 721 11-203 382 11-463 879 II-73I 393 12.006 107 II 12.168 715 12.483 466 12-807 796 I3-I4I 992 13.486 351 12 13.412 090 13.795 553 14-192 030 14-601 962 IS. 025 806 13 14.680 332 15.140 442 15-617 790 I6.II3 030 16.626 838 14 15.973 938 16.518 953 17-086 324 17-676 986 18.291 911 IS 17.293 417 17-931 927 18.598 914 19-295 681 20.023 588 16 18.639 285 19-380 225 20.156 881 20-971 030 21.824 531 17 20.012 071 20.864 730 21.761 588 22-705 016 23-697 512 18 21.412 312 22.386 349 23-414 435 24.499 691 25-645 413 19 22.840 559 23.946 007 25-116 868 26-357 181 27-671 229 20 24.297 370 25.544 658 26.870 375 28.279 682 29-778 079 21 25.783 317 27.183 274 28.676 486 30.269 471 31.969 202 22 27.298 984 28.862 8S6 30.536 780 32.328 902 34.247 970 23 28.844 963 30-584 427 32-452 884 34.460 414 36.617 889 24 30.421 863 32-349 038 34-426 470 36.666 528 39.082 604 25 32.030 300 34-157 764 36-459 264 38.949 857 41.645 908 26 33.670 9r6 36.011 708 38-553 042 41-313 102 44-311 745 27 35.344 324 37-912 001 40.709 634 43-759 060 47.084 214 28 37-051 210 39.859 801 42.930 923 46-290 627 49-967 S83 29 38.792 23s 41-856 296 45-218 850 48.910 800 52.966 286 30 40.568 079 ^3-902 703 47-575 416 SI. 622 677 S6.,o84 938 31 42.379 441 46-000 271 50-002 678 54-429 471 S9.328 33S 32 4^.227 030 48.150 278^ 52.502 759 57-334 503 62.701 469 33 46. Ill 570 50-354 034 55-077 841 60-341 210 66.209 527 34 48.033 802 52.612 885 57-730 177 63-453 IS2 69.857 909 3S 49.994 478 54-928 207 60-462 082 66-674 013 73-652 225 36 51.994 367 57-301 413 63-275 944 70.007 603 77-598 314 37 54.034 255 59-733 948 66-174 223 73.457 869 81-702 246 38 56.114 940 62-227 297 69-159 449 77.028 895 85-970 336 39 58.237 238 64-782 979 72-234 233 80-724 906 90-409 ISO 40 60.401 983 67-402 554 75-401 260 84.550 278 95-025 516 41 62.610 023 70.087 617 78-663 298 88.509 538 99-826 536 42 64.862 223 72.839 808 82.023 197 92.607 371 104-819 598 43 67.159 468 75.660 803 85.483 892 96.848 629 I10.012 382 44 69.502 657 78.552 323 89.048 409 101.238 331 IIS-412 877 45 71.892 710 81.516 131 92.719 861 105.781 673 121-029 392 Q W c3 OJ b( H ni ;h lU -rt >. X! -n Si 6 ni rA) 8 1^, hH (A, o D u ^ c<3 CJ ^ HH T3 ps; 3 C") u |Jh •c 1^ Ijh H & h a t ^ ^ % ^ !d c ■u -3 S i 0] a - " M ft a ii ^ S:&a ft "2 J3 " 3 ^ :;: t % a III S ft c o > ° 1) "^ o a 4 •O M ft f? 1 5 .2 ■, 1 3 oi ^3 • 1 a o H c o d ">. *t! t: o >. ^ cd (1 t>^ C 9^ cd u 3 II (d 1= d • C o a 2o ;J C d U .So >, oc <. O ro « ^ c 1*1 c O oo o o li^i •* fS (-; oi -c ■a c J c o to O \n ^C C 0» 00 -d- •c c ^C c o o Oi M (o in OC c Tj- C § ^ «n ro gfe^s C 4 t- 1- H (A "S p 1- &0 c« 4J O a b rt 1 0. t- rt c c J o V o d o o t^ Ih ,n -H en (i [i III c c C 8qS i O D O P. •O u Ih •O e; 'w (4 T) W a DO -0 t: 2 2 -c T 2 x •e-'O S •d -o "i o c o "c C "o "c "c O ^ "o 3 1-5 O O OOC oo O O O en O O ■d '^^ u tn a < t CJ ^ a a cd £ § o 1 'd o U < o B < rt c c ci! i: :3 1- c c 1 1 •3 -o S j3 c "t? rt rt rt 1 g rt 1 T Ill 16 < < pq pq m n t. u 493 494 APPENDIX o '^ « o "^ o ^ ^ O n) .-"Si- 6 o" & ^ ^ :S a 'o O ^ S"g p. o e.2 •= S c 3 :3 . 4^ P rt S .9 2; ■" g " o c ^ c "3 u-i ro fO 0\ (^ o o r- o n ^ fN j^ O w alue erms U. S o ^n 1- to li-i on n r~ m M ro rty Tt 00 00 00 r- 00 Oi fO h t' r^ r- r~ -o o t- ■o i- t^ »o o 1- ■"^ rf -^ Ov w Oi H W s M 'S- > E- 00 1 >> o a < s 3 o 3 o fa « a Hankow Kiaochow Nankin Niuchwan Ningpo 00 c IX oc o Takau Tientsin Yuan Hongkong British 1 a s a o 1 _Q o (X o 13 *0 "CJ td tJ 'O 13 'd 'o'o'o'o'o 'o'o'o OOOOO OOO §5 g s g O 3 « o M a OOQWW iiifeO VALUES OF FOREIGN COINS 495 3 i! +a O 6 >. 