M m ,iiii I, I I I 1 I jjJL;:!LL'.iii. B^HWlfH«l»--lEiPRlf^ Mliiliiliiiiltl I i i m m iiii mui m J M ■HMl. ^^7 CORNELL UNIVERSITY LIBRARY Cornell University Library HG 2481.L37 Banking reform, 3 1924 019 229 537 »» JUL DATE DUE m. PRINTED IN U.S.A. Cornell University Library The original of tiiis book is in tine Cornell University Library. There are no known copyright restrictions in the United States on the use of the text. http://www.archive.org/details/cu31924019229537 BANKING REFORM EDITED BY J. LAURENCE LAUGHLIN ofessor of Political Economy in the University of Chicago; Author of "The Principles of Money"; "The History of Bimetallism in the United States"; "The Abridgment of J. S. Mill's Political Economy"; "Reciprocity" ; etc. CHICAGO THE NATIONAL CITIZENS' LEAGUE For the Promotion of a Sound Banking System 1912 Copyright, 1912, By The National Citizens' League For the Promotion of a Sound Banking System i^axB THE BLAKCLY PHINTINO COMPANY CHICAGO PREFACE THIS volume is intended to furnish a plain, untechnical ex- position of the defects of our present banking and currency system, together with a discussion of the remedies. Not since the Civil War has the country been confronted with a mone- tary and banking question of greater importance to business pros- perity. The adequacy of the banking system affects the everyday existence of the laborer, farmer and merchant. The unnecessary expense of obtaining credit under a bad banking system is borne by the borrower; the impossibility of getting loans in a time of panic shuts up factory and shop and falls most severely upon the wage- earner who loses his employment. Unemployment is largely increased by financial panics. The reason for the existence of the National Citizens' League, which is made up of business men, is found in the fact that the reform affects the borrowing business man more than the lending bank; the bank can always protect itself by sacrificing the bor- rower. There is practically no class in the community not directly concerned in the outcome of this campaign of education. This book explains the effects of our banking system and of its reform on every class. It has long been seen that our currency is needlessly inelastic ; that our credit system is even more dangerously inelastic; that our large gold supply is ineffectively used; that the scattering of re- serves forbids co-operative action by the banks in times of stress; that our rigid reserve system even breeds panics; that state banks and trust companies are doing commercial banking but without cooperation with national banks; that our Independent Sub-Treas- ury often attacks the reserves of banks at times of danger and works without business-like economy and efiiciency ; that idle funds of banks drift to New York and on call loans feed stock specula- tion ; and that our trade is greatly hampered by lack of American banking facilities in foreign countries. For these reasons the peo- ple are calling loudly for legislation which shall be non-partisan and formed on seasoned experience, without breaking with our iii iv PREFACE democratic system of independent banks. It should also be a mat- ter of care that elasticity should be obtained without the dangers of over-expansion. The reform should not take the shape of a dominant central bank, nor should it be the creaturej of politics. For this reason the Government of the United States should not enter the discount and deposit business of banking ; but, on the other hand, it should supervise and regulate a cooperative means of assistance, like an enlarged clearing-house association, in the common interest, and require the banks to pay all the cost of providing capital, supplying gold reserves, and issuing notes under its close supervision. Thus the surplus profits of note-issues and of discounts would go to the people of the United States. Moreover, in any legislation, care should be taken that control of our credit system should not pass into the hands of any sinister political or financial interests. For these good and sufficient reasons, the National Citizens' League, organized in most of the States of the Union, is now carry- ing on a campaign of education so that the worth of every meafl- ure proposed to Congress may be rightly judged. For this reason the plan of the National Monetary Commission — ^the elaborate and most discussed plan before the public — ^has been given extended study. The League, however, is not committed to any specific meas- ure. If discussion shows that any other plan is superior to that now before Congress, it will support that plan. It will favor any measure which incorporates its fundamental principles without re- gard to its origin. It realizes, however, that the remedy for the defects of our present credit system lies in some form of a coopera- tive institution, evolved from our clearing-house experience, by whatever name it may be called, which will remove the defects of to-day. The evil of separate sections, working at odds, can no longer be tolerated. The cooperation desired should be country- wide, providing for the importation of gold, in the interest of all banks, big and little, giving assistance to all in times of stress, and supplying uniformity in the rate of discount. SUch advantages could not be gained by dividing the country into independent de- tached sections, leaving the situation much as it is to-day. But this cooperative agency should furnish the indispensable economy of united reserves and common places for the rediscount of commer- cial paper impossible under a system of separate organizations. In the preparation of this volume, especial acknowledgment is PEBFACE V made to Professor H. Parker Willis of George Washington Uni- TCrsity. The question of constitutionality has heen treated by Dean James P. Hall, of the Law School of the University of Chicago; and in the legal question regarding acceptances, valuable aid was given by Professor F. E. Mechem of the same school. Indebtedness for assistance, advice and care-taking industry is due to Professor W. A. Scott, of the University of Wisconsin; Mr. A. D. Welton, Mr. Frank H. Fayant ; and Professor M. S. Wildnmn, of North- western University. J. Laurence Laughlin, Chairman of the Bxecutive Committee, National Citizens' League. Chicago, April 15, ISia. CONTENTS I. The National Banking System § 1. The National Banking System 1 § 2. Scope of the National Banking System and Cap- ital Invested 2 § 3. Chartering National Banks 4 § 4. National Bank Note Issues, Their Restriction and Regulation 5 § 5. How Banks Are Classed Under the Reserve System 6 § 6. Relations of Banks to Bach Other 7 § 7. Duties of the Comptroller of the Currency 8 § 8. National Banks the Mainstay of the Whole Banking System 9 § 9. Relation of the National Banks to the Govern- ment 10 §10. Defects of the National Banking System 11 §11. Remedy for the Defects 13 II. A Co-operative Agency § 1. Defects of Banking System Diagnosed 15 § 2. Means of Cooperation 16 § 3. Why Cooperation Is Necessary 17 § 4. Protection to Deposits 19 § 5. Final Extinction of National Bank Notes 19 § 6. Control Over Expansion 21 §7. Uniform Rate of Discount 23 § 8. Discount Market for Acceptances 23 § 9. Protection from Wall Street .^ 24 §10. Political Pressure to Secure Government De- posits 26 §11. Our International Position 27 III. Present Eeseeve Requirements § 1. Rigidity of the System 29 § 2. Our Reserve System Makes Credit Inelastic. 31 § 3. Foreign Practice in Contrast with Ours 33 § 4. Stringencies Bring Out Fundamental Defects . . 41 § 5. Redepositing Reserves Encourages Speculation 43 § 6. Our Reserve System Implies High Cost of Loans 45 § 7. Country Paper at a Disadvantage 48 § 8. Lack of Discount Market Limits Loans 50 § 9. Remedy 51 IV. Our Inelastic Credit System § 1. Panic Conditions 53 § 2. Dangerous Grasping for Reserves 55 § 3. Ways of Converting Assets into Immediate Means of Payment 56 § 4. Bank Notes Not a Deslrahle Remedy for Panics 60 § 5. Remedy Must Touch Lending Power of Banks. . 65 § 6. Restoration of Confidence if Assets Good 66 vii viii CONTENTS § 7. Experience of Other Countries 68 § 8. Remedies for Panics Not in Temporary Meas- ures 69 § 9. Importation of Gold for Reserves 72 V. Commercial Paper § 1. Classification of Loans 75 § 2. Nature and Origin of Commercial Paper 76 § 3. Types of Commercial Paper 78 § 4. Characteristics of Commercial Paper 81 § 5. Reserve Association Restricted to Commercial Paper 82 § 6. American Practice With Promissory Notes 84 § 7. Commercial Paper a Protection Against Over- Expansion 87 VI. Acceptances and a Discount Market § 1. European Accepted Bills of Exchange ^ . 90 § 2. American Promissory Notes 91 § 3. National Banks Cannot Accept Bills of Ex- change 93 § 4. A Discount Market 96 § 5. Danger of Over-Expansion 101 § 6. The Rate of Discount 102 § 7. Uniform Rate of Discount in United States 104 VII. Speculation and Call Loans § 1. Analysis of Bank Credit 109 § 2. Origin of Call Loans 110 § 3. Real Security for Commercial Loans Ill §4. Extent of Call Loans 113 § 5. Development of Margin Trading from Call Loans 115 § 6. Banks Would Prefer Not to Lend for Specula- tive Purposes 116 S 7. How Discount Market Would Work 118 § 8. Reserve Association Would Be an Intermediary Between Banks 119 § 9. Possibilities of Evading Charter Requirements as to Commercial Loans 120 §10. Banks Would Protect Themselves 121 VIII. The Inelasticity of Note Issues § 1. Why National Bank Notes Were First Issued. . 124 §2. Foreign Systems of Note Issua 125 § 3. Motives for Note Issues 126 § 4. Working of National System 127 § 5. An Inelastic Currency System and Its Effects . . 128 § 6. Panic Conditions and "Emergency Currency" . . -129 § 7. Actual Note Issues 130 § 8. Relation of Notes to Bonds 133 § 9. Notes Limited by Cost of Bonds 134 §10. Notes Not Quickly Obtained 137 §11. Criticism of Conditions 139 IX. Inflation and Over-Expansion § 1. Fear of Inflation , 142 § 2. How Inflation Is Revealed and Produced 142 CONTENTS ix § 3. Safeguards Regarding Investments and Re- 4emption 144 § 4. Regarding Adequate Reserves 147 § 5. Limitation of Note Issues 149 § 6. The National Reserve Association and Inflation 151 § 7. Fear That the National Reserve Association Will Stimulate Inflation 154 § 8. Inflation, Theoretically Imaginable, but Not Possible 157 X. Bond-Secured and Banking Currency § 1. Retiring the National Bank Notes 161 § 2. Refunding the Bonds 163 § 3. Other Plans for Using the Bonds 164 § -4. An Alternative Method and Objections to It. . . . 165 § 5. The Monetary Commission's Plan 166 § 6. Disposition of the Bonds 167 § 7. The Question of Monopoly 169 § 8. Use of Profits from Note Issues 170 § 9. Access to Notes 172 §10. Security of the Notes 173 XI. The Clbaring-House System § 1. Clearlng-House Associations the Only Form of Cooperation .-. 175 § 2. Development of . Clearlng-House Functions 176 § 3. Methods of Clearlng-House Examiners 177 § 4. Government Recognition of Clearlng-House Ex- aminations 180 § 5. Issue of Clearlng-House Certificates 182 § 6. Nature of the Issue Function 184 § 7. Action by Congress Following 1907 Panic 185 § 8. National Currency Associations and Why Few Have Been Organized 186 § 9. Associations, Both Clearlng-House and "Na- tional Currency," Have Been Incomplete 187 §10. The Question of Infiatlon 188 §11. Avoidance of Infiatlon 191 §12. Advantage of Regularity 191 §13. Need of Extending Clearlng-House Functions. . 192 XII. CO-OPBBATION OR CENTRALIZATION ? § 1. Three General Types of Banking 194 § 2. Banking Systems in the United States 194 § 3. European Banks 196 § 4. Canadian System 197 § S. Defects of the Competitive System In the United States 198 § 6. Statistics as to Distribution of Reserves and Deposits 199 § 7. Tendency to Concentration of Control -202 § 8. Development of Joint Control — Holding Com- panies 204 § 9. Effect of Government Deposits 207 §10. Cooperation Under Present System Limited 208 §11. Organized Legal Cooperation 211 §12. Economy of Reserves 214 §13. Kinds of Paper Rediscounted 216 CONTENTS §14. Gains of Legal Cooperation 218 §15. Summary 220 XIII. Control of the Eeseeve Association § 1. The Pear of Making Present Bad Conditions Permanent 222 § 2. A National Reserve Association — Possibility of Keeping It Free from Speculative Influences 224 § 3. How to Prevent Concentration of Funds 225 § 4. Directors of National Reserve Association and How Chosen 228 § 5. What Is Meant by "Control" 231 § 6. Possibility of Control of Reserve Association Discussed 232 § 7. The Idea of Control Through a Holding Com- pany 235 § 8. Publicity and a Free Banking System as Safe- guards 237 § 9. The Question of Share Infl,uence 239 — §10. Possible Control Through Favor 241 §11. Geographical Control and Sectional Opposition 243 §12. Unity of Banking Interests 245 §13. Political Control and the Evil It Would Work 245 §14. To What Use Could Control of the Reserve Association Be Put? 247 §15. Control of Other Banks Would Not Interest Bankers 251 §16. Safety Through Establishment of a Market for Commercial Paper 254 §17. Why Large Banks Do Not Oppose Reserve Plan 254 XIV. Small Banks and the National Eesekve Association § 1. Small Banks as Members of National Reserve Association 257 § 2. New Duties and Privileges 258 § 3. No Rediscount Facilities Under Present System 258 § 4. Economies 259 ~ § 5. Small Banks to Control National Reserve As- sociation 261 § 6. The Chief Danger Now Confronting the Small Bank 262 § 7. Many Problems of the Small Bank Would Be Solved 263 § 8. Commercial Paper and How It is Regarded . . 264 § 9. Commercial and Investment Loans 265 §10. Small Banks Will Become Really Independent 266 §11. Divorced from Reserve City Banks 266 XV. State Banks and Trust Companies § 1. A Large Number of State Banks and Trust Companies 269 § 2. The Problem of State Banks 270 § 3. Control of State and National Banks by Each Other 273 § 4. Reserve Plan Puts State and National Banks on Same Footing 275 I 6. Trust Companies and Mutual Savings Banks. . 277 CONTENTS xi § 6. Uniformity of Examination 278 § 7. A Single Discount Market 279 § 8. Benefit of a Reserve Association to Institutions Outside It 281 XVI. The Non-Boerower's Interest in Banking § 1. Interest in Banking Is General 283 § 2. Relations of People to Banks 284 - i 3. Interest of the Depositors 285 - § 4. Safeguards for Interests of the Wage-Earner.. 289 "^ i 5. How Bank Credit Reacts on the Laborer 290 — § 6. Stability of Industry 292 § 7. Influence of the Supply of Money 293 XVII. The Small Merchant § 1. Small Merchants Form a Large Group of Bank Customers 297 — § 2. The Small Merchant and His Customers — Busi- ness on a Cash Basis 298 § 3. How the Bank Comes in 300 § 4. Bank Competition Prevents Discrimination 302 § 5. Benefit of an Institution for Rediscounting 304 "" § 6. Small Merchant as a Depositor 306 § 7. Handicaps of the Present Banking System and Advantages of the One Proposed 307 XVIII. The Farmer and the Bank _ § 1. Seasonal Character of Agriculture and Crop Moving 309 — § 2. Farmers' Loans Under Present Banking System 311 § 3. DifiBculty Due to Inelastic Note and Credit Sys- tem , 314 § 4. The Remedy in Cooperation 317 § 5. Experience of Canada 318 § 6. Idle Funds and a Discount Market 320 XIX. Movement of Cotton i 1. Financing Import and Export Business 325 § 2. New York Supplies Cash to Move the Cotton.. 325 § 3. How Cotton Is Bought from the Producer 327 § 4. Defects of Present Banking System in Relation to the Cotton Movement 329 § 5. Cotton Movement and a Discount Market 331 § 6. The Bill of Lading 338 § 7. Acceptances 340 XX. The Depositor § 1. Relation of the Depositor to the Bank 342 ~ § 2. Guarantee of Deposits 344 § 3. Shortcomings of Examination 345 — § 4. Bank Failures 347 § 5. The Question of Rediscounts 350 § 6. Segregation of Commercial and Other Banks.. 353 xii CONTENTS XXI. The Reserve Association as Fiscal Agent of the Federal Government § 1. Banks as Government Depositories and Estab- lishment of the Independent Treasury System 355 § 2. Workings of the System 356 § 3. Exchange Functions of the Treasury 357 § 4. Foreign Experience 358 § 5. Plan of National Reserve Association 359 § 6. Contrast with Present System 361 § 7. The Question of Safety of the Government Funds 367 § 8. Public Function of National Reserve Associa- tion 370 XXII. International Position of the United States i 1. Readjustment of the Banking System to Meet Foreign Trade Conditions 371 § 2. Uniform Discount Rate and the Flow of Specie 373 § 3. United States Not Considered as a Center of Finance 374 § 4. Purchase and Sale of Exchange 375 § 5. Reserve Association to Do Banking Business Abroad 377 § 6. International Flow of Gold 379 § 7. Foreign Exchange Banks 380 XXIII. Constitutionality of a National Reserve Asso- ciation 386 Appendix— The National Citizens' League 419 BANKING REFORM BANKING REFORM CHAPTBH I THE NATIONAL BANKING SYSTEM §1. The National Banking System — Revising Banking Systems to Fit Changing Conditions — §2. Scope of the National Banking System and Capital Invested — §3. Chartering National Banks — Safeguards Against Banking Monopoly — §4. National Bank Note Issues, Their Restriction and Regulation — Inelasticity of Note System — §5. How Banks Are Classed Under the Reserve System — Regulations for the Independence of National Banks — §6. Relations of Banks to Bach Other — §7. Duties of the Comptroller of the Currency — Co- operation Among National Banks Practically Impossible — §8. Na- tional Banks Only an Element in the Banking System — National Banks the Mainstay of the Whole Banking System — §9. Relation of the National Banks to the Government — §10. Defects of the National Banking System — §11. Remedy for the Defects. §1. Organized in 1863, the national banking system has had a life of nearly fifty years. Within that period little has been done to alter its scope or Constitution. The first enactment was modi- fied in important particulars June 24, 1864, but the two measures may be considered substantially one. Subsequent innovations have been such as were necessitated by extraneous features of national policy — ^the redemption of the greenbacks, the refunding of the pub- lic debt from time to time, and others. Fundamentally, the plan of banking for which the system itself stands is what it was at the beginning. Few systems of banking can last for half a century without re- quiring substantial modification. The Canadian banking system is remodeled every decade, in pursuance of a requirement embodied in ganifi "g the fundamental law which governs it. The legislation of European Systems countries is frequently revised and adjusted to current necessities, changing This is an unavoidable outgrowth of changing commercial conditions Conditions which call for changes in the legislative adjustments that control them. Today the national banking system presents serious prob- lems to the commercial world. These call loudly for study and solu- 1 2 FIFTY YBAES OF NATIONAL BANKING tion. Bill after bill has been presented to Congress within the past ten years, but of all this multitude of measures not one has received more than cursory study and none has ever been seriously con- sidered as a practical question. It is for the commercial community to decide whether the present system shall be continued, or whether one better adapted to current needs and designed to furnish suitable protection to the business interests, to the farmers, and to the sal- aried and consuming classes of the country, shall be enacted. Scope of National Banking System and Capital Invested §3. According to the latest figures of the Comptroller of the Currency, the national banking system now includes 7,301 active institutions. Many have been formed only to fail or go out of busi- ness, but the system has steadily grown in the number of active banks until it has reached its present proportions. In reviewing the condition of the system and in tracing its in- ternal problems, it is essential to bear in mind the principal features relating to the distribution of capital among banks of different classes and among different states and localities throughout the country. The following table, compiled by the Comptroller of the Currency, furnishes the chief data with regard to this subject: BDMMAHY, BY STATES, GEOGRAPHICAL DIVISIONS, AND CLASSES, OF NATIONAL BANKS ORGANIZED FROM MARCH 14, 1900, TO OCTOBER 31. 1911, AND THE PAID IN CAPITAL STOCK OF ALL REPORTING NATIONAL BANKS ON SEPTEMBER I, 1911. States, etc. Capital {25,000 Capital over (25.000 and less than 150,000 Capital t50,000 and over Total organi- zations National banks reporting Sept. 1, 1911 No. Capital No. Capital No. Capital No. Capital No. Capital paidin- New England States HMne 4 4 5 1 $100,000 100,000 125,000 25,000 7 2 2 19 1 4 {385,000 200,000 190,000 4,450,000 500,000 200,000 11 7 7 20 1 8 $485,000 330,000 275,000 4,475J)00 500,000 300,000 70 56 51 188 22 79 S7.850.000 00 New Hampshire. . 130,000 5,235,000.00 5,210,000.00 53,467,600 00 Rhode Island. . . . 6,775 250 00 4 100,000 19,914,200.00 Total 18 450,000 30,000 35 5,885,000 64 6,365,000 466 98,451,950.00 Eastern States New York New Jersey Pennsylvania Delaware 97 61 219 6 31 2,425,000 1,275,000 6,475,500 150,000 775,000 9 7 24 3 I 287,500 210,000 807,000 95,000 172,000 97 41 223 17,970,000 3.510,000 24,080,000 203 99 466 9 49 4 20,682,500 4,995,000 30,362,000 245,000 2.427,000 1,250,00C 462 196 832 28 107 11 172,143,369.50 21,987,000.00 118,319,390.00 2,373,985.00 17,582,410.00 6,102,000.00 Maryland District of Colum- bia 13 4 1,480.000 1,250,000 Total 404) 10,100,000 48 1,571,500 378 48,290,000 830 59,961,500 1,636 338,608,154.60 CAPITAL OF NATIONAL BANKS states, etc. Capital $25,000 Capital over $25,000 and less than $50,000 Capital $60,000 and over Total organi- cations reporting Sept. 1, 1911 No. Capital No. Capital No. Capital No. Capital No. Capital paid in Southern States Virginia 49 35 21 12 26 7 33 6 12 219 20 62 32 $1,225,000 875,000 625,000 300,000 625,000 175,000 825,000 150,000 300.000 5,475,000 600,000 1,300,000 800,000 10 11 4 $356,000 396,000 130,000 42 39 28 20 49 25 33 19 19 136 26 36 31 $4,665,000 3,265,000 2,710,000 2,136,000 4,660,000 4,126,000 2,776,000 1,816,000 3,410,000 14,160,000 2,020,000 6,270,000 3,385,000 101 86 53 32 94 36 76 28 32 439 46 94 69 $6,146,000 4,535,000 3,365,000 2.435,000 5.950,000 4.426,000 3,904,500 2,066,000 3,740.000 22,321,000 2,660,000 6,800,000 4,365,000 129 107 74 43 114 45 83 30 32 613 47 144 100 $16,668,600.00 West Virginia North Carolina... South Carolina. . . 9,337,000.00 8,386.000.00 6,410,000.00 Georgia 20 4 10 3 1 84 1 7 6 676,000 125,000 304,600 90,000 3 0,000 2,686,000 30,000 230,000 180,000 13,944,600.00 Florida 6,966.530.00 9,469,000.00 Mississippi 3,230,000.00 8,146.000.00 Texas 45.026,000.00 Arkansas 4.460,000.00 Kentucky Tennessee 17.450.900.00 12,436,000.00 Total 623 109 90 169 14 35 176 111 34 13,075,000 2,726,000 2,260,000 3,976,000 350,000 876,000 4,400,000 2,775,000 850,000 161 18 16 18 4 4 15 19 14 6,231,600 628,000 483,000 628,600 130,000 126,000 471,000 630,000 450,000 501 86 67 86 26 28 29 60 40 54.286,000 12,725,000 9,150,000 13.750,000 4,790,000 3,360.000 4,600,000 3,646,000 12,886.000 1,185 213 172 263 44 67 220 190 88 72,691.600 16,078,000 11,883.000 18,363,600 6,270,000 4,350,000 9,371.000 7,060,000 14,185,000 1,461 380 260 437 100 128 272 329 132 169,927.430.00 ailddle Weatern States Ohio 62,449,100 00 Indiana 27,428,000.00 Illinois 74,785,000.00 14,710,000.00 Wisconsin 17,130,000 00 Minnesota 22,771,000.00 21,520.000 00 36,880.000,00 Total 728 18,200,000 107 3,546,600 422 64.796,000 1,267 80,540,600 2,038 276,673,100.00- Western States North Dakota... South Dakota.... Nebraska 121 68 103 92 23 11 61 24 306 3,026,000 1,700,000 2,575,000 2,300,000 575,000 276,000 1,276,000 600,000 7,650,000 7 3 20 10 4 215,000 90.000 715,000 360,000 130,000 9 13 38 30 16 11 38 10 80 500,000 700,000 3.335,000 2.300.00. 1,340,000 625,000 3,310,000 675,000 4,566,000 137 84 161 132 43 22 100 38 392 3,740,000 2,490,000 6.626,000 4,960,000 2.045.000 900,000 4,946,000 1,300,000 13.065,000 148 102 246 210 58 29 128 41 278 5,286,000.00 4,205,000.00 16,185,100.00 12,012,600 00 ^nnistnp , , 4,940,000 00 1.685,000.00 10,830,000 00 Colorado 11 4 26 361,000 125,000 860,000 New Mexico Oklahoma 2,020,000.00 12,717.500.00 Total 799 19,976,000 85 2,866,000 225 17,240,000 1,109 40,071,000 1,240 69.880,100.00 Faslflc States Washmgton 34 32 90 27 6 3 4 850,000 800,000 2,260,000 675,000 150,000 75,000 100,000 2 2 5 3 1 70,000 66,000 160,000 95,000 30,000 30 23 97 13 6 9 6 1 3,495,000 1,595,000 24.662.800 910.000 1.626,000 1.225,000 260,000 50,000 66 67 192 43 12 12 10 1 4,415,000 2,461,000 26,972,800 1,680,000 1,206.000 1,300,000 380,000 60,000 80 78 204 46 21 11 13 2 12,200,000.00 8,216,000.00 52,607,650.00 2.640,000.00 2,830,000.00 1,742,000.00 1,056,000.00 100,000.00 California Idaho Utah 1 30.000 Alaska Total 196 4,900,000 1 4 441,000 183 33,112,800 393 38,453,800 455 81,290,660.00 Island Possessions 2 50,000 2 1 550.000 100.000 4 1 600,000 100,000 4 1 610,000.00 100,000.00 Total 2 50,000 3 650,000 5 700,000 6 710,000.00 Grand Total.. 2.670 66,750,000 416 13,676,500 1,747 224,257.800 4,833 304,683,300 7,301 1.025,441,384.50 A FEEE BANKING SYSTEM Chartering of National Banks Safeguards Against Banking Monopoly §3. The most striking and characteristic feature of the na- tional banking system is that access to it is freely granted. Under the national banking act, any five persons possessing the necessary capital may apply to the Comptroller of the Currency for a charter incorporating them to do business as a national bank. The charters thus granted run for twenty years and give to the institutions re- ceiving them the usual corporate powers. Their capital is required to be paid up in money within six months after opening the doors for business, 30 per cent in specie being on hand in the vaults at the outset. Theoretically, there is therefore no reason why any number of groups of men should not gain access to the national banking sys- tem as they desire. The only restriction comes from the policy of the Comptroller of the Currency. It is not mandatory upon the Comptroller that he grant national bank charters. In practice, therefore, he limits his extension of such charters to those cases in which he finds, after special examination, that there is a genuine demand for a bank, and that such an institution can be created with- out imperiling the business of any existing institution. Under these conditions, and on the supposition that the men who apply for incorporation are solvent and are known business factors of proper standing in the community where they propose to organize the bank, the Comptroller of the Currency will usually grant them a charter. Of late, there has been a strenuous effort to discourage the granting of charters to promoters or persons whose object in effecting organization was not that of conducting the business of banking along sober and conservative lines. These restrictions, however, are purely a minimum. They are the neces- sary and fundamental requirements which must be enforced in order that the system may be kept free of injurious influences and main- tained upon a basis of essential soundness and legitimacy. The importance of the free banking principle thus provided for can hardly be over-estimated. It guarantees that the business of banking shall not, as in some countries, become a monopoly, and that it shall be freely open to all those who desire to enter it in good faith and with genuine capital. This idea of free access to the occupation is with justide regarded as fundamental in the American system of banking,' and nothing could be more improbable than that any change will ever be made tending to limit or destroy this feature of it. The banks themselves properly desire that, so far as possible. SAFEGUAEDS PEOVIDBD BY LAW 3 they shall be guaranteed against outside interference and shall be enabled to continue their business upon their own lines and without the domination of, or subservience to, larger institutions under the control of others. Every proposal for a change in the existing system must, there- fore, necessarilj' maintain these two ideas — freedom of access and freedom from control. This, however, does not necessarily mean that the banks are not to be limited and restrained at proper points, in order that they may be subjected to those methods of supervision which experience has shown to be necessary in all banking systems. They are, in fact, thus subject to oversight at the present time, for the law prescribes how their capital shall be paid and how their busi- ness shall be done. The question of further legislation is not that of limiting or destroying freedom of access or competition, but is merely that of prescribing proper regulations designed to protect the banks them- selves and the public against the development of evils at points requiring gpecial safeguard. What are these points ? §4. A peculiar feature of the national banking system, grow- National ing out of the circumstances of its origin, is seen in the present method of issuing and securing bank notes. The bank note is Their theoretically different in no respect from any other form of banking Restriction credit, yet for reasons which will later be reviewed, it has been Regulation deemed specially worthy of restriction and limitation by legislative bodies. In the national banking system, it was from the first provided that the total issue of notes by all the banks of the system should not exceed a specified sum, set at $300,000,000. It was further required that in no case should the total amount of notes obtained by any bank exceed the capital of that bank. Third, it was provided til at the notes should be protected by national bonds which the banks were required to buy and deposit with the Treasurer of the United States, receiving back notes not to exceed 90 per cent of the face value of the bonds. Fourth, it was required that at least a specified percentage of its capital should be put by each bank into the form of bonds, such bonds to be used at its discretion as a basis for demanding issues of notes from the Treasury. Today all of these requirements and restrictions are in operation, except that which limits the total amount of notes issued by all banks. Bank Note Issues, THE ISSUE OF BANKNOTES Inelasticity of Note System The limitation of outstanding issues to 90 per cent of the face value of the bonds has been displaced by one which permits the taking out of notes up to the par value of the bonds deposited, sup- posing these bonds to be selling at par or better. Under these con- ditions, it is evident that the total note issue cannot exceed the total amount of national bonds in existence, and in the case of any given bank, cannot exceed the amount of its capital. It is, moreover, obvious that the policy of the banks in taking out notes, above the minimum amount of bonds which they are required to buy in any event, would depend in no small degree upon the price of the bonds. In fact, the issues of bank notes actually taken out have varied and fluctuated largely in accordance with the price of bonds. Today the total note issue of all the banks is about $700,000,000. It is one of the most severe criticisms upon the national banking system at the present time that these notes displace gold, are expensive, fail to respond to the needs of the community, and are inelastin, often contracting when they are needed and expanding when they are not needed. The note system has been one of the points at which the National Bank Act has been most severely criticised, and in respect to which there has been the most strenuous demand for a rectification of existing conditions. How Banks Are Classed Under the Reserve System §5. More fundamentally significant to the national banking systein, and equally as characteristic as the note issue plan, is the pe- culiar reserve system established under the act as modified in 1864. By this system three classes of banks are established. Three cities. New York, Chicago, and St. Louis, are designated as "central reserve cities," while some forty-seven others are designated as "reserve cities." All other banks are classed as "country banks." The re- serve cities are Boston, Albany, Brooklyn, Philadelphia, Pittsburgh, Baltimore, Washiugton, Savannah, New Orleans, Dallas, Fort Worth, Galveston, Houston, San Antonio, Waco, Louisville, Cin- cinnati, Cleveland, Columbus, Indianapolis, Detroit, Milwaukee, Minneapolis, St. Paul, Cedar Eapids, Des Moines, Dubuque, Sioux City, Kansas City (Mo.), St. Joseph, Lincoln, Omaha, South Omaha, Kansas City (Kans.), Topeka, "Wichita, Denver, Pueblo, Muskogee, Oklahoma City, Seattle, Spokane, Tacoma, Portland Los Angeles, San Francisco, and Salt Lake City. The country banks are all those not situated m either of the groups of cities already referred to, INDEPENDElSrCE OF THE BANKS 7 Under the terms of the National Banking Act, no bank is per- mitted to establish branches. Every bank is presumably an inde- pendent institution. According to the same law, country banks are required to hold a reserve equal to 15 per cent of their outstand- Regulations ing liabilities, and may re-deposit 9 per cent of it with reserve city dependence banks. They thus retain in their own vaults, at the minimum, cash of National equal to only 6 per cent of their outstanding liabilities. The reserve city banks, which are required to hold a reserve equal to 25 per cent of their outstanding liabilities, may re-deposit one-half of this amount, or 12J^ per cent, with banks in central reserve cities. They may thus do business with cash in the vaults equal to only 121/^ per cent of their liabilities, provided they have on hand with banks in reserve cities a deposit credit equal to 12^^ per cent more of their outstanding liabilities. As a matter of fact the banks have availed themselves of this reserve provision very extensively, and much of the present so-caUed reserves consists not of cash in their own vaults but of deposits in other banks in reserve cities. At a recent date of report to the Comptroller of the Currency, about 551 millions of dollars repre- sented the total reserve held by country banks, while of this sum only .246 millions was actually in the possession of these banks in the form of lawful money. AU the national banks of the country had reserves of 1,404 millions, of which only 863 millions was actual lawful money in hand. §6. It is evident that as a result of this reserve system, very Relations intimate relations between different classes of banks must exist. ?* Banks to Each On the other hand, banks in the country and in reserve cities which Other have deposited their reserves with other banks are necessarily pro- foundly interested in the condition of these other institutions. To them they look for the resources which will enable them to fill up their own reserves in times of sudden demand for payment. To them they must look for accommodation through direct loans, or through the discounting of paper, or through some one of the various meth- ods which are employed for granting relief to the smaller institu- tions when the stronger and larger banks are in position to afford such aid. Conversely, the city banks look with interest to the outside in- stitutions as the source of deposits which they expect to use in times of financial ease and slack business in th$ country, for tlie 8 THE SYSTEM OF SUPEEVISION purpose ol facilitating transactions in the cities and general finan- cial operations. It is thus not true that our national banking sys- tem, though theoretically made up of more than 7,300 individual units, is actually composed of that nuanber of independent organiza- tions. On the contrary, the tie between the, institutions, resulting from the present use of reserves, is an extremely close and intimate one. It is a tie which sometimes furthers the good of all who are connected by it, but perhaps as often is injurious or dangerous in its effects upon the welfare of the banks whose business is thus inter- twined. Certain it is that in studying the development of the na- tional banking system and in considering proposed changes with ref- erence thereto, it is not possible to consider the different institutions as if they were independent. They must rather be regarded as already connected with one another, and changes must be spoken of simply as substituting a different kind of relationship for one which already exists. Duties §7. By the terms of the national bank act, the general over- ComDtroll sight and control of the system is committed to an officer known as of the the Comptroller of the Currency, under the general Jurisdiction of urrenoy ^j^^ Secretary of the Treasury. It is the Comptroller who has to do with the chartering of banks, regular examinations of them by bank examiners, the study of the returns made by the banks through these examiners, the writing of letters designed to call the attention of banks to cases in which they have failed to live up to the require- ments of the system, and in general to take charge of the enforce- ment of the national banking act. The Comptroller is an officer whose ofSce is largely ministerial and who cannot be expected to use a large amount of personal dis- cretion or judgment. The bank act indicates his duties, on the whole, quite precisely, and he can use a latitude of action only in those cases where there is doubt about the actual arrival of some event which has been provided for in the law. For example, it may be a question of judgment vrith him when to declare a bank insolvent and when to pursue the course mapped out in the act for the pur- pose of closing the institution. Upon the Comptroller depends much of the effective working of the banking system, since to him is committed the duty of seeing that the functions of the organization are adequately and properly fulfilled, and that there are no viola- EELATION OF BANKS TO BACH OTHEE 9 tions of charter. In proportion as lie is able effectively to carry out this duty the system is likely to be eSectively carried on. It is iustly said that the banks have a much more vital interest Cooperation "■ •' Among in the proper conduct of their affairs than the Comptroller himself National can have, and that they may be relied upon to accomplish the results ppgcttcaMy that are sought. This might be true if banks were perfectly inde- Impossible pendent factors operating in accord with considerations of general well-being. But this is far from the reality. The larger banks have scanty means of knowing the details of one another's affairs and no means at all of enforcing their own ideas upon one another in any case. The smaller banks, while to an extent overseen and influenced by the larger, are not in touch with one another or able to judge of the movement of credit in the operations of the other institutions. This condition means that there is strong need for some agency which will tend to unite the competing institutions in a certain de- gree and will in some measure afford a common bond between the banks. It is this which the Comptroller of the Currency is called upon to supply, and in so far as he is able under the law to furnish it he is an effective officer. The question whether he can effectively. perform such a function is, however, largely dependent upon many conditions in the system itself. Of late years the great development of the class of small banks, the increasing difficulty of judging the value and quality of the paper held by the banks, and a variety of other factors have tended to diminish the efficiency of the Comp- troller as a link between the widely scattered and separated banks of the system. §8. The national banking system has come more and more National within recent years to be merely one element in a great scheme of 5^?'*®,> •' •' ° Only One banking. As the most recent reports of the government show, the Element ^national banks number only about 7,300 out of an aggregate of per- '" *J'* haps 25,000 institutions, including in that total, state banks, private System banks, and loan and trust companies. These other institutions are organized under the laws of the several states, and their position will call for special discussion at a later point. It should be noted here merely that the national banking sys- tem stands in a peculiar position with respect to the banks of the states, for more than one reason. Not only is it the largest single set of institutions under one jurisdiction, but the terms of the national bank act, in limiting the kinds of business which the banks 10 NATIONAL AND STATE BANKS National Banks the Mainstay of the Banking System may do, have marked them out in a pectdiar sense as what are known as commercial banks. They are the institutions to which are com- mitted the keeping of the funds of the country and the mainte- nance of a proper protection against outstanding liabilities. This is true for two reasons. The national banks, if they conform to the law, cannot invest their funds in anything except live, short-time commercial paper so that their resources are kept in a fluid condi- tion. The national banks, moreover, have tended in an increasing degree to become the reserve holders of the country, the state banks and trust companies re-depositing their funds with the national banks, which are permitted to dispose of them as they see fit. In some states, requirements have been made as to the amount of reserve to be held by such state banks and trust companies that place them nearly or wholly on a par with the national banks. But in many states this is not true ; and in most, the national institu- tions are subject to stricter regulation than the competing banks organized under state law. National banks are therefore subject to much more severe judgment than the state institutions, and they have thus far occupied a more responsible position. By reason of the act of Congress imposing on state bank notes a prohibitive tax, the power of note issue has practically been made a monopoly of the national banks, and thus they have again been differentiated from the institutions organized under state law. For these reasons the national banks are in reality the core of the credit and financial system of the country, and a change in their organization implies a change in the whole system of which they are a part. Relation of the National Banks to the Government §9. The relation of the national banks to the government is now clear, in so far as matters of organization and oversight are concerned. But in another sense, the national banks have a relation to the government that is possessed by no other class of institutions. They are not the holders of government resources, these being held, under the independent treasury system, in the Treasury and sub- treasuries of the United States. But, since it frequently happens that the withdrawal of funds from circulation and their segregation in the Treasury is injurious to the community, the government is obliged to employ a banking mechanism for the purpose of again placing them in circulation. It must, moreover, at times make use of banking methods, in order that its operations may conform, even if only remotely, to the requirements of modern business. The CAEE OF PUBLIC FUNDS 11 national banking system is the agency through which this connec- tion between the government and the community is eilected. When government funds are to be deposited in banks, they are Government placed solely with national institutions. Even then they are re- National quired to be protected by the deposit of bonds of specified classes, q^" ' to an equal amount, with the Treasury Department. When banking machinery has to be used for the purpose of making payments, it is the national institutions that are invariably utilized. Large quanti- ties of funds are constantly held in national banks by the Treasurer of the United States and by government disbursing officers, while other officials, such as collectors of internal revenue, are permitted, upon their own authority, and at their own risk, to keep their funds in national banks and to receive payments in the form of checks and drafts upon other banks. Such arrangements are uniformly made with national banks. National bank notes are received by the government in many classes of payments and are regularly re- deemed at the Treasury out of a fund provided for that purpose. It is thus clear that, despite the limitations of the independent i^gthod of treasury system, the national banks have an immediate and im- Handling portant relationship to the government and its funds. A change pyndg in the status of the national institutions must profoundly affect the Antiquated methods of handling government funds ; conversely, a change in the latter will have an important influence upon the national banks. It is probable, however, that the national institutions would feel the effect of such a change far less than would the Treasury itself, since the present method of dealing with public funds has proved antiquated, inadequate and ineffectual. One of the most serious difficulties encountered in dealing with the banking problem today is found in the method of disposing of and caring for public moneys. It is evident that the day cannot long be deferred when the Treasury will have to abandon the pres- ent plan of withdrawing its funds from circulation and piling them up in the government vaults. The circumstances of modern busi- ness require that the government modernize its methods. The gov- ernment is a huge business institution, but it has not learned to 11 se banks in a business way. ^ §10. The defects of the national banking system are nat- m'aily found at those points where its characteristic features are 12 DISTUKBING METHODS Defects of the National Banking System National Banking System Gives No Protection Against Panics most distinctly seen. In other particulars the system has not been different from any other. It is at the special points where it was formerly adjusted, with a view to meeting the particular require- ments of the community, that it has tended to become obsolete or unsatisfactory, and it is consequently at these points that the sys- tem is necessarily calling for improvement and strengthening. No one desires to minimize the importance of the characteristic features of the national banking system. It is necessary to recognize the desirability of preserving its chief and essential merits. What is desired is to extend, elaborate and refine these merits, and to add such new methods of organization as will enable the banks to per- form more perfectly, for their own service and that of the public, the functions entrusted to them at the time when the system was first set on foot. The fundamental defect of the national banking system is to be sought in the fact that it is not in any proper sense a "sys- tem" of banking at all, but a series of banks artificially grouped. Because of the lack of cooperative or fundamental relationships between the institutions, it is not possible for them to exercise any general policy with reference to the control of reserves, the fix- ing of rates of discount, or the granting of loans. They can only act independently of one another, and the well-conducted insti- tutions must, therefore, suffer from the mistakes of others whose conduct tends to arouse suspicion or alarm in the mind of the pablic. Because of this situation, it will be seen, the national banking system as at present conducted is in a sense a breeder of panics, while it fails entirely to grant any adequate relief from these commercial convulsions. It entirely fails to supply a note circulation, elastic, sound, adequate, and well adjusted to local necessities. It furnishes no general market for commercial paper, no matter how high the quality of such paper may be. It fails to meet the legitimate demands of the farmer, the de- positor, the small merchant, and of other customer classes, just as it imposes upon the banks themselves' severe hardship, due to their inability to protect themselves adequately against loss of con- fidence. In conjunction with the independent Treasury system, it furnishes only an inadequate and disturbing method of dis- posing of public funds, and is thereby an incalculable and uncertain factor in the money market. Its unavoidable lack of a discount policy prevents it from controlling the international flow of specie SUMMAEY OF DEFECTS la as is done by the other banking systems of the world, or of supply- ing facilities for the transaction of foreign trade. The defects will be treated of at greater length in following chapters. From the foregoing brief discussion, it is seen that the aspects The Great of the national banking system which are deemed most worthy of the Day is study, and which have furnished thus far most cause for dissatisfac- Cooperation tion and for the feeling that improvements are feasible and desir- able, grow out of the note issue function, the present reserve organ- ization, the method of overseeing and inspecting the operations of the banks, and the conditions in the system which permit unduly independent action at times when such action may injure both those banks which resort to it and those who are indirectly affected by such action. In general, it may he said that the great problem of the national banking system to-day is cooperation — cooperation among the ianhs themselves, cooperation between them and the government, and cooperation between them and the business public. Nearly all of the difficulties which have arisen in the history of the system have grown out of the lack of cooperative effort, implying as it does a failure to mass the full strength of the banks behind the business community in times of special demand for funds, whether these demands fell at particular seasons of the year or at periods of panic and difficulty. §11. In the belief that the existing difficulties of the national Remedy banking system are those which follow from a lack of coopera- tion, it is designed herewith to discuss plans for a cooperative organization of a kind which would unite the banks into a single, coherent whole and would thereby not only place the strength of all at the service of any one, whenever aid could be legitimately demanded, but would economize the funds of the country and reduce the charge for banking accommodation, while equalizing such charges throughout the different portions of the United States. This plan is not intended to remove any of the essential features of the national banking system, or to increase the power of any element in it. It is intended as a labor-saving device for the common good of the community and for the perfecting of the system by adjust- ing its different parts to one another and enabling them to work harmoniously. In the following pages, the effort is made to explain the nature of this mechanism and to indicate what its effect would be upon certain aspects of the national banking system. Particular for the Defects 14 PLAN OF TREATMENT effort has been made to explain how it would provide for the diffi- culties which now exist, and how far it could be depended upon to rectify evils in the system, which to-day constitute a serious menace to banking integrity and commercial soundness. In carrying out this design, a general survey of the proposed plan is first offered, and then its detailed operation is dealt with. CHAPTEE II A COOPERATIVE AGENCY Defects of Banking System Diagnosed — 2. Means of Coopera- tion — 3. Why Cooperation Is Necessary — 4. Protection to De- posits — 5. Pinal Extinction of National Bank Notes — 6. Control over Expansion — 7. Uniform Rate of Discount — 8. Discount Market for Acceptances — 9. Protection from Wall Street — 10. Political Pressure to Secure Government Deposits — 11. Our International Position. §1. The panics of 1893 and 1907 taught the weaknesses of the monetary and banking system of the United States with con- vincing thoroughness. It was demonstrated even more convinc- Defects ingly in 1907, that when the system is subjected to any strain be- °^ Banking yond the ordinary it collapses. From the resultant injury no class Diagnosed of society is exempt. The experiences mentioned and the study that followed advanced the question to the point where remedies for known defects should be given legislative attention, discus- sion and action. We have, in fact, reached the point where we are ready to profit by our own experiences and disasters, and to take account of the results of carefully devised European methods. Although European conditions differ so much from ours that their institutions cannot be bodily transferred to our country, we have much to leam from them. Direct copying would be folly; we must take only that which aids us in a natural evolution out of our own past. The central bank of Europe is not suited to our con- ditions ; it is contrary to the spirit of our institutions ; and, in any event, it would be politically impossible. For do we need a bank central of the type of the Second United States Bank (1816-1836), which Bank excited the opposition of Andrew Jackson. We do not need a dominating, powerful Central Bank; what we need is not central- ization, but cooperation — entered into by all our institutions of credit — ^to the end that we may avoid selfish isolation and create a federation in the interest of all the banks, small as well as great. We do not need an institution which discounts for the general pub- 16 DECENTRALIZATION THE AIM lie and competes for business ; but we do need a cooperative uuiou of all the banks in the common interest whenever danger appears. This cooperation, moreover, is more in the interest of the bor- rower than of the banker. §2. Means of cooperation devised by a National Reserve Association should be aimed at a decentralization, rather than at a centralization, of credit — as opposed to a dependence of local banks upon centralized institutions, as now. Under the plan evolved by the National Monetary Commission all the banks in a locality would be grouped into a local Association, composed of not less than ten banks, whose combined capital and surplus should not be less than $5,000,000. Bach separate Association would have local self-government; but yet, as we shall see, it would be a part of a cooperative plan. Three-fifths of the gov- erning directors of the Association would be chosen on the basis of votes of banks without regard to size, each bank having one vote; and two-fifths of the directors would be chosen on the basis of of votes in proportion to shares held in the National Reserve Asso- CoQperation elation (i. e., in proportion to capital). It is also proposed, as a check against centralized control of local associations, that if a sin- gle shareholder had a forty per cent ownership in a chain of banks, the whole' chain would have but one vote — and this rule would apply whether the shareholder were a bank, individual, corporation or association. Then, while locally self-governed, these Associations would be grouped in fifteen districts, into which the whole country would be divided. All the local Associations in a district would federate themselves — as in a republic — ^to form a branch of the National Reserve Association. The governing board of each district branch would consist of not less than twelve directors in addition to the manager; one-half the directors would be elected by the member banks, each bank having one vote; one-third would be elected by the member banks on the basis of the shares held in the National " Reserve Association ; the remaining one-sixth would be chosen by the directors already elected from the agricultural, commercial and industrial ranks. The district branches would be federated in the National Re- serve Association. The national directors would be chosen as fol- lows : Each of the branches would elect two directors, one of whom must be neither a bank ofiicer nor a bank director, but must rep- POWEK TO LOAN IS NEEDED 17 resent the agricultural, commercial, industrial and other interests of his district; nine additional directors would be elected by voting representatives from the branches, each to cast a number of votes equal to the number of shares held in the National Eeserve Asso- ciation by the banks in his district; there would be seven ex officio members of the board — the governor and two- deputy go.vernors, to- gether with the Secretary of the Treasury, the Secretary of Com- merce and Labor, the Secretary of Agriculture and the Comptroller of the Currency. The executive officers would be appointed by the board of directors. Not more than three directors would be elected from any one district. The executive committee would be com- posed of nine members, including the three executive officers and the Comptroller of the Currency. §3. Cooperation of our credit institutions, state and national, I is desired, in order that the business public, producer and merchant, having legitimate demands for loans, should not be cut ofE from them by unnecessary and accidental conditions of panic. When why collections are slow, or when an unexpected emersrency arises, the Cooperation ' ^ ° •' ' Is Necessary borrower, holding staple goods or unquestioned collateral, ought not to be forced into bankruptcy by the inability to get the means of paying his maturing obligations. Moreover, seasonal demands arise which cause a stringency in the loan market and put an undue strain on our system of credit. The financing of the cotton or grain movement in the autumn has always been a cause of appre- hension in the money market. Demands of this character have given rise to a desire for a greater elasticity in our monetary and banking system. Such elas- ticity is thought of in connection with two difEerent possibilities: (1) normal seasonal demands, such as the recurring needs of crop- moving; and (2) abnormal demands at the time of a financial panic. A common idea is that these demands can be met only by Elasticity the issue of notes, or by some medium of exchange to be circulated of the in the hands of the public. This is the ground for some crude plans "'■'■*"«'y aiming at the issue of paper by the Government. In truth, while there is always a need for some change money in the pockets of everyone, some till and counter money in the hands of business houses and banks, and lawful money for settling clearing-house balances, the fundamental need is not solely for a medium of ex- change (sufficiently provided by checks drawn on deposit accounts), 18 CEEDIT NEEDED MORE THAN MONEY but for loan power. If a borrower can get a loan, he will never have any difficulty in transferring his credit because of any lack of a medium of exchange. In financing the movement of cotton and grain in the autumn, demands for cash from the country districts fall directly on the Crop"*' "^ reserves of banks, because there are no means of providing tempo- Movement rary needs for cash except by drawing down reserves, and thus con- stricting the lending power of the banks, to the serious detriment of the borrower. Likewise, but to a more acute degree of danger, in a time of panic the real need is not so much the issue of notes for circula- tion in the hands of the public (except to protect reserves), as for a loan to meet a maturing obligation. That is, the question is more truly one of the organization of credit than of the injection of addi- tional money into the circulation. For these reasons, it would be the purpose of a National Ee- serve Association, or whatever the cooperative agency may be called, to provide an elastic currency whenever it was needed by the public; to make this possible without drawing down bank reserves; to give credits based on cotton, grain and the like, with- out expensive shipments of cash to and fro; and, finally, in time of panic, to provide the possibility of getting loans — ^which is more important than an increase of the circulation. These ends would be accomplished by the individual bank — Rediscounts national bank, state bank, or trust company receiving deposits — by Branches presenting picked assets to be rediscounted by the branch offices of Reserve ^^^ National Reserve Association. This opportunity would be ex- Association tended equitably to eveiy subscribing bank, big or little, without dis- crimination. The credit given the borrowing bank could be used as a part of its legal reserve, which would thus enable it to meet the demands of its customers, or it could get National Reserve Associa- tion notes to the same amount, and place these in its reserves. This would be merely an evolution out of our experience with Clearing- House Associations, and an improvement upon, and legalization of, the idea of Clearing-House Loan Certificates well known to bank- ing history. The individual banks would be able to obtain such redis- counts in four different ways : (1) Any bank might, without any guaranty, have twenty-eight-day paper discounted upon its own endorsement. CONVEETING ASSETS INTO CASH 19 (8) If the paper should nin for more than twenty-eight days, hut not longer than four months, it would have to be guaranteed by the local Association. (3) In times of stress, the subscribing bank might bor- Re^gcount row under careful restrictions directly on its own obligation, if System the loan were protected by satisfactory collateral and guaran- Y/°"^^ teed by the local Association. (4) Time bills of exchange, running not over ninety days and accepted by houses or banks in good standing, might be purchased by the National Eeserve Association from sub- scribing banks to a limited amount. If any banks were at first not disposed to take any interest in the plan, thinking they could earn more on their capital than by subscribing to a National Eeserve Association, they would find themselves "outside of the breastworks" when a stringency came, and would learn the advantage of membership by stern experience. §4. The safety to depositors is also to be kept in mind. If, for instance, a country national bank had $100,000 deposits, it would be obliged under the present law to keep $6,000 on hand in lawful money. In times of doubt, depositors would measure the Protection ability of the bank to meet a run by this amount of cash ; and in a short time this reserve would be easily exhausted and the bank obliged to close its doors. The depositors owning the claims to the remaining $94,000 would then be forced to await the process of liquidation before they could get cash for their deposits. In case, however, the bank were a member of a National Eeserve Associa- tion, the public would know that the ability of the bank to pay ofE depositors would not depend upon the amount of actual cash held at any moment, but upon the amount and character of its assets which could be used as a basis of discount at the National Eeserve Asso- ciation. That is, an institution like a National Eeserve Associa- tion would most eifeetually enable a bank with sound assets to con- vert them into cash, and serve as the best method yet known of guaranteeing cash payments to the individual depositor. §5. The inelasticity of our national bank circulation, or of any notes based on the security of bonds, has long been admitted. It is not desirable, however, to make any sudden or drastic changes which might cause possible disturbance or losses. There has been 30 GEEENBACKS COSTLY more or less antagonism to the issue of notes by banks, on the ground that the profit of issuing notes should go to the United States by the issue of its own notes. In our own experience, how- ever, the issue of greenbacks has, in fact, been costly to the Treas- ury because of the expense of maintaining reserves. But since the profit to a bank in discounting can be obtained as truly when it grants the borrower a demand deposit account as when it issues to him its demand notes, the note-issues cannot be regarded as a spe- cial source of profit. This explains why state banks, issuing no notes, can accumulate large profits as well as national banks. But if there is any value in the idea of withdrawing the notes of na- Flnal tional banks, it appears in the plan of the National Eeserve Associa- f National *^°^' which proposes the eventual extinction of national bank notes Bank Notes and their replacement by notes of an office which would be closely under the supervision of the Treasury. Thus all the dangers and disadvantages of Government notes would be escaped, while all sur- plus profits from discounts, above four or five per cent to share- holders, would go to the Association's surplus or to the United States Treasury. In this way, the people would get whatever profits arose from the issue of notes by the National Eeserve Association ; and the national bank notes would ultimately disappear. The bonds now .owned by the banks for the security of na- tional bank circulation would be taken over by the National Ee- serve Association, which would assume the redemption of the na- tional bank notes. These bonds are largely two per cents, which have a fictitious value due to the circulation privilege. Therefore, if the circulation privilege were withdrawn, to prevent injustice the Treasury should be empowered to refund them at a rate (say three per cent) based on investment conditions and the credit of the Treasury. If the losses had to be borne by the banks, they would properly decline to enter the cooperative union. The banks, state and national, would be required to provide Not a the capital of the National Eeserve Association. Banks would making °°* S^* more than four or five per cent on their stock in the Na- Institutlon tional Eeserve Association, and it should be provided that earnings beyond that dividend should partly go to surplus, or to a contin- gent fund, but mainly to the Treasury of the United States. Thus a National Eeserve Association would by no means be a profit- making institution to its shareholders, and there would be no in- ducement to the management to over-expand for the sake of larger earnings. MEANING OF ELASTICITY 21 §6. Elasticity of the currency properly implies, not only ex- pansion Tinder legitimate need, but contraction when the need has passed. The expansion of credit, however, may take place by an undue expansion of loans, which shows itself in an enlargement of the deposit accounts credited to borrowing banks — in case notep are not needed by them. The obvious protection from over-expan- sion of loans, in normal times, and the avoidance of support to speculation, would be found in requiring a National Eeserve As- sociation to keep a large gold and cash reserve for its demand lia- bilities, both notes and deposits. Should the reserve fall below a legally-fixed limit, the deficiency should be progressively taxed, so Control that for the protection of its diminishing reserves the National Ee- g^**" serve Association would raise the discount rate, thus making the borrowing banks pay the tax imposed. This would stop any loan demand for speculative purposes. Thus the National Eeserve As- sociation notes would be quickly available in time of stress, but could not profitably be kept out when not needed. They would be redeemable on demand, in gold, or lawful money, and the total demand liabilities would be protected by a substratum of bonds (as in the case of the note issues of the Bank of England), a stratum of lawful money, a stratum of gold, and a stratum of short-time commercial paper (as in the case of the Eeichsbank of Germany). The relative amounts of the stratum of short-time paper and the stratum of cash would be controlled by the tax on loans. There can be no over-expansion where there is immediate redemption in cash of all demand liabilities. The fall of reserves is always a signal of danger under the present system. Indeed, when reserves fall to the legal limit Grasping (twenty-five per cent in central reserve cities), we have no reserves ^'" in the proper sense of the term. The surplus reserve is the only one which can really be made use of. Consequently, our rigid legal percentage of reserves causes a sudden stoppage of loans, and often failure and ruin to needy borrowers. Hence, at present, all atten- tion is centered on the quantity of a bank's cash reserves. If trou- ble threatens, each separate bank clutches at reserve money in selfish isolation. Herein is our great danger. At such a time, the large banking institutions have exceptional power to aid, or refuse help to, smaller institutions. Fnder present conditions, when small banks must go for assistance to the large banks, we have a system of prac- tical centralization, based on special favors to desirable correspond- ents. 22 CONTEOLLING EXPANSION Economy of Reserves The Country's Supply of Gold Is Useless In Emergency Under any plan for a cooperative banking agency, the re- serves Bhould be so mobilized that aid can be given at the point of danger in amounts sufficient to prevent failures. The present scattering of reserves and the grasping of legal money would be stopped, because any bank having good assets arising from loans could get rediscounts at the National Eeserve Association anB thereby replenish its reserves. As things are now, because of scat- tered reserves, a local bank, even though having good paper, would not be sure of assistance in time of need from its correspondent in a large central city. It would be otherwise with a National Eeserve Association. Of course, no bank could secure rediscounts on un- satisfactory paper; but in case of stress and strain the banks, large or small, having good discountable paper would know of a cer- tainty that the National Eeserve Association would be in a position to make a loan. This kind of cooperation means a decentraliza- tion of banking credit. The safety of a bank would be judged by the character of its assets rather than, as now, by the amount of its cash reserves. The advantage of combining reserves has been likened to having a large reservoir of water, available as a protec- tion against fire by any one householder, as compared with a sys- tem in which each would have only its single pail of water. If water reserves are scattered, then when a fire comes, each would try to steal the other's water. In order to stop this unnecessary grasping for legal reserve money — ^to hold the reserves (as in a reservoir) for the common good in a place where they can be directed as a whole against threatened danger — it is proposed that the banks should keep the legal reserves now required to be kept in their own vaults (6 per cent for country banks, 12% per cent for reserve city banks, and 25 per cent for central reserve city banks), in the National Eeserve Association vaults. Today we have a quantity of gold in this coun- try so large as to meet all possible dangers, but it is so scattered, or so disposed, as to be practically useless in a serious emergency. In such a situation, the United States Treasury is subject to private demands for deposits of government money. This should not be. By creating a proper efficiency and economy of reserves and by pro- tecting them with the note-issuing power of a National Eeserve Association, thus applying business sense to public finance, the exchanges of the country could be carried on at a less cost, and vital dangers to our credit could be avoided or lessened. METHODS IN EUEOPE 23 §7. In Europe, the ability to raise or lower the rate of dis- count affords an effective means of controlling undue expansion of loans, and yet to give legitimate aid in time of pressure. In this country, the requirement of a fixed percentage of reserves is often a source of danger, for it is unlawful to increase loans just when reserves are running down below the legal limit and when loans are imperatively needed. The long and successful experience of Europe teaches us that a sliding scale of rates for loans, falling as reserves fill up and rising as reserves decline, is the best device to prevent over-expansion of credit, and yet to afford aid in time of danger. Uniform To accomplish this end, there should be some means by which the Discount National Eeserve Association could from time to time indicate to its borrowers — the banks — the current rate of discount which would rise as reserves fell, and vice versa. Obviously, a National Eeserve Association must treat all borrowers, big and little, alike; and hence the rate of discount must be uniform to all applicants. This, of course, is primarily in the interest of the borrowing pub- lic. The banks in some districts where capital is scarce and rates high would not enjoy this provision; and in old districts where rates are now very low, it might possibly raise them a little — equalizing rates more or less throughout the country, much like the effect of branch banking in Canada. On the other hand, it is to be remembered that the dealings of a National Eeserve Association would be only with banks, and not with the public. Hence, as in such central money markets as London, Paris and Berlin, there would be the reserve agency's rate of discount; and alongside that an unofficial rate (on the street) of individual banks with their customers depending, as now, upon the conditions of demand and supply of loanable funds and upon the quality of the paper offered. Thus, in practice, there would remain a desirable elasticity of rates, together with a governing force regulating the general level. §8. In this country, promissory notes make up the bulk of Discount our banking paper, and their security varies as widely as does the standing of the borrowers. In Europe, on the contrary, the bill ances of exchange is the usual form of paper. An American merchant, who has a bill for goods he has pur- chased, borrows money on his own promissory note at the bank, pays the bill with it and gets the cash discount. His obligation Market for Accept- 24 EEADY MARKET FOE ACCEPTANCES Difference Between American and European Methods is thus transferred from the concern he bought of to the bank where he made the loan. Ordinarily, the bank does not know for what purpose he borrowed the money, and he may or may not use the proceeds of the loan to pay his bill for merchandise. A de- posit credit is given him at the bank and he draws checks against it. In Europe the seller of the merchandise draws a time bill on the buyer; or, what is of especial interest in the financing of for- eign trade, the buyer (importer) enters into an arrangement with his bank by which the seller (exporter) draws directly on the bank, and the bank accepts the bill. (See Chapter VI.) The bank hafl its protection from the buyer of the merchandise, the seller is insured by the credit of the bank and the accepted bill goes on the market. The paper so created explains on its face the nature of the transaction out of which it grew. Such acceptances can be bought and sold in any discount mar- ket where the bank has standing. They form an asset immediately convertible into cash, being even superior to a government bond. In the United States, the right to accept a time bill of exchange is now forbidden by the courts to national banks. It is proposed that acceptances of time bills of exchange should be made possible to subscribing banks. Should acceptances of this kind be allowed to all subscribing banks, however, without restraint, there might be dangerous over-expansion of credit. Therefore, the use of ac- ceptances should be hedged in by such restrictions as will prevent all possibilities of abuse and over-expansion. Moreover, it must be kept in mind that in the United States the development of credit to the manufacturer, jobber and retailer has been so carefully worked out that those in good standing can borrow on one-name promissory notes, enabling them to pay cash for materials and goods, and thus gaining the highest trade dis- counts. This is one reason why so little strictly commercial paper exists in this country, as compared with bills of exchange created on the sale of goods in Europe. This fabric of credit in the United States — probably more advanced here than in Europe — should be carefully protected, and in no case should the system of accept- ances be introduced at the expense of stability and safety to our existing structure of credit. §9. The right of subscribing banks to accept time bills of exchange and the creation of a discount market would help to free our money market from the influences that aim to use bank funds CHECK ON SPECULATIVE LOANS 25 for speculation in Wall Street. To accomplish this end still fur- ther, the election of directors of the allied associations and of the final governing body of the reserve agency should be so contrived protection that any group of special interests, financial or political, could *j""" not control its policy, or use the organization for their selfish street advantage. The local self-government of each Association, and the federation of the Associations, should be so built up from independent units that domination by a few, no matter how power- ful, would be humanly impossible. The existence of directors drawn from trade, industry and agriculture, would bring to bear the vigilance of the borrowing, as distinct from the lending, public. Moreover, the plan of a National Eeserve Association, follow- ing the long-established policy of European banking, aims to en- courage commercial loans arising from an exchange of goods, and to discourage loans arising from stock exchange transactions. In the Monetary Commission's plan rediscounts (not guaranteed) for subscribing banks by the National Eeserve Association are espe- cially forbidden, if known to be used for carrying stocks, bonds, or other investment securities. Only in case of great stress, and only with the approval of the Executive Committee of the Na- tional Eeserve Association and the Secretary of the Treasury, would discounts be allowed directly to a subscribing bank, when pro- tected by securities — and even then, only when endorsed by the local Association. This rule follows European experience, by which a- higher rate of discount is usually charged for loans based on stock exchange securities than for bills arising from the purchase and sale of staple goods. The one end to be sought is the protection of the commercial The One interests of the country. Under the present system of recog- p[."l '*t* „* nizing speculative securities as equal or superior to commercial of paper as the basis for bank loans, legitimate business and stock Legitimate speculation are too closely connected. The one suffers when the other is unduly extended. There have been notable instances in recent years of the inability of the country to finance a speculative and a business boom at the same time. And yet so closely are the two connected under our centralizing system that the collapse or partial collapse of either reacts on the other. Wherever the trou- ble starts, the result is the same and business inevitably suffers. Legitimate business is in need of protection and is to be divorced from its relation to speculation. 86 XO HELP FEOM TEEASUEY NEEDED Likewise, a National Beserve Association, acting as the coop- erative organization of all the banks in the country, should be able to import gold for the protection of the reserves, for the com- mon goody instead of leaving this operation, as now, to the leader- ship of large private institutions in close connection with the securities market. Such action would be public, and every sub- Bcribing bank, large or small, would be a participant in the result- ing stability of the combined reserves. Also, when a National Eeserve Association became the custodian of the funds of the Treasury, it would end all possible pressure upon the Treasury to come to the aid of the money market in stringencies caused by the movement of the crops, or an acute financial crisis. If Wall Street operators needed assistance, they would be obliged to get it through their own banks, which would have to assume all the responsibility, knowing they could get little or no help from rediscounts with the National Eeserve Association. §10. In times past, the Treasury of the United States with a surplus has caused unnecessary diflBculties in the market, because sums due the Treasury were drawn from the lawful reserves of the banks, without any regard to the conditions of business or the needs Political of borrowers. This mechanical operation has long been seen to tcTs^eciTr ^® obsolete ; and the obvious remedy has been the deposit of gov- Government emment funds in the national banks designated as depositories. Deposits g^^ ^jjjg jj^g resulted in political pressure to obtain government deposits for this or that district. Moreover, the Treasury has necessarily been called on, in times of panic, to help privately- owned national banks by deposits which filled up their reserves and rescued the borrowers from ruin. All these methods are un- desirable, clumsy and contrary to the seasoned experience of older countries. If a National Eeserve Association were established, the force of a panic and the pressure for lawful money reserves would be met by the combined reserves of a cooperative, decentralized in- stitution. Should the funds of the United States Treasury also be kept with a National Eeserve Association, there would be no more The Fiscal unexpected, jerky calls from the Treasury for cash; the payments Agent of jjy ^nd to the Treasury would be adjusted by credits on the books Treasury of the reserve association in a businesslike way, after the fashion of any other large commercial operation, without the present ex- INTEENATIONAL PEESTIGE 27 pensive and disturbing movement of cash. N"© other country of importance maintains such an antiquated system as ours, which dates back to 1846, when government payments were small and business conditions were very different from what they are now. Not only would our system of credit be thus relieved from un- necessary shocks coming from the Treasury, but the power of the Treasury to interfere with the money market would cease, and with it all political connection with our banking situation. Moreover, the expense of handling the funds of the United States Treasury would be transferred to the National Eeserve Association, while its operations would come directly under the eye of Treasury offi- cials. For all these reasons, the proposed reserve agency should be made the fiscal agent of the Treasury. §11. Great as is our wealth as a nation (about $135,000,- 000,000), and vast as is our foreign trade (some $3,500,- 000,000 a year), our banking and credit system is not what it ought to be in view of our real merits as a trading nation. To gain prestige due us in international finance, much depends on our organization of credit. Certain steps in the right direction are obvious: (1) Foreign capital will flow into our money markets Our if we are wise enough to create an international discount national market through the use of acceptances. This kind of paper Position would be useful in creating credits in Europe, on which we could draw for gold in the day of need. In other words, acceptances would open to us the door to the abundant capital of older nations, instead of our being obliged to make in- tense demands at certain seasons upon our own capital at home. (3) Our ill-regulated credit system, with its spasmodic and violent reactions, causes us to make special demands on Europe for gold which are regarded as unreasonable and un- necessary. We are looked upon as a nuisance and as a creator of financial disturbance. Our detached and unorganized mass of banks prevents us from acting unitedly in the com- mon interest with foreign countries. Therefore, a coop- erative institution, acting as the representative of all our banks — instead of private institutions acting for their own correspondents, and for only a small number of the banks — 28 AMERICAN BANKS ABEOAD Lack of Banking Facilitres Handicaps Foreign Trade should be established, which would have the standing, capital and power to borrow gold abroad upon the deposit of govern- ment bonds, to deal in foreign exchange, and, in general, to protect our bankiug and credit position in international trade. (3) Our trade, especially in the East and in South America, is handicapped by the absence of American banking facilities. This has been long recognized by the merchants in our export trade. Other countries, like Great Britain, Germany, and even Italy, Belgium and Prance, have been quite active in this important matter. It- should, therefore, be permitted to a National Eeserve Association to establish under its supervision branches in foreign countries which might worthily represent the wealth and banking power of the United States and assist our own merchants who wish to sell their goods in other lands. CHAPTBE III PRESENT RESERVE REQUIREMENTS Rigidity of the System— 2. Our Reserve System Makes Credit In- elastic — 3. Foreign Practice in Contrast With Ours — 4. Stringencies Bring Out Fundamental Defects — 5. Redepositing Reserves En- courages Speculation — 6. Our Reserve System Implies High Cost of Loans — 7. Country Paper at a Disadvantage — 8. Lack of Dis- count Market Limits Loans — 9. Remedy. §1. The outline of the present reserve requirements under the national banking system has already been sketched. It un- doubtedly constitutes the foremost problem in the present sys- Reserves tem of banking, inasmuch as the control of his reserves, and the Present general condition of the reserves of the country, as a whole, is al- ,„ental ways the chief anxiety of the careful and far-seeing banker. We Question are aware that the national banking system fails to perform its functions adequately at the present time. In seeking for a rem- edy which shall not only insure a greater soundness than at pres- ent, but shall further supply the desired elements of economy and flexibility, attention is therefore given, first of all, to the question of reserves under our national system and the methods by which they may be better dealt with. What chiefly strikes the student of reserve conditions under the national system is the fact that the banks of the country are required to maintain a rigid amount of reserve money. In the country banks are required to hold reserves of 15 per cent of their outstanding liabilities. Eeserve city and central reserve city banks must hold 35 per cent; the country banks are required to keep 6 out of their 15, and the reserve city banks 12% out of their 25 per cent of reserve in their own vaults ; but the country banks may deposit 9 per cent with reserve agents, and reserve city banks 121/^ per cent in central reserve banks. As the banks of the country are called upon to maintain their reserves in this rigid way it is obvious that they must stop lending whenever the line of safety drawn by the law is reached. They have then in practice as a flexible resource only what are known as "surplus reserves" — the amount of cash re- 29 30 SURPLUS EESEEVES Excess Reserves Held by National Banks sources held over and above the sum specified by the law as their minimum or "legal" reserve. Just how much margin this actually leaves the banks in the several parts of the country may be under- stood from a recent analysis (1910-1911) of reports to the Comp- troller of the Currency in which are shown the various reserves and surplus reserves. This analysis is as follows : Per Cent Date of Call Reserve Held Reserve Held Reserve City Banks Central Reserve Cities Nov. 10 $353,883,747 25.44 Jan. 7 367,733,656 25.83 Mar. 7 441,079,390 26.77 June 7 459,639,243 27.37 Sept. 1 426,547,745 26.00 Other Reserve Cities Nov. 10 432,633,340 25.36 Jan. 7 443,601,978 25.81 Mar. 7 464,220,842 25.49 June 7 481,364,283 26.03 Sept. 1 471,051,269 25.46 Total Reserve Cities Nov. 10 786,517,087 25.39 Jan. 7 811,335,635 25.82 Mar. 7 905,300,232 26.10 June 7 941,003,526 26.66 Sept. 1 897,599,014 25.71 Country Banks New England States Nov. 10 50,908,260 16.63 Jan. 7 50,365,635 16.25 Mar. 7 50,429,520 16.58 June 7 51,483,341 16.66 Sept. 1 50,386,037 16.20 Eastern States Nov. 10 152,949,762 16.49 Jan. 7 151,327,893 16.31 Mar. 7 153,838,553 16.36 June 7 159,213,845 16.58 Sept. 1 158,454,286 16.13 Southern States Nov. 10 91,441,126 17.61 Jan. 7 96,292,240 17.67 Mar. 7 93,799,050 17.45 June 7 92,110,198 17.63 Sept. 1 87,737,299 17.30 Middle Western States Nov. 10 146,005,871 16.97 Jan. 7 145,986,538 16.93 Mar. 7 145,607,478 16.49 June 7 148,174,025 16.85 Sept. 1 148,781,250 16.47 "Western States Nov. 10 53,024,253 17.34 Jan. 7 52,157,682 17.55 Mar. 7 61,653,814 17.08 June 7 52,089,389 17.50 Sept. 1 61,121,223 17.15 Pacific States Nov. 10 33,267,577 17.72 Jan. 7 33,231,881 18.21 Mar. 7 33,154,664 18.31 June 7 33,647,376 17.82 Sept. 1 33,408,858 17.62 Amount of Excess Reserve $ 6,102,585 11,917,926 29,222,530 39,727,578 16,366,078 6,115,050 13,940,367 8.996,195 18,982,597 8,510,136 12,217,635 25,858,294 38,218,725 58,710,175 24,876,214 4,995,796 3,884,202 4,807,444 5,132,821 3,728,725 13,830,947 12,182,812 12,793,149 15,129,165 11,105,320 13,542,607 14,559,848 13,176,534 13,765,559 11,655,886 16,916,961 16,666,927 13,140,752 16,234,313 13,243,280 7,146,742 7,571,676 6,295,378 7,438,048 6,396,365 5,101,222 6,868,785 5,995,525 5,317,351 4,973,021 EIGIDITY OF EESEEVES 31 It is thus clear that the rigidity of reserve requirements on the part of the banks subjects them to. the necessity of promptly ceasing to loan when their reserve line is approached, or else of building up their reserves in some other way. They can do the latter only by applying to other banks for accommodation; that is, by selling to the other banks certain of their assets, or bor- rowing from them some of the latter's funds. Of course, this process is resorted to in a degree by all banks, but, for reasons which will later be examined more in detail, present conditions do not admit of its being carried veiy far when the need is most urgent. §2. The chief reason why larger banks are not able to assist smaller institutions to a greater extent than they now do, and why smaller banks need this larger accommodation, is the attempt to maintain many small reserves at different points throughout the country. Since every bank recognizes that it must keep up its reserve funds to the figure indicated by law, unless Many it is willing to subject itself to the danger of being closed by the Reserves Comptroller, it feels the necessity of drawing upon other banks for funds whenever it finds the required minimum in danger of being trespassed upon. No bank, therefore, which holds the de- posits of other banks, can ever feel sure that it may not be hastily called upon to supply them with actual cash; and since every bank has outstanding liabilities several times greater than the amount of its reserves, a sudden demand for cash from all parts of the country results in depleting the funds in reserve cities and central reserve cities to a point where they are in danger of fall- ing below the legal requirement. The larger banks of the coun- Fear of try thus live in a condition of doubt whether they may not sud- denly be required to part with the whole of their surplus reserves and thereby to be deprived of the power to make further loans to their customers. Whenever there is a sudden call for large loans in the in- terior, the necessities of the public cannot be satisfied by the simple process of testing the paper offered to the banks and then resell- ing it to the larger institutions which hold the reserves of the count]^; nor can the whole transaction be settled on a basis of bank credit. Under our system, actual currency must move. The rigid reserve system requires that a given proportion of liabilities be maintained in the vaults. Moreover, with notes practically in- Sudden Demands 32 MEETING DEMANDS FOE LOANS Why Currency Must Move Unnec- essary Shipment of Currency Elasticity of Credit Under Good Banl redemption fund with the Treasury (keeping it idle and unpro- Notea ductive so long as the money is there held) , and the cost of engrav- ing and printing the notes, as well as the pro rata share of the expenses of operating the bank. Due to these conditions, banks find little profit in note issue at the present time. An estimate of the cost of note issue, ignoring the cost of reserve, is given aa follows by the Comptroller: 136 PROFITS FEOM NOTE ISSUES 3 e h •a a n s U a s > G |i< g 4-> (4 r: to s o Q o tH n. 3 •< D9 ° n , « o g fl^ oooooooooo to to CO (0 (0 (Q gQ (o (0 fff <=* -5 o .a s IX ; gPg (4 o b*t-^(ocococoeqr4ei :3 to . 1 CQ oi H ooooooL__ _ 2 » » s Sg OOOoOOOOO OOOoOOOOO' ooooooooeoooDoeoDo O OOOo^OOOOO OOOoOOOOOO OOO^OOOOOO ^ 01 h S M S c ^ _ « g ■s s II »< to rH (1) ^ n g 5 w eg O ° it a ■a oooo(=>ooooo )C oooooooooo ffl •» e^ .o O O O o O I c4 o o o o O I O O O o O I Tj O O O o O • o o o o o o < S rt rH fH rt tH t o - • > o o ) O O I o o o o i3*H a " 3 8 ffl ° s g ^ o i2 « a c fl ♦' *^ -a M «i •" _ » g c (^ iH >S 00 o a O cH h 43 C m >< s o ^ « cs " » 2 „ "* B ■" "O « 'O M * BH B rl S J3 ►. M 01 B "^ ■" B. t; " „ o - " o 3 i! £ I K ,a 3 '9 3 *H o ce « •" B ^1 § 5 M n B o o oiooo egiaoooooooooooOM ooooo'ooow'o OOOoOOOOOO •H B h P S B h c -5 ■" - t a « « t! >. 