3 O M ffi -a 2 sl i^ 2 ft " ■o a 3 ^ lion erti po .2 si Q .2 Qj "1 ^2 8 SOS ^ t 3 -g s I 0) -^ lO O O O 1-1 I O ro O O O I *0 0\ "1 QO Oi < 00 M N TT Tl" I m O O O O 00 OD C^ O 00 O ^ Ot o o >o o o ■^ '^ o w o o» tnOiAOOOOOtO OOOO vOOO(*:'^0(*)Or*3 r-oo<^ >OO00Oi>- OOCt ooioOMtnOMrOHi usnh •^1 s " b S s pi. Q Ph 2 tij c =3 w 3 ,i5 t: B o O « 0. J >< Q I * a 2 « « CL, O O M m 0. M _i A, M hJ »i Q Q fH Oi Q W fc, CO 1j nj *u 'ti nj 'O T3 ^3 TJ *ti "1!^ ^3 'o'o-S'o'o'o 'o'o'o'o'o'o OOwOOO OOOOOO 'O 'O ^3 *0 ^3 ^3 irJ '^ *tJ ^ 'O l3 '^ 'TiJ 'O 'S^'o'o'o'o'o'o'o 'o'3'o "o "o "o ooooooooo oc3o O O O ag ° s s ^ ;^ ^ ^ ^ P^ PLi s si X ? > 1 rt e3| i l£ A. in. B^ K CO c ;:p B-S en U3 U3 e APPENDIX E ALPHABETICAL LIST OF REFERENCES Agger, E. E. Organized Banking. New York, Henry Holt & Co., 1918. 385 pp. American Warehousemen's Association, Pittsburgh, Pa. Warehouse Receipts as Collateral. 1920. 24 pp. Anderson, Jr. , B. M. The Value of Money. New York, The Macmillan Co., 1917. 610 pp. Brady, J. E. Law of Bank Checks. New York, Banking Law Journal, 1915. 463 pp. Brown, H. G. International Trade and Exchange. New York, The Macmillan Co., 1914. 153, 197 pp. Chamber of Commerce of the United States. Trade Acceptances, Sup- porting and Opposing Arguments. Washington, 1918. 24 pp. Cleveland, F. A. Funds and Their Uses. New York, D. Appleton & Co., 1910. 304 pp. Cole, W. M. Accounts, Their Construction and Interpretation. Rev. and Enl. Ed. Boston, Houghton, Mifflin & Co., 1915. 445 pp. Commercial Paper and Bills of Exchange of the World. New York, Banking Law Journal, 1915. 70 pp. Conant, C. A. Principles of Money and Banking. New York, Harper & Bros., 1905. 2 vol. Conway, T. Jr., and Patterson, E. M. Operation of the New Bank Act. Philadelphia, J. B. Lippincott & Co., 1914. 431 pp. Davenport, H. J. Economics of Enterprise. New York, The Macmillan Co., 1913. 544 pp. Dunbar, C. F. Theory and History of Banking. 3d Ed. New York, G. P. Putnam's Sons, 191 7. 297 pp. Duncan, C. S. Marketing, Its Problems and Methods. New York, D. Appleton & Co., 1920. 500 pp. Escher, F. Foreign Exchange Explained. New York, The Macmillan Co., 1917. 219 pp. Ettinger, R. P., and Golieb, D. E. Credits and Collections. New York, Prentice-Hall Inc., 1917. 390 pp. 496 ALPHABETICAL LIST OF REFERENCES 497 Exporters' Encyclopedia. New York, Exporters' Encyclopedia Co. Annual. Fetter, F. A. Modern Economic Problems. New York, Century Co., 1922. 498 pp. Filsinger, E. B. Trading with Latin America. Irving National Bank, 233 Broadway, New York, 191 7. 183 pp. Fisher, I. Stabilizing the Dollar. New York, The Macmillan Co., 1920. 30s pp. — — and Brown, H. G. Purchasing Power of Money. New Ed. Rev. New York, The Macmillan Co., 1913. 501 pp. Fiske, A. K. Modern Bank. Rev. Ed. New York, D. Appleton & Co., 1919. 345 pp. Harris, R. S. Practical Banking. Boston, Houghton, Miflain& Co., 1915. 309 pp. Hatfield, H. R. Modern Accounting. New York, D. Appleton & Co., 1909. 367 pp. Holdsworth, J. T. Money and Banking. New York, D. Appleton & Co., 1920. 515 pp. Hough, B. O. Elementary Lessons in Exporting. New York, Johnston Export Publishing Co., 1909. 427 pp. Huebner, S. S. Stock Market. New York, D. Appleton & Co., 1922. 496 pp. Huffcut, E. W. Law of Negotiable Instruments, Statutes, Cases and Authorities. 2d Ed. Rev. and Enl. by F. D. Colson. New York, Baker, Voorhis & Co., 1910. 