3 S « 2 „ o a M ^^ S B B 5 » 3 History of the National Bank Currency, p. 20, National Monetary Commission. Conditions 140 EETBNTION OP LONG-SECUBED ISSUES Use of Other Than Government Bonds Rapid Redemp- tion cf Notes Necessary to Safety ous because of the operations on bonds growing out of the use of such securities as trust investments and the like. The problem of government deposits in banks has further tended to enhance the difficulty since it has appeared that the depositing of public funds upon a pledge of bonds exerted a strong constricting influence upon the currency at precisely the periods when expansion was wanted and vice versa. For these reasons even those who have been willing to accept theoretically the idea of bond security behind bank notes have not been willing to accept a basis whicir implied dependence upon government bonds under existing conditions. This has raised the question whether it is not possible to re- tain a bond secured circulation by employing other classes of bonds as security behind the notes. The question was answered by Con- gress tentatively in the Aldrich-Vreeland law, which, besides a provi- sion that notes might be issued under specified conditions by na- tional currency associations, also contained a provision that notes might be issued direct to banks by the Treasury Department, pro- vided that the banks would deposit with the Treasury other bonds of specified classes. Of course it was seen that this greatly increased the danger of issues of notes based upon bonds of an "outside" character. These issues would necessarily tend to displace gold, because they are not issued in response to business demand, but in order to earn profits from the investment in bonds which backed them, combined with the interest on the loans through which they were forced into circulation. Consequently the Aldrich-Vreeland law provided for a heavy tax on such note issues and a like provi- sion has been carried in nearly every suggestion for banking reform that has been put forward within recent years. It has been seen that the question of redemption — rapid and thorough — or of some other means of insuring the retirement of the notes was a fundamental prerequisite if safety was to be in any way ensured. Consequently the proposal to retain the bond-secured basis for the currency by allowing the substitution of other bonds has received only a very qualified approval from those who Tere friendly to the general ideas of the national banking system. The question has been greatly broadened by the decrease in the stress that competent students have been disposed to place upon the note question, owing to the more extensive study of banking problems that has been undertaken within recent years. There has been a tendency to consider the note-issue question as identical with OVER-EMPHASIS ON THE NOTE QUESTION 141 the question of other forms of bank credit and to endeavor to ascer- tain how such credit forms should be treated in order to secure proper assurance of safety, as well as proper redemption, contrac- tion and expansion of notes along with other means of extending accommodation. Altogether the subject has lost the special char- acter which it possessed as long as the national banking system was regarded as satisfactory in other particulars. The note issue problem has now become a part of the general banking discussion. In popular talk about questions of currency and banking in general, however, there continues to be a good deal of over-emphasis upon the note question, and the fear is repeatedly expressed that if the exercise of the note issue function is not re- stricted in some exceptional way, what is called "inflation" will result. The problem of inflation is as serious in connection with other forms of bank credit as it is with notes. It is worthy, there- fore, to be considered in a separate chapter. CHAPTER IX INFLATION AND OVER-EXPANSION 1. Pear of Inflation — 2. How Inflation Is Revealed and Produced — 3. Safeguards Regarding Investments and Redemption — i. Re- garding Adequate Reserves — 5. Limitation of Note Issues — 6. The National Reserve Association and Inflation — 7. Fear That the National Reserve Association Will Stimulate Inflation — 8. Inflation, Theoretically Imaginable, But Not Possible. Inflation and Over- expansion Used Syn- onymously §1. In current discussions of banking, there is an almost invariable expression of fear lest any particular plan that is pro- posed may lead to what is called "over-expansion." This term is sometimes used interchangeably with the expressioii, "inflation." The two are practically synonymous as employed in current argu- ment on the subject of banking, and there is general agreement that they constitute a serious menace to soundness in the manage- ment of any system which offers a field for them. It is, there- fore, considered a test of any system of banking to ascertain whether it affords an undue opportunity for this expansion or inflation. In former chapters reference has been made to inflation in connection with note-currency, and it has been pointed out that the proper protection of the credit-granting operation avoids the danger of this over-expansion or inflation. It is now, however, necessary to explain in greater detail the methods by which such inflation is to be guarded against. Inflation Revealed by the Condition of Banks §2. Inflation or over-expansion is ordinarily revealed in the condition of banks. It exists in the case of an individual bank when, through loans, discounts or other investments, it has created against itself demand obligations in the form of book credits or notes which it is unable easily and readily to liquidate as the need for such liquidation appears. When such conditions are common to the banks of an entire community or country, there exists local or national inflation or over-expansion, a condition which is quite 142 CONDITIONS LEADING TO INFLATION 143 certain to end in a crisis, or, at any rate, in prolonged business depression. In order clearly to reveal the manner in which such con- ditions may be, and usually are, brought about, we must dis- tinguish two functions of commercial banks and note the means available for performing them. The most fundamental of these is their service as local, na- tional and international bookkeepers in the current exchange of all kinds of goods and products. For such exchanges time is re- quired and. credit is often wanted to bridge over these time gaps. Thus, the farmer needs goods of various kinds during the period Commer- of the growth of the crops, by the sale of which he must pay for as National the goods J the manufacturer must buy raw materials, pay his work- ""^ Inter- men and meet various other expenses during the time required Book- for the manufacture of the goods, by the sale of which he must keepers ultimately pay these bills; the wholesaler must buy goods con- siderably in advance of the date of selling and receiving payment for them ; and the same may be said of the retailer and of every link in our complicated chain of cooperative production. In the last analysis this function of commercial banks resolves itself into a process of bookkeeping by which the purchases and sales between the people of a given community, between those of different communities and between nations, are offset against each other in the form of debits and credits. Promissory notes, time bills of exchange, checks, drafts and bank notes, represent simply different steps in this process of bookkeeping. Another function of banks is their service as intermediaries in the investment of capital. In this capacity they receive people's .savings, which they credit as time deposits, and invest them directly or indirectly in the farms, factories, railroads and other industrial enterprises of the world, or in its homes, public buildings, wharves, etc. It should be carefully noted that these two functions differ inflation essentially and that a bank's means for performing them come Pi^duced from different sources. In the one case it is balancing on its books fusion of the current purchases and sales of its constituents; in the other. Commercial it is balancing their savings against permanent investments. Dif- investment ficulty arises in the form of inflation or over-expansion when the Securities latter business is confused with the former in such a manner that the banks overlook the fact that they cannot safely put into per- 144 BANKS AS TEADE BOOKKEEPEES Importance of Perfect Clearing Arrange- ments and Adequate Reserves Limitation of Loans as invest- ment Securities manent investments more than the savings entrusted to them. If they exchange their own demand ohligations against investment securities, there will be forthcoming no ofEsets, except the annual profits from the enterprises in which the investments were made, and it will take several years for such offsets to become complete. Meantime, they will be called upon to liquidate the credits they have granted and they will lack the necessary means. In the performance of the function of balancing purchases against sales, inflation can only arise when the exchange machinery is not complete, or when it is out of order, or when the banks have miscalculated, or failed to note the proportion established by the habits of the community between the vohime of transactions effected by means of cash and those effected by means of bank devices. In order that this balancing of purchases against sales may be complete, clearing arrangements must be established between the banks in all parts of the commercial world, which will work con- tinuously and perfectly. To the extent that these arrangements are incomplete, or fail to work, banks are certain to be called upon to liquidate their demand obligations in money. The fact that not all purchases and sales are represented on the books of the banks, some being effected by means of money and credit supplied by other agencies, also renders this process of bookkeeping incomplete and subjects banks to demands for cash. It is at this point that the necessty for cash reserves becomes apparent; and then it becomes evident that a failure to maintain such reserves in proper volume results in inflation. §3. In order to protect the community against inflation or over-expansion, therefore, safeguards must be devised to (1) prevent banks from tying up more than their savings deposits and their capital and surplus in investment securities and (3) to prevent their maintenance of inadequate reserves. Some of the means to these ends are direct and others are indirect in their operation. The chief of the direct means is legislative regulation of the proportion of a bank's resources that may be loaned on investment securities and the enforcement of such laws by rigid systems of inspection and supervision. In the past, such legislation has been faulty and incomplete, partly because of the difiiculty of setting up a practicable standard for distinguishing between commercial and investment securities, and partly, probably chiefly, because the importance of this distinction has not been understood. COMMEECIAL AND INVESTMENT LOANS 145 As samples of the kind of legislation here under consideration may be cited the provisions of onr national bank act and of many of our state banking acts prohibiting investments in real-estate and prohibiting, or limiting, investments on real-estate security as col- lateral. In France and Germany the statutes regulative of the Illustration Bank of France and the Imperial Bank, respectively, limit the Limitations bills which these banks may purchase to those which mature in not more than ninety days and which are secured by at least two names of solvent persons, and, in the case of the former bank, by an additional endorsement or by high-grade collateral. In the case of the Imperial Bank, the requirement is also made that the bank must hold enough of such bills to cover, together with its cash, the entire amount of its note issues and that the proportion of cash must not be less than 33% per cent. In our legislation no direct attempt has been made to draw a line between commercial and investment paper ; but the French and German legislation aims to accomplish this end, the theory being that the great bulk of short-time paper is commercial. The only A Possible step beyond that taken by the German and French legislators ®^*P '" that could probably effectively be taken by legislative bodies is the careful definition by statute of the two categories of paper and the fixing of the proportion of each kind that a bank might accept in accordance with the proportion between commercial and savings deposits, adding to the latter the bank's capital and surplus funds. The enforcement of such laws by inspection and supervision is difficult and can only be successful when backed by sound judg- ment, good will and good business methods on the part of bank gnforce- officials. The organization of ef&cient credit departments in large "^^nt of banks and personal investigation by loaning officers of the use to be made of borrowed funds, backed by frequent consultation of up- to-date balance sheets in smaller banks, are essential. Another direct means is the provision of as complete clearing arrangements as possible. Checks, drafts and bank notes are docu- ments essential to the complete posting of the books by which these exchange processes are accomplished, and machinery must exist for securing the speedy recording on the books of banks of the debit and credit operations they represent. For the clearing of checks and drafts elaborate machinery has been developed all' over the world, mostly by the voluntary action of banks themselves. In this country clearing houses do the work 146 BANK NOTES AS EBSBKVES Clearing of Checks and Drafts Clearing of Bank Notes Motives for the Pre- sentation of Notes for Redemption for the banks of the cities in which they are located, and, where clearing houses do not exist, daily clearings are effected by the direct exchange of checks between the banks themselves. Between different localities and between this and other countries, the work of clearing is accomplished by the correspondence system. In Europe the central banks with their branches play an important role, especially in inter-municipal and international clearing. The clearing of bank notes is a more difficult problem. Be- ing in form suitable for use as hand-to-hand currency, the public does not have the same motive for returning them to the banks as they do in the case of checks and drafts, and, when they are presented at any other than the bank of issue, the receiving bank does not always have a strong motive for presenting them for re- demption to the issuing bank. Especially is this the case where the issue privilege is monopolized by a single bank and where other banks are permitted to count such notes as a part of theii reserves. Eegarding this matter of the motive back of the presentation of notes for redemption, it should not be forgotten, however, that, so far as the public is concerned, in the United States at least, all forms of currency are constantly passing in and out of the banks. It is not the custom in this country for people to hoard money or to carry large amounts of it around on their persons. The desire of most people to avoid the danger of loss and theft, or to receive the interest everywhere paid on savings deposits, is sufficient in most cases to bring the money back to the banks in a comparatively short period of time. The case is somewhat different as regards the motive of a receiving bank in presenting for redemption the notes of another bank. Here the question is one primarily of the profit- ableness and the limitations on issues. If a bank has power to issue notes freely and finds it profitable and easy so to do, it will return for redemption the notes of other institutions and use its own in their place. The sluggishness of redemption under our national banking system is due chiefly to the very small profits that are obtainable through the issue of notes, to the difficulty of procuring bonds to deposit as security, and to the time and ex- pense involved in our machinery of redemption. In the early history of New England, when her banks were issuing notes against commercial assets and the Suffolk, system supplied easily accessible MOTIVES FOE EEDBMPTION" 147 and inexpensive machinery for redemption, bank notes were re- deemed on the average about ten times a year. When all note issues proceed from a single institution the re- demption of notes is primarily a problem of reserves and of the exchange of one form of money for another. If the non-issuing Hf^^'^P*'"" banks are obliged to keep currency locked up in their vaults be- sues Are cause they are compelled so to do by law, or because of the diificnlty Centralized of obtaining it in time of need, bank notes are as likely to be kept under lock and key as any other form of currency, and so redemp- tion will be sluggish. If, on the other hand, banks can easily and quickly secure currency by rediscounts, they will find it profitable to hold as "secondary" reserves interest-bearing rediscountable paper rather than currency, and the latter, including bank notes, will flow into the vaults of the reserve-holding institution or institu- tions. Another motive for redemption under a system of issue by a single institution is the desire to exchange one kind of currency or money for another. In Europe gold is commonly obtained for ex- Desire to port or other purposes by the presentation of bank notes for re- ^xchange demption. This is an almost universal practice in England and of Currency it is common in Germany and France. It is sometimes interfered 'o'" Another with in Germany by the inauguration of a restrictive policy by the Imperial Bank, and in France by the legal privilege enjoyed by the Bank of Prance of redeeming its notes in silver five franc pieces. The desire to exchange bank notes for other forms of currency is promoted by the issue of the notes in denominations too large for convenient use by the general public. In that case banks can- not use them as till money except in small quantities, and speedily send them in to the reserve-holding institution for credit or for exchange for currency of lower denominations. §4. Other direct methods of guarding against inflation pertain to the maintenance of adequate reserves. In most couiitries this matter is left to the voluntary action of the banks themselves, the Reserves as theory apparently being that their self-interest is a sufficiently a Checi< strong motive to this end and that they alone have the knowl- inflation edge and means necessary for a proper solution of the problem. In the United States we have attempted to secure this end by laws which fix a minimum below which banks are not permitted to allow their reserves to fall and prescribe the elements of which they must consist. 148 CASH DEMANDS UPON BANKS What Constitutes Adequate Reserves Sources of Reserve Funds In other portions of this book the evils and disadvantages of our system have been portrayed. Suffice it here to note what constitutes adequate reserves and what are the means available for their maintenance. Eeserves are adequate when they enable banks to meet all the demands for cash normally made upon them and likely to be made upon them on extraordinary occasions. The demands for cash normally and regularly made upon them are determined by the habits of their communities relative to the use of hand-to-hand money as distinguished from checks; and these habits are the re- sult partly of tradition and long continued use and partly of the fact that for many purposes hand-to-hand money is more conven- ient than checks. These cash demands come from banks' regulai customers in the form of the presentation of checks for encashment, and in the form of demands from other banks for the settlement of balances either through clearing-houses or by the direct presenta- tion of claims. Their magnitude and fluctuations are made known to the banks by experience. There are, of course, irregularities which cannot be foreseen and which cannot be exactly calculated, but these usually form but a small percentage of the total. Extraordinary demands usually arise from the shattering of credit, from unforeseen changes in the volume of business trans- acted, from unusual events, such as wars, the payment of indemni- ties, etc., and in the United States also from the operations of our independent treasury system. Demands for cash, whether ordinary or extraordinary, must' be met by the gold and silver coin already in circulation, by the new supplies resulting from the output of gold and silver mines and brought to or purchased by mints, by notes supplied by govern- ments, and by bank notes. In the case of the United States, some of these elements, especially government notes and silver coin, are limited in various ways by legislation, and losses or gains of specie may result from fluctuations in the balance between the imports and the exports of gold or other forms of money. These funds pass into the banks by the ordinary process of deposit, and, as has already been noted, the greater part of the supply is in an almost constant state of circulation through them. There is no inherent difficulty in the banks securing an adequate supply of hand-to-hand money, provided the bank note element is based on commercial assets. In that ease, if the re- PREVENTIVES OF INFLATION 149 demption systein hereinbefore discussed is complete and works perfectly, it will expand and contract automatically so as to render the entire volume of currency just sufficient to meet the needs. S?J^-^*^x°^- Difficulties in the maintenance of adequate reserves arise when Maintaining such an elastic element is lacking, or when the clearing and re- "^^^''^^^ demption systems are inadequate, or when a country curtails its gold supply by a system of iiduciaiy currency which is purely local in its character and which is so large in volume as to leave too small a place for the local circulation of gold coin. In this latter event the banks may find difficulty in meeting their foreign balances, which, as a rule, are payable only in the yellow metal. §5. As indirect methods of preventing inflation, may be men- tioned various plans for the limitation of note issues. In the early history of state banking in this country previous to the Civil War, especially in New England, laws were enacted limiting the amount of notes that might be issued to some percentage of the Limitation capital, as, for example, 100, 125, or 150. The English Bank of Note Act of 1844, usually known as the Peel Act, fixed an absolute limit beyond which the bank note element in the currency might not be expanded, by prescribing that after a date mentioned in the act private and joint stock banks might not under any circumstances increase their issues and the Bank of England might not increase its issues beyond £14,000,000, except in exchange for gold, pound for pound, or in substitution for the lapsed issues of other banks. In this latter case it could increase its issues by two-thirds of the amount lapsed, provided the Government, by resolution, should give it permission so to do. French law sets a limit beyond which the issues of the Bank of France may not go, but in the past it has raised the limit several times to meet the growing needs of the country for this kind of currency. Our National Banking Act limits the issues of national banks to the amount of the paid-up capital. This kind of legislation has usually been inspired by the hope and the expectation that the limitation of note issues would cor- respondingly limit the activities of banks and thus keep them within safe bounds. Sometimes also, especially in the case of the Peel Act, other theories and motives have been back of the legisla- tion. It should be noted, however, that the mere limitation of the 150 METHODS OP EESTEICTING NOTE ISSUES ' amount of business a bank may do does not necessarily prevent inflation, because it does not insure its choice of the right kind of securities as investments, adequate redemption and clearing arrangements, or adequate reserves. Furthermore, the limitation of note issues only leaves the doors wide open for expansion thrqugh checking accounts and does not, therefore, nowadays seriously re- strict a bank's operations. Wlien the earliest of this kind of legis- " lation was passed, however, deposit banking was in its infancy and limitations on note issues were much more effective than they are today. Another method of restriction which has been favored by some reasoners and has found a place in certain banking systems is the imposition of a tax upon note issues beyond a certain point. Occa- sionally this tax is made progressive, rising as the amount of the notes increases and falling as it decreases, until at a designated of'^Note °" P°i^t it is cut off entirely. The purpose of such a tax is to check Issues the issue of notes and the corresponding granting of credits by ^^ making it unprofitable, or, in case the rate of interest is high enough to yield a profit in spite of the tax, to insure the speedy retirement of the notes and the contraction of the credits granted when the rate of interest falls. The tax idea has been adopted in the German banking sys- tem, which is probably its best known exemplification. In that country notes form the usual medium of exchange. It has, how- ever, frequently been urged elsewhere and has been a favorite and staple recommendation in the United States as a means of limiting the over-issues of bank notes, even though checks drawn on de- posits form the usual medium of exchange. In the Aldrich-Vree- land law, whose provisions have elsewhere been described, the tax plan is applied for the purpose of restricting the issue of "emerg- ency currency" therein provided for. The terms of the original plan were so extreme in this regard that they provided for a tax running as high as 10 per cent per annum if the notes remained outstanding long enough. This, it is supposed, would tend to re- duce the volume of the currency in circulation. By using the tax in conjunction with a reserve requirement, as is done in the Ger- man system, it is assumed that an even stronger safeguard is ob- tained. Thus, if the notes exceed a certain multiple of the amount of reserve on hand, they are to be subjected to. a tax which in- creases as the relation to the reserve increases. In this event, the bank could cut off the tax in either of two ways — ^by retiring its THE HEAET OF THE PEOBI^EM 151 circulation or by building up its reserve so as to make it a larger percentage of the outstanding notes. The Aldrich-Vreeland law adopts the cruder plan of simply applying the tax in proportion to the time the notes stay out, without any reference to the ques- tion whether they are backed by an increasing amount of coin or not. §6. In the plans for a National Eeserve Association, sug- gested by the Monetary Commission, several provisions have a bear- ing on this matter of inflation or over-expansion. In the first place. Restriction it restricts the discounts of the proposed Association to commercial |gun|^ ^^ paper and thus strikes at the very heart of the problem. Its book Commercial credits are not to be protected by any kind of investment paper, and only that portion of its notes are to be so secured which are to be substituted for the present circulation of our national banks ; and this condition will last only so long as the Government bonds, acquired in the process, are retained by the Association. As fast as it disposes of these bonds to the investing public, it will to some extent substitute commercial paper for them as a basis for its issues. Other provisions bearing upon this matter are those which con- stitute this Association the reserve-holding institution for the en- tire country. If the banks of the country generally take advantage of the privileges granted in these provisions, they wiU cease to ceptraliza- hold more currency in their vaults than current demands upon tlon of them necessitate; and the currency of the country, including its ^s^""^*' bank notes, will circulate through the Eeserve Association in the manner above indicated. Eedemption of notes will thus be auto- matic and as regular and frequent as it is in France or Germany. The only danger here lies in the possibility of hoarding by the people or by the banks. In that case, bank notes are as likely to be hoarded as any other form of currency, unless their denominations p^ggi. are so large as to render their use unlikely by people who are bility of apt to hoard and so large as to supply to banks a motive for send- '^°='"'''"8 ing them in for exchange for other forms of money or for credit. Experience, therefore, may suggest the advisability of issuing most of the notes of the Association in relatively large denominations. Eegarding the matter of hoarding, it may be said that there is nothing in the plan of the Association, or in its realization, to encourage such a practice. On the contrary, it offers many induce- ments of the opposite kind. It will increase the safety of banking 152 RESERVES AGAINST NOTE ISSUES Motive for With- drawing Redundant Notes The Tax on Cir- cuiation Increased Facilities for Clearing operations generally and thus the willingness of people to entrust their funds to banks, and it will remove from the latter the neces- sity of keeping currency locked up in their vaults as reserves and furnish them inducements to turn over to the Association their surplus supplies. If experience should show that these induce- ments need to be made stronger, the Association might agree to pay the expenses of return shipments of its notes. It should be noted that the proposed National Reserve Asso- ciation will not have the same motive for keeping its notes out- standing that a bank would have which is managed primarily for the earning of dividends for its stockholders. Restricted as it would be in the amount of dividends it can declare, its primary motive would be to keep the banking system of the country safe and strong and our currency in proper relation to our needs. In the matter of the return of its notes for redemption after the need for them had passed, its interests would be identical with those of the public. The plan of the Monetary Commission, however, does not rely upon the selfTinterest of the Association as an inducement to seek the return of its notes. It provides an additional motive in the form of a progressive tax on the notes when they exceed $900,- 000,000, a sum less than $200,000,000 in excess of the amount of National bank notes now outstanding and probably no larger, if it is as large, as the country will need in the crop-moving season. A further check against excessive issues is provided in the requirement that a reserve of 50 per cent of the amount of de- posits and notes must be carried in legal tender money, or in lieu of such reserves, a heavy tax paid. Moreover, no more notes can be issued when the gold in the reserves falls below 331^' per cent of the note-issues. Hence, at that point, borrowing banks demanding notes would be refused loans. A further check against inflation is provided in the increased facilities for clearing offered by the Reserve Association. The local associations are to be permitted to assume clearing functions, and, to the extent that they do, the time required for the collection of checks will be shortened and their return to the banks upon which they are drawn correspondingly hastened. Furthermore, the cen- tral office and the branches of the Reserve Association will con- stitute additional links in the national bookkeeping process, and will offset against each other on their books many of the mutual claims of banks which now remain unsettled for longer or shorter GOVERNMENT DEPOSITS 15:5 periods of time, and, when they are settled, occasion a considerable demand for cash. In this connection should be considered other provisions which supply the Association with the means of replenishing its reserves, if the streams of money flowing into its vaults from regular Means of sources should at any time be inadequate. These are the provisions q^^^ which authorize the Association to deal in foreign bills of exchange purchased from other bankers or on foreign markets and to regulate its rate of discount according to its needs. Both these provisions will enable the Association to bring gold into its vaults from foreign sources. When its reserves are large, it can purchase foreign bills, and it can sell them for gold when its supply of money is short. It will probably also be able to attract gold by raising its rate of discount. This will certainly be possible when the volume of bank acceptances becomes large and a regular market for them is established. European bankers will then invest in them, when the rates are higher than they are at home, just as they now do in London bills. Still another feature of the proposed plan for a National Ee- serve Association deserves mention in connection with this subject of inflation, and that is the provision that it shall hold the de- Abolition of posits of the federal government. The operation of our independent pendent" treasury system at the present time is a source of embarrassment Treasury to banks because of the uncertainty of its drafts upon, and its con- tribution to, their reserves. By unexpectedly withdrawing reserve? from the banks, it leaves them less able to meet their demand lia- bilities in cash. It is thus a cause of inflation, and its abolition, so far as concerns the holding of the treasury balances, will be a safeguard against this evil. Finally, and most important of all checks on over-expansion, there is the increasing rate of discount which the National Eeserve Association would charge as its reserves decline. That is, any gen- eral tendency to apply to the National Reserve Association for loans would directly increase its immediate liabilities in its deposit or note items, and thus lower the percentage of cash reserves to these liabilities. Automatically the rate of discount to borrowing banks Raising should rise, thus making it more expensive to carry the loan. ^^_^ Hence, there would be created a self-interest on the part of the Rate borrower to pay off the loan. Moreover, no speculative accounts created for carrying goods which show a tendency to rising prices could endure the increasing rates of interest. The experience of 154 CRITICISM OF PROPOSED EEMEDY Most Effective Brake on Over- Expansion Europe shows the influence of the rate of discount. In England, where conditions of banking more nearly resemble our own, the in- crease in the rate at the Bank of England at once drives away ap- plications for loans, except where absolutely needed. Then, when the pressure for loans ceases, the rate of discount falls as a matter of course. Here, then, is the one most effective brake which the National Reserve Association would apply to prevent over-expan- sion. Taken in connection with the other preventives above men- tioned there need be no fear of over-expansion, with ordinary intel- ligent management and courage. In recent proposals now before Congress it is not left to the will of the management to decide when the time has arrived to raise the rate. As soon as the reserves fall below 50 per cent of the notes and deposits a progressive tax is im- posed, which is intended to force the National Reserve Association to reimburse itself by raising the rate to the borrower. In addition to this provision, the loans to any one subscribing bank should not exceed its capital; and none should make accept- ances to exceed one-half its capital and surplus. Contention of Those Who Foresee Inflation §7. In spite of those safeguards the fear has been expressed that the National Reserve Association will promote or stimulate inflation. Critics of the plan (of allowing the banks to count as reserves notes or credits obtained from the Association by redis- counting their commercial paper) argue that this easy way of in- creasing reserves would lead to an enormous inflation of loans. National bank loans are now about six times as large as the re- serves, and it is argued that any increase in the reserves would re- sult in an increase in loans in the same ratio. Banks, when loaned up to the limit, could rediscount commercial paper to the amount of their capital, and could then pyramid more loans on the basis of the notes or credits thus obtained from the Association. The operation would be accelerated, it is argued, because the proposed transfer to the Association of the greater part of the reserves now held by the banks would enable the Association to expand its lia- bilities to from two to three times the amount of the cash so re- ceived. The fear resulting from this argument is based upon the failure to distinguish, on the one hand, between the possible and the practicable expansion of loans; and, on the other, between the kind of loan expansion which results in inflation and that which does not so result. The above calculation measures the extent to VOLUME OF BUSINESS NO TEST ]5fi which the National Eeserve Association might possibly increase accommodations to the commerce of the country, but it is no meas- ure of the extent to which it would be. practicable to increase loans under given conditions. If the crops of the country and the output of our mines and factories and the incomes and corresponding consumption power of our people should increase in proper proportions to each other to such an extent that the increased volume of exchanges would re- quire for their execution the degree of expansion of loans and de- posits indicated in the above calculations, such expansion would take place J and it would carry with it no inflation and be in no sense dangerous, because in this increased volume of exchanges the purchases and sales would offset each other on the books of the banks just as readily and easily as would be the case in a smaller volume of exchanges. It is not the magnitude of the number of items in the debit and credit accounts of banks that is significant in this connection, but the balance between the two, and that balance may be just as readily struck when the number is large as when it is small. For instance, loans based on cotton evidenced by ware- house receipts could be increased in the autumn to a sum equal to the amount of the crop without resulting in expansion. As has been shown in previous paragraphs, the striking of the RiiL'tfon balance is the important thing, and to this end the primary con- Between sideration from the banking standpoint is the differentiation between L" h^^q'"^"* commercial and savings deposits and the fixing of the relation be- mercial tween the amount of commercial and investment paper purchased '^^P^'" in accordance with the proportion between their magnitudes, modi- fied by the capital and surplus funds of the banks themselves. But it may be asked, how can the banks be induced or com- pelled to observe such distinctions and to shape their practices accordingly ? So far as supplying inducements is concerned, the National Eeserve Association will be a mighty force. Since it will take commercial paper only and will create a national and international market for it, the banks will be obliged to make the distinction above mentioned and will have the strongest possible motive for shaping the practices of their customers accordingly. As an aid to this end they will be able to offer them the induce- ment of lower rates on such paper. So far as compulsion is concerned, the necessity of constantly liquidating the book credits banks create will be quite adequate. If a bank makes the mistake of creating too great a volume of 156 EESTRAINTS OX BANKS Charge That the Associa- tion's Notes Will Displace Gold credits against investment securities, it will find itself speedily checked up by adverse clearing-house balances and the presenta- tion of checks for encashment, which demands it will find diflBculty in meeting, even through access to the National Eeserve Associa- tion, because of the very shortage of commercial paper which lies at the basis of the trouble. The effective restraint of banks under such conditions will be accomplished by the clearing and redemption facilities before described. So long as the checks and sight drafts issued in these credit operations are speedily returned to the banks against which they are drawn and the notes issued by the National Reserve Asso- ciation are constantly and regularly returned to it for redemption, there can be no inflation or over-expansion of loans. It is, there- fore, with the perfection or imperfection of these features of the plan that the question of inflation is primarily connected. Another phase of the inflation fear is presented in the charge that the notes of the National Eeserve Association would displace large quantities of gold in our circulation and thus endanger the maintenance of our standard of value. This, like the other, may be shown to be groundless. To the extent that the National Eeserve Association assumes the issue privileges of the national banks, and as long as it re- tains the bonds purchased in the process, its notes will fill the place now occupied by the national bank notes, and will not in any respect change the existing relation between the gold and the fiduciary elements in our currency. The additional untaxed issues to be allowed will be no more than adequate to meet the in- creased currency demands of the crop-moving and spring-open- ing seasons and will be speedily retired by the process of re- demption previously described when the need for them has passed. There is, therefore, no ground whatever for fear that they will displace gold. Indeed, they may occasion an increase in the gold supply, since the Association may find it necessary to secure the increased reserves required by the importation of gold. The rea^ son why, under existing law, it may be charged that undesirable increases of national bank notes are driving out gold, is that there is no effective means of contracting these notes when once issued. An elastic note circulation which contracts when not needed would not drive out gold. Conditions will not differ essentially if the Association should make use of its right further to extend its issues by the payment ASSOCIATION NOTES AS EESEEVES 157 of the tax prescribed. Such an issue would represent a greater or less degree of emergency, would be absorbed by the increased cur- rency demand thus occasioned, and would be speedily retired when this demand disappears. Meantime, as in the previous ease, the Association may have found it necessary to import gold as a means of increasing its reserves. This fear is doubtless responsible for the suggestion that the National Eeserve Association should not be permitted to count as reserves any form of money except gold. If, as above indicated, should there is no danger of the displacement of gold by notes of the *'?