885 pp. Jevons, W. S. Money and the Mechanism of Exchange. New York, D. Appleton & Co., 1875. 484 pp. Johnson, E. R., and Huebner, G. G. Railroad Traffic and Rates. New York, D. Appleton & Co., 191 1. 2 vol. Johnson, J. F. Money and Currency. New Ed. Boston, Ginn & Co., 1921. 425 pp. Kemmerer, E. W. A B C of the Federal Reserve System. 4th Ed. Princeton University Press, 1920. 208 pp. Money and Credit Instruments in Their Relation to General Prices. New York, Henry Holt & Co., 1909. 160 pp. Kinley, D. Money. New York, The Macmillan Co., 1904. Kirkbride, F. B., Sterrett, J. E., and Willis, H. P. Modern Trust Company. 5th Ed. NewYork, The Macmillan Co., 1920. 549 PP- Kniffin, W. H. Business Man and His Bank. New York, McGraw-Hill Book Co., 1920. 278 pp. 498 APPENDIX Kniffin, W. H., Commercial Paper, Acceptances and the Analysis of Credit Statements. New York, Bankers Publishing Co., 1918. 162 pp. Practical Work of a Bank. New York, Bankers Publishing Co., 1919. 604 pp. Savings Bank and Its Practical Work. New York, Bankers Publish- ing Co., 1918. S41 PP- Langston, L. H. See below under "National City Bank of New York." Laughlin, J. L. Principles of Money. New York, Charles Scribner's Sons, 1903. sso pp. McMaster, J. S. McMaster's Irregular and Regular Commercial Paper. New York, McMaster Co., 1903. Margraff, A. W. International Exchange. 4th Ed. New York, Anthony W. Margraff, 1912. 299 pp. Mathewson, P. Acceptances, Trade and Bankers. New York, D. Apple- ton & Co., 1921. 372 pp. Meeker, E. J. Work of the Stock Exchange. New York, Ronald Press Co., 1922. 633 pp. Mitchell, W. C. Index Numbers of Wholesale Prices in the United States and Foreign Countries. Washington, D. C. U. S. Bureau of Labor Statistics, July, 1915. (Bulletin No. 173.) Monetary Commission of the Indianapolis Convention. Report 1898. Chicago, University of Chicago Press, 1898. 608 pp. Moore, W. U. Law of Commercial Paper. New York, D. Appleton & Co., 1918. 309 pp. Moulton, H. G. Financial Organization of Society. Chicago, Uni- versity of Chicago Press, 1920. 789 pp. Principles of Money and Banking. Chicago, University of Chicago Press, 1916. 283, 502 pp. Muhleman, M. L. Monetary and Banking Systems. New York, Mone- tary Publishing Co., 1908. 218 pp. National City Bank of New York. National Banking Under the Federal Reserve System. New York, The Bank, 1921. 152 pp. Practical Bank Operation. Prepared by L. H. Langston. New York, Ronald Press Co., 1921. 2 vol. O'Mally, F. Our South American Trade and Its Financing. New York, National City Bank, 1920. 125 pp. Paton, W. A., and Stevenson, R. A. Principles of Accounting. New York, The MacmOlan Co., 1918. 685 pp. Phillips, C. A. Bank Credit. New York, The Macmillan Co., 1920. 374 pp. ALPHABETICAL LIST OF REFERENCES 499 Phillips, C. A., Readings in Money and Banking. New York, The Macmillan Co., 1916. 845 pp. Pratt, S. S. Work of WaU Street. 3d Ed. New York, D. Appleton & Co., 1921. 447 pp. Robb, T. P. Guaranty of Bank Deposits. Boston, Houghton, Mifflin & Co., 1921. 225 pp. Rosenthal, H. S. Encyclopedia of Building, Loan and Savings Associa- tions. 4th Ed. The Author, 15 W. 6th St., Cincinnati, Ohio, 1920. Soo pp. Schaub, L. F., and Isaacs, N. Law in Business Problems. New York, The Macmillan Co., 1921. 821 pp. Scott, W. A. Money and Banking, sth Ed. New York, Henry Holt & Co., 1916. 406 pp. Shaw, A. W., Co. Loans and Discounts.. Chicago, A. W. Shaw Co., 1918. 334 pp. Shugrue, M. J. Problems in Foreign Exchange. New York, D. Appleton & Co., 1920. 173 pp. Snider, G. E., Maule, W. M., and MacElwee, R. S. Paper Work in Ex- port Trade. Washington, Government Printing Office, 1920. 152 pp. (U. S. Bureau of Foreign and Domestic Commerce. Miscel- laneous series No. 85.) Stockwell, H. G. Net Worth and the Balance Sheet. New York, The Ronald Press Co., 1912. 206 pp. Taussig, F. W. Principles of Economics. 3d Ed. New York, The Mac- millan Co., 19 21. 2 vol. Taylor, F. M. Some Chapters on Money. Ann Arbor, Mich., George Wahr, 1906. 316 pp. Tillyard, F. Banking and Negotiable Instruments, sth Ed. London, A. & C. Black; New York, The Macmillan Co. 403 pp. ' United States Government Documents. Apply to Superintendent of Documents, Washington, D. C. Walker, F. A. Money. New York, Henry Holt & Co., 1906. 550 pp. WaU, A. Analytical Credits. Indianapolis, Bobbs-MerrUl Co., 1921. 258 pp. Bankers' Credit Manual. Indianapohs, Bobbs-Merrill Co., 1919. 247 pp. Westerfield, R. B. Banking Principles and Practice. New York, Ronald Press Co., 1921. 5 vol. 1370 pp. Whitaker, A. C. Foreign Exchange. New York, D. Appleton .& Co., 1919. 646 pp. 500 APPENDIX White, H. Money and Banking Illustrated by American History, sth Ed. Boston, Ginn & Co., 1914. S4i PP- (References in this book are to the fourth edition, 191 1.) Willis, H. P. American Banking. Rev. Ed. Chicago, La Salle Extension University, 1921. 336 pp. The Federal Reserve. Garden City, N. Y., Doubleday, Page & Co., 1915. 342 pp. and Edwards, G. W. Banking and Business. New York, Harper & Bros., 1922. 573 pp. York, T. Foreign Exchange. New York, Ronald Press Co., 1920. 182 pp. INDEX Acceptances, bank, abuses of, 364 authorized by Federal Reserve Act, 314 diagrammatic illustration, 359- 361 distinguished from commercial paper, 55 form of, 39 purchases by federal reserve banks, 343 typical illustrations, 357 compared with single-name paper, 186 development of, 305 entries on balance sheet, 135-136 shown in credit statement, 241, 246 trade, 38 advantages of, 366 objections to, 367 typical illustration, 365 Accommodation paper, 48, 187 Accounts, adjustment in bank statement, 132 payable, 245 receivable, 217, 234-237 basis for loans, 192 Agricultural credit, 114-116 Agricultural paper, 55 (See also " Cattle loans " ; " Cotton loans " ; "Grain bills") Aldrich-Vreeland law, 307 Analysis ratios in credit statement, 220-230 Arbitrage in foreign exchange, 406 Authority to purchase, 75 B Bailee receipt, 69 Balance sheet, federal reserve bank, 352-356 national bank, 126-140 significance of, in credit statement, 211 Bank acceptances (See "Acceptances, bank") Bank credit, 166 Bank notes (See also "Federal re- serve bank notes"; "Federal reserve notes"; "National bank notes") advertising, benefit of, 165 compared with deposit currency, 164 entries on the balance sheet, 136 inelasticity of, 168, 301, 323 nature of, 164 security of, 165 Bank of England, 316 Bank postal remittance, 50 Bank statement, effect of operations on, 126-136 , illustrated, 137-140 Banking, commercial, 98-100 early history of, 94 investment, 100 private, 100 Banking house, investment in, 268 Banks (See also "Federal reserve banks"; "National banks"; "Savings banks"; etc.) branch, 11 1 charter authority, 98, 123 classification, of 96 according to capital, 143 definition of, 95 early examples of, 95 number of, 109-111 organization of, 122 Bars, bullion, 