*t|^^*°' Association, there seems to be no good reason for placing this Reserve limitation upon it. There may be good grounds for the desire to p°"fu^Le|y increase our supply of gold, but there is no reason for shifting the of Gold responsibility for any shortage we may have from the Congress of the United States where it belongs. Indeed, if it i? desirable to retain our greenbacks and to preserve, without change in the conditions of redemption, our silver coin and silver certificates, it is equally desirable that the National Eeserve Association should be allowed to consider them as reserves. Any other arrangement would amount to a discrimination between the different elements of our currency, the exact parity between which the Secretary of the Treasury is obliged by law to maintain. If Congress is ready to acknowledge that such a discrimination should be made, it should proceed at once to the retirement of the greenbacks and to the re- duction of pur silver currency to a subsidiary basis. Under such conditions the reserves of the Association would consist exclusively of gold. §8. The question may be raised whether a borrowing bank should be permitted to count the notes of the National Eeserve Association in its lawful reserve. It has been generally agreed that it should so count its credits on the books of the National Eeserve Association. Then, why discriminate against the notes ? The notes of the Issue Department of the Bank of Englaud, as is well known, are counted in the reserve of the Banking Department. But the conditions there are not the same as here. Moreover, it may be urged that the borrowing bank, if allowed to hold the notes of the National Eeserve Association in its reserve, would have no motive for sending them in for redemption, since they would be as good aa gold ; that the proceeds of one loan in the form of National Ee- serve Association notes could as reserves form the basis of addi- 158 PYEAMIDING LOANS Theoretical Case of Pyramiding Loans. Concrete Case as the Answer tional loans by the subscribing bank from four to sixteen times as much more; and that in a period of 28 days a first loan might be made the occasion of a very dangerous pyramid of credit. For instance, a bank with a capital of $100,000 might get a rediscount of $30,000 for 28 days, and place $30,000 of ISTational Reserve Association notes in its reserves. If obliged to keep 25 per cent reserves, the bank might, it is said, make new loans for $120,- 000. With the commercial paper thus obtained, the subscribing bank might get another rediscount for $70,000 more from the Na- tional Eeserve Association, and add $70,000 more notes to its law- ful reserves ; and then be enabled to again increase its loans) to its customers by perhaps $280,000. Thus, on an initial loan of $30,- 000, the subscribing bank might increase its loans by a total of $400,000. If its percentage of reserves were only 15, then the total would be much larger. In such an instance as this, it should be noted that expansion is as possible with credit accounts on the books of the National Ee- serve Association, when the outcome of a loan, as it is with Na- tional Eeserve Association notes. But, it is assumed that the credits would not be so expansible, since they must soon be liquidated by extinguishing a credit at the National Eeserve Association when the loan is repaid. But we may take the case of the notes as the most extreme case. What would be the restrictions on such pyramiding as is de- scribed above? (1) If a rediscount is made directly to the bank (and not guaranteed by the local association) the loan must be paid back within 28 days. (2) The subscribing bank, when expanding loans to its own customers must count upon these customers draw- ing down the amounts loaned them, perhaps by 75 per cent. If so, then customers to whom were loaned $400,000 would call for $300,000 of cash from the reserves (or checks from other banks would be presented to that amount at the clearing-house). But the bank wciuld have had only $100,000 (equal to its capital) of National Eeserve Association notes in its reserve. That is, the re- quirement of reserves (which would remain as now) would at once hobble the bank from any such pyramiding. In short, its lending power would be obviously limited, as explained earlier in this chapter. In the example given, the bank having received notes to the amount of its capital ($100,000) would probably not dare to grant loans on the basis of reserve (which it must give up in 28 days) of more than once or twice the amount of this reserve. If it BANXING SELF-PEESEKVATION 159 made loans of $200,000, and drafts were made by customers on their accounts to even 50 per cent, then all the National Eeserve Association notes would be exhausted. To say nothing of strict surveillance by bank examinations, ordinary banking self-preserva- tion would prevent such attempts at expansion. And what is true of National Eeserve Association notes would also be true of credits on the books of the National Reserve Association. On the other hand, if the public already had circulation enough for its business habits, additional notes would not be drawn from the banks taken as a whole; and the new reserves would in truth carry a larger amount of loans than indicated. If such operations were really to be feared, it might be pos- sible entirely to prevent them by a provision forbidding any sub- scribing bank to hold more than (say) 10 per cent of its lawful reserves in notes of the National Eeserve Association on an aver- age during any one calendar month; but this provision is doubt- less unnecessary. In the whole matter of over-expansion, the crux of the ques- tion is due provision for elasticity of notes and credit. Elasticity in extending notes and credit in time of need must be always ac- companied by proper regulations for their contraction when the need has passed by. The rising rate of discount is the practiced Redemption and proved instrument for bringing about contraction of credit °^ Notes, when not needed. In the case of notes, provided immediate re- demption by the National Reserve Association is secured, any sur- plus not needed by the public would be sent in for deposit or re- demption ; and the banks would have no reason for" holding on to them, because if returned to the National Reserve Association, they would still form a credit on the books of that institution as re- serves. The banks would retain them only to satisfy the calls of customers for cash when receipts of cash fell below demands. More than that, a situation would be created by the National Reserve Association in which there is a premium on getting rid of notes of the Association and of any other forms of money. That is, the motive for carrying dead cash, which earns nothing, is taken away by the knowledge that liquid assets in the form of good com- Dead "cash mercial paper can at any moment be converted into bank reserves, a Live If so, a bank will have a positive inducement to change dead cash '^®®**' in its assets to interest-bearing assets to the fullest possible extent. Thus, more of the bank's assets will be earning a return than ever before, and the reserves of the country will be economized with 160 REDEMPTION IN GOLD safety. Under such conditions, there will exist a strong incentive to each subscribing bank to send in the notes of the National Re- serve Association, and thus secure the quick redemption which is so necessary a part of elasticity of the circulation. In addition, the banks in cities having a foreign trade and Quick which may be called upon for gold for exports or other purposes Redemption would be led to present the notes of the National Reserve Associa- to'ltasficKy ^^^^ ^ ^^ redeemed in gold. There would thus be another reason for driving in the notes for redemption. Obviously it would be well, for this reason, to issue a considerable portion of the notes of the Association in large denominations. CHAPTEE X BOND-SECURED AND BANKING CURRENCY I. Retiring the National Bank Notes — 2. Refunding the Bonds — 3. Other Plans for Using the Bonds— 4. An Alternative Method and Objections to It — 5. The Monetary Commission's Plan — 6. Disposi- tion of the Bonds — 7. The Question of Monopoly — 8. Use of Profits from Note Issues — 9. Access to Notes — 10. Security of the Notes. §1. It may be agreed that the substitution of bank notes not based upon government bonds for the present bond-secured cur- rency would be a very desirable change in present banking methods in the United States, and yet there may be very sharp disagree- ment as to what should take the place of such notes and how Retiring the various conditions connected with the problem of retirement National should be dealt with. Naturally, a system of note issue which Bank has been in operation for half a century, and around which '^°*** many interests have been developed, cannot be easily broken off in favor of another. Numerous problems of detail require atten- tion, equities must be recognized, and the operation, however beneficial in its main purpose, must be carried out in such a way as to cause as little friction during the transition as may be. Many plans for making the actual change from a bond-secured bank currency to one not so secured have been offered during the past two decades. In all of them, of course, there is fundamentally present the question. What would be the effect of such a change upon changing government bonds and their owners? As we have seen, the bond- ^* secured currency was first resorted to in order to create a market Basis for bonds. It ultimately succeeded in accomplishing this end. The chief effect of the artificial requirement that banks should invest in government bonds as a condition of their existence has been greatly to raise the price of the bonds themselves. The old 6 per cent and 4 per cent bonds commanded a very high premium, running as high as 40 per cent above par. In the act of March 14,, 1900, the national debt was consoli- dated into a genera] 2 per cent loan, of which about $730,000,000 161 162 THE TWO PEE CENT BONDS Decline in the Price of Bonds Price Above the Natural Value of Bonds Summary Change would Cause Large Loss to Banks is now outstanding. Most of the other bonds, as they ran out, were converted into two per cents, and it was supposed that the twos would sell at about par. In fact, they sold at a premium of as high as 8 per cent within a year after the first issue was put out. In recent years prices of all bonds have tended to decline and the twos have gone down as others have, reaching a general level of about 101. Of the $730,000,000 outstanding, not less than $690,- 000,000 are held by banks for the purpose of protecting government deposits or issues of currency. This means that the loss due to the depreciation of the bonds has fallen in very large measure upon the banks. The total amount of such loss is estimated by the Comp- troller of the Currency at probably about $30,000,000 — a loss which has been simply "written ofE" by the banks on their books. In spite of this reduction in price, it remains true that the bonds are very far above their natural value. This is shown in several ways. Sales of short time bonds bearing 3 per cent interest and not available for circulation purposes brought only about par in 1907. The postal savings bonds recently placed on the mar- ket, which bore 2^ per cent interest and could not be used to pro- tect circulation, have sold at 92^/^. Comparisons of our borrowing power with that of foreign countries confirm the belief that our bonds are not entitled to anything like their present price on an investment basis. This idea is fully borne out by the table lately compiled in the Treasury Department. (See next page.) The infiuence which has maintained the value of the 2 per cent bonds has been the fact that they could be used behind circu- lation. If that were removed, they would undoubtedly fall to a point somewhere between 80 and 85. The banks which hold them would thus lose 15 or 20 per cent of the par value of the bonds. It would be an impossible and unfair suggestion to secure the alteration of present methods of issuing currency by any plan which would impose on the banks so heavy a loss as would thus be neces- sitated. The banks took the bonds in good faith and with the cir- culation privilege as one element in their value. To strip the bonds of this privilege would be equivalent to taking away one of the favorable terms and conditions upon which they were disposed of at the time when the banks took them over. This would be prac- tically equivalent to the repudiation of a part of the value of the bonds, that is to say, a part of the debt of the government. As such it is not to be thought of. Neither from the standpoint of equity, nor from that of political expediency and possibility, nor PEICES OF FOREIGN" BONDS AVERAGE ANNUAL NET PRICE OF GOVERNMENT BONDS OF ENGLAND, FRANCE, GERMaNT AND UNITED STATES, 1878-1909. The quotations for English consols, French rentes and German imperial loans from 1878 to 1907 are taken from the "Materiallen zur Beurteilung der Zusammenhange zwischen dem BfEentlichen Schuldenwesen und dem Kapitalmarkte," Berlin, 1908. The quotations for United States bonds were compiled by the United States Treasury Department. Tear 1878 1 3 Per Ct. ,.. 94.44 .. 96.75 .. 97.62 .. 99.25 .. 99.75 .. 100.44 .. 100.25 .. 98.58 .. 100.05 .. 101.05 'nglish Consols, 2% Per Ct. 2% Per Ct. French Rente, 3 Per Ct. 74.23 79.64 83.16 83.80 81.24 78.02 76.81 79.19 81.23 79.75 81.26 84.56 90.34 93.90 97.01 96.84 99.67 101.65 101.78 102.95 102.47 100.86 100.22 100.84 100.22 97.75 97.16 98.83 97.27 94.47 95.80 •97.20 4 Per Ct. 95.72 97.89 99.89 101.46 101.53 102.09 103.13 104.25 105.99 106. ,i9 107.93 108.16 106.75 106.00 106.90 107.24 106.59 105.68 105.48 103.64 German Imperial Loans. S'^PerCt. 3PerCt. 162! 88 ■■.'.■.■.■. 99.79 102.45 103.70 100.45 87.05 98.39 85.11 99.97 86.27 100.38 86.27 102.39 90.72 104.44 98.91 104.58 99.22 103.59 97.66 102.65 95.52 99.77 90.71 95.80 86.74 99.54 89.27 102.06 92.18 102.30 91.49 101.94 90.02 101.33 90.08 99.54 87.73 94.66 84.15 ^92.21 82.88 t95.U •84.71 4 Per Ct. of 1907. 100.67 100.60 106.32 115.37 119.26 119.84 121.55 122.28 126.21 127.17 126.72 127.83 122.74 118.59 115.64 111.93 114.01 112.01 108.80 112.60 111.55 112.96 115.15 112.93 110.47 110.30 106.74 104.61 102.84 100.95 United States Bonds. 4 Per Ct. 2 Per Ct. of 1925. of 1930. i2i!53 '.'.'.'.'.'. 116.23 124.53 125.27 129.68 134.52 104.04 138.32 107.30 136.69 108.78 135.27 107.09 131.98 104.99 132.36 104.16 130.26 103.95 126.58 105.18 121.25 103.93 119.11 101.47 3 Per Ct. of 1908- 1918. 1879 1880 1881 1882 1S83 1884.. 1885 1886 1887 95.21 98.71 97.67 96.15 95.39 96.34 98.03 100.73 105.86 110.55 112.06 110.62 106.84 99.29 93.95 94.01 1888 1889 1890 1891 1892 1893 1894 1895 1896 1897 1898 105.31 108.20 109.72 109.34 107.93 107.78 105.67 104.00 103.16 102.47 1899 1900 1901 1902 1903 90.44 87.97 89.52 88.01 83.83 •85.92 •83.76 1904 1905 1906 1907 1908 1909.... 101.75 ^Compiled from BMnanzherald. Special Docket No. 570, 61st Congress, Second Session, p. 279. Bonds TO MAINTAIN VALUE OF THE BONDS 163 from that of public credit, can such an idea be entertained. Even if it could be carried through Congress, it would put into hopeless jeopardy the relations of the government with the investing public for the future. §2. If it be accepted as axiomatic that the government must, in the event -of a change in circulation methods, in some way take a course that will maintain the value of the bonds so that the banks _ , ., Refunding shall not be obliged to carry them at a heavy depreciation or be the obliged to lose the amount of their shrinkage below par, the ques- tion remains how it would be possible to protect the banks against loss at the same time that the note issue basis was changed. The simplest and most obvious method of effecting the transi- tion would be to refund the bonds directly at a higher rate of in- terest. The government would say to the banks : You may bring your bonds to us and receive in exchange other bonds of similar par value bearing a higher rate of interest. Or it could say: We will redeem your bonds at par at any time that they are turned in, and you will get the money by a new flotation of bonds, although we know that in order to get par for the new bonds we shall have to pay a higher rate of interest. What would this operation cost? Light on that question is thrown by the recent sales of government bonds under the terms of the act passed by Congress in February, 1911, which authorized the sale of Panama Canal securities without the circulation priv- ,, -^ Measure ilege, bearing 3 per cent interest. At this rate, the securities brought of the in rather more than 3 per cent premium. This, however, was on ^gnt'T" the relatively small sale of $50,000,000. If all of the $730,000,000 Present of twos now outstanding were to be refunded by the issue of 3 po"°^ "^ per cents, it is safe to say that not more than par could be realized for them. This would imply an increase of 1 per cent annually on the whole $730,000,000 of debt, a charge which would amount to about $7,300,000 in addition to present charges. The amount which would thus have to be paid by the govern- ment for the purpose of relieving the existing bonds of the circula- tion privilege would be large, but it should be borne ia mind that this is nothing more than a just indebtedness which must be liqui- dated in order that the creditors of the government may be equit- ably dealt with. 164 CIECULATION PEIVILEGES other Plans for Using the Bonds National Currency Has Displaced Gold §3. While the refunding of the bonds at a higher rate of interest is the simple, natural and direct plan for meeting the needs of the case, the question has frequently been raised whether there is not some substitute wherby the cost thus to be incurred would be avoided. The question is specifically asked whether exist- ing bonds could not be allowed to retain the circulation privilege, the banks themselves being permitted, as at present, to buy bonds and secure notes from the government by depositing such bonds with the Treasury. Various plans have come before Congress in which it is pro- vided that, before issuing any notes not secured by bonds, national banks shall be required to have outstanding a specified amount of their capitalization in the form of notes secured by national bonds. This, it is assumed, would leave the banks the privilege of issuing currency, and would keep the bonds on their present basis without the necessity of stripping them of the circulation privilege and thereby incurring a large expense of the kind already indicated. Such plans of course are dependent for success upon the assump- tion that such a scheme would meet the requirements of bank-note reform sufficiently well. How far would they probably attain that object ? Too much emphasis can hardly be laid upon the statement that such a hybrid proposal as this would not reach the desired end. As we have seen in former chapters, the currency of the United States is now redundant. The national bank notes have displaced gold and gold representatives to an amount equal to their own volume. Consequently, they have taken for themselves a place which ought to be filled, so far as it is filled at all, by gold representatives. The notes do not expand and contract in proportion to changes in credit needs, and consequently there is on their part neither the power to supply a solid legal tender currency nor to furnish the credit ele- ment needed at times when demands for loans in the form of notes become urgent. Therefore, a plan which practically retained the existing bond-secured notes would not meet the requirements of the case at all. If the present notes were kept outstanding in practically their total volume, it is questionable how effective a new note-currency, which was superadded to them would be. Perhaps it would be only an "emergency currency," subject to all the defects and criticisms which apply in the case of such currency and not fulfilling the ordinary requirements of the situation at all. More probably, the NOTE ISSUE PEOBLEMS 165 new currency would at least partially displace the bond-secured notes. If it should do that, the loss on the bonds, although not likely to be as great as would ensue from a complete deprivation of their power to act as security, would be more or less severe, and the banks would therefore suffer correspondingly from the sacrifice ^f involved in the change. However this might be, the combination Various of a new plan of note issue with the remnants of the old plan would ^gp condemn the currency system of the United States to the reten- Nevy ■^ J Currency tion of a foreign and purely artificial body of notes — ^the bond- secured currency — ^with all of its well-known evils, for a period of years. This period would continue at least until the maturity of the bonds, or nearly 20 years. Then the country would have an opportunity of deciding whether or not to continue to maintain the circulation power now possessed by the bonds, and might or might not answer in the affirmative. If it did so answer, the result would by the retention of this foreign element of bond-secured currency- for an indefinite time. §4. Alternative with the two methods of dealing with the bond question, in the event of a change in methods of issuing cur- rency, is the proposal that in some way the cost of making the An transition shall be laid upon those who are to get the benefit of the Alternative greater convenience, and perhaps larger opportunities for profit, which arise from the introduction of a new method of note issue. In connection with the National Reserve Association plan, it has been proposed that the new institution should be vested with the exclusive privilege of note issue, and in return should take over from the banks at par the total volume of the bonds they now pos- sess. A scheme suggested by some in the same connection has been that the national banks be allowed to continue their present method' of issuing notes, and that the new institution be permitted to issue its own notes in addition. This latter variant of the proposal would be open to the objection already sketched, in that it would retain the Banks to bond-secured currency in existence. Yet there are legal and other ^''°°®® difficulties connected with any plan which would directly deprive Retaining the banks, which now own the bonds, of their circulation riarhts. Circulation ° Rights Discussion has therefore settled down upon the suggestion that, and Their while the existing banks shall be recognized in the enjoyment of Surrender their present privileges and be permitted to retain them if they wish, it shall be made to their interest to cede these privileges to 166 TWO SYSTEMS OF CIECULATION" the proposed new institution and in exchange to receiye the assur- ance of direct redemption of their bonds. The effect of this plan will be to enable a bank to choose between retaining its bonds and its circulation rights and transferring them to the new institution. It is probable that the present national system contains not a few banks which for reasons of sentiment, or on some other ground, would probably retain their circulation privileges if they could be assured of having always the power to transfer their bonds to the Eeserve Association at par, so that they would lose nothing. This plan is considered undesirable for the reason that it would tend to maintain a proportion at least of existing national bank notes in circulation by the side of the new system, and there- fore it has been suggested that any forthcoming plan should limit the time during which the transfer to the Eeserve Association could be made to a brief period, perhaps a year. If that were done, it is probable that most of the bonds would be transferred to the Eeserve Association and would be paid for by it at par, while it would, of course, receive the right to issue an equal amount of circulation, although this circulation would not be directly based on the bonds, as it is at present. The The detailed scheme by which the Monetary Commission bill Monetary proposes to work out this change may be outlined as follows, from sion's the actual measure which has been introduced in Congress to em- P'a" body the suggestions of the Commission: Sec. 48. There shall be no further issue of circulating notes hy any national bank beyond the amount now outstanding. Na- tional banks may maintain their present note issue, but whenever a bank retires the whole or any part of its existing issue, its right to reissue the notes so retired shall thereupon cease. Sec. 49. The National Reserve Association shall, for a period of one year from the date of its organization, offer to purchase at a price not less than par and accrued interest the two per centum bonds held by subscribing national banks and deposited to secure their circulating notes. The National Reserve Association shall take over the bonds so purchased and assume responsibility for the redemption upon presentation of outstanding notes secured thereby. The National Reserve Association shall issue, on the terms herein provided, its own notes as the outstanding notes secured by such bonds so held shall be presented for redemption, and may issue further notes from time to time to meet business requirements. It being the policy of the United States to retire as rapidly as pos- sible, consistent with the public interests, bond-secured circulation and to substitute therefor notes of the National Reserve Associa- MONETARY COMMISSION'S SOLUTION 16? tlon of a character and secured and redeemed in the manner pro- vided for in this Act. Sec. 55. Upon application of the National Reserve Association the Secretary of the Treasury shall exchange the two per centum bonds of the United States bearing the circulation privilege pur- chased from subscribing banks for three per centum bonds of the United States without the circulation privilege, payable after fifty years from the date of issue. The National Reserve Association shall hold the three per centum bonds so issued during the period of its corporate existence: Provided, That after five years from the date of its organization the Secretary of the Treasury may, at his option, permit the National Reserve Association to sell not more than fifty million dollars of such bonds annually: And pro- vided further, That the United States reserves the right at any time to pay any of such bonds before maturity, or to purchase any of them at par for the trustees of the postal savings, or otherwise. Sec. 56. The National Reserve Association shall pay to the government a special franchise tax of one and one-half per centum annually during the period of its charter upon an amount equal to the par value of such United States bonds transferred to it by the subscribing banks. §6. It is evident that the effect of this plan would be to en- able the banks at once to turn their bonds into current funds. The while they would simultaneously lose the power of issuing any f/'x'hi notes. An equal amount of notes would, however, be issued (if they Plan were wanted) by the National Eeserve Association, so that the "shortage of currency" so often dreaded would not make its ap- pearance. Trom that time on, those who wished to get notes would have to look exclusively to the National Eeserve Association. Few, if any, banks would be willing to take the chance of holding their bonds and keeping their notes outstanding. By the terms of the plan outlined, the government would turn these 2 per cent bonds into 3 per cents, thereby involving itself in an additional charge of 1 per cent interest on the total volume taken over. Simultaneously, it would lose the tax of i/^ of 1 per cent on national bank notes which is now collected. It would thus, theoretically, be a loser to the extent of li^ per cent Govern- on the total volume of bonds taken over. The Monetary Commis- ^ou^d sion's plan would refund this amount to the government by pay- Be a ing out of the profits of the Reserve Association a franchise tax an- Loser**'''^' nually to the extent oi V/z per cent on the total volume of bonds thus transferred. The effect would be to leave the government exactly where it is at present, so far as expense is concerned, ex- 168 EFFECT OF FRANCHISE TAX cept that it would save the various items of outlay which are now involved in caring for national bank currency and which are paid for out of the % per cent tax now collected on notes. The criticism has been made on the plan that it is merely a way of concealing the real fact that the government has to pay the cost of the operation. This is because the Monetary Commis- sion's plan, and every other plaii of the same sort thus far proposed, has provided for giving the government all of the profits of a Na- tional Eeserve Association or other cooperative institution over and above a fair minimum interest on the capital invested. If 1^^ per cent on the total volume of the bonds is first deducted as a franchise tax, the volume of profits available for division is the- oretically reduced to that extent. Of course this is not quite fair, because in all of the plans that have been suggested, the payment of a fair-going rate of interest on the capitalization of the concern is to be provided for first, and the balance is to be transferred to the government. Under the proposed plan, the franchise tax would be a kind of first mortgage upon the gross income of the institu- tion. It would be one of those expenses that must be provided for in any ease, no matter what happened. It would come out of the receipts of the Association before any division of profits was made, whether to stockholders or to the government. One of the good features of this plan would be that the fu- ture of the bonds would be provided for. The government does not desire to see its bonds sold at a discount. Yet 2 per cent Ditposftlon bonds cannot be sold on any other basis. At 3 per cent they could of the ijg gQiij ^Q investors at par, judging from the prices at present rul- ing in the bond market. It would be possible, therefore, for the National Eeserve Association gradually to sell them out to invest- ors. This would be desirable also from the standpoint of the Na- tional Eeserve Association itself. It is not well that a large volume of long-time securities should be retained in the portfolio of a great institution which is to deal primarily in commercial paper. As soon, therefore, as the National Eeserve Association could re- lieve itself of the bonds without injuring their standing in the market, it would be well to do so. The Monetary Commission's plan provides for the sale of these bonds at the discretion of the National Eeserve Association at a specified rate of $50,000,000 per annum. This would not be a suflBciently rapid rate either to inter- fere with the floating of new government loans or to clog the bond market. The object would be to have the securities absorbed bv ALL BANKS WOUIiD CONTEOL NOTE ISSUES 169 the sound, gilt-edged investmeiit demand of the country, thereby providing a permanent place for the bonds and putting them where they need cause no worry either to the government or to the Ee- serve Association. They would be taken by persons who want a perfectly safe investment and are willing to accept a very mooer- Avoid ate rate of interest. In that way, an equal amount of the fluid capi- Jj|°s^|j"„^jj tal of the country would be drawn into the Reserve Association in Market exchange for the bonds, and would be by it used as a basis for banking. In the long run, the bonds would thus be entirely eliminated from the commercial banking system of the country and a corre- sponding amount of bank funds now tied up in these bonds would be released for use in meeting the current demands of the com- mercial public. That would be a consummation devoutly to be wished. §7. It would remain true that the power of bank note issue The under this plan would be vested in a single great institution and Question might be referred to as a "note monopoly." This is often men- Monopoly tioned as an objection to the proposal. Just what basis has this objection ? It should be admitted at the outset that the proposed plan would, exactly as alleged, make the note issue power a monopoly in the sense that it would vest it solely in a single institution. This institution, however, would be controlled by the banks of the coun- try that held stock in it, and any bank that chose to become a stock- holder could do so. The "monopoly" existing, therefore, would be a monopoly in the same sense that the power of note issue is a monopoly in the hands of banks generally. Indeed, from some points of view the degree of monopoly of the power of note issue would be less than that which exists at present. Under current conditions, only national banks can take out notes, and state banks are practically cut ofE from issuing their own notes, although theoretically permitted to do so, by reason of the 10 per cent tax on issues which is levied in consequence of the act of Congress passed in 1866. Under the proposed plan, state banks would be stockholders in the Eeserve Association and could secure the use of its notes on exactly the same terms as na- tional banks. A much more immediate and direct access to bank note issues, and such benefit as may be derivable from them, would 170 LESS MONOPOLY THAN ABKOAD be guaranteed to them. In this way, then, the monopoly element in the control of note issues would be less than it is at the present moment. In no country are bank notes permitted to issue without any restriction whatever, and in many they are issued only by a single institution, or in th? main by such an institution, with a very limited power of note issue surviving in the hands of a few other smaller banks. The chief institution is the residual legatee of this power as it is given up by the other banks. The proposed situ- ation in the United States would provide far les,s monopoly con- trol than, exists in France, England or Germany. Profits From Note Issues Possible Harm Through Excessive Charges for Notes §8. The real question in connection with the problem of monopoly of note issue is not, however, one of theoretical monopoly, but is whether the profits obtained from the use of the notes are properly employed. Where would they go under the proposed sys- tem? Presumably they would go to the government in the form of dividends or bonus, after the limited rate of return on capital invested, provided for in the bill, had actually been liquidated. That is to say, the government would get all of the pecuniary benefit accruing to the National Reserve Association through its exercise of the note monopoly. In that case, it would appear that no com- plaint could reasonably be made, because of the fact that the sole power of note issue had been vested in the National Eeserve Asso- ciation. While in some ways this would be a satisfactory assurance, it would not be a complete reply to the charge of monopoly. It might very well happen that all of the proceeds obtained by the use of the note-issue power would actually be turned over to the public by provisions requiring the payment of all excess profits to the govern- ment, and yet harm might be inflicted upon the community as a whole through the exacting of excessive charges for the use of the notes. This would be a very serious evil if it existed, and one whose effects could not be waved aside by the mere statement that the profits were all returned to the public. In this connection it should first be noted, however, that if the profits obtained from the use of the notes, like those obtained from other branches of the in- stitution's business, were to go to the government, there would be no inducement from the standpoint of profit for the charging NATIONAL EESEEVE ASSOCIATION NOTES 171 of an exorbitant rate on those loans to customers which took the form of notes. This reduces the question to the real problem involved, which is: Would the charge made by the Eeserve Association for the • use of its notes be reasonable, and would it be such as to place the T*'*. Rc3l facilities of the institution under the new note plan fully at the problem disposal of those who needed them? In answering this question, '• **i* there are several points to be observed. First of all, the plan of f^^ Notes the Eeserve Association, as already fully shown, would be such as to draw no line of distinction between loans made through the crediting of funds on the books, and loans made through the issue of notes. The reserve requirements would be the same with respect to notes as with respect to deposits, and in every other particular there would be the same general basis of equality. It is evident, therefore, that there would be no reason on the face of things to suppose that the institution would charge an unfair rate for loans which it was desired to take in the'note form. Next should be considered the question. What will regulate its rate of discount, whether for loans made in the form of notes or QuUeg in those in the form of deposits ? Certainly not the profit to be earned Fixing by the institution, for reasons already fully set forth. The in- Qjgggun^ stitution would be guided in fixing its rate of discount partly, of course, by the general rates current in the community as a whole, and partly by the policy of its directors with reference to the ex- tension or restriction of commercial credit and the controlling of exportation and importation of specie. Whatever their policy on these points might be, there would probably be no time when the rate which they would charge for the issue of bank notes would even remotely approach the high rates which are now charged in those parts of the country where bank notes are chiefly used. In few, if any, countries is there so great a discrepancy between dif- ferent regions as regards rates of discount, as exists in the United States. The main function of the Eeserve Association would be to equalize rates of discount charged for paper of similar classes in different parts of the country. It is, therefore, an absolute certainty Loans in that, in equalizing this rate, a very great reduction would be ef- Form of fected, as compared with the rates now charged in the more distant ° ** and more thinly settled portions of the United States, which are those where the present demand for note currency is greatest. Al- together it is impossible to escape the positive conclusion that the 172 FAA^OEITISM IN NOTE ISSUES effect of the proposed plan would be greatly to reduce the cost of loans taken in the fonn of bank notes as compared with the present rates of charge. §9. It may be feared by some that, while the rates of charge would be low, the proposed institution would in some way render access to the notes more difficult than at present. That is to say, it might be true that favored institutions under the new regime would be able to get the notes they wanted, and to lend them to their customers, a good deal more cheaply than they now can, yet there might be circumstances and conditions which would interpose to prevent their getting them at all. This is merely another form of the statement that the Eeserve Association would tend to be influenced by motives of favoritism. No basis for such a charge exists. On the contrary, the pro- posed plan makes extremely stringent provision for guaranteeing to every bank absolute equality of opportunity and of treatment at the offices of the Eeserve Association. Nothing more need be said on that point. It is worth while, however, to observe that, assuming such equality of treatment, the access of the banks generally to the notes would be vastly easier than it now is. At the present time, those institutions which have large issues of notes outstanding for the convenience of their customers, find, in times of stress, that it is very hard for them to get any further currency. This is due, in the first place, to the fact that bonds are at times exceed- ingly difficult to obtain under any conditions. A notable instance of this kind was observed during the panic of 1907, when the bonds were practically out of reach so far as related to new note issues. Moreover, banks which are in the habit of issuing notes to meet the needs of their customers are likely to be close to the upper limit of what they can issue, even with an unlimited amount of bonds at their disposal. When they have outstanding a sum of notes equal to their capitalization, they can issue no more. Under those conditions, banks are obliged to obtain the notes by getting other banks to iasue and lend such notes, for use by the institutions which stand in need of them. This is a familiar situation at crop-moving times. The notes may be obtained from the larger banks in any one of a variety of ways, either by loans made to officers or directors, or by any of the other roundabout SAFEGUAEDING PUBLIC INTEKBST 173 methods that are familiar. The fact remains that this is the way in which notes are now ohtained by those banks that find them- selves pretty well up to the limit of note issue. They are, in a word, obliged to depend upon the willingness of other banks to accommodate them. The other banks are sometimes ready to extend this aid and sometimes not. This merely amounts to a statement that on no conceivable basis could the situation under the proposed plan be worse than that which exists under present methods of banking. Such is, in fact, the case. The methods of the Reserve Association in regard would to the issue of notes would, even under the worst conditions, be P« . . Improved better than those which have prevailed under the National Bank under System at its best. A review of the provisions of the National Ee- New Plan serve plan will confirm this belief in every particular, since it will show that at every point the interests of the several banks have been thoroughly safeguarded as against the Eeserve Association, while the motives of self-interest which might conceivably prompt the managers of the Eeserve Association to take action in the in- terest of certain banks or groups of banks, have been carefully eliminated. With every reason to accommodate the public in the matter of note issue, and with the possibility of selfish motives destroyed, the Eeserve Association would be found at the service of every would part of the country that needed accommodation in the note form, Serve the only question being the presentation of sound commercial paper country of the kind specified, in sufficient quantity to get the notes that were asked for. Here, as in every other branch of the business, the question which banks would have to face would be merely the kinds of transactions on the part of their customers which they were engaged in financing. This, however, would be a general question applicable to the whole problem of reorganizing the bank- ing system and not exceptionally prominent in connection with the note issues. There remains the question whether the interest of the public would be sufficiently safeguarded under the plan which has been ^^'l'^'^'*^ proposed for retiring the national bank notes and for putting in Notes their place issues of the National Eeserve Association. This is a problem of security. At the present time, the notes of the national banks are pro- tected by government bonds to an equal amount deposited with the Treasury. They may be redeemed out of a fund equal to 5 174 PEOTECTION OF THE NOTES Soundness of Such a Currency per cent of their face, which is kept with the Treasury, or out of any funds the hanks which issued them may have on hand. The notes would be backed by gold and other lawful money to the extent of 50 per cent of their value, while they would be payable to the government and could be deposited with the banks, thereby at any time substituting the obligation of a local bank for that of the Eeserve Association. This makes it plain that the new notes would be thrice protected ; first, by an enormously large reserve kept in the fundamental money of the country, gold ; second, by the obli- gation of the government to receive these notes in payment to it at any time and in any amount ; third, by the obligation of every bank in the system to substitute its own promise to pay for the notes of the Eeserve Association. The notes would be as sound as the gov- ernment, and as sound as the whole banking system of the country, which is the same as saying that they would be as sound as the whole structure of the business of the country. More than this could not be required. CHAPTER XI THE CLEARING-HOUSE SYSTEM 1. Clearing-House Associations the Only Form of Cooperation — 2. Development of Clearlng-House Functions — 3. Methods of Clearing- House Examiners — 4. Government Recognition of Clearing-House Examinations — 5. Issue of Clearing-House Certificates — 6. Nature of the Issue Function — 7. Action by Congress Following 1907 Panic — 8. National Currency Associations and Why Few Have Been Organized — 9. Associations, both Clearing-House and "Na- tional Currency," Have Been Incomplete — 10. The Question of In- flation^ll. Avoidance of Inflation — 12. Advantage of Regular- ity — 13. Need of Extending Clearing-House Functions. §1. Only one real effort at genuine cooperation has been made by the banks of the national system. This has been seen in the establishment of clearing-houses which, thus far, have been simply informal, unincorporated associations, organized for the purpose of mutual aid, but having in ordinary times only mechani- Clearlng- cal functions connected with the clearing-process itself. In the H°"se following pages it is intended to describe briefly the clearing- tlons Only house function and to set it in its relation to the general banking ^T."" °* , problem. It is not designed to discuss the details of the clearing process. These have been made frequently and thoroughly famil- iar. The intention is to show the position assumed by the clearing- house as an organization in its relation to the banks of the country. The original cause of clearing-house organization was un- doubtedly the plain need of cooperation among the banks. Insti- tutions located here and there within the same city or region saw the necessity of mutual cooperation and assistance in exchanging their checks and drafts. This was simply a labor-saving device intended to avoid the necessity of going from bank to bank for the purpose of presenting items for cashing. The constitution of the New York Clearing-house adopted in 1853 provided that the manager, under control of the clearing-house committee, should """he have full charge of all businesg and should superintend the opera- coBpeMtlon tion of clearing, the adjustment and settlement of balances, the 175 176 DEVELOPMENT OF CLEARING-HOUSES The First Clearing- House Association keeping of the records of transactions as they take place from day to day, and the preparation and publication of detail bank state- ments. The clearing-house committee was to have charge of the general business affairs of the institution and if necessary to ex- amine any member of the association. A "conference commit- tee" was to be annually elected and its function was, in concur- rence with the clearing-house committee, to suspend any bank from the privileges of the clearing-house in case of necessity, until the pleasure of the association was ascertained thereon. No sus- pension, however, was to take place except under very carefully restricted conditions. Other provisions were intended to govern the membership and the methods of doing business. Throughout the whole list of provisions ran the idea of estab- lishing such rules and regulations as might be considered neces- sary to control the management of a large business concern chiefly organized with a view to the offsetting of claims and the adjust- ment of balances. There was no idea at the outset of carrying the notion of cooperation to the extent of protecting the banks which might be members of the clearing-house against one another's ope- rations, should the latter become objectionable. Neither was there any apparent intention of providing for the relief of members of the clearing-house in the event that they should become hard- pressed by creditors or financially embarrassed. Other clearing-houses were organized on similar lines and those which have been subsequently created have imitated the earlier institutions. The confessed purpose of the clearing-houses is therefore the useful one of effecting a division of labor. Develop- ment of Clearing- House FunctluMS §3. Gradually other functions have been added by the clear- ing-houses to their original duties. The m,ost natural function to be joined to those originally fixed was that of mutual supervision and inspection on the part of the banks. This early came into ex- istence in a more or less distinct form. Mr. James G. Cannon in his work on "Clearing-Houses" says on that subject : It is significant of the ever widening scope of clearing-house supervision and usefulness that several associations have in the past few years, after giving careful consideration to the subject, appointed special bank examiners, assisted, where necessary, by trained experts under rigid regulation and ready to go to work at a moment's notice. This departure has been deemed of sufficient importance to warrant a complete explanation p{ the conditions, under wliich these examiners operate. CLEARING-HOUSE EXAMINERS 177 The mere establishment of associations and the requirement that statements be formulated as thus indicated was only the first step forward. As time has gone on, the general supervision of the clearing-house over its members has been extended to a broad, if vague, requirement that they shall conduct their business in ac- Clearing- cordance with professional principles and shall scrupulously ob- Ethics serve the known and recognized obligations of banking. Thus has come into existence a decidedly important function whose futility has been recognized on many occasions. In all those places where clearing-houses have been organ- ized, an important factor in their work is the establishment of a kind of joint oversight, which enables banks to repress any irregu- lar practices and to maintain a high standard of management among the group of participating institutions taken as a whole. This is rendered possible through regular bank statements pre- pared by the different institutions, and through the work of a clearing-house examiner, who regularly goes through the different institutions and makes a thorough inspection of their accounts and assets in behalf of the association. Until recently such examiners have worked in only a few cities. During the summer of 1911, however, Comptroller of the Currency Murray induced several cit- ies to appoint regular clearing-house examiners, and, in order to make such action worth while, he indicated a willingness to re- lieve banks which supported a clearing-house examiner who made regular inspections of a certain number of the examinations usu- ciearing- ally made by government examiners. Tha offer was accepted Examiners with satisfaction in several places, and the system has thus far worked so well that it is likely to be considerably extended. Thus an informal relationship between the government and a co-operat- ing group of banks has been brought about in so far as inspection and examination of paper is concerned. Even where there is no regular examiner, the banks of a clearing-house, more or less, keep watch on one another's transactions, thus taking, in a loose way, joint action intended to insure soundness in the commercial paper of the community. §3. This most recent extension of clearing-house duties and recognition of the establishments by the government through the order that where clearing-house examiners are appointed the num- ber of government examinations through regular national bank examiners will be substantially decreased, is worthy of further study. 178 CHICAGO AND ST. LOUIS SYSTEM Methods of Clearlng- House Examiners Chicago and St. Louis System In these cities the clearing-house examiner is appointed by the banks and is jointly paid by them. The aid of a staff of assistants is given him, and together these clearing-house examiners inspect the banks, keeping the results of their inquiries strictly to them- selves, so far as details are concerned. If they detect irregularities, it is their duty to call them to the attention of the bank or, in case of necessity, to the clearing-house managers. In a report on the method of conducting clearing-house examinations in Chicago and St. Louis, a report subsequently used as a basis for the introduction of the clearing-house examiner system at Pittsburgh, the follow- ing description of the methods employed is given : The duties of the Clearing-House Bank Examiner, of what his force consists and the manner in which he performs his duties, as adopted by the St. Louis Clearing-House Association, are as fol- lows: The Department includes the Examiner and three assistants. Before entering upon his duties, the Examiner signs a written contract that in case of his resignation or dismissal, be will not connect himself with any bank or trust company within three hundred miles of St. Louis, for a period of three years, and each of his assistants enters into a similar obligation for the same period. The object of this stipulation is apparent. They have in St. Louis seventeen members of the Clearing-House, and thirty- eight associate members, the associate members being Banks and Trust companies clearing through members. This gives a total of flfty-five banks and trust companies under the control of the Clear- ing-House, and subject to its rules and examinations. Without notice, the examiner, of his own volition, and with his assistants, enters any bank or trust company and commences his examination. All information he asks for must be given him, and all books and papers placed before him as in the case of a national or state bank examination. When the examination is completed, he makes duplicate reports, stating all the essential facts obtained in his investigation — whether the institution has the required amount of cash on hand, the amounts of its past due paper, the amount of its bad debts, if any, the amount due by the directors as payers, endorsers or as guarantors, and the amount due by corporations in which they are interested, the value of bonds carried and whether they are carried at a sum in excess of the market value, whether the amount shown as capital, surplus and undivided profits is represented not by bad, but by good assets; in other words, whether the published statements are true, and finally, a complete state- ment of the bank's condition is set out, with any suggestion which, in his judgment, sound banking requires him to make. One copy of the report is delivered by the examiner to the president of the institution examined, and each director of that institution is notified by mail of such delivery, accompanied by a METHODS OF EXAMINEES 179 written request that the director notify the examiner in writing of the receipt of the notice. If, at the end of two_ weeks, the examiner has not received from the director the acknowledgment desired, he sends a second notice, or a third, if necessary, It being the purpose of the committee to establish the fact that every director of every institution which is a member of, or connected with, the St. Louis Clearlng-House, Is informed of the condition of his institution as ascertained by the Clearlng-House bank examiner. If the examination discloses nothing indicating bad manage- ment or unsafe condition, the examiner places the duplicate In his flies and writes to the Chairman of the Committee of Manage- ment. If, on the other hand, the examiner finds conditions different from the case above stated, he sends a letter addressed to the Chairman of the Committee of Management. A meeting of the Committee of Management, which Committee consists of five mem- bers and the President of the Association, who is a member ex- offlcio, is called, and the examiner makes his report, the manager of the Clearing-House acting as secretary of the Committee and keeping full minutes of its proceedings. The Examiner's report is read and considered in detail. He is then directed to notify the President of the Institution that the Committee requests that cer- tain steps be taken which, in its opinion, are advisable and nec- essary. If this request is not complied with, the Chairman of the Com- mittee requests the President and the cashier of the bank in question to appear before the Committee, when they are notified of the matters complained of and Informed that unless they are corrected, their institution will be suspended from the Clearing- House until a meeting of the Clearing-House has been called, and the whole matter in all its details placed before it. The President and cashier are informed at once that no member of the Clearing- House, or any other than those in the room, knows, or will ever know, of the Committee's action or the fact that their Institution has been under criticism, provided the required action be taken. In no case yet has the Committee been compelled to suspend a bank or trust company, and in no case has any institution made any complaint that it had become known that its affairs were under discussion. In either city If the examiner finds unwarranted con- ditions in a bank after having completed his examination, he calls the matter to the attention of the officers of the bank, and if proper adjustment is made, makes no mention of it in his report. In speaking of the clearing-house examination system, Mr. James G. Cannon says : The clearing-house association of Chicago was the pioneer in the establishment of an Independent system of clearing-house bank examinations in this country, its system having been inaugurated on June 1, 1906, with results that have to the present time more than fulfilled the expectations of the bankers of that community. Bank Directors Notified of Exami- nation First Action of Report Dis- closes Bad Practices 180 LEGALITY OP CLEAEING HOUSES The chairman of the clearing-house committee, speaking In this connection only recently, said: "The result of our experience in Chicago is most satisfactory and gratifying. The banks have almost unanimously adopted every suggestion made by the clear- ing-house committee for their betterment and strength. In several Success In Instances, the committee, from its wider knowledge of the financial Chicago situation, has been able to save some of the smaller institutions from loss by enabling them to take hold of conditions in time. I cannot properly go into such details as would illustrate the effect- iveness of clearing-house examinations as we have experienced it, and can only say in a general way that it has been even more satis- factory than I anticipated it would be before it was undertaken." Govern- §4. Comptroller Murray's order, in which he directs a sub- jT*"* --tion st^t^^i°^ °f ths clearing-house examination for the regular national of Clearing- bank examinations up to a certain point, was first suggested in a Examlna- letter written by him and reading as follows : tlons. My Dear Mr. The greatest force In this country to-day for safe and conserva- tive banking is a well-organized clearing-house association, having its own clearing-house examiner, and it is my earnest wish that at least every reserve city shall have its own clearing-house examiner. The three central reserve cities, New York, Chicago and St. Louis, have adopted the plan, and in addition a number of reserve cities, including Kansas City, Minneapolis, St. Paul, St. Joseph, Los Angeles, San Francisco, Milwaukee, Philadelphia, Oklahoma City, Nashville and Cleveland. Every one of the objections always urged against a clearing- house examiner was used before these clearing-house associations adopted the plan, and every single one of the objections, by actual experience, has fallen to the ground. The fact is tbat no real argu- ment from any angle can be made against the wisdom and efficiency of such a plan of supervision. Give to the state super- visors of banks all the power they ask; give to the Comptroller of the Currency all the power he may want, and then let each select the very best examiners available, and, even with these ideal conditions, an effective clearing-house association, with an efficient clearing-house examiner, will be by far a more potent factor for Bound banking in the community than either or both combined. The total assets held by all the banks in the United States will approximate $22,500,000,000, making the banking power (capital, surplus, circulation and deposits) of the country $21,000,000,000, a sum greater than the combined banking power of the United King- dom, France and Germany. Of this vast total, more than one-half is in the central reserve and reserve city banks and represents a power exceeding that of the United Kingdom, and also exceeding the combined banking power of France and Germany, EXTENSION OF EXAMINEE SYSTEM 181 Nearly one-fourth of the hanking power of the country, as a whole, is lodged in the central reserve cities alone. New York, Chicago and St. Louis, and more than another ono-fourth is represented by the banking strength of the forty-seven reserve cities. No stone ought to be left unturned to securely safeguard the handling of this great wealth. If we are to have supervision of banks at all, let us have the best that can be had. And by all means let us have it in our reserve cities. That supervision Is not the state examination and control; it is not the national examina- tion and control; but it is the control of an efficient clearing-house association, and an efficient clearing-house examiner, under the authority and with the advice of a clearing-house committee com- posed without exception of the ablest and most experienced bankers. There are clearing-house examiners in fourteen of the reserve cities and the plan in each city is in some respects different. I ask you to communicate at once with these different clearing-house associations, and ask them to give you in detail the plan under which they are working. I also invite your attention to an address delivered by Mr. James B. Forgan, president of the First National Bank of Chicago, on the subject of clearing-house examinations by clearing-house examiners, at a meeting of the clearing-house section of the Ameri- can Bankers' Association at their convention held in Los Angeles in October last; also, to an article on clearing-house examinations by Mr. Joseph T. Talbert, now vice-president of the National City Bank of New York, which can be found in the Journal of the American Bankers' Association for January, 1909. So far as argument is concerned, based on actual experience, it seems to me that these addresses of Mr. Forgan and Mr. Tal- bert contain all that need be said on the subject. The plan suggested is as follows: First : In cities where the charge would not be a great burden on the banks they should have their own examiner, selected and paid by the banks of the clearing-house association. Second: Where this would be such a burden on the banks as to make it impracticable, an arrangement may be made with the national bank examiner to furnish the clearing-house committee with a copy of his report to the Comptroller; and in case there happened to be — as is likely — state banks and trust companies, the bank examiner should make an independent examination of them and report directly to the clearing-house. For this' service he would be entitled to a reasonable compensation, but the ex- pense to the banks would be so light as not to make it a burden. In case the second plan is adopted, of having the national bank examiner or the state bank examiner act as a clearing-house examiner, the details can be easily worked out at a conference between the clearing-house association and the examiner and state 182 CLEARING-HOUSE CEETIFICATBS other Views of the System of Examina- tions. supervisor, if a state examiner is selected, or between the clearing house association and the comptroller, if a national bank examiner is selected. I earnestly ask that this letter be read at a full meeting of your clearing-house association; that you at once enter into corre- spondence with the cities having their own clearing-house ex- aminers, that you adopt some one of the plans now working so admirably in those cities, or a modified plan. If you take this up in the spirit which I think you should, and which it is hoped that you will, we will have, in at least all the reserve cities, what we should have had as soon as they were made such — a clearing- house examiner. Yours very respectfully, (Signed) LAWRENCE O. MURRAY, Comptroller. The functions of the examination system have been described by another authority as follows: The idea of having a clearing-house bank examiner is not to hamper the banks in any way, but to prevent them from taking undue risks in order to secure high rates of interest, or go into underwriting schemes of a questionable character, or allow direct- ors or officers of an institution loaning the banks' funds to corpora- tions in which they are interested, provided they are not well secured; also to prevent firms and corporations securing larger lines of credit than they should be entitled to, based on their assets, and to enable the banks to check up firms, individuals or corporations that make false statements. Issue of Clearing House Cer- tificates. First Used In 1860. §5. It is thus plain that so far as oversight is concerned the clearing-house association has demonstrated its eflBciency so clearly as to be recognized by government authority. But by the side of this function has been developed another which has been exercised only in exceptional instances. This is the so-called . clearing-house certificate or currency function which in substance has been the providing of a certain kind of reserve resource through the con- certed action of the banks, in order that they may be relieved of the pressure and danger growing out of severe strain upon their resources in times of panic or stringency. The earliest issue of clearing-house loan certificates occurred in 1860. There had been a serious decline in bank business toward the close of 1860. In consequence the clearing-house banks of New York adopted a resolution whereby it was proposed that any bank in the association might, at its option, deposit with a com- mittee of five persons to be appointed for that purpose an amount of its bills receivable. United States stocks. Treasury notes, or stocks of the State of New York, to be approved by the Committee, which CERTIFICATES IN 1907 PANIC 183 should be authorized to issue thereon to the bank depositing them certificates of deposit, bearing interest at 7 per cent per annum, in denominations of $5,000 and $10,000 each, to an amount equal to 75 per cent of the deposit. These certificates might be used in the settlement of balances at the clearing-house for a period of 30 days from the date thereof, and were to be received by the creditor banks during that period daily in certain proportions. The association also agreed that the specie belonging to the asso- ciated banks should be considered and treated as a common fund for mutual aid and protection, and a committee of the clearing- house was given authority to "equalize" the fund by assessment or otherwise as occasion might seem to demand. This expedient was again resorted to in 1861, and again in 1863 and 1864, but after that date no further loan certificates were issued until 1873, when a very much larger issue was miade. In that year also the loan certificate expedient was adopted by the other Boston clearing-house association and by those of Philadelphia, of Such Baltimore, St. Louis, New Orleans and Cincinnati. Again in 1879, Certificates a small issue was put out by the New Orleans association, and again in 1884, New York resorted to the certificates. In 1890 there were issues in New York, Boston, and Philadelphia. In 1893, the use of the certificates was again undertaken, and issues were made at New York, Boston, Baltimore, New Orleans and Cincin- nati. Small issues were put out at Buffalo, Pittsburgh, Detroit, Atlanta, Birmingham, Eichmond, Chattanooga, and other places. Again in 1896, there was a small issue at New Orleans, and a small issue in 1895-1896 was used at Boston and at Philadelphia. Probably the most extensive issue of clearing-house certificates ever made was in 1907 when New York and practically all of the other principal cities of the country issued clearing-house loan certificates. In many smaller manufacturing towns there were issued so-called clearing-house checks or cashier's checks in small denominations to supply the need of cash. These were simply checks printed from steel plates in small denominations and issued to the various clearing-house banks, which then signed them, through their cashiers, and paid them out to persons who desired funds. In some places, the clearing-house loan certificates were made the basis for issues, dollar for dollar, of clearing-house checks running as low as one dollar in denomination. 184 A REDISCOUNTING OF PAPBB Nature of Issue Function Purpose of Certificates Was to Meet Panic Demands for Casli Highest Form of Cooperation. Success and Perma- nence of tile Plan §6. It is obvious from this outline that the essential function performed by the clearing-houses in connection with the issue of loan certificates and checks has been the rediscounting of paper. Such rediscount was in the form of a credit which was practically as good as legal tender money inasmuch as, by common agreement, the banks of the clearing-house associations undertook to receive it in payment of all obligations, and thereby converted it into a means of cash payment available to any reasonable amount. They substantially entered into an agreement not to attempt to drain away one another's cash, but to treat the cash as a common fund. The purpose of the clearing-house certificate system has been to afford the banks the means of liquidating paper at a time when they are peculiarly in want of cash owing to panic demands upon them. The banks which feel the need of cash hypothecate, with a committee of the clearing-house, paper of satisfactory quality which they happen to have, and get in return clearing-house loan certifi- cates to (say) 75 per cent of the amount of the paper thus pledged. By making the clearing-house certificates payable in liquidation of all sums due from one bank to another, the clearing-houses have practically relieved their members for the time being of the neces- sity of directly settling in cash such obligations as are presented to them by other banks. Since a rate of interest is charged on the certificates, the banks desire to retire them as soon as they can. The use of these certificates practically throws the whole body of clearing-house banks into the form of a commercial unit dur- ing the period of stringency. This is probably the highest and closest form of cooperation established among the banks. The success of the plan is evident from the repeated employ- ment of this expedient over a period lasting half a century, and by the continuous extension of the system to the smaller clearing- houses which have taken it up in recent years as necessity seemed to demand. The success of the clearing-house loan certificate plan has often raised the question in the minds of observers why this plan was not made a permanent feature of clearing-house organization so that it could be resorted to at any time, and the very great power of expansion in accommodation resulting from it be realized. So acceptable has this notion been to many persons, that for years past there have been bills regularly presented to Congress for the pur- Arguments LEGALIZATION OF LOAN CEETIFICATES 185 pose of legalizing issues of loan certificates by recognizing the right of the clearing-houses to get then^ out — a right which is, to say the least, very doubtful under the conditions of existing law. Very little support haa been accorded to these efEorts by the clearing- house banks themselves. Apparently, their view has been that the legalization of the scheme, and the adoption of an act making it Against permanent, would destroy its basis of success. It has been con- g'^^e^' tended that, if the scheme were to be regularly resorted to, the Plan effect of it would be to encourage banks to expand their operations because they would know that they could get relief at any time by applying to the clearing-house committee and obtaining loan certifi- cates. What is good medicine for a sharp attack of disease, it has been picturesquely stated, is not desirable as a regular diet. This aphorism hardly meets the real facts in the case, but at all events it explains the grounds upon which there has been a hesitation on the part of bankers to see the clearing-houses regularly endowed with the function of issuing these certificates. §7. Without the support of bankers and almost against their wishes. Congress, however, has practically legalized something analogous to the clearing-house certificates. After the panic of 1907, there was a strong demand for legislation which would render the recurrence of such an event improbable or impossible. Under the stimulus of popular demand. Congress, which had previously Action by been indifferent to the wishes of the community in regard to bank- Following ing reform, attempted to adopt legislation designed to avoid future r/lgn/ panics. Two plans were placed before it, the one simply providing that banks might, if they desired, present bonds of specified kinds, other than national, to the Treasury Department and receive back circulating notes in a specified proportion of the face of the bonds. Such notes, however, were to be quite heavily taxed on the ground that they were an "emergency currency" and as such to be "driven in" as soon as possible. The other plan provided for the issue of notes by associations of banks to be organized in various districts into which the country was to be divided. Notes of this kind were not to be based upon any specified securities expressly segregated for that purpose, but were to be in the nature of so-called "asset currency" protected by the joint action of the banks in the district associations. Finally, 186 NATIONAL CUEEENCY ASSOCIATIONS No Notes Have Been Taken Out Under This Law after several months of struggle, a new plan was evolved whereby so-called "clearing-house associations" were to be formed for the express purpose of getting out notes when desired. Ultimately this again was changed to a plan for the formation of "National Cur- rency Associations" which were to have nothing to do with clearing- houses, but were apparently intended to be the inheritors of that part of the clearing-house function which had been previously rep- resented by loan certificate issues. This plan was at last consolidated with the bill which pro- vided for the issue of notes direct from the Treasury to banks which might deposit approved securities (other than national bonds) with it, the resulting legislation being known as the "Aid- rich- Vreeland" law. In this law it was provided that in addition to the issues of notes which might be obtained direct from the Treasury, other is- sues could be had from the National Currency Associations. Such associations would consist of not less than ten banks having a com- bined capitalization of at least $5,000,000, situated in contiguous territory. The issue of the notes was to follow lines that had already been made familiar by the clearing-houses. Securities of a specified kind were to be receivable by the National Currency Associations and, when thus received, issues of notes up to 75 per cent of the value of the securities might be obtained from the Treasury by the Association and distributed to the banks which had deposited the collateral with the National Currency Associations. The banks in any association were, however, to be jointly responsible for the notes thus obtained and issued. Under this plan no notes have ever been taken out and only a few such associations — seventeen in all — ^have been organized. §8. It is clear that, with the National Currency Associations as with the clearing-house associations, what has been done has been to provide a means for rediscounting commercial paper, the form of the rediscount being the issue of notes jointly guaranteed by the banks which were the members of the organization apply- Aaaociatlona ^^S ^"^ *^s notes. It would be easy to say that the failure to organ- Have Not ize more of these associations and the entire failure to get out any notes is due to the fact that no commercial crisis or stringency has supervened since the legislation was adopted that would render such a force necessary. Of course, this neglects the fact fully commented upon elsewhere in this discussion, that the clearing-house associa- Been Organized DEFECTS OF EMEEGENCY CUEEENCY 187 tion or National Currency Association merely fills a need which constantly exists, and that in the past issues of notes by such asso- ciations have occurred when it was impossible to get along without them on account of the extreme necessities of the case. The reason why no notes have been issued by the National Currency Associa- tions is not altogether that there has been no occasion to demand them. Nor can any similar explanation be accepted for the failure to get out clearing-house certificates except during certain specified years when panic or stringency had driven the banks to a resort to that expedient. In the case of the clearing-houses, the notes were not issued Clearlng- except upon extraordinary occasion and were then driven in as Notes early as circumstances would permit, because the strong banks did Regarded not care to be responsible for them any longer than was necessary, Extra-Legal and because the( whole thing was looked upon as an extra-legal, if Expedient not an illegal, expedient. In this case of the National Currency Associations, the in- activity may be attributed to the fact that the getting out of such notes is severely penalized by the imposition of a very heavy tax upon them and by the fact that the notes constitute an unlimited liability upon all of the banks which are parties to the National Currency Association. Moreover, through defects in the law, the character of the commercial paper which miay be received by such associations as a backing for issues of notes is very far from being clearly described, so that in many places it would appear that R,*'*Law'" very little paper would be available as security behind the notes if the law were rigidly adhered to. But, entirely apart from all these questions of technique is the fact that the issue of notes or loan certificates is manifestly a temporary expedient upon a tem- porary basis and is vitiated by this "emergency" quality. The banks do not care to arouse alarm by employing an expedient which is regarded by the community as a danger signal, while no individual bank is willing, except in case of extremity, to ask other institutions to consider the getting out of notes, since this step would necessitate an exposure of its own affairs, and an ex- planation of the reasons which had led it to so unusual a step. §9. It is clear that the associations, whether clearing-house or national currency, have been incomplete in their operations and that what they lacked was (a) legal sanction and recognition as Associations permanent institutions, and (b) legal oversight and restraint. Incomplete 188 INFLATION OF CEEDIT The harm that came from issues of certificates was due to the fact that they were regarded as the result of danger, if not of dis- aster. The good that came from them lay in the fact that they converted sound and unquestionably valid assets into immediate means of payment. The danger seen in them resided in the fact that it was feared that they would give to weak institutions a power to expand accommodation to which they were not entitled and which might work hardship to sounder and better managed institutions. The cooperative idea implied in the associations was their distinguishing beneficial factor, and it is this that should now be carried a step further by placing the clearing-houses or national The currency associations upon a permanent working basis — or what is Idea'**'"' ^* the same thing, by borrowing the idea of cooperation from them and organizing an institution to apply it regularly and systematically. Such an institution would maintain and accept the germ idea of the clearing-house or National Currency Association — that of the rediscounting of paper and the conversion of it into resources which might be used as reserve funds. It would, however, carry this notion further by keeping the institution always open for business and thereby rendering it possible for its operations to go on without shock or alarm to the community. Involved in this thought would also be the abolition of everything that could be considered to penalize the use of the resources of the institution. Proper restraint and oversight would be obtained by the application of professional knowledge and skill to the business of testing paper presented for rediscounting. §10. With such professional skill and oversight applied to the operations of a cooperative association, how far would there be a warrant for the belief of inflation ? The belief is frequently expressed that the clearing-house principle, so-called (meaning thereby the principle of converting assets into immediate re- sources), would be carried to an extreme, and inflation would Question result. It is well to note the exact effect produced by the clearing- of Inflation house loan certificates when they were issued, and to consider the probable result of producing this same effect under usual circumstances. The action of the clearing-houses in issuing loan certificates (and the action proposed for the national currency associations) NEED OF LOANS IN CEISES 189 was to be that of accepting given securities and issuing notes in exchange therefor. In ordinary discussion, it is assumed that thesa issues gave relief because they "increased the quantity of money" in the community. A shortage in money had been brought about as a result of public clamor and uncertainty, and this shortage had ivnsappre- to be relieved in some way. The relief was obtained, it was sup- hensions of posed, by issuing notes which took the place of some money that For had been withdrawn from the banks and had disappeared through Clearing- hoarding or otherwise. This was a complete misapprehension of the Issues situation and was not only erroneous in its statement of facts, but in its view of the theory upon which the action of the clearing- house was founded. The conditions by which clearing-house banks have found themselves confronted in times of difficulty have been that, although assets of known value were available, they could not be quickly tested and converted into resources, thus making them available for the purpose of liquidating obligations whose settlement was called for. The issue of the loan certificates grew out of two distinct propositions: (1) the joint guaranty by the banks of the paper of- fered to them, since they issued notes based thereon to the extent of 75 per cent of the paper accepted; (3) the creation of a readily available and recognizable form of resource. It should be perfectly Real plain that precisely as much good would have been done, had the Nature of the Trans- clearing-house, instead of issuing these "certificates" or "notes," action granted to the banks presenting paper and asking for the certifi- cates a right to draw upon the clearing-house a check which should have been valid simply in payments to other banks. Confusion has arisem from the use of paper certificates, or notes of the kind referred to, which have effectually masked the real nature of the transaction. This real nature lay in the examination and testing of credit paper and in the joint agreement to accept such paper when once it had been tested, and certified. Now, what is inflation ? It is currently stated that, if clearing- houses were to continue the operation just described, the result would be inflation. So eager have clearing-house associations been to avoid this danger, that they have usually penalized the use of what Is the certificates by charging a very high rate of interest on them. '"f'at'°"? This has been intended to "drive the certificates in," and, as the cer- tificates have usually come in very rapidly when the need for 190 EEDEMPTION A CHECK ON INFLATION Redemption the Remedy for Inflation Credit Inflation Prompt Exchange the Test of Sound- ness them was over, it has been supposed that they had been driven in by this rate of interest or tax. Inflation, however, is not to be feared if every loan is based upon sound values which are promptly redeemable. The avoidance of inflation is found in redemption. Constant redeemability of obligations means that these obligations cannot become inflated — ^that is, cannot become too numerous. If, for example, an issue of bank notes is thoroughly and fully protected by cash reserves, yet the notes on the average remain in circula- tion for some time, the meaning is that the notes are needed in circulation and that the community is more benefited by having them kept outstanding than by having them redeemed and re- tired. If there is no method of prompU redemption, or if there is an artificial stimulus to the issue of notes which has no relation to commercial necessities — as in a bond-secured currency — ^then there may be inflation. That is to say, the notes may get into circulation and stay there without reference to the exchange function they perform. This inflation may occur just as easily in the granting of bank credits. The danger is there seen when banks accept paper and allow deposit credits on the strength of it, notwithstanding that the paper cannot be promptly met or is of doubtful value. In this case, banks are practically putting their resources behind property which does not grow out of actual commercial exchanges and which, therefore, however good it may be in the long run, is not a quick asset. Persons who know that they can go to banks and obtain abnormal credit in this way, whether it be in the form of notes or deposit accounts, recognize that they are able to use as purchasing power values which under other conditions they would have great difficulty in disposing of. This is inflation, and it is a process which has nothing what- ever to do with the amount of currency in existence or in cir- culation. Prom this, then, it is clear that inflation is to be feared only when the extension of credit is made upon an unwise basis and when, therefore, there is doubt about the immediate con- vertibility of the credit that is granted and, perhaps, some doubt even about its ultimate convertibility. By convertibility is not necessarily meant convertibility into "money" or "currency," as many persons loosely assume. It means convertibility either into money or into bank credits that have more recently been created. TEST OF SOUND ASSETS 191 Activity and prompt exchange are the tests of soundness. When there is this kind of activity, there is nothing to be feared from the extension of credit in the way described. §11. Inflation is avoided, therefore, when paper is carefully tested before being guaranteed, and is found acceptable as a basis for immediate funds. If this testing is carried out with sufficient care, and if it applies only to the live assets of the community, there is nothing to be feared from a constant resort to it. More- Avoidance over, there is no occasion for penalizing those who make use of of inflation it. The charge properly made by thein is the regular commlercial charge for the use of capital in a given form for the period the paper haa to run. By making this charge, an institution, or a cooperative group of institutions, is relieved of the necessity of "carrying" any paper, and merely extends a business service for which it is properly compensated. Those who thus convert their assets into immediate resources do so because such resources are more valuable to them than the cost of making the exchange. They convert their paper into resources in this way because other per- sons are calling upon them to liquidate demand obligations or ^f Conver- because they see a possibility of using these resources as a means ''•>" of extending their business still further. For either of these rea- sons, they are willing to pay the price of conversion. When they have done so, there is no hazard or risk unless they are unable to meet their maturing obligation when it falls due, or, what is the same thing, unless the person or firm who made the paper originally is unable to meet it when it falls due. In either of these cases there has simply been a miscarriage of the conversion opera- .tion — ^that is, something has been mistaken for quick assets which was not so. The remedy in this case is not to make it more ex- pensive for all future borrowers to get their accommodation, but is to employ more capable men or to install a more efEective sys- tem for the purpose of testing the paper that is offered as a basis for credit. §13. In this matter of converting commercial obligations Advantaae into means of pajnnent, just as in all other banking operations, of Regu- there is an immense advantage on the side of regularity. The *"■ y* operations of the clearing-house were unsatisfactory as regards the issue of loan certificates because the function was an irregular one. 192 COOPEKATIVE PRINCIPLE EXTENDED Application of the Clearing House Principle. There was no regular machinery for carrying it on, nor was there any specified capital set apart. The loan certificates consequently came into existence sporadically, and by means of hastily organ- ized processes. The same thing would necessarily be true of the currency now permitted to be taken out by National Currency As- sociations, although the hasty and unorganized character of the transaction would not be so conspicuous with them as it was with the clearing-houses. Neither institution can afford the steady responsible type of accommodation that is wanted. That can be obtained only by set- ting aside a definite capital and creating a definite organization to do the work of converting heterogeneous commercial credits, varying in origin and in type and resembling one another only in their activity and short term, into immediate means of payment. Such an institution, operating in the way indicated, has all the advantage which come from economy and regularity in its opera- tion. It represents simply the further carrying out of the co- operative principle embodied in the clearing-house and the subject- ing of this principle to stated and recognized methods of applica- tion for the benefit of all who may need to invoke its assistance. Need of Extending Clearing House Functions. §13. Prom what has been said, it must be plain that an or- ganization of banks which undertook to carry further the principles involved in the joint testing of credits would find that the other functions allied to this testing of credit which had heretofore been performed by clearing-houses would be much more easily performed by such an organization. It has been seen how clearing-house banks cooperated for the purpose of bringing pressure to bear upon every member in order to compel them all to avoid questionable practices and to live up to the best professional methods in vogue. It was noted that this result is accomplished by ordering either periodic and sporadic, or (where a clearing-house examiner is em- ployed), regular examinations or tests of the condition of the banks. There will always be a field for the exercise of this function of joint examination no matter whether the ultimate process of test- ing paper and converting it into immediate resources be confided to some special institution or not. It is plain that the work of such an institution, if properly carried out, would render immensely more simple the problem of exercising the proper mutual control over bank operations. It PEOMOTION OF GOOD BANKING 193 would place a heavy premium upon those methods of banking which resulted in the creation of the right kinds of paper and would penalize those methods of banking which resulted in grant- ing accommodation to persons who were not entitled to it as esti- mated by the immediate character of their resources. While, Would Make therefore, an institution of the kind described would be able to do Better vastly more effective work than the clearing-houses by simply Banking, carrying the principles employed by them to a higher point of per- fection, it would in no wise usurp their functions. They would still have an abundant field for the performance of the work which they were fundamentally authorized to undertake — that of clear- ing checks and items that were deposited with the various banks. They would, moreover, exercise an oversight over one another which could not be exerted by any other institution of more general scope. Unless such an institution were organized with branches, which has been proposed by nobody under existing conditions, it would be necessary for the work of testing credit and making" loans to be complemented by the. efforts of the clearing-houses. But this work of testing credit and making loans must be carried on with a fixed capital and upon a definite basis of business enterprise. Without that, it inevitably assumes the temporary or sporadic character it has heretofore had under the clearing-house system, and which it would necessarily retain under the plan provided for in the Aldrich- Vreeland Act. A cooperative institution would introduce no new principle beyond that which has been pursued by the clearing-houses and which it was sought to legalize in the Aldrich-Vreeland Act. All that would be done would be to carry this principle further, sys- E"ement of tematize its working, and subject it to the safeguards and checks Novelty, which are necessary in order to prevent undesirable conditions from growing up. The only element of novelty in the system would be that of organization and stability of method coupled with the exten- sion of the plan harmoniously throughout the country. CHAPTEE XII. COOPERATION OR CENTRALIZATION? Three General Types of Banking. — 2. Banking Systems in the United States — 3. European Banks — 4. Canadian System — 5. De- fects of the Competitive System in the United States — 6. Statistics as to Distribution of Reserves and Deposits — 7. Tendency to Con- centration of Control. — 8. Development of Joint Control — Holding Companies — 9. Effect of Government Deposits — 10. Cooperation under Present System Limjted — 11. Organized Legal Cooperation — 12. Economy of Reserves — 13. Kinds of Paper Rediscounted — 14. Gains of Legal Cooperation — 15. Summary. Threo General Banking Types §1. A review of the banking systems in vogue throughout tho world at the present time shows that they may be classified as be- longing to three general groups or types: (1) Those depending on a central bank as their principal feature; (2) those based on independent competitive banks; and (3) those involving a coopera- tive principle. The question as to which plan is best adapted to the needs of a commercial country has been actively discussed for a long time. Probably no final answer can be given to it. The decision in every case must depend upon the conditions existing at the time in any given .country. In general, the tendency of modern commercial countries has been away from the purely competitive and independent type of banking system. There has been a strong drift toward either centralization or cooperation. In some cases, this drift has been guided by legislation; in others, it has gone on without any official or legal recognition, simply by virtue of the demands of business and economy of resources. A Central Bank In United States §2. Early in the history of the United States, the idea of centralization in banking was advocated. Hamilton urged the establishment of a large central bank in his famous report on that subject in 1791. Later in the same year such a bank was actually established and lasted for twenty years. Meanwhile, many banks 194 EAELY BANKING SYSTEMS 19a had been chartered by the several states and had come into opera- tion on a competitive basis. After the close of the charter granted the first bank of the United States, a renewal was refused by Congress, and there ensued a period of about five years during which full opportunity was given state banks for development. In that period, the United States government had no single financial institution upon which to rely, but called upon the state banks for such loans, and other banking facilities, as it stood in need of. This proved unsatisfactory, and in 1816 the Second Bank of the United States received a twenty- year charter. This bank, like its predecessor, acted as fiscal agent of the government, furnished such loans as the Treasury needed, and generally exerted a steadying and controlling influence over the state banks, which continued to be chartered upon a competitive basis. A renewal of its charter was also refused after a long and bitter political struggle, lasting from 1839 until the close of the existence of the institution. From 1837 down to the Civil War, the system of banking in the United States was entirely under state control and rested on a purely competitive basis. No federal legislation relating to bank- ing was adopted, and the only serious innovation upon previous con- ditions was found in the establishment of the independent Treas- ury, which was to act as the custodian of public funds. Under this state banking system, as many different kinds of currency as there State were banks in the country were issued, while the government could not in case of necessity obtain the support of any very strong single institution. After the opening of the Civil War, the national bank act was passed (1863) for the purpose of supplying a uniform cur- rency and aiding the government, through the purchase of bonds which were to be used as security behind bank notes. Later (1866), state bank notes were driven out of circulation by a ten per cent National tax levied upon them. Access to the banking system was free, those ^""'*' who would organize a bank being permitted to do so without re- striction, provided they were able to furnish the necessary capital and comply with moderate requirements concerning the conduct of business. Since 1863, the national banking system has been