17 BiUs of exchange (See also "Foreign exchange") acceptance of, 89 classes of, 37, 374 definition of, 34 form of, 35 parties to, 36 presentment of, go uses of, 38-41 Bills of lading, export, 59 501 502 INDEX Bill of lading— Continued form of, 6i negotiability of, 62 ocean, 59 straight and order, 58 through, 60 transactions illustrating use of, 60-62 Bills payable, 242-245 Bills receivable, 191, 232 Bimetallism in U. S., 431-433 Bland Act, 22, 432 Blank indorsement, 84 Bonded indebtedness in credit state- ment, 249 Bonds, held by banks, 263 pledged for national bank notes, 169 Branch banks. III Building and loan associations, 1 16 Call loans, 176-179 Call money, 420-426 Capital, bank, 142-144 comparison with, deposits, 155, 205 loans, 205 manufactures and railroads, 148 surplus and undivided profits, federal reserve banks, 311 national banks, 104 state banks, 144 Cash, credit statement, in, 231 reserve, not counted as, 274 Cashier's check, 46 Cattle loans, 194 Certificates, clearing-house, 291 deposit, 53 gold, 9, 25 silver, 10, 25 Certified check, 45 Checks (See also "Indorsements") cashier's, 46 certified, 45 drawing of, 42 example of old, 42 form of, 41 presentation of, 43 responsibility of parties, 44 stale, 44 Checks — Continued stop-payment of, 46 volume settled at clearing house, 291 Checking accounts, cost, 158 Circular notes, 51 Circulation (See also "Bank notes"; "Federal reserve notes") federal reserve bank, 325 national bank, inelastic, 168, 301, 323 per capita, 14 tables of, 29-30 Clean bills of exchange, 391 Clearing house, 289-299 certificates, 291 exchanges, 134 significance of figures, 298 Coinage, charges, 16 gold, 14 Coins, foreign, value of, 493-495 gold, 14-18 minor, 24 silver dollars, 22 subsidiary silver, 24 Collateral loan agreement, 189 Collateral loans, 188-191 Commercial credit instruments, 34 Commercial paper, 54 buying, principles for, 199-202 fixed assets, not used for financing, 244 rediscounts by federal reserve banks, 338 Commercial paper broker, 202 Commodity paper, 55 Comptroller of the Currency, super- vision over national banks, 123 Conditional indorsement, 86 Contingent liabilities in credit state- ment, 249 Co-operative banks, 116 Cotton loans, 195 Country banks, reserve of, 272-275 Credit, nature of, 3-6 relation to, bank notes, 166 money, i price, 6, 442 Credit instruments, commercial, 34 exchange medium, 5 volume of, 56 INDEX 503 Credit statement, 208-218 (See also "Accounts receivable"; "Bills payable"; "Bills receivable") audited statement, 212 form of, 213 illustrations of, 255-262 merchandise, 237-241 ratios in analysis of, 220-230 Credit unions, 117 Crime of 1873, 432 Current assets, 221 Current liabilities, 221 Demand loans, 176-178 Deposit, certificate of, 53 currency, 153-155 compared with bank notes, 164 Deposits, charges made for small accounts, 159 guaranty of, 161-163 interest on, bank, 160 individual, 159 relation to, capital, 155, 205 loans, 150-153, 205 reserve, 276-291 savings, 157 source of, 150 time and demand, 156-157 Discount calculations, 1 81-185 Discount companies, 1 19-122 Discount market, use of bank accept- ances, 362 Documentary bills, 391 Dollar exchange, 376^397 Domestic exchange, 294 Double-name paper, 47 Drafts (See " Bills of exchange") E Earnings of federal reserve banks, 350 Elevator paper, 55 Equation of exchange, 446-448 Failures, causes of, 208 Federal Farm Loan Act, 115 Federal land banks, 114 Federal