continually in existence and nearly 10,000 institutions have been chartered at the date of the last Comptroller's Eeport, 1911, of which 7,301 are 196 FOEEIGN BANKING SYSTEMS etill in existence. States and territories hare in the meantime gone on incorporating banks under their own laws. Thus there has been perfectly free competition in banking throughout the United States, save in so far as related to the issue of notes. This function has been reserved to a single class of banks — those in the national system — ^but within the national system there has been absolute freedom of action in issuing notes subject to the requirements of the national bank act. These restrictions have been the same for all banks of similar size. Bank of England Bank of France Relchs- bank of Germany §3. The course of development in the United States has been very different from that which has existed abroad. In England, the Bank of England was chartered in 1694 and has continued from that day to this, standing in a peculiar relation to the government as its fiscal agent, and ultimately taking to itself the function of note issue in a practically exclusive manner. By long-developed custom, the Bank of England has become the reserve holder of the country and has grown into what is practically a banker's bank, although it does an extensive business with individuals. In this peculiar position, the Bank of England is able to act largely as the financial dictator of the English credit system — a power which it has exercised with judgment, non-partisanship and discretion. In France, the Bank of Prance was developed in 1800-1803 and has continued in operation since that time. It enjoys a monopoly of note-issue, practically holds the reserves of the country, and, while doing an extensive business with individuals, also serves as the great market for rediscounting paper presented by other banks and financial institutions. With its system of branches through- out France, it operates as a controlling agency, regulating in the main the banking customs, and determining -the flow of specie into and out of the country, subject to the general conditions of interna- tional trade. Similar functions are exercised by the Imperial Bank of Ger- many, organized in 1875. Most of the continental countries of Europe have followed this same system of establishing central in- stitutions, standing in close relation to the governments of these states and exercising a general oversight over banking. Most of them, however, are privately owned. A recognition of the public quality of the service with which they are entrusted is obtained by subjecting them to constant and wa;tchful government oversight, THE CANADIAN BANKS 197 while in the case of most, there is direct governmental participa^ tion in the management of their affairs. The effort is made in every ease to give the commercial public a voice in the management of the European institutions, and to ensure that they shall be carried on in such a Banks way as to serve the commercial interests of the countries where they are situated. The pressure of public opinion in the highly organized and closely centralized countries of Europe also has an important influ- ence in keeping the banks true to their public quality and prevent- ing them from neglecting the duties which fall upon them in conse- quence thereof. Thus, in most of the European states, the basis of the banking system is found in a strong central bank which con- stitutes the connecting link between the government and the public. This bank holds the reserves of the other banks to a very large ex- tent, and furnishes credit to the commimity, besides regulating the importation and exportation of specie. §4. Canada has developed her banking system in a different way, and may be regarded as the best example of the cooperative type of banking to which reference was made above. The peculiarity of Canada's system lies in the fact that, although there is no single in- stitution possessing an exclusive monopoly of note-issue, or of any other function, and although there is no government bank holding Canadian public funds and possessing the power to dictate the use that shall system^ be made of the cash resources of the country, practically all of Canada's banks are of large size. At present only twenty-seven dif- ferent institutions are in operation, and the requirement of the law is that no new institution shall receive a charter if it has a capital below $500,000. Every bank is permitted to establish as many branches as it sees fit, and some institutions operate hundreds of such branch offices, there being in all nearly 3,000 branch offices. Branches Notes are issued by all of the banks, but they are guaranteed by a fund which is contributed by the various institutions, and which is used for the purpose of redeeming^ the outstanding notes of failed banks, being reimbursed, so far as possible, from the assets of such banks when their affairs are settled. Thus Canada, without having a centralized banking system, enjoys many of the advantages of such a system. The number of responsible managers of the banks is small and consultations can easily be had. The banks — as said — are all substantial in size, and 198 NO BEANCH BANKS IN THE UNITED STATES the degree of cooperation among them is high, even in those par- ticulars that are not subject to legal regulation. Under the law, they are required to cooperate absolutely in safeguarding their notes, and they have always succeeded in protecting them fully. On the other hand, a measure of competition is assured by the pos- sibility of chartering new banks, each with the issue function, at any time when applicants with sufiBcient capital in their possession present themselves. Moreover, the keenest of competition in serv- ing the public is secured through the operation of the branch system. Thus, although access to the Canadian banking system is not a mere routine matter, as it practically is in the United States, there is an approach to free banking at the same time that there is pre- served a very substantial part of the advantages of central banking. §5. The United States affords probably the best example of a competitive or free banking system. In the effort to assure per- fectly unhampered access to the system, admission has been made Our general, the law providing for the granting of charters through a Banking' merely routine or administrative act on the part of the Comptroller System of the Currency in Washington. In order to prevent the pressure omp tive jjj competition from being applied by large institutions to small ones, the law has practically prohibited the establishment of branches, while interpretations of the act by the Supreme Court have rendered it illegal for one bank to control the stock of an- other.' Altogether the idea of individualism and separation in banking has been developed here as far as law could bring it about. The good features of this system have been so fully realized that it is probable that its fundamental features may be regarded as firmly fixed. There is no probability that free access to the business of banking will be denied under any legislation. At present there seems to be little chance that the establishment of branches will be permitted. This means that there will be a permanent retention of conditions in which many very small banks must exist in order to meet the needs of the communities they serve, and in which there will be no" direct control by one institution, or group of institutions, over another. The maintenance of such conditions necessarily involves some rather serious suffering. Among the difficulties which have been 'See California National Bank vs. Kennedy, 167 U. S. 362; also First National Bank of Concord vs. Hawkins, 124 _U. S. 364. NATIONAL BANK EESEEVBS 199 found to be characteristic of the national system, are those of wide diffusion of reserves, extravagance in the use of banking resources, lack of cooperation, inability to finance large operations with ease, lack of control over the exportation and importation of specie and Defect* Qumerous others. Yet it is probable that all of these defects would be endured if it were true that competition and independence had been maintained contemporaneously with them, or that it could not be had without them. Neither of these suppositions holds good ; for today a high degree of banking centralization has, unknown to the community, been produced ; while an easy means of escape from it and from the evils incident to the present system is undoubtedly available. The truth about existing conditions in the banking sys- tem of the United States and the actual degree of centralisation that has been attained can be best understood from a survey of the pres- ent relations between banks. How this system operates to put the funds out of the control of their owners is seen by a survey of the actual distribution of reserves at the present moment. §6. The following figures show the reserves of country national banks (1883-1910) classified as lawful money held, due from reserve agents (held by other banks on deposit), redemption fund (held by the Treasury). Classifloation of Reserve Number of Lawful Due from Redemption Total banks money agents fund amount Date MiUions Millions Millions Millions Distribution Oct. 8,1883. ...2,253 $61.0 $84.1 $11.3 $157.5 of Reserves Sept. 30, 1884. ...2,417 66.1 79.7 10.5 156.3 Oct. 1,1885. . . .2,467 71.4 95.9 10.2 177.5 Oct. 7,1886. ...2,590 77.9 99.5 8.7 186.2 Oct. 5,1887. ...2,756 83.4 100.9 6.6 190.9 Oct. 4,1888. ...2,847 84.7 119.0 6.2 209.8 Sept. 30, 1889 . ...2,992 86.7 132.4 5.5 224.6 Oct. 3,1890. ...3,207 92.0 128.5 5.2 225.5 Sept. 25, 1891 . ...3,333 97.1 133.0 5.4 235.5 Sept. 30,1892. ...3,430 105.5 163.5 5.8 274.8 Oct. 3,1893. ...3,434 117.1 106.9 6.6 230.6 Oct. 2, 1894. ...3,411 106.8 161.6 6.5 274.9 Sept. 28,1895. ...3,365 102.3 147.7 6.6 256.6 Oct. 6,1896. ...3,329 119.0 125.0 7.2 251.3 Oct. 5,1897. ...3,276 111.7 192.5 7.2 311.4 200 PEACTICE OF EEDEPOSITINQ Classification of Reserve Number of Lawful Due from Redemption Total banks money agents fund amount Date Millions Millions Millions Millions Sept. 20,1898., ...3,259 $116.4 $209.6 $7.1 $333.1 Sept. 7,1899., ...3,274 123.6 274.0 7.4 405.0 Sept. 5,1900., , . .3,540 122.0 282.9 9.4 414.3 Sept. 30,1901., ...3,885 130.4 288.1 10.4 429.0 Sept. 15,1902., ...4,268 134.7 150.7 10.2 295.6 Sept. 9,1903., ...4,691 150.8 155.8 11.8 318.4 Sept. 6,1904., ...5,065 150.9 163.8 13.1 327.8 Aug. 25,1905., ...5,412 164.2 181.9 14.5 360.6 Sept. 4,1906., ...5,781 177.5 204.7 16.2 398.4 Aug. 22,1907., ...6,178 199.6 226.7 17.2 443.5 Sept. 23,1908., ...6,482 215.8 220.1 19.1 455.1 Sept. 1,1909., ...6,595 219.7 241.5 20.6 481.9 Sept. 1,1910. ...6,791 229.8 258.3 21.1 509.3 Dec. 5,1911.. ,..6,949 246.3 283.1 22.3 551.7 Redeposits In Other National Banks In State Bank* The showing indicates the extent to which the country banks have placed their resources at the disposal of others. In 1911 much less than one-half ($246.3 millions) the total reserve ($551.7 mil- lions) was in the actual possession of the country banks. But the practice of redepositing bank funds has been carried much beyond the limits of the reserve system. In the following table is reviewed the growth of the items "due to national banks," and "due to state and private banks" during the years since 1875. The figures are given by five-year periods down to the year 1900 and once a year thereafter, the date chosen being the earliest report date in each year. From this compilation it can be seen that, while the growth in the items has been irregular, the tendency has been strongly upward. For the report of January 31, 1910, the figures show $962,000,000 against $137,000,000 in 1875. For 1900 (Feb- ruary 13), the figure was $536,000,000. The item "due to state and private banks" does not show the same steady growth, but fluctuates considerably, though it is now largely in advance of the figures for 1900. One reason why this latter item has not grown more rapidly may be the large development of the trust company system and the increase of deposits in national banks carried in favor of these institutions. Taken in the aggregate, the items "due to banks" have grown much faster than the capitalization of the na- tional Bystem. POWEE OF CITY BANKS 301 Bank Deposits In National Banks Due to Due to State and National Banks Private Banks Date Millions Millions Mar. 1, ISI-S ,...$137 $ 55 Feb. 21, 1880 170 65 Mar. 10, 1885 , 205 82 Feb. 28, 1890 297 137 Feb. 28, 1894 343 173 Feb. 13, 1900 536 318 • Feb. 13, 1900 518 318 Feb. 5, 1901 655 273 Feb. 25, 1902 685 311 Feb. 6, 1903 673 298 Jan. 22, 1904 692 293 Jan. 11, 1905 753 312 Jan. 39, 1906 825 364 Jan. 36, 1907 900 396 Feb. 14, 1908 807 364 Feb. 5, 1909 1030 457 Jan. 31, 1910 962 489 Dec. 5, 1911 :.. 1011 532 The effect of the redeposit system has been to give to the city banks actual control over the fluid funds of the country in very large measure. Naturally this control has centered in New York City. The outcome has been that, without the necessity of con- Central Iza- , tion of trolling the stock of country institutions, large city banks have Reserves In through the redeposit system been able to exert the practical con- New York trol of which so much is now heard. The following ta.bulation shows the growth of the system in New York City, since 1890 : Bank Deposits In New York Due to Due to State and National Banks Private Banks Date Millions Millions Feb. 28, 1890 $123 $ 48 Mar. 5, 1895 137 63 Feb. 13, 1900 328 108 Feb. 5, 1901 2'85 76 Feb. 35, 1903 380 78 Feb. 6, 1903 367 73 Jan. 22, 1904 269 72 Jan. 11, 1905 290 83 Jan. 29, 1906 385 88 Jan. 26, 1907 309 84 Feb. 14, 1908 275 71 Feb. 5, 1909 364 94 Jan. 31, 1910 305 100 Dec. 5, 1911 326 106 203 METHODS OF SMALL BANKS state Banks Deposit in National Banlould be classified into three classes, and the terms of oflBce of these three classes would be respectively, one, two, and three years. Thereafter, members of the board would be elected for a term of three years. No member of any national or state legislative body would Restric- tions on Board Member- ship 230 QUESTION OF MANAGEMENT be a director of the National Eeserve Association, nor of any of the branches, nor of any local association. The directors of the National Eeserve Association would an- nually elect from their number an executive committee and such other committees as the by-laws of the National Eeserve Associa- tion might provide. The executive committee would consist of nine members, of whom the Governor of the National Eeserve Asso- ciation would be ex-officio chairman and the Secretary of the Treas- ury and the Comptroller of the Currency, ex-officio members; but not more than one of the elected members would be chosen from any one district. The power of the Executive Committee would be limited to the execution of the general policy of action determined by the whole board of directors. There would be a board of examination elected by the board of directors, from persons outside the banking profession, of which the Secretary of the Treasury would be ex-officio chairman. Real Con- This selection, it should be dear, places the institution *uocal"Asso- in the hands of men chosen by the several branch oflSces and elations of repfesentatives of the Federal Government. The real control, therefore, goes back in the last analysis to the local associations of banks since these are the agencies for choosing the directorates of the branch offices. If the operations of the local associations have been sufficiently safeguarded, the general management of the Eeserve Association, as a whole, is adequately protected. For the reasons which were stated in connection with the discussion of these local associations of banks, therefore, it is believed that provision has been made in this tentative plan for keeping the fundamental units in the scheme of federated management — ^the local association of banks — free of any possible influence originating with selfish or ambitious financiers who might seek to divert bank funds to their own purposes. The question how the Eeserve Association would be managed and directed, is, of course, fundamental. If it were to be managed in such a way as to allow special influence or recognition to certain banks, or groups of banks, the situation would be dangerous. But it is possible to throw safeguards arpund the enterprise by methods that will not only prevent the development of undue control or influence by large banks and speculative interests, but will largely destroy the influence exerted by such institutions upon the financial system of the country at the present time. As has been seen, POSSIBLE DOMINATION OF DIKECTOKATBS 231 Reserve Association Must be Safe- guarded the tendency to ceLtralization of control which exists today among the banks is partly a product of united ownership of stock, either in whoLe or in part, by the same controlling interests. It 1» feared by some that imder such a system as has been proposed, Manage- the National Eeserve Association could be dominated by groups of the of financiers who already have or would acquire large holdings in existing national banks. If, for example, a group of financial interests had a dominating influence in a chain of banks stretch- ing through the various districts into which the country would be divided under the National Eeserve Association plan, might not the interests in question bring about a concert of action in their favor throughout the various districts and at the various branch offices of the National Eeserve Association? Or if the principal banks of a given city, such as New York, were in large measure controlled by a common financial interest, might not there be a development of practical control over that particular branch office? If such were to be the case, the conditions which already exist in some measure under present methods of banking, would be produced, and perhaps exaggerated. If there were no suitable safeguards upon the methods of voting stock, such a growth of control might reasonably be feared, although it would be far from being the most serious danger to be met. §5. It is fitting that the question how this proposed system would be controlled should be carefully considered. For the reasons already stated, many bankers and borrowers are fearful lest a new system of legislation should throw them still more into the hands of outsiders, who might use their power for selfish ends. In con- sidering the extent to which the proposed new plan would be sub- ject to danger of this kind, it is well to understand clearly what is meant by "controlling" an institution. The most obvious form of such control would be seen in ar- rangements that might lead to domination in the choice of directors or other governing factors in the new National Eeserve Associa- tion. If the new iastitution were so shaped that certain very lim- ited financial interests might exert an undue influence in the selec- tion of a majority of the directors, the result would be to enable them to dictate to the new institution. They could put their own men in charge of its affairs, and these men would presumably be guided by the welfare of the persons who had placed them in con- trol. What \s Meant by "Control" 238 SECTIONAL CONTEOL Sectional Control Also a Danger to be Considered Possibility of Political Control A type of control which might exist, apart from the direct personal influence already sketched, would be seen in the possi- bility of geographieal or sectional control. Directors might be chosen in such a way as to permit them to form groups among themselyesj whereby one part of the country would be more power- ful than other parts, and would thus be able to direct the policy of the new institution into channels that would forward its own interest as opposed to those of the country as a whole, or of other communities which were competing with those that were most strongly placed in the Board of Directors. More subtle than either of these types of control over the directorate would be a condition, or situation, in which the new institution practically dominated the banks by refusing them discounts or accommodation at its pleasure. If such a condition should be established that certain large banks, even though not very strongly represented in the directorate, were able to get better treatment from the Eessrve Asso- ciation than others, or in any way to influence or direct its policy, the influential character of their position would speedily have its effect in coercing smaller institutions. The smaller banks would see that by deferring to the wishes of the larger institutions they might secure for themselves a friend whose good offices with the National Reserve Association would be very valuable, or who could be used as an intermediary for the purpose of getting rediscounts and doing business which might be rejected, if application were made to the National Reserve Aflsociation simply on the merits of the paper as such. Apart from these types of control, it is worth while also to mention the possibility of political control due to the development of a considerable body of directors chosen under political influences or amenable to political considerations. All of these types of con- trol over banking institutions may either be observed at the present time in the United States, or are found exemplified in its banking history. The question how far any new institution would be af- fected by considerations of the same sort is, therefore, a thoroughly practical and reasonable one. The different types of control thus possibly to be exerted may be taken up in their order, beginning with the most elementary form— that of direct intervention in the ^ choice of the personnel of the new institution. §6. As has been seen at an earlier point, the small banks pre- ponderate in the United States. This is true of every part of the CONTKOL BY PUECHASE 233 country. More than 60 per cent of the banks have capitals below $100,000, and more than 90 per cent below $350,000. On the sur- face, then, the power of electing directors, both to the local asso- ciation of banks, to the branches of the National Eeserve Associa- Ban^g tion, and ultimately to the Eeserve Association itself, would un- Are in the deniably and conspicuously rest in the hands of the smaller institu- tions. The unit system of voting already described, and the com- paratively small number of directors in local -associations who would be chosen on a voting basis proportioned to stock ownership in the National Eeserve Association, would give a very great pre- ponderance to the small banks. But this condition would hold true only if the small banks were absolutely independent of one an- other and of the large banks. How far, then, would it be possible for large banks to control the smaller institutions, and through them the National Eeserve Association? How far could outside capitalists do the same thing? Assuming that there were no legal restrictions upon the holdings of bank stocks by another bank, so that it was in this respect upon the same footing as a corporation or individual, it is clear that in order to be able to dictate the action of small banks under the system of unit voting already described, it would be necessary for the bank, corporation or capi- talist, aiming at such control to obtain a majority of bank votes. Let it be supposed that a syndicate should undertake to get why control of the N. E. A. It is proper to inquire how easy or difii- Control cult the undertaking would be from^he point of view of cost alone, smaii It will be readily seen that such control could only be had through Banks the vote of eight of the fifteen branch directories. To secure this to be it must be necessary to control the majority votes of one more than Feared half of the local associations in each of these eight districts. This could be done either by securing the unit votes of over half the banks in a local association, that is, by controlling a large number of small banks, or by securing the stock vote — amounting to two-fifths the whole — ^plus enough unit votes to carry fifty-one per cent of the votes cast in electing a branch board. The presumption is that any such syndicate would choose the former course as requiring the less outlay of capital. At least three solutions of this problem have been attempted, each writer using different conditions and assumptions. The first of these calculations starts with the syndicate as an outside party com- pelled to buy in at every point. Assuming that the necessary bank 334 CALCULATIONS OF THE COST stocks could be had at $300 per share — ayerage book value is a lit- tle more than that— the cost would be $856,485,174, Another calculation supposes a syndicate to be formed among banks already existing and controlling at the outset all banks in all the forty-two cities of 100,000 population. Assuming no expendi- ture necessary for control of the banks in these 42 cities, it would still be necessary to buy or to organize anew 7,000 banks, properly $175,000,000 distributed; and at $25,000 each this could be done by the outlav as an In [- •' tiai Outlay of $175,000,000. But, of course, the final sum required would be larger than this. A third calculation is based on the distribution of branches as proposed by the bill of the Monetary Commission, as follows : ISTew England— 1 Eastern States— 2 South— 4 Middle "West— 4 Par West— 4 Granting the extreme case that the three branches in New England and the Eastern States were already in combination, it would be necessary to secure control of five branches in the South, Middle West, or Far West. From the best information available, it appears that the four branches in the South would involve 4,689 banks with capital and surplus of $372,700,000; four in Middle West, 5,655 banks with capital and surplus of $314,800,000; four in the Far West, 5,334 banks, with a capital and surplus of $314,- 800,000. Assuming no opposition from public opinion, the most eco- nomical course would be to purchase the four districts of the South and one in the Far West. Supposing the stock of the banks could be had for its book value, the purchase of one-half the southern banks outright would cost $186,000,000 ; but a controlling interest (51 per cent) could be had for $95,000,000, because -it would be necessary to have only 51 per cent of the stock of one-half the banks to be controlled. Add to this the cost of control in one branch from the Far West computed in the same manner and we get a total of $114,790,000. But the book value of Southern banks averages approximately $80,000 per bank. By purchasing one of these and dividing its capital for the purpose of increasing the number of unit votes to be controlled by the syndicate, three new banks cotdd be established with a capital of $25,000 each with a balance of $5,000 to spare. By buying 1,125 banks, 3,580 new ones could be created out of them. When the original number of 4,689 is reduced by the number A Theo- retical and Fanciful Calculation THE QUESTION OF PrBLIC OPINION 235 bought, 3,580 would constitute a majority and give a controlling voice in the four branches. This operation on the basis of a 61 per cent stock control would cost but $46,000,000. To secure the fifth branch by a similar method in the Far West, where the book value is $60,000, would require the control of only 400 banks and 51 per cent would cost $13,240,000; or a grand total for the five districts of $58,240,000. Supposing that the old banks could not be bought economically, control might be secured by the institution of new ones with the minimum capital of $25,000 each. To control four branches in the South, 4,690 banks would be required, costing $117,250,000. On [^"JJ'Pg'as the basis of 51 per cent control, the cost would be $59,797,500. Favorable Adding the cost of one branch in the Par West computed on the ^f^^f'°^' same basis, the e.ntire cost of control would be $76,797,000. This computation is as favorable as it can be made to the possibility of control; although, as will be shown, there could be no motive for acquiring control. Such a computation is wholly theoretical, and takes no account of public opinion, the unwillingness of banks to give up their inde- pendence, and the great improbability that directors and local busi- ness men would allow the banks to put their borrowers in a posi- tion where loans could be dictated by a controlling syndicate. The improbability is so great that this computation — ^making it as ex- treme as the case would allow — cannot be taken seriously. More- over, it assumes that bankers as a class have no honor, no inde- pendence, no regard for the business conditions of the country, and are responsive only to the desire for gain; when, in truth, they have the same average qualities as other large classes of the com- munity. §7. One method of controlling the stock of a large number of banks which has been considered by some of those who are afraid of ambitious financial influence in the National Eeserve Associa- tion is the formation of a holding company probably in connec- tion with some large national bank. The idea of such a company, it .j.^^ j . is supposed, would be that of acquiring the stocks of various banks of Control in order to exert a direct influence in their affairs. In those cases Ti^^SI'^'' ' rfoldfng where such stocks were owned to the extent of a majority of the Company shares of the banks to which they relate, the holding company would naturally be able to dictate the policy of the controlled in- Btitutions in harmony with that of the larger banks and, of course. 236 CONTEOL BY HOLDING COMPANY Present Affiliations of Ban 1(3 Why a Holding Company Scheme of Control Is Impracti- cable. could dictate the names, or, at all events, the action of the directors themselves. Where there was no majority, but merely a consider- able holding, large influence could be exerted. This would be en- tirely feasible, provided that substantial purchase and holding of stock could be brought about. The fear has a basis since, in some instances, companies of the kind indicated have already been or- ganized and have confessedly put forward as one of their objects the ownership and control of national bank stock. As already seen, at least 300 national banks have at the present time formed affiliations with trust companies or state banks. In these instances the stock of the national bank is held by the same persons who hold the stock of the state bank or trust company. As the stock of the two institutions thus allied is controlled by an identical body of stockholders, the actions of both will be har- monious. The state institutions can usually be employed, if desired, to purchase bank stocks which are then practically under control of the national bank. But whether the plan pursued be the estab- lishment of a holding company of the kind indicated, or a joint ownership of shares in a state and national institution, uniformity of action and policy is insured. In such cases, it is evident that to the extent of their stock holdings such concerns might be able to exert a more than proportionate influence in the affairs of the ITational Beserve Association. The question whether relationships of this kind are legal or not is still under adjudication and an adverse opinion has been rendered by Attorney-General "Wickersham. Even supposing that such relationships shall be upheld, however, the difficulties of ex- tending the control to any extent that would make the operation worth while would be impossible for the same reason which has been sketched in speaking of the possibility of direct ownership of the small banks by an individual or concern which might attempt this method of obtaining enough votes to place itself in a com- manding position. No holding company could, as a practical mat- ter of fact, acquire enough bank stock to give it a direct majority of votes in the Eeserve Association. As for gaining control of one of the branches of the Eeserve Association and thereby direct- ing the operations of that particular branch, the undertaking would be more reasonable, but still out of the question, for reasons that will be stated presently. The mere question of obtaining control of the majority of the stock of enough banks to give a majority, eitiier in the directorate of the Association itself, or any one of COST OF CONTROL IS PROHIBITIVE 337 its branches, would require so great an expenditure that it may fairly be considered impossible, simply as a problem in financial organization and in the acquirement of funds suflBcient to obtain the necessary bank stocks by direct purchase. It has, moreover, been suggested that corporations be forbidden to own national bank stock — a plan favored by Deputy Comptroller T. P. Kane. This would render holding company control of national banks impos- sible.^ §8. Discussions of such forms of control are largely academic, although it has been thought well to review them here for the pur- pose of citing every possibility of domination, no matter how re- mote. The fact remains that in practice an individual or a con- cern, even with unlimited capital, will be unable to get a majority of the stock in any such number of institutions as would enable him, or it, to carry out such a plan. Long before a majority of the stock in all of the banks of a small community can be acquired, the operations of one engaged in such a transaction would have at- A Simple Remedy for Possible Holding Company Control. 'OI the possibility of a, voting trust or trusteeship Mr. M. S. Wlldman rays: Let It be supposed that the stock of the subsidiary banks be Individually owned, but placed In trust, with power in the trustee to vote It in determin- ing the policies and directories of the particular banks. There Is no well- grounded objection to this, in so far as it concerns the Inside working- of the banks in question. However, there is serious objection to allowing a bank, whose stock Is so held, to exercise full voting-power in the Reserve Asso- ciation. The law should provide, therefore, that the voting-power of a bank shall be curtailed in the proportion In which its stock may be held in trust, whether the trustee be an Individual, a committee or a corporation. Trustee- ships for bank stocks are very common and desirable; cases of Individual insolvency, the settlement of estates, and the protection of wards, are among the circumstances which give rise to them. The question arises whether any substantial hardship would result from limiting the power of a banit whose stock Is so held, in voting for directors of the local association. The vote cast by a trustee is substantially a vote by proxy. Voting of proxies may not be objectionable in determining the policies of separate banks, but there is precedent for its prohibition when the public Interest is supposed to be involved. Of the twenty-five thousand shares of the First Bank of the United States, at one time no less than eighteen thousand were held by others than citizens of this country. According to law, none of these owners of shares could vote, either in person or by proxy, and the control of the institution actually rested with a small minority, holding less than a third of the stock. To this situation no serious objection was raised; and that there was no substantial hardship was proved by the fact that Euro- peans were anxious to buy the stock at prices far above par. Moreover, the principle of proxy-voting Is condemned in the plan now proposed, in the provision that each bank may vote only through its properly-designated offi- cers; and this provision is followed by the words, "There shaU be no proxies." No objection has been raised to this restriction. If the prohibition of proxies be no hardship, the restriction of the voting-power of any bank to the extent that Its stock Is not held by the equitable owner could certainly Involve no hardship of practical importance. 238 COMPETITION" AS A SAFEGUAED Goodwill of Banks Not Pur- chasable Publicity and a Free Banking System Are Safeguards. tracted the attention of the community. Usually, the attention of the local business public would be riveted upon the operation a long time before such control could be obtained of the shares of even one banking institution. It would be impossible jn practice to obtain this kind of stock ownership in very many institutions. Even if it could be obtained by some manipulation or sleight of hand, the fact would remain that the influence thus acquired was largely an empty shell. One who buys a bank under a free banking system gets noth- ing but the bank's assets; he does not purchase the good will of the banks unless the customers are willing to continue it. Other banks can be organized without difficulty and would be thus or- ganized. The persons who acquired control of the stocks of the different banks would be obliged to pay for them and they would thus provide the old shareholders with the means of reopening com- peting institutions. Such a bank "trust" as has been described might find itself met at every point by as many new institutions as it got control of; Local communities would not be willing to sec their credit entirely in the hands of outside interests any more than they are at the present time. They would transfer their business to other institutions. The only condition under which such a pos- sibility could be seriously considered would be one in which the number of banks in a community or in the coun- try was limited, or in which the organization of the banks was made dependent upon the granting of a special charter. Neither of these conditions can or does exist in the United States today nor is it likely ever to exist. At present, both the Federal Government and all of the states grant bank charters under special laws which allow perfectly free organization of institutions. The National Eeserve plan provides that banks organized under state laws shall be allowed to participate in the National Eeserve Association upon equal terms with the members of the national system. Nothing is more wildly improbable than that the national and all of the state governments should jointly abolish the free banking system and limit the number of institutions to those which now exist, or even render access to the systems more difficult than it is at the present time. Considering, then, the difficulty of acquiring the control of even one institution and the infinitely increased difficulty of ob- taining control of all those in a given community or of a large number scattered through different communities, and taking this in conjunction with the fact that the purchase of bank stock would A BAXKBFS VIEW 239 supply the means for competitive banking, it must fairly be con- ceded that the fears expressed on this score are entirely chimerical. There is no possibility of the development of any such type of con- trol of the directorates of the different institutions. Neither the unit control of different banks nor the acquirement of sufficient shares by a holding company with or without a national bank affilia- tion would attain the object sought. The difficulties in the way gf the purchases of such bank stock as are here referred to have been set forth by a banker of interna- tional prominence, who has discussed the estimate of cost of control already given above from a critical standpoint. He says that "if one succeeded in acquiring one bank in a city without creating comment, A Banker's one would be doing well, but to try to do this with more than half such a of the banJcs of that city would create such a stir that it could not Possibility. possibly be done secretly. If, in addition, a bank of the city having a capital of $50,000 should see that sum reduced for no plausible reason whatever — it being presumed that the capital would not have been raised to $50,000 unless the bank required that amount for its standing and its business — and if the only excuse for such action which could be given to the astonished directors would be that it was being done wholesale all over the coiintry, so that the 'ring* might control the situation, it is easy to perceive the indignation that would be aroused and how very welcome a means of advertising would be given to those banks that had remained independent. To acquire a bank against the will of its management and its directors is buying nothing but an empty shell. It is the easiest thing for the directors and the management to take out a new charter and to raise the new capital of $35,000 and to take with them all of the business and all the good will that the old bank commanded. Moreover, the ring would find it a pretty hard propo- sition to feed. 50 per cent of all the bants of a given community and make them valuable. It would be for this reason a very unprofit- able investment." §9. It is fair to ask whether, even if absolute control of the type described could not be attained, it would not be possible by a judicious acquisition of the stock of influential banks scattered here and there throughout the country to exert a strong general in- fluence in favor of a special "ticket" to be put up for election to the directorate of the National Reserve Association. This sugges- tion in its more general form must be put aside when it is ob- 240 LIMITATION ON VOTING POWBE The Question of Stock Influence. Possible Control of the Local Asso- ciations and a Remedy, served that the country is to be divided into 15 districts, in each of virhich a separate organization is to Ijc maintained. Ab many sets of directors as there are districts must be elected. Suppose, how- ever, that a bank limited its operations to the affairs of its own dis- trict — ^how far could it go? It would find in such a case that it must secure the election of directorates under its control in all of the local associations existing throughout the district since these would be the ultimate source from which the directors of the branches (one branch to a district) of the Niational Keserve As- sociation would be drawn. This would necessitate its scattering its efforts throughout the various local associations in a way that would be found impracticable for the same reasons that would obtain in the case of the institution as a whole. It may also be asked whether an institution might riot secure the control of the directorate of its own local association by obtain- ing the majority of the stock in enough of the institutions which were members of the Association to enable it to control a majority of the directorate. It should be frankly stated that such a situa- tion would be possible, even if not very probable. It could, how- ever, very readily be met by making the acquirement of stock of no service in electing directors. If it were provided that no institu- tion should vote in elections of the National Eeserve Association and its branches to an extent greater than was represented by the independent holders of shares by stockholders the whole difQculty of which so much is now made would be obviated. All possibilities of danger could be overcome by the adoption of a provision in the act allowing a person (or corporation) to select the bank in which he owns shares and wishes his shares to be counted, but reducing the voting power of any other bank in such proportion as the same person owns shares in such other bank.^ Such a provision would be very drastic, and should be resorted to only as an extreme meas- ure to remove the motive to the acquirement of control over stock 'The Wll of the Monetary Commission contains the following provision: "That In case forty per centum of the capital stock in any subscribing bank is owned directly or indirectly by any other subscribing bank, or In case forty per centum of the capital stock In each of two or more subscribing banks, being members of the same local association, is owned directly or indirectly by the same person, persons, copartnership, voluntary association, trustee, or corporation, then and in either of such cases, neither of such banks shall be entitled to vote separately, as a unit, or upon Its stock, except that such banks acting together, as one unit, shall be entitled to one vote, for the election of the board of directors of such local association. In no case shall voting by proxy be allowed. The authorized representative of a bank, as herein provided, shall be its president, vice-president, or cashier." CONTROL BY FAVOR 241 in a number of institutions, inasmuch as it would debar the hold- ers from obtaining any increase in their voting power at meetings of the National Reserve Association. It would not debar anyone from owning shares in more than one bank for profit, but it would debar such ownership from being used to control the association. There would be no reason for fearing, with such a provision of law, that any particular institution would succeed in exerting an undue power or influence over the operations of a branch of the Reserve Association. In the last analysis the question would be whether the banks themselves were able to maintain their own autonomy and thereby retain the management of the associations and of the branches of the National Reserve Association in their own hands. It would be easy to require the names of all stocldiolders in every bank own- ing shares in the National Reserve Association to be filed with thfe National Reserve Association head office or possibly with the Comp- troller of the Currency. By prohibiting any bank from casting a full vote in elections for directors of the local associations or of the branches, provided any of their stock were controlled by other banks or by stockholders in other banks, it would be practicable to elimin- ate this kind of joint influence. Inasmuch as, in that case, only those banks would be full voting units whose stock control was dissociated from that of other banks, the exercise of any cen- tral iafluence over the National Reserve Association would be practically precluded and it would be impossible for any individual, or corporation, no matter how much bank stock he or it might buy, to acquire more than a voting power baeed upon its maximum share ownership in a single institution. The fear of control of the local associations or of the branches of the National Reserve Association would thus be absolutely removed. There would be far less danger of such control than there is today of the joint control of groups of banks. The possibility that the local units would be used in the interest of some financial power would be out of the question. §10. There are other methods than those of stock ownership possrble by which banks are today controlled by other banks. One of these Control is the distribution of special favors. A large institution, for ex- pavor and ample, has planned to underwrite certain bonds. It apportions Hope of these bonds among a certain number of other institutions, and when the securities are sold and expenses paid the profits are dis- tributed in accordance with the original assignments of securities. Profits. 342 -EXTENT OF INFLUENCE BY FAVOR Smair Banks and Public Sentiment as Factors of Safety. Thus a clear gain accrues to the banks which have originally been designated as recipients of these favors. The knowledge that a large bank has it in its power to distribute profitable opportunities in this way is of course a strong inducement in every case to the small bank to observe the wishes of the larger institution so far as it can. Influ- ence of this kind rarely extends to the country banks, but it is ex- erted by the institutions of high capitalization situated in financial centers over banks in the same city or in other reserve cities. In return it is of course expected that the banks thus given considera- tion will exert themselves to serve the interest of the larger bank. If they do so by directing deposits toward it, and otherwise facilitat- ing its operations, the obligation is cancelled. Why might not a similar kind of influence be exerted by such large institutions over other banks in order to induce them to cast their votes in the Na- tional Reserve Association for some indicated candidate or candi- dates who are acceptable to the larger institution? There is under existing conditions nothing to prevent such influence from being exercised nor is there anything in the pro- posed plan that would do so. Whether such influences would ex- tend very far must, however, be considered seriously open to ques- tion. It is highly improbable that many banks could be brought to terms in this wa]^. In every business organization, as in all po- litical or governmental organizations, there will usually be a pos- sibility of irregular work. No system can be devised which will make every citizen upright, and in the same way, no system can be devised that will compel every bank to be disinterested or to main- tain its own individuality if it does not so choose. The fact re- mains that the great majority of banks neither could be thus con- trolled nor would they allow themselves to fall under influence of this kind. Public opinion would be too strongly against it in those few places where such possibilities were open, and in others, the danger, as already noted, would be practically non-existent. In the aggregate the smaller banks, not subject to such control and voting as units, would be able to direct matters. But all this would be of no service if there remained condi- tions that would continue the present system of inter-bank control in full force and would compel the smaller institutions to rely or depend upon the larger. If there were such conditions under the new system, the introduction of elaborately devised machinery would not correct the evils complained of. It would be impossible to con- trol directorates in such a way as to eliminate the chance of undue SECTIONAL EIVALEIBS 343 influence by large banks if it remained true that rediscounts were to be granted as a matter of favor. In order to abolish the exist- ing tendency toward undue control and to provide an adequate safe- guard against the extension or renewal of it under the new system, it is necessary to make such provision as will guarantee the banks against any necessity of depending upon others and will assure them absolute equality of treatment at the hands of the National Eeserve Association or its branches when they apply for it. This ia what the plan provides for. §11. While it is an easy matter to prevent the domination of the Eeserve Association by any control of capital stock by any insti- tution or group of institutions, the question is frequently asked whether a certain geographical control over a National Eeserve Association might not be exerted. Not a few persons have feared that the distribution of capitalization among the banks of the country would be such as to ensure a controlling power to the '•'east" or to some other section. This, of course, assumes that one section of the country has banking interests that are opposed to those of other sections. Nothing of the kind is true save in so far as there may be speculative centers which afford a greater demand for funds than would come from ordinary commercial sources. It should be borne in mind in this connection that "speculation" is not local or confined to any part of the country. Active real estate speculation exists nearly everywhere. It has been particularly note- worthy in the middle western and western states of late years and has at times imposed a very serious strain on the banks which were called upon to provide the resources with which to carry it on. On the other hand, speculation on the exchanges is not confined to New York or the Eastern states. There is as active speculation on the Chicago Board of Trade as there is on the Eastern stock exchanges. The problem of keeping the funds of the public out of the hands of speculators is one that must be settled by the bankers in their capacity as such, and not by the establishment of govern- mental machinery for the purpose. But the National Eeserve As- sociation would at all events afford no special or peculiar facilities whereby banks in any one seption of the country would be able to control or outvote those representing any other section. As has been stated, the real operations of the proposed re- serve association would be transacted at the branch offices, each of which would work in close conjunction with local associations of Geograph- ical Control and Sectional Opposition. Keeping Funds Away From Speculators Is a Banking Problem, Not One of Law. 244 SECTIONAL BANK CAPITALIZATION banks. There need be nothing to warrant the belief that such local associations would be influenced by anything except the interests of those who composed them. It would be of far more importance, then, to see that the local associations of banks were kept free of any improper influence than to attempt to safeguard the geographi- cal control of the National Reserve Association. Figures for the capitalization of banks do not warrant the belief that there is any given section of the country which is superior in its banking power No Section to any other. The traditional classification of states as New Eng- P°"j''"3nt land. Eastern, Middle, Western, Pacific, etc., shows the following Power. arrangement of bank capitalization for the national system : % New England States $98,451,950 9 Eastern States 338,508,154 33 Southern States 159,927,430 16 Middle Western States 276,673,100 27 Western States 69,880,100 7 Pacific States 87,290,650 8 For all banks the arrangement is as follows : New England States '. $138,499,518 8 Eastern States 581,370,131 33 Southern States 297,137,727 16 Middle Western States 509,622,221 28 Western States 118,075,127 7 Pacific States 149,279,601 8 Then, if New England, which has 8 per cent of the banking capital of the country, had one branch ; the Eastern States, with 33 per cent, had two branches ; the Southern States, with 16 per cent, had four branches; the Middle Western States, with 27 per cent, had four branches ; and the Western and Pacific States, with 15 per cent, had four branches, certainly the West and South would easily outvote the East — especially the New York district. Even if it be assumed that the states west of the Mississippi have interests of a banking kind different from those east of that line, and that in meetings of the National Eeserve Association, or some similar institution where voting power was based on bank capital, there would be a direct voting opposition between them, it is clear that there would still be enough voting power, even in the western states, to make any action that might be deemed obnoxious to the interests of the west practically impossible. The National Eeserve Association plan would provide for a strong representa- tion of the government on the controlling board of the organiza- tion. This in itself would make possible the turning of any given Interests BANKS INTEEESTED IN EACH OTHEE'S SUCCESS 246 decision one way or the other according as the equities of the case might demand. No administration could afford to take obviously inequitable action, distasteful to any large portion of the country since it would speedily be rebuked at the polls and its successoi* would feel the necessity of rectifying the mistakes that had been made by forcing an undesired policy upon the country. Sectional action would work in the same way to safeguard the National Ee- serve Association. Finally, it is entirely possible to provide that not more than a given number of directors in the National reserve board shall be drawn from any given area or section. §12. It cannot be too strongly emphasized that there is no unity of such opposition of banking interests as is suggested by the point of Banking view of sectional jealousy or opposition. Every part of the coun- try is interested in the banking success of every other part. A com- plete identity of interest exists. New York banks and foreign in- stitutions join in furnishing the capital needed to move the cotton crop and they perform the same service so far as necessary in bring- ing the western cereal and other crops to market and in assisting to finance the movement of manufactured goods generally. There is no ground for supposing that they have any interest opposed to the welfare of bankers in other parts of the country. It is, of course, a constant matter of competition between different groups of tankers to secure as much of the good paper offering in the com- munity as they themselves can carry. They do not care to see this paper, when profitable, taken up by outside institutions. Yet the interests of such banks are entirely identical from the banking standpoint. From the standpoint of profitmaking they are opposed, as are the interests of any competitors. The question of equality of opportunity among such competitors, and not an imaginary con- flict of interest between sections of the country, is the real prob- lem to be met in connection with the control of the National Ee- serve Association. This is the issue which is dealt with in those portions of the plan relating to the organization of local associa- tions. How these associations will be organized and how they would operate in conjunction with the branch ofBces of the Eeserve Association is the real and fundamental problem of the whole question of organization of banking under the new plan. §13. It is as important to keep the business of banking free from political control as it is from that of ambitious financial in- ,246 POLITICAL CONTROL Political Control and tiie Evil It Would Work. How Danger of Political Control is Guardad Against. fluences which might use the funds of the institution for their own ends. Political control or undue influence in any banking institu- tion implies two distinct evils: (1) the appointment of directory or ofiBcers under conditions such as make their tenure of office de- pendent upon changes in party supremacy and (2) the extensions of loans to persons belonging to or affiliated with the dominant po- litical party and hence likely to exert some influence in the affairs of the government as affecting the bank granting the favors. In some cases this political influence in the making of loans may go so far as to bring about the extension of accommodation for the direct purpose of assuring the retention of given persons in office. Of course it is obvious that neither of these conditions ought to be allowed to exist. The choice of directors in a manner that makes their tenure dependent upon political changes implies a shifting , 'control of the institution which is undesirable from every stand- point. Nothing is more important in the management of any com- mercial institution than strength and continuity of policy. Neither of these qualities can be expected from persons who are subject to removal or appointment not on the strength of merit but upon that of party affiliation or prejudice. On the other hand, the mak- ing of loans in such a way as to placate politicians necessarily means rottenness in banking management and is, if anything, more to be feared than the making of loans in a way that would placate financial interests. The latter are likely to give security for the loans, in which case the thing chiefly to be feared is the diversion of funds from more important to the less desirable objects; while the ordinary type of political loan is likely to be made on inade- quate security, the "influence" of the person who seeks the "ac- commodation serving to insure the acceptance of security that would not otherwise be considered as bankable. These evils of political control are not imaginary, but were more or less exemplified in the history of the first and second banks of the United States, particularly in that of the second bank. They are likely to appear in any institution which is largely controlled by a board of directors whose majority consists of government ap- pointees. For this reason the National Eeserve Association plan seeks to guard against tiie introduction of a political type of con- trol of the institution by providing for the appointment of four directors only out of 46 in all at the instance of the President. Even these would not be directly named by him inasmuch as they would be the regular officers of the government — ^the Secretary of the GOVERNMENT'S EEPEESENTATION 247 Treasary, Comptroller of the Currency, etc. With this small num- ber of representatives standing for the government it could never be feared that they would exert a controlling voice in the manage- ment of the affairs of the institution, since they would he so largely outnumbered by the directors chosen in the several districts into which the country would be divided for specified terms of years. The question may be asked why there should he any political or governmental appointees whatever upon the board of directors. Several reasons exist for giving the government this kind of repre- sentation. The proposed institution is to be the holder of the funda of the government and would perform important functions grow- ing out of this holding of funds. There is therefore the same rea- Q*v*°n^en''t son why the government should be represented upon the directo- Representa- rate as there is for the representation of any other interest. The *^°^f]Pg^^ Reserve Association is to be a great public institution, not organ- Directors, ized primarily for profit, and exerting a powerful infiuence in the banking system of the country. Thus every reason exists for gov- ernmental oversight and examination, and for that more intimate knowledge of policy which could be obtained only by having direct representation in the directorate. This would be attained by the choice of the officials already indicated as members of the board of directors and by the free use of a policy of publicity. Some public men who have recently discussed the question of control of the Eeserve Association have taken the view that it ought to be almost entirely managed by directors appointed by the Presi- dent and subject to confirmation by the Senate. This would be the extreme type of political control tested in the past and found want- ing for the reasons already stated. Others have gone to the oppo- site extreme by complaining of the presence of any representatives of the government upon the board. The proper course lies inter- mediate between these two radical views. It consists in giving to the representatives of the people a due voice and oversight of the affairs of the institution that they may be conducted with an eye to the general good, while refusing a dominating influence to such gov- ernmental ofiBcers. This is in order that there may be sufficient con< tinuity of policy, and that the controlling spirits in the organiza- tion may be chosen for their success and skill in banking rather than for the possession of those qualities which lead to political success. §14. What has thus far been said is entirely based upon the assumption that the control of the Reserve Association when ob- 248 MOTIVES FOE SEEKING CONTROL To What Uae Could Control of the Reserve Association Be Put7 Speculative Securities Not Recog- nized as Collateral. tained would be of such value as to induce banks to go to the most extreme length in their effort to secure it. It has been assumed that the holding of a position of leadership or authority in the National Eeserve Association would be of decided value and signifi- cance to the banks that succeeded in acquiring it. Is this the case ? Obviously, mere "control" is not wanted for its own sake. Capital- ists will not go to the trouble of manipulating votes, much less will they expend large sums of money, in order merely to obtain the prestige involved in the management of a Eeserve Association rep- resenting the combined banks of the country. If they were willing to undertake the work on a basis of mere public spirit or ambition and without any ulterior object, there might be no harm in allow- ing them to direct the management of the institution. But of course the supposition of those who are concerned about the control of the Eeserve Association is that those who are seeking it are doing so because they want to use the funds for some purpose of their own. This can only be (1) the making of loans upon security of a spe- cial type that would be in their possession more largely than in that of other banks, or else (3) the making of loans to them to the ex- clusion of loans to other persons. If either of these ends could be attained there would be a motive in attempting to acquire con- trol of the Eeserve Association. If neither of them could be at- tained, there would be no reason why any one should wish to obtain such control even though the attainment of it might be a com- paratively simple matter. What is feared by most persons who express a dread of ambi- tious financial control is that the funds of the Eeserve Association would be employed for the purpose of making loans on stocks or other speculative securities. The fundamental intention of the Ee- serve Association is to promote commercial banking. Only in specially guarded cases would the making of loans on collateral be permitted at all. On this point the provisions of the Eeserve Association plan would afford f uU protection by requiring that loans on collateral security could be made only when in the opinion of the governor of the National Reserve Asso- ciation, the public interests should so reauire, such opinion to be concurred in by the executive committee of the National Reserve Association and to have the definite approval of the Secretary of the Treasury. In such cases the National Reserve Association would be allowed through a branch to discount the direct obligation of a depositing bank, indorsed by its local association, provided that the indorsement of the local associa- tion should be fully secured by the pledge and deposit with it A DEFECT IN THE PEESENT SYSTEM 249 of satisfactory securities, wliich should be held by the local association for account of the National Reserve Association. In no such case should the amount loaned by the National Reserve Association exceed three-fourths of the actual value of the securities so pledged. In another way an institution such as has been described would render the idea of .central control more than ever remote from facts. At present small local banks, as has been explained, are subject to How Large control by reason of the fact that in times of stress or special de- Favor Small mand for funds they have to look to city banks for accommodation. ^"'|j ^"^.^ This accommodation is not usually extended in the form of a redis- count in this country. A- strong prejudice exists among the banks against making application to another bank for a rediscount. But the same object is attained in other vrays. Officers of the small bank secure personal loans from the larger institution and turn them over to their own bank for its use, the nature of the operation being perfectly well understood by the institution which grants the loan. Or the small bank may secure from the larger institution permis- sion to draw on it in excess of its credit. This practice gives rise frequently to large amounts of overdrafts upon which the small in- stitutions pay interest just as they would on, a straight loan prop- erly secured. It does not matter whether the extension of accom- modation in this way is technically called a "rediscount" or not. The fact that the small institutions have to come to the larger banks for aid remains and is the fundamental consideration. Under the present system by refusing to grant such accommodation the "larger institutions can practically direct the policy of the small ones under certain conditions, if they feel so disposed, while by favoring them under other conditions they are able to promote the develop- ment of certain kinds of business. This is obviously bad policy. Banks should feel assurance that if they extend accommodation to customers on live commercial paper growing out of legitimate transactions they wiU be able to dispose of it. They are not able to do so to-day. The only means of getting relief from this kind of control is found in the establishment of some system which will render it possible for banks to know with great deiiniteness what they can expect in the way of rediscount and how far they can safely go in extending credit to potential borrowers upon certain classes of se- curity. The advantage of a federation, or cooperative association, of banks of the kind referred to is that under it there would be this possibility of exact knowledge regarding the kind of credit that 250 EQUAL OPPORTUNITY FOR REDISCOUNT Limitations on Use of Other Securities Than Commercial Paper. could be obtained and the extent to which it could be had. Else- where, the methods by which discounts would be granted at the branches of the National Reserve Association have been fully de- scribed. At this point it is enough to say that under the proposed plan any subscribing bank would be allowed to apply to its local association for a guaranty of the commercial paper which it desired to rediscount at the branch of the National Reserve Association in its district, while it would be unlikely the ofBcers of an asso- ciation would refuse a rediscount to any bank when the collateral was beyond question, on the ground that the business of the sub- scribing bank was not important or for any similar reason. By limiting the total amount of the guarantees which a local associa- tion could make to the total aggregate surplus and capital of the banks forming the association, and by requiring that every bank should have on deposit with the National Reserve Association a specified and adequate percentage of the total credit granted to such bank by the association, the danger of over-loans would be met. It would be provided that loans might be granted direct to any shareholding bank in given classes of cases intended to cover all regular and non-speculative commercial operations. The plan of the Reserve Association in short contemplates that loans shall be made only under conditions that will give all institu- / tions a perfectly equal opportunity. That is to say, the Reserve As- sociation is to be called upon to discount all paper of a particularly described kind, no matter where it may originate or what bank may hold it. Its operations are to be absolutely dispassionate and non-partisan, as nearly automatic as the nature of the case will permit. All of the privileges and advantages of the National Reserve Association should be equitably and proportionately extended to every subscribing bank. Any such bank may obtain loans from the National Reserve Association in any of the four following ways : 1. Bediscounts not guaranteed. The National Reserve Asso- ciation may through a branch rediscount for and with the endorse- ment of any depositing bank, such notes- as the bank may have discounted for its customers, rediscounted for other banks, or pur- chased through commercial paper brokers, the proceeds of which have leen used for commercial, industrial, or agricultural purposes, and not for carrying stocks, honds, or other investment securities. Such notes and bills should have a maturity of not more than twenty-eight days, and should have been made at least thirty days THE REDISCOUNT EULES 251 prior to the date of rediscoimt. The amount so rediscounted should in no case exceed the capital of the bank applying for the redis- Functions count. The aggregate of such notes and bills bearing the signa- Reserve ture or endorsement of any one person, company, corporation, or Association firm, rediscounted for any one bank, should at no time exceed ten per cent of the capital and surplus of said bank. 2. Bediscounts guaranteed. The National Eeserve Associa- tion should also rediscount for any depositing bank similar notes and bills of exchange arising out of commercial transactions having more than twenty-eight days to run, but not exceeding four months, provided the paper has been guaranteed by the local association of which the bank asking for the rediscount is a member. 3. Direct loans to a lank. Whenever the public interests so require, the National Eeserve Association may, with the approval of the governor, the executive committee and the Secretary of the Treasury, discount the direct obligation of a depositing bank, in- dorsed by its local association, provided that the endorsement of the local association should be fully secured by the pledge and deposit with it of satisfactory securities, which should be held by the local association for the account of the National Eeserve Association; but in no such case should the amount loaned by the National Ee- serve Association exceed three-fourths of the actual value of ihe securities so pledged. 4. Acceptances. The National Eeserve Association may, whenever its own condition and the general financial conditions warrant such investment, purchase to a limited amount from a depositing bank acceptances of banks or houses of unquestioned financial responsibility. Such acceptances should arise from com- mercial transactions and have a maturity not exceeding ninety days, and should be of a character generally known in the market as prime bills. Such acceptances should also bear the endorsement of the depositing bank selling the same, which endorsement should be other than that of the acceptor. §15. If every bank, entitled by virtue of the fact that it is a stockholder to receive accommodation at the offices of the National Eeserve Association, shall be assured of such accommodation, and if every bank shall recognize that its only claim to such accommo- dation is to be the ownership of specified classes of paper presented for rediscounting, it will direct its efforts towwrd the acquirement of this hind of paper rather than toward the control of the Reserve 352 ASSOCIATION'S POWBE TO EEDISCOUNT Control of Other Banks Would Not Interest Bankers No Need of Striving for Control to Insure the Gaining of Rights Association. That is to say, its objects will be served by comply- ing with the rules which are enjoined upon all those who ought to receive accommodation rather than by attempting to exercise autho-- ity of a merely administrative kind. This means, in short, that the institution is to be placed upon a basis where the directors shall have absolutely no power to favor one bank or to engage in the lands of business that are feared. There remains only the question whether it might be worth while to be in control of the Eeserve Association in order to make sure that in the event of inability to rediscount beyond a certain sum those who were most influential should be able to get first chance at the accommodations. If it were true that the Eeserve Association could rediscount only a very moderate amount of paper such as is the case with many of the larger banks at the present day so that certain applicants for accommodation would necessarily be unsatis- fied there niight still be a sufiScient reason for securing a decisive influence in the management in the institution. There is, how- ever, no basis for any such assumption. Careful restrictions are imposed upon the classes of paper that are to be acceptable at ttie ofiices of the Eeserve Association; there are provisions for large note issues to be made by the institution; and with the ar- rangement regarding reserves which permits of their continuous reduction in order to meet necessities (provided that borrowers are willing to pay the additional cost entailed by an increased rate of discount, largely based upon the amount of the lowering^ of the reserve beyond a specified point), there would be no reason what- ever to fear that the Association would ever be unable to comply with all legitimate demands made upon it for the rediscounting of paper. Experience with clearing-house certificates in the past, as well as the experience of foreign banks, furnishes abundant evidence to show that there is small prospect of exhausting the credit-grant- ing powers of -the Association, or of pressing it close to the limit beyond which it cannot safely go in extending accommodation. If, therefore, the operations of the institution were restricted to certain classes of paper, if the discounting of such paper were made invari- able so that no favoritism could be allowed to creep in ; so that, in short, everj' bank would be assured of the same treatment as every other; and if, finally, the credit-affording powers of the institution within the limits set for it were practically limitless, the consequence would be that no object whatever could be served by obtaining the ASSOCIATION'S GBNEEAL POLICY 353 upper hand in its management. Violation of the statutes of the institution -would be a heavily-penalized offense and ofScers would be under the same supervisoiy authority that is today exerted by the government over the doings of the banking institutions through- Govern- out the national system. Supervls- It has been suggested that a motive for trying to gain con- "^Y Powers trol over the National Eeserve Association might exist in a desire sociation to favor concerns allied with dominant financial interests as against Officers other concerns who were their rivals probably in the same kind of business. Inasmuch as their paper would be commercial, and not secured by stock exchange collateral, here might be a situa- tion in which good commercial paper might be refused by Branch ofBcials at the behest of the great "interests," if they could gain control; thus, even if stock exchange collateral were unavailable, there might be a motive for gaining control. As to this suggestion there are several points to be considered : (1) The customer retains all his present relations with his bank unchanged. His bank, which wishes his account, retains its pres- ent relations with its correspondent bank, from which it can get rediscounts. If a customer is discriminated against, that implies that no bank wishes his account. (3) The real point at issue is, will the National Eeserve Association discriminate against any one subscribing bank which presents good commercial paper ? Will it be possible to refuse such good paper for the real purpose of driv- ing a rival out of business? This is a difficulty to some minds. The bank, of course, has the alternative of going either to its cor- respondent bank, as now, or to the Branch of the National Eeserve Association. The paper is passed upon by the executive officers of the Branch. These officers are governed by by-laws made by the Directors of the Branch, who are in turn the creatures of the local associations. The action of the branches in rediscounting must, therefore, be amenable to the opinion of the locality. (3) Ques- tions of general policy for the whole country, such as the total magnitude of loans made, reserves to be carried, the uniform rate of discount, and the like must be determined, of course, by the Board at Washington ; but the question as to what paper shall be accepted must be determined by the Branch, which is representa- tive if its region. There can obviously be no compulsory discount- ing ordained by law, any more than good weather can be required by law for the Fourth of July. In the main, reliance must be placed on the character of the management, as in all banking sys- 254 BBISrEFITS OP AX INDEPENDENT ASSOCIATION Safety Through Establish- ment of an Ample Market for Commercial Paper Why Large Banks Do Not Oppose Reserve Plan. terns. This character of the management can be obtained by the kind of directors chosen by local associations. §16. In studying the steps which must be taken in order to remove the conditions that give rise to present-day centralization of control in banking, the conclusion is inevitably reached that the most effective method of avoiding this type of control is that of furnishing an ample and satisfactory market for commercial paper. By this means banks would be assured full consideration of their necessities and could feel confident that they would be supplied ds occasion might demand. If assured of a permanent and reliable in- stitution at which to present their paper for rediscount, and with which to redeposit such reserve funds as they did not immediately need, they would cease to feel dependent upon the good will of large city institutions which must be placated in order to insure their aid in an emergency or financial stringency. On the other hand, if banks were supplied with an assured method of obtaining ex- change, they would be relieved of the necessity of relying upon a correspondent bank for that service. These and other necessities of similar character could be fully met by the establishment of a strong institution dealing only or primarily with banks, and in- tended to supply them with an absolutely fair and unbiased agency with which to transact their outside business, from which to get loans, and through which to transfer funds to other banks. They would not, with such an institution at hand, need to trouble them- selves about anything except the careful testing of the commercial paper presented to them, in the effort to make sure that the security was safe. All this is based upon the assumption that such an in- stitution, when established, would, as stated, be absolutely inde- pendent, free of partisan control, and under no subtle financial in- fluence which would lead it to prefer one bank or group of banks to another. §17. The question may arise — if the plan of the National Reserve Association would tend to divert idle funds from the central reserve cities, especially from New York ; reduce the amount which can be loaned at call on the stock exchange ; direct capital more or less away from speculative loans to the discount markets for legiti- mate commercial paper; and break up the present feudal depend- ence of smaller banks upon very large ones : Why do not the large banks in the central reserve cities oppose the plan with all their energy ? WHY LARGE BANKS DO NOT OPPOSE 255 No doubt on this question has ever arisen in the minds of any managers of large banks who have passed through crises like those of 1893 and 1907. In an emergency, or crisis, the large banking institution finds itself confronted with exactly the same sort of dif- ficulty, the same restrictions on its power to make new loans, the same inability to provide loans to old customers, as those which confront the small institution; only, it may be said that the diffi- culties, although of the same kind, are greater, harder to meet, and carry with them larger possibilities of disaster. For instance, a local bank in Missouri, or Kansas, may find itself "loaned up" to its limit, and yet in an emergency additional demands for loans from merchants and farmers are pressing hard. Its duty is to serve the local community ; but under the present inelasticity of credit the bank is bound hand and foot. If it fails to use good judgment, or to render aid to legitimate customers, it would cause failures throughout its constituency. Its only help is from its large cor- respondent bank, probably in St. Louis, Chicago, or New York. So far the facts are clear. Now, how is it with the large bank having hundreds or thou- sands of small correspondent banks looking to it for favors, or funds, in time of stress ? As these are scattered over a wide terri- tory, the accumulated demands from correspondent banks, when trouble comes, are something tremendous. The failure to respond to aid would, when trouble comes, break down a local bank and carry Lgpge with it all its customers. The same thing is true of a cen- Banks Have tral reserve city bank. That is, the large bank has exactly the xi"mes of" same kind of thing to meet as the small bank, only on a larger scale, stress. with immensely greater responsibilities. If the small bank, there- fore, would get relief out of a National Reserve Association, how much more would it be to the interest of the large bank to seek the establishment of such an agency. The common sense of the matter is, of course, that advantages from such a plan would inure to all banks, small or large. In a storm on a rocky coast, when two boats, one small and one large, are using all their seamanship to protect themselves from disaster, a shipwreck of the larger would carry distress to more families throughout the land than that of the smaller ship. The suffering of any one of ten persons on the small boat is, of course, as poignant as that of any one of a thou- sand on the big boat; but the full extent of the ruin caused by the latter is very much greater. That is, aids to safe navigation — lighthouses, buoys and charts — are quite as much to the interest of CHAPTEE XIV SMALL BANKS AND THE NATIONAL RESERVE ASSOCIATION 1. Small Banks as Members of National Reserve Association — 2. New Duties and Privileges— 3. No Rediscount Facilities Under Present System — 4. Economies — 5. Small Banks to Control National Re- serve Association — 6. The Chief Danger Now Confronting the Small Bank — 7. Many Problems of the Small Bank Would Be Solved — 8. Commercial Paper and How It Is Regarded — 9. Com- mercial and Investment Loans — 10. Small Banks Will Become Really Independent — 11. Divorced Prom Reserve City Banks. §1. The National Eeserve Association is proposed as a means of completing and perfecting the process of organization of our banking institutions which has been in progress at least since the establishment of our national banking system. It is designed to serve these institutions, not to compete with them ; to add something to what they already have, to increase their usefulness, not to take Small something away from them or to supplant them. Constituting as yf/" m* ^'^^ they do probably seventy-five per cent of the total number, small Concerned banks are vitally concerned in this project. The plan at present under consideration places before such a bank first of all the alternative of becoming a member of a National Eeserve Association or of remaining outside. Assuming that it de- cides to become a part of the organization, it would be required to subscribe for stock in the Association to the amount of twenty per cent of its capital and to pay half that amount in cash, the other half remaining subject to call. It would also be required to join with the other banks in its vicinity, which had also become members Member- of the Association, in the formation of a local Association. It would f^'R '" *'^* not be required to sever any of its existing relations with other Reserve banks. It could retaia its correspondents, its membership in the Association clearing house, if it had one, and its bank customers. It could form any new relations of this kind that might be desired. Its rela- tions to the national or the state system to which it belongs would 257 258 EFFECT OF MEMBEESHIP not be in any respect disturbed. I^ational banks would continue as at present to be inspected and supervised by the Comptroller of the Currency and his assistants, and state banks and trust companies by the state officers at present entrusted with that duty. New Duties and New Privileges Reserves Not Locked Up §8. These simple additions to the connections of the small bank would impose upon it new duties and give it privileges not now enjoyed. Chief among the former are the choice of one of its officers as its representative in the election of directors of the local Association and his equipment with any desired instructions, and, in conjunction with fellow members of the Association, the choice of representatives to vote for directors of the district Association and to vote the stock of the Association in the election of directors of the district branch and of the National Association. Another is the assumption, in conjunction with fellow members of the local Asso- ciation, of the obligation to make good any losses involved in the non-payment by any member, of the paper bearing the endorsement of the local Association, which, the bank had rediscounted at any branch or at the central office ; the amount of its obligation in such a case being determined by the proportion its capital and surplus bear to the aggregate capital and surplus of all the banks of the local Association. A third is the obligation to report to the Na- tional Reserve Association monthly or oftener, if required, the prin- cipal items in its balance sheet and to submit to examination by representatives of the local Association. The new privileges to be made available pertain to its re- serves, rediscounts and loans, clearings a.nd transfers, note issues and holdings of government bonds. It would be permitted to count as part of its legal reserve its balances in any of the offices of the Association in addition to those with its present reserve agents which it is now permitted to count. This would relieve the smaH bank of the obligation now imposed of keeping locked up in its vaults cash to the amount of at least six per cent of its deposits. It would also be relieved of the necessity of keeping reserves against time deposits payable more than thirty days ahead. No Redis- count Facilities Under Present System §3. In the matter of rediscounts small banks at the present time have very limited, if any, facilities. Occasionally as a special favor their correspondents will take some of their customers' paper, but ordinarily they are obliged to hold such paper until maturity and frequently to renew it. The plan for a National Reserve Asso- WHAT MAY BE EEDISCOUNTED 259 elation proposes materiaUy to change this condition of affairs by furnishing adequate rediscount facilities. Genuine commercial bills maturing in not more than twenty-eight days, which have been made at least thirty days previously, are to be rediscountable directly; that is, when presented by the bank itself without the medi- ation of its local Association. Bills of the same character matur- ing in not to exceed four months are to be acceptable for redis- count when endorsed by the local Association. In cases of special need loans are also to be made directly to banks on the security of their own paper endorsed by the local Association and secured by collateral.. Such loans, however, must have the approval of the Sec- retary of the Treasury, and are intended to meet special exigencies only and would not probably, therefore, be often available for small banks. It should be noted that the extension of these rediscount and loan facilities to all banks will benefit the small ones not only di- rectly but also indirectly by making it possible for their large cor- indirect respondents to grant them facilities in this line not now possible, "'j W*" *» Being able themselves to secure ample accommodations from the Ee- Benefits serve Association, these correspondents will be able without danger bershlp?n' to rediscount for their small-bank customers and to loan to them. Reserve The latter would thus doubtless be able to rediscount other paper than that acceptable to the Eeserve Association and would be able to avoid application to the local Association, if for any reason that should not seem desirable. Small banks which do not belong to the Association would in this way also be able to enjoy some of its advantages. §4. Another very valuable privilege is that of the transfer without charge of the whole or any part of a bank's balance with the Eeserve Association to any other bank having an account with the Association. This would practically eliminate exchange charges and greatly diminish the time now required for the making of ex- changes between distant places. Another saving would be effected fnd"Av'o'i'cr- by the privilege of securing without cost shipments of the circulat- a"<:e of ing notes of the Association. Since these would serve all the pur- shrpping"" poses of cash and could be counted as a part of the legal reserve. Currency banks would be saved the greater part of the expense now involved in currency shipments to replenish depleted supplies. Another feature of the plan of great importance to small banks 260 CLEAEING HOUSE POWEES National Banks Could Make Loans on Real Estate Seeurity is the privilege to be accorded local Associations of exercising the powers and functions of clearing houses. If these Associations should generally avail themselves of this privilege, the collections of the small banks would be greatly facilitated and the greater part of the expense now involved in them eliminated. Since these local Associations would embrace the entire country and would be con- nected with each other through the branches and tiie central office of the general Association, banks would have no difficulty in dSspos- ing at par of any check or draft, no matter in what part of the country drawn or payable. Since clearing balances would be made payable in checks against balances in the Eeserve Association's offices, no shipment of currency would be required in their settle- ment. This privilege would remove one of the chief causes of fric- tion now existing between small banks and their correspondents, a considerable amount of irritation now being caused by the refusal of the latter from time to time to accept certain checks or to collect them without a heavy charge for exchange. All the privileges thus far described would be available to state and national banks alike. The latter would enjoy the additional one of being able, if they so desire, to dispose of their government bonds at par without forfeiting their national charters. The plan does not contemplate the application to national banks of any pres- sure to give up their present issues, but it offers them the opportu- nity on terms that are fair and that involve little, if any, loss. The extension of their note issues beyond the amount outstanding at the date of the organization of the Association is, not to be permitted. The plan further proposes to permit national banks to lend a portion of their savings deposits on real estate security, thus remov- ing one of the handicaps under which they now operate in competi- tion with state institutions. This privilege concerns principally the small banks of this group, especially those located in small towns and country districts. It would greatly enlarge their capacity to serve their present constituents and to add to their number. Another privilege is offered national banks by this plan, name- ly, that of accepting bills for their customers. This concerns small institutions as well as large, although the latter will doubtless make most use of it, at any rate at first. To the small bank, howeTOr, it offers a form of two-name paper whidi in mainy cases it will be able to substitute for the one-name paper it is now obliged to accept. SMALL BANKS WOULD BE STBENGTHENED 861 §5. The asBumptiQn of tlw obligations and the enjoyment of the privileges which have been mentioned are calculated to strengthen the small banks of the country, improve their business methods and remove from them the chief obstacles in the way of their proper development and the chief dangers which now threaten Banks to them. In substantiation of this claim it should be noted fij-st of ^°"*''<'' all that the plan now under consideration proposes to put the con- Reserve trol of the National Eeserve Association in their hands on the as- Association sumption that an institution which is designed for the service of banks ought to be controlled and managed by them ; otherwise there is danger of its becoming a master instead of a servant. The as- sumption of such an obligation is a great responsibility, and like all great responsibilities it promises the development of strength as well as power. One of the penalties which our small banks have been obliged to pay for their independence of ownership, their close connection with local interests and their circumscribed field of operations is relative isolation. They are at a distance from the larger currents of affairs. and in ordinary tim«s out of touch with them. As a rule only when crises threaten or actually occur does the fact that they are but parts of a great mechanism of exchange, international in the scope of its operation and influence, strike their attention and im- press them in a vivid manner. Among the consequences of this isolation are inaccessibility to sources of information essential to the proper training of their officers and to the safest and most suc- cessful conduct of their business, and a' species of provincialism which stands in the way of progress. A National Eeserve Association controlled by them would bring small banks into close touch with each other, with larger banks in the commercial centers, and with itself, the balance wheel of the entire system. As members of a local Association and finan- cially responsible for losses resulting from defaulted paper redis- counted by fellow members, they would be forced to interest them- Responsl- selvet, in each other's affairs and in the economic activities of the re- would gion embraced in the Association. Having the duty to vote for di- MakeThem rectors of the branches and of the central Association at Washing- fui and ton and being vitally interested in the discount, reserve and issue Jl^?