Reserve Act, passage of, 308 Federal reserve bank notes, 10, 27, 326 Federal reserve banks, 105 balance sheet, 352-356 capital, 311 clearing-house settlements, 292 discount rates, 317 earnings, 350 management of, 312 rediscounting by, 333-343 relation to the government, 329 reserves, 326 held for member banks, 318 statement of, 353 Federal Reserve Board, 309 Federal reserve collection system, 294-297 Federal reserve districts, 309-311 Federal reserve notes, 10, 27 early issues, 335 expansion due to war, 347 provisions of original act, 344 volume of, 345 Federal reserve system, complaints against it, 335 development by the war, 336 early development, 333 elasticity ot note issues, 323-326 Finance bills, 40, 403 First United States Bank, 427 Foreign coins, value of, 495 Foreign exchange, classification of bills, 374-375 dollar exchange, 376 pegging, 380 principles of, 370-384 process of, 385-394 typical transactions, 395-408 Free gold and federal reserve banks, 350 Gold, bars, 17 certificates, 9-10, 25 coinage, 14-18 coins, foreign, 17 cubic contents, 19 effect of export and import on bank credit, 281 imports and exports, 20 mining, proposed subsidy, 21-22 mint price, 21 production, 19-20 stock, 18-19 504 INDEX Gold reserve and federal reserve notes, 346 Gold settlement fund, 297 Gold Standard Act of 1900, 22 Government promissory notes, 428 Grain bills, 197-198 Greenbacks, 9, 25 Guaranty of deposits, 161-163 H Hypothecation, 190 certificate, 69-70 Income sheet, 251-252 Index members, 434-435 Indor;iements, blank, 84 conditional, 86 forms of, 84-89 illustrations, 87-89 liabilities of parties, 91 qualified, 85 restrictive, 85 Industrial savings banks, 109 Inflation, demand for, 434 Insurance of merchandise, 241 Interest, accrued, 128 calculations, 181-185 loans, on, call, 178 time, 180 rates of, 204 tables, 484-492 Inventory, appraisal, 238 sales, comparison with, 253 Investment banking, 100, 266-268 Investment credit instruments, 34 Land banks, federal, 114 Lawful money, 8,11 Legal tender, 8,11 issues, 429-431 Letters of credit, advantages in use of, 73-74 commercial, 388 customers' liability under, 135 domestic letters, 74 drafts drawn under, 388 Letters of credit — Continued import and export letters, 71-73 purpose of, 71 travelers', 75-79 Liberty bonds, basis for redis- counting, 337-34° Loans, bank, 128 call, 176-179 cattle, 194 collateral, 188-191 commercial, 175 cotton, 195-196 demand, 176 grain bills, 197 merchandise, 193 mortgage, 199 rates of interest on, 204 relation to, capital, 205 deposit, 150-153, 205 reserve, 276-281 time, 179 M Medium of exchange, 2 Merchandise, ratio of sales to, 227 turnover, 223-225 Merchandise loans, 193 Mill paper, 55 Minor coins, 12, 24 Mint price of gold, 15-16 Mints, 17 Monetary circulation, tables, 29-30 Monetary stock, 12-14 Money, changes in form of, 28-31 circulation, 12-14 credit, forms of, 28 definitions of, 2 functions of, I lawful, 8 orders, 49-50 paper, 9 rates, 414-420 redemption of, 31 relation to credit, i Money changers, 94 Money market, factors affecting, 414 Morris-plan banks, 118 Mortgage loans, 199 Multiple standard of value, 448 Mutual savings banks, 108 INDEX 505 N National bank notes, 10, 26 inelasticity of, 168, 301, 323 origin of, 167 profit on, 169-172 volume of, 172 National banking system, Act of 1863, 103 defects, 301-308 growth, 104 origin of, 102 National banks, capital of, 105 number of, 104 organization of, 123 reserve of, 271, 302 supervision of, 123 National Monetary Commission, recommendations of, 307 Negotiability, attributes of, 83 bills of lading, 62-63 historical development of, 80-82 meaning, 80 purpose of, 82-83 warehouse receipt, 65 Negotiable instruments, 82 law, 83 Net worth, bank, 126 ratio to, assets, 227 debts, 228 sales, 228 New York bank statement, 410 New York money market, 409-426 Notes payable, 242-245 Notes receivable, 232-234 O Open- market operations, 202 federal reserve banksj 317 Panic of 1907, 307 Paper money, 9 effect of depreciation upon ex- change, 379 federal reserve bank notes, 27 federal reserve notes, 10, 27 government issues, 428-431 national bank notes, 26 United States notes, 25 Pegging exchange, 380 Phillips, C. A., on bank reserve, 286- 288 Pittman Act, 23-24 Postal saving system, 113 Prices, (See also "Index numbers") influence of changes in, 438-440 volume of currency, relation to, 445 Problems, with solutions, 453-476 without solutions, 477-482 Promissory notes, 46 government, 428 Protest, fees, 92 meaning of, 91 requirements of, 92-93 Qualified indorsement, 85 Quantity theory of money, 440-445 Receivables, purchased by discount banks, 120 ratio of, merchandise to, 225-227 sales to, 228 Redemption fund, 168 Redemption of moneys, 31 Rediscounts, development of, 305 entries on the balance sheet, 137 federal reserve banks, 313-317, 342 interbank, 323 Renewal of notes, 245 Renewal rate on call loans, 424 Reserve banks, 270 Reserve cities, 271 Reserve in a credit statement, 247 Reserves, bank statement, 41 1 computation, method of, 283-285 federal reserve banks, 326, 347 loans and deposits, relation to, 276-281 national banks, 302 reduction of, 321 Restrictive indorsement, 85 Sales, credit statement, 252 5o6 INDEX Sales — Continued inventory, comparison with, 253 ratio to, fixed assets, 229 merchandise, 227 net worth, 228 receivables, 228 Savings banks, 97 definition of, 108 industrial, 109 mutual, 108 school, 109 stock, 109 territorial distribution of, 108 School savings banks, 109 Second United States Bank, 427 Securities, classes of, held by banks, 263 holdings of banks, 263-269 policy of investment by banks, 263-268 Sherman Act, 22, 433 Shipper's draft, 63 Shipper's invoice, 62 Shipping documents and bankers' acceptances, 358 Silver, certificates, 10, 25 demonetized, 431 dollars, 22 subsidiary, 24 Silver dollars, coinage, 22 legal tender, 23 seigniorage on, 23 Silver purchase acts, 432 Single-name paper, 47-48, 185-187 Stabilized dollar, 449 Stale check, 44 Standard of value, 2 State banks, 105-106 . capital, 144 membership in federal reserve system, 327-328 State banks — Cordinued organization of, 124 Stockholders' liability, 145 Subsidiary silver, 24 Surplus, bank, 127 capital, comparison with, 147 creation of, 133 growth of, 146 nature of, 145 Tabular standard of value, 448 Tolerance of the mint, 15 Trade acceptances, (See "Accept- ances, trade") Travelers' checks, 51-53 Travelers' letters of credit, 75-79 Trust companies, 106-108 affiliation with a national bank, 112 Trust receipt, form of, 68 Turnover, merchandise, 223-225 U Undivided profits, 127 compared with capital and surplus, 147 nature of, 147 Unearned discount, 128 United States notes, 25 W War obligations, rediscounting by federal reserve banks, 338 Warehouse receipts, 64-66 negotiability, 65 Warehousing system in Louisiana, 67 Wilson, President, appeal to state banks to join federal reserve system, 328