^®. policies practiced by them, they would be obliged to study these interested matters, and through them the financial and commercial facts and movements on which they are based. No bank could properly per- 262 UNMAEKETABLB SECTJEITIES The Chief Danger Now Con- fronting the Small Bank Its Rela- tion to Its Constit- uents Per- sonal and Private form its function in the proposed organization without strengthen- ing itB ofiSeers and directors along lines which tend to develop length and breadth of vision, broad-mindedness, wider and deeper knowl- edge of banking and commercial affairs, and the spirit of cooperation and patriotism. §6. Among the more obvious services a National Eeserve As- sociation will render the small banks, are the removal of the chief danger which now menaces them, the increase of their capacity to serve their constituents, and the power it will place in their hands for the inducement of the cooperation of their constituents in the development of sounder business methods. The chief danger which now menaces the small bank which honestly and faithfully serves its constituents is the locking up of its resources in unmarketable securities. Its chief business is the re- ceipt of deposits which it agrees to pay on demand and their loan for considerable periods of time on personal security, usually one- name paper. Its borrowers consist chieily of local business men who are little known outside of their home town and whose paper in consequence is unmarketable except at the local bank. The quality of this paper varies widely, but, all things considered, is high. It is not revealed by the face of the instrument itself, however; can be tested as a rule only by the banker of the man who makes it; and his method of putting it to a test would frequently not pass mus- ter in a court of credit men. In fact it is the essential conservatism and soundness of the methods of the average American business man upon which dependence is placed rather than upon balance sheets, careful investigation, or collateral. Moreover, the small banker's relation to his constituents is per- sonal and private. In this respect it resembles that of a physician to his patient. The business man expects his banker to afford him such accommodations as he needs in the form of loans, and the banker is obliged practically to assume this obligation. His cash resources, however, which are even further beyond his power of regu- lation and control, bear no necessary relation to the magnitude of these loans. They depend primarily upon the amount of money in circulation in the community, the number of his depositors who are not borrowers and the relative proportion of time to demand de- posits. If it were not for the fact that most of his borrowers re- ceive the proceeds of their loans in the form of balances against which they check, and his ability consequently to pay off one cus- TEOUBLES OF THE SMALL BANK 363 tomer by borrowing from another, he could not do business at alL But in spite, of the high development of the check system in this country, the danger of being called upon for mora cash than he re- ceives from his customers in the normal course of events constantly menaces him. At the present time he is able to provide against this only in a very imperfect and haphazard manner. There is no regu- lar and normal way of so doing. He must always resort to such expedients as his ingenuity and conditions at the time suggest. §7. The National Eeserve Association will completely change all this. It will provide an easy, normal and always available method of adjusting cash resources to needs, and that, too, without compelling the small banker to change in any essential particular National his present business methods or without in any way curtailing his Reserve activities. In case he is threatened by a shortage of cash, he will would simply need to select those notes from his portfolio which mature E^'Y* Many Problems in the near future and which he knows from experience or from pre- of the Small arrangement with the customers whose names are upon them, will Bank be paid at maturity instead of renewed, and turn them over to the nearest branch of the National Eeserve Association for rediscount. A favorable credit balance will thus be created against which he can draw to the extent of his need. Upon demand the Association will even ship him currency free of charge. This privilege of rediscount will not only relieve the small banker of his chief anxiety and his chief danger, but will enlarge his capacity to serve his constituents. Safety now compels him either to keep on hand funds in excess of his real needs and in excess of the legal reserve, which he is forbidden to use, or else to invest in such securities as he can readily turn into cash, and these are rarely the kind that his customers can supply. In either case his constitu- ents are deprived of the use of funds which the National Eeserve As- sociation will enable him to place at their disposal. Furthermore, the National Eeserve Association will enable the small banker to place at the disposal of his customers foreign capi- tal to a degree which is now impossible. He will not be obliged to outside reject a good loan simply because he is "loaned up." He can always Capital Will turn such a loan over to the Eeserve Association, provided only the ^' j,'i']|bie proceeds are to be used for strictly commercial purposes. This limitation will prevent him from lending assistance to such of his customers as are interested in over-expansion and inflation, but in no way interfere with his aiding them in the prosecution of legiti- mate commerce. 364 INVESTMENT LOANS The fear has been expressed that danger lurks in the scheme at this point, that the National Eeserve Association will make it so easy for the small banker to get capital for his customers that they will be encouraged to embark in all kinds of inflation schemes. This fear is based upon a misconception of the nature of the com- mercial paper to which it is proposed to limit the investments of the Association, and upon a failure to note the effects of variations in the rate of discount. The Term "Commer- cial Paper" and How It Regarded Is Usually §8. The term "commercial paper" is commonly used in this country to mean paper that is sold about the country by brokers, and small bankers, having frequently suffered loss from investments in it, do not rank it highly. Indeed many of them will have nothing to do with it. Emphasis should be placed on the fact that as the term is used in connection with the National Eeserve Association it means something very different, namely, paper which represents move- ments of goods from producers to consumers, the transformation of raw materials into finished products, of the seed, fertilizers, ma- chinery, labor and tools of the farmer into crops, and of lean into fat cattle, etc., etc. It should be contrasted with investment paper, which represents the capitalization of new enterprises and the en- largement of old ones, the purchase of land, water powers, irrigation projects, the construction of buildings, the opening up of mines, and the building of railroads, lighting and heating plants, etc. Com- mercial paper in this sense is to be found in every community. It is presented to the banker by his own customers and is more abundant than any other form of loan. Inflation results when investment loans exceed current savings, because when this happens, banks assume demand obligations, that is, issue currency against obligations which will not be paid for years, and the currency consequently piles up, accumulates, instead of being returned and redeemed. When, however, they invest in commercial paper, they simply act as intermediaries in an exchange of goods against goods, the currency which they create being re- turned to them for cancellation by the completion of the processes of exchange in which it originates, and this normally happens, sometimes in a few hours, usually in a few days or weeks, and at the longest in a few months. Against the possibility of even temporary inflation caused by over-investment in commercial paper of the longest maturities or by a temporary stoppage of the ordinary processes of commerce, the Loans LOWBE EATBS PEOBABLE 265 power of the Eeserve Association to regtilate the rate of discount is a safeguard. When tjiat rate is raised, it will check the rapidity of safeguard exchange operations all along the line and diminish their magni- Against . ■■ ™ ..,■■., -J n 1 mi T. Inflation tude. When it is lowered the opposite will happen. The Eeserve Association will thus be able to maintain a proper adjustment be- tween the country's commerce and its credit operations. §9. The emphasis which the Eeserve Association will be forced to place on commercial paper and the fact that it will supply for the first time in this country an open market for such paper will tend to influence in a wholesome fashion the business habits of small banks and their constituents. Few of these now observe in their practice, and perhaps many of them are unconscious of, the Commercial distinction which has just been drawn between commercial and in- investment vestment loans. In consequence they contribute, without doubt un- consciously in most cases, to the inflation of credit which character- izes every period of prosperity. The National Eeserve Asso- ciation will force this distinction upon their attention and will furnish them a strong motive for its observance in practice. Unless our experience proves to be different from that of other countries, once a market for commercial paper is created, it will be placed at the top of the list of bank investments, and the rate on it vrill be the lowest in the market. Small bankers will, therefore, be able to offer customers decidedly better terms for paper of this kind than for any other, thus furnishing them the strongest kind of a motive for giving this character to as large a proportion of their obligations as possible. This will also materially aid such bankers in the very difiB- cult task of inducing their customers to disclose the uses to which they propose to put borrowed funds and to supply financial state- ments of their business operations. At the present time small bank- ers are able to get this information only to a limited extent, especi- ally in regard to paper furnished by note-brokers. When they are able to offer a customer a one or two per cent reduction in the rate of interest on all paper which bears on its face or in the form of at- tached documents the evidence of its commercial character, he wfll no longer hesitate to furnish what is wanted. If he does, he will force his banker to the conclusion that he cannot furnish it and thus injure his own credit. It is at this point that the significance of the proposal to allow 266 CHECK ON BAD BANKING When Accept- ances Will be Superior to Promissory Notes banks to accept drafts for their customers appears. Such accept- ances will be useful and superior to promissory notes only in the financing of purchases of goods at distant points, the buyer in such cases being able to discount a bank acceptance, but not that of an unknown merchant. The name and location of the drawer will in most cases reveal to the accepting bank the nature of the transac- tion on which the bill is based, and the customer will derive the ad- vantage of getting credit for the period in question at a lower rate than would otherwise be possible. Small Bank Will Become Really In- dependent Best Guarantee to Depositors §10. Not 80 obvious, perhaps, but quite as important iu the long run are the scrutiny and supervision of his fellow bankers and the increase in real independence which the National Eeserve Association will bring to the small banker. In order that the offi- cers of the local Associations may be in a position to pass intelli- gently upon the quality of the paper submitted to them for redis- count, they must carefully study the business methods of the bank- ers with whom they deal, and this study will not be spasmodic but continuous. Their fund of knowledge will constantly increase and become the common property of the entire banking community. Every bank will have a pecuniary interest in keeping its fellows up to a high grade of soundness and will be obliged to conduct its own affairs in the open. The knowledge of this fact and the conscious- ness of this scrutiny will be the most efficient check on bad banking yet devised in this country. It will do for small banks everywhere what clearing-house inspection in some of our large cities has done for banks thus associated. This mutual scrutiny and supervision will furnish the best pos- sible guarantee to depositors. Deposits can never be in danger so long as loans are properly made and safeguarded and are readily transmutable into cash, and it is primarily on loans that this scru- tiny will be concentrated. The borrowers of a bank will gradually be revealed by the paper sent up for rediscount and their character will be put to the test of outside, disinterested investigation. In this investigation the banker will ultimately find his strongest weapon against the undue pressure of unscrupulous and plunging borrowers. §11. It is a widespread belief at the present time that the much boasted independence of the small American bank has been partially, if not wholly, lost. Without attempting to examine the WHAT 28-DAY PAPEE IS 267 validity of the grounds usually assigned for this belief, it is perti- nent to note the fact that a degree of dependence upon reserve city banks and the stock market is unavoidable under present conditions. The small banker must have liquid assets and his only method of getting them now is by the favor of his reserve agent in granting him rediscounts, or loans on collateral, or by investments in stock exchange securities. Whichever horn of the dilemma he chooses, he delivers his fortunes in part into the hands of other people. His reserve agent is not obliged to rediscount for him or to grant him loans. Neither obligation is necessarily involved in the reserve iMatlonal agent function. The small banker must ask these privileges as a Reserve favor and in consequence must be prepared to grant favors in re- yyin q^ turn, and these return favors at times may seriously interfere with "ver the his independence. When he invests in stock exchange securities with Banker the expectation of turning these into cash in case of need, he throws ^r"""., . his fortunes to that extent into the hands of the people who have most influence in the marketing of such securities, and, in order to be on the right side of the market, he is tempted to seek their favor and to follow their advice. The National Eeserve Association will deliver him from both kinds of thralldom. It will give him an institution of his own in which he has property rights and over which he has control, to which he can always turn for cash as a right instead of a favor, which in fact exists primarily for the purpose of rendering him this service. He will then be truly independent, an equal among equals, the arbiter of his own fortunes. § 12. Recently the fear has been expressed that some small banks would be unable to derive much benefit from rediscounts through the proposed Eeserve Association because the greater part of the paper they hold is of longer maturities than four months, the maximum the Association is to be allowed to accept. This fear is based upon a misconception of the clause in the proposed act which permits rediscounts of paper maturing in not less than twenty-eight days. Such paper must have been in the possession Small of the bank for at least thirty days, but it may have teen there for Banks' a much longer period. Every bank always has on hand paper ma^ Privileges turing during the coming month. So far as this regulation is con- Ample cerned it matters not how long it may have been in the bank's possession. Provided it' is actually payable within twenty-eight days it falls within the categorj-^ of directly rediscountable paper. 368 NEW FACILITIES It should furthermore be remembered that nothing in the pro- posed plan prevents correspondents from rediseounting for their bank customers pa,per of longer maturities than four months, and their ability to rediscount with the Reserve Association will give them facilities for so doing which they do not now possess and a motive for so doing which does not now exist. Such banks will ordinarily have plenty of paper which falls within the rediscount- able categories and, in order to prevent the removal of their bank customers' balances to the Reserve Association, they will find it in their interest to accommodate them in every possible way. CHAPTBE XV STATE BANKS AND TRUST COMPANIES A Large Number of State Banks and Trust Companies — 2. The Problem of State Banks — 3. Control of State and National Banks by Each Other — 4. Reserve Plan Puts State and National Banks on Same Footing — 5. Trust Companies and Mutual Savings Banks— 6. Uniformity of Examination — T. A Single Discount Market — 8. Benefit of a Reserve Association to ikstttutions Outside It. §1. The national banking system is merely the core of the present system of banking in the United States. The national institutions number over 7,300, while beside them there exist in- Large stitutions organized under state laws to the number of at least 17,- Number 000 or 18,000. Some of the state banks have small capital; others Banks and large capital and resources. Some of the strongest banks in the Trust country are private partnerships organized under state laws and "'"P^" *' engaged in foreign trade and operations for which other banks have no fiaeilities. Con'gfess has paid little attention to these various classes of institutions, except fhat in 1866 it taxed the notes of state banks at the rate of 10 per cent so as to make the further issue and circulation of such notes impracticable. It was then diesired to reserve the function of note-issue entirely to national banks, but beyond this early and exceptional action, the federal government has not sought to interfere with the activities of the State institu- tions. While it is true that there is great variaKon in Hhe laws of the several States, it is also true that in the niain the banking sys- tems of the states have been copied from the national banking Banking system. The trust company laws of the several states have been a "-^ws later evolution designed to permit I3ie gfowth of a class of institu- After tions equipped to do special kinds of business allied to banking, the These trust cbttipanies originally engaged chiefly in the operations s^tenf which their name implies; then having large funds of their own, 269 270 TRUST COMPANIES Develop- ment of Trust Companies where not prevented by law, they understock to do their own banking, and rapidly developed into concerns possessing large banking departments receiving funds and making loans in very much the same way as regular banks. While many of them are strong, highly-organized institutions with large reserves, they have in general been disposed to do a much broader type of business than the banks, to accept much less convertible security, and to be much less stringently managed in respect to ihe maintenance of reserves and the liquidity of assets. But, in the aggregate, both the trust companies and the state banks are performing a very substantial share of the regular banking business of the coun- try—so much in fact that their welfare has a direct and immediate relationship to that of the national banks. Their position, there- fore, in relation to any new legislation is fundamental. The Problem of State Banks Close Relations of State and National Banks §3. The essential problems which have come to the front with respect to the relations of state and national banks may be sum- marized as follows: (1) The equalization of conditions of business and competition between state and national institutions; (2) the equalization of methods of banking and government oversight be- tween the two classes of banks; (3) the harmonizing of the inter- ests of the two groups of banks so as to strengthen and unify the discount market of the country for the future. New legislation, whatever it may be, must consider these three important phases of the situation. If such legislation should relate only to national banks, it might operate to give these institutions a decided advan- tage over their competitors. In this connection must also be borne in mind the fact that by a process of joint ownership and stock control a very close re- lationship has been established between state and national banks in many cases and that this inter-relationship must be so regulated by law as to prevent the use of state laws by national institutions for the purpose of controlling others and vice versa. This raises the question whether so close a relationship should be permitted to continue, and if not what substitute can be found for it or how the difficulty which it was intended to remedy can be overcome. It is generally conceded that the continued maintenance of banks in a different position before the law, controlled in de- cidedly different ways, and subject to entirely different require- ments, must necessarily cause serious interference with the har- RELATIONS OF NATIONAL TO STATE BANKS 271 monious and uniform organization of any system of general bank- ing control. In brief, the question presented is : What shall be the future relations between national banks and institutions organized under state laws, in order to promote the best interests of both? Further explanation of the difficulties which arise out of differ- ences in competitive conditions shows that the national banks are subjected to very decided restrictions with reference to the classes of business they can do. For example, they may not lend more than an amount equal to 10 per cent of their capitalization to any [jg^y^'n individual or corporation, capitalization being interpreted to mean National capitalization plus surplus when the latter does not exceed 30 per ^^"^' cent of nominal capital. They may not incur obligations of cer- tain specified kinds or make loans on security of given classes such as real estate. Moreover, they are obliged to submit to examination at times and under conditions which are quite different from those that govern in the case of the state banks. The trust companies are in a particularly favored condition. In many states they are subject to negligible reserve requirements, whereas the national banks, as we have elsewhere noted, are very closely bound down in the matter of reserves. The same thing is true with reference to the classes of operations in which they Advantages can engage. by Trust A great deal of business offered to a national bank in the Companies ordinary course of events must be refused. When thus refused, it naturally goes to some other institution, frequently a rival bank organized under state laws or to a trust company which is aflBliated with a state bank. The national bank is thus sending business to its rivals. It is not only debarred from earning the profits which , might be obtained from the rejected business, but it also loses the valuable financial connections which might be established through the acceptance of this business. On many accounts, therefore, it finds the sacrifice of the operations which are closed to it under the national banking law a great source of weakness. Although in the main the restrictions of the bank act are wise, when taken in the aggregate as they apply to the banks as a complete group, it remains true that there are many instances in which they work a decided hardship and in which, therefore, the bank affected by them is naturally restive under these restraints. Urged on by the pressure of competition offered by state in- stitutions not subject to restrictions as stringent as those of the 272 COMPETITION OF STATE BANKS national act, many national banks have devoted themselves to de- vising ways of competing successfully with the state institutions, ^'y» of while at the same time technically observing the requirements of the Law the national bank act. The method most favored in that connec- tion has been the organization of institutions under state law, closely affiliated with the national banks themselves and at the same time able to do all those classes of business which are within the reach of the state institutions, although beyond the scope of the national bank's powers. This system of organizing affiliated state institutions has been greatly developed. It discloses many elements of danger. In- vestigations made by the Comptroller of the Currency at the re- quest of the Secretary of the Treasury have shown that in not less Elements than 300 cases national banks are thus affiliated with state institu- ?ii AffiMatlon *^°°® — either banks or trust companies. Sometimes they are united of National by the common ownership of stock by bodies of stockholders prac- B^'^'kB*'*** tically identical for the two institutions, and sometimes by an ar- rangement wherein the stock of each institution is made non-trans- ferable except upon condition that the stock of the other is simul- taneously transferred along with it, share for share. The dangers inhering in this relationship have been seen partly in the possibility of the establishment of an inter-bank control which might conceivably become dangerous. Particularly would this danger exist from certain standpoints in the event that a Ee- serve Association were to be organized whose stock should be owned by the banks of the country, in proportion to their own capital stock. Under existing Iscw, national banks are forbidden to own the stock of other banks, for although the law does not contain any such prohibition in express terms, the Supreme Court has de- cided tha;t this is its intent. But by close affiliation with a state institution in the way just referred to, it is entirely possible for the national bank to reach the same end as if it actually owned or controlled the stock of other banks. Through the intermediation of the trust company or state bank, the national bank can frequently hold and direct the use of such stock in other institutions. It is true that there are states which forbid this kind of control by prohibiting banks organized^ under their laws from owning the stock of other banks. This pro- hibition is found in a number of states. But there are many others where it does not exist. CONTEOL OF BANK STOCKS 373 Even if the question of control be left out of account, it re- mains a fact that the association of a national and state institution in the way referred to is likely to be always a matter of criticism. It evidently gives to the bank which is organized under the more stringent set of laws a means of taking advantage of the laws of the less stringent jurisdiction. This raises in a serious way the question how to rectify the relationships between national and state banks, and bring them to a proper basis. § 3. So strongly have the national authorities felt on this subject of bank control that President Taft and Secretary Me- Control Veagh in recent communications to Congress have demanded legis- and lation prohibiting national banks from directly or indirectly con- National trolling the stock of other banks. Legal difBculties have been raised j, ^g^i, in connection with the adoption of such legislation. But in spite of Other these difBculties the fact remains that the spirit of the enactment is the most important matter and that a plain prohibition incor- porated into existing law would go a long way in correcting the conditions complained of. The National Monetary Commission in the banking plan lately presented by it to Congress has recognized the necessity of guarding against the possibility of such control as has been referred to and has therefore incorporated in its proposed bill the following pro- vision : That in case forty per centum of the capital stock in any sub- scribing'bank is owned directly or indirectly hy any other sub- scribing bank, or in case forty per centum of the capital stock in each of two or more subscribing banks, being members of the Prohibitory same local association, is owned directly or indirectly by the same Provision person, persons, co-partnership, voluntary association, trustee, or '" corporation, then and in either of such cases, neither of such banks ^„ ,_" shall be entitled to vote separately, as a unit, or upon its stock, sion's Biil except that such banks acting together, as one unit, shall be en- titled to one vote, for the election of the board of directors of such local association. In no case shall voting by proxy be al- lowed. The authorized representative of a bank, as herein pro- vided, shall be its president, vice-president, or cashier. There may be difference of opinion as to the question whether this provision is sufficiently stringent or not, but it is clear that the amount of stock which could be permitted to be controlled by another bank may be decreased to any extent that is desired. The extreme penalty available to the government is simply the loss of voting power in the National Eeserve Association, and for any 2?4 PROVISIONS AGAINST INTEE-BANK CONTROL Equality as to Business of Banks Enlarged Powers of National Banks Objections In Behalf of State Banks further legislation designed to prevent the junction of banks in this way it would be necessary to go to the state legislature. The adoption of a provision like that just referred to would, however, entirely prevent the possibility of action by any one bank designed to increase its influence in the National Reserve Association or any similar institution whose stock was held by banks, through the ownership of stock in other banks that enjoyed the privilege of voting in such a concern. Probably a more important means of checking the growing tendency toward joint control of national and state banks is seen in the effort to place these institutions upon a basis of equality, in respect to the business they can do. We have already noted that one important reason why national banks have sought to affiliate themselves in this way with the state banks is that the latter usu- ally have broader powers, while trust companies organized under state laws almost invariably have. If the national banks had the same kind of powers that are possessed by state banks and trust companies, they would not seek to establish this sort of inter-bank control. The plan of a reserve association proposed by the National Monetary Commission gives to national banks the power of lending a certain portion of their resources upon real estate security, enables them to do a savings business upon more satisfactory terms than at present, and broadens their authority in other directions. With these concessions made to the competitive demands of business, it is likely that the national banks would be largely relieved of any necessity. or strong desire for establishing close afiBliations with state institutions. In fact, some of those who have made a close comparison of national and state banks from the standpoint of actual business competition are disposed to think that the national banks would have the advantage of the state organized concerns, in which case there would be no motive for affiliation. In speaking on this point before the American Bankers' As- sociation at the 1911 meeting in New Orleans, President F. H. Goff of the Cleveland Trust Company, of Cleveland, Ohio, ex- pressed the opinion that state banks would be at a disadvantage in a number of respects under the proposed plan. These he enum- erates as follows: (1) State banks could not accept paper drawn on them selves. (2) In many states they could not establish branches. UXIFOEM RESERVE REQUIREMENTS 275 (3) They could not own stock In banks doing business in foreign countries. (4) In most jurisdictions they would be compelled to main- tain greater reserves against their demand deposits than is re- quired by the law of the state where they are located. (5) While national banks would not be required to keep any reserve for time deposits not payable within 30 days, state banks in most jurisdictions would be compelled to do so. (6) While national banks would be required to keep a re- serve for savings deposits equal to only 40 per cent of that re- quired for demand deposits, which in reserve cities would be ten per cent and in non-reserve cities 6 per cent, state banks in many cities would be compelled to maintain a 15 per cent reserve against savings liabilities. (7) Funds deposited with the Reserve Association could not be counted as reserve. (8) Notes of the Reserve Association held by state banks could not be counted as reserve. (9) State banks must agree to submit to such examinations and to make such reports as may be required by federal law or by the local association. § 4. These supposed difficulties grow out of the fact that the National Monetary Commission plan calls for the establishment of uniform reserve requirements in connection with state banks which become members of the National Reserve Association. Such re- quirement would, it is supposed, subject the state banks to the onerous features of the new legislation, while they would not be relieved, as the national banks would be, of those onerous features of pian ' existing legislation which were no longer necessary because of the "n Regard organization of the National Reserve Association. The require- ^anks ments of the National Monetary Commission's plan on this sub- ject have met with general approval and are as follows : The subscriptions of a bank or trust company incorporated under the laws of any state or of the District of Columbia to the capital stock of the National Reserve Association shall be made subject to the following conditions: First. That (a) if a bank, it shall have a paid-in and unim- paired capital of not less than that required for a national bank in the same locality; and that (b) if a trust company, it shall have an unimpaired surplus of not less than twenty per centum of its capital, and if located in a place having a population of six thousand inhabitants or less shall have a* paid-in and unimpaired capital of not less than fifty thousand dollars; if located in a city having a population of more than six thousand inhabitants and not more than fifty thousand inhabitants shall have a paid-in and, 276 COEEECTION OF INEQUALITIES BY STATES unimpaired capital of not less than one hundred thousand dollars; If located in a city having a iwpulation of more than fifty thousand inhabitants and not more than two hundred thousand inhabitants shall have a paid-in and unimpaired capital of not less than two hundred thousand dollars; if located in a city having a population of more than two hundred thousand inhabitants and not more than three hundred thousand inhabitants shall have a paid-in and unimpaired capital of not less than three hundred thousand dollars; if located in a city having a population of more than three hundred thousand inhabitants and not more than four hun- dred thousand inhabitants shall have a paid-in and unimpaired capital of not less than four hundred thousand dollars; and if lo- cated in a city having a population of more than four hundred thousand inhabitants shall have a paid-in and unimpaired capital of not less than five hundred thousand dollars. Second. That it shall have and agree to maintain against its demand deposits a reserve of like character and proportion to that required by law of a national bank in the same locality; provided, however, that deposits which it may have with any subscribing national bank, state bank, or trust company in a city designated in the national banking laws as a reserve city or a central reserve city shall count as reserve in like manner and to the same extent as similar deposits of a national bank with national banks in such cities. Third. That it shall have and agree to maintain against other classes of deposits the percentages of reserve required by this act. Fourth. That it shall agree to submit to such examinations and to make such reports as are required by law and to comply with the requirements and conditions imposed by this act and regulations made in conformity therewith. While it may be conceded that under this condition of affairs the state banks would be at a relative disadvantage, it is not likely they would long continue in that condition. Mr. Goff, whom we have already quoted, says : "While the disadvantages at the outset would be many and burdensome, I am confident the legislatures in the several states can be relied upon to promptly enact legislation correcting these inequalities." There is no doubt that this opin- ion is well founded. In fact, it is one of the best features of the National Reserve plan that it would tend to unify the state and national banking Would systems. With a definite pattern aiforded by federal legislation. Unify with which the state banks were willing to comply in order that * they might be placed upon terms of equality in competing with national banks, it may be expected that progress toward uniformity in banking legislation throughout the country would be much more IJNIFOKM BANKING LAWS 277 rapid than ever before. This uniformity would be exceedingly de- sirable, since it would take away the possibility of evading legal provisions. At the same time it would prevent the transaction of undesirable forms of business that are sometimes undertaken by banks as a result of their being "played off" against one another by designing borrowers. The tendency would be to segregate and harmonize into one general group all the commercial banks of the country whether organized under state or national laws. Those that did not choose to conform to the requirements laid down in the legislation, with respect to reserves, kinds of business done, etc., would remain out of the National Reserve Association and would at once be recog- nized as belonging to quite a, different class of banking institutions, outjjde They would exercise in their way as good and effective a function the as that performed by the banks, whether state or national, that had ^°^,^^^^ brought themselves into conformity with the provisions of the pro- Reserve posed reform, but their position in the community and the rules Association of their action would be quite different. They would be set apart, not as being state institutions, the line of distinction drawn at present, but as being institutions properly classed as not strictly banks in the proper sense of the term. § 5. The question has been raised whether under these cir- cumstances it is desirable or necessary to admit such institutions as trust companies and mutual savings banks to membership in J™** the National Eeserve Association. It must be admitted that in and many instances these institutions are not now commercial banks ^utuat and that, if they were to accept the requirements of the National Banljekac- Banks Must .^ he has no provide .uk with biUs of Credit CHAPTER XVIII ■■ purchaser who has on would be possible THE FARMER AND THE i T^^l^^Z 1. Seasonal Character of Agriculture and Crop-M?^^^ purchaser of his Loans Under Present Banking System— Cycle came. The funds are — d. Difficulty Due to Inelastic Note - V'. • a- 4. j Remedy in Cooperation— 5. Experif^® products m motion towards and a Discount Market. jt is the average time required to the security is usually the products §1. It has been pointed - millions of people live in thr- one billion acres of land. T'-^'^ ^^^ °^ Wheatville, we may suppose, buUdingsismorethan34bi''' '^^ ^^^ requires i;hat $30,000 of this of all is that the annual proa^®^^"®"' $12,000 of this $30,000 must be lars, or about as much p^'wful money (greenbacks, gold and silver), banks; in other word-'^'^i^? ^^^ '^ violated and the bank may be farms would pay rJiptroUer. To do the ordinary business of the bank agriculture excf*'^ ^^ ^'^^ '^^ needed, since the money deposited day by Country road enterpT^'^^ffsets the amount paid out. But in order to have funds the IjT-'iie'lSig cities, on which drafts may be drawn to accommodate niav«*stomers and to lessen the risk of keeping large sums in its vaults, th' the bank keeps part of its reserves in nearby reserve city banks, and ii( smaller accounts at Chicago, St. Louis and New York. The form in which the borrower wishes to get his accommoda- c: tion from the bank is that which will be most acceptable as a means a of payment to the persons he owes. In a city the borrower will generally make his payments by drawing checks upon the deposit account which the bank gives him as the result of the loan. In a sparsely settled country community where the number of banks is small and where the use of checks is not customary, the bor- rower will generally ask from the bank some forms of cash. The farm hands and others who are to receive the payments involved in gathering the crops prefer to have a medium of exchange which will pass current among them more easily than the bank check. This is usually satisfied by any form of cash. In short, during the crop- moving period, the banker must bear in mind that he must meet an Bank Re- serves ^x 310 ' HARVEST DEMAND FOE FUNDS More V Wealth ^re, are to some extent dependent upon climatic conditions — upon Mean'' tidlk;T)ring or the fall trade. For instance, the general retail trade More ment ^i^ward movement at times when the seasons are changing, ^'■*'"* and sale of'^fijgnding depression at the height of the season. But in improved baJi^nd flow of trade there is invariably a steady cur- operative reserve > which continues at nearly the same volume •r and represents the normal consumption needs the farmer, however, are peculiar. At the time *-ho pTound is being prepared and seeded, there is '^s, but none of these are at all com- ^s in the harvest season. After the din upon the banks is removed. ^f agriculture means a seasonal fiwise a seasonal character to allied with agriculture. The lod deal more brisk after a .•■Han it is at any other time. *^-^ Likewise, there is some ■^ agricultural regions ^ "-^rms into the vU- ^'•heref ore create ■'*^-^-.. ■"g and "'v a ;r- d- th g CUEKEN'CY NEEDED BY FAEMEES 311 Perhaps the fanner has disposed of the crop as it stands to a middleman or agent, as is frequently done in the case of apple and other fruit crops. The middleman in that case may seek ac- ^*"j* commodation either at the local bank or elsewhere. If he has no provide collateral to offer as credit, he may furnish the bank with bills of Credit lading covering the produce in transit to some purchaser who has bought the goods from him. Such a transaction would be possible only after a portion of the products had been gathered and deliv- ered to the transportation company. Whether the demand for the loan comes from, the farmer, or from some local purchaser of his products, the demands upon the banks are the same. The funds are needed for the purpose of setting the products in motion towards the consumer. The term of credit is the average time required to complete this movement ; and the security is usually the products themselves. §3. The, local national bank of Wheatville, we may suppose, has deposits of $300,000; the law requires ihat $30,000 of this must be kept as a "legal reserve"; $13,000 of this $30,000 must be kept in its vaults in lawful money (greenbacks, gold and silver). If paid out the banking law is violated and the bank may be closed by the Comptroller. To do the ordinary business of the bank perhaps $5,000 in cash is needed, since the money deposited day by Country day about offsets the amount paid out. But in order to have funds '" *" in the big cities, on which drafts may be drawn to accommodate customers and to lessen the risk of keeping large sums in its vaults, the bank keeps part of its reserves in nearby reserve city banks, and smaller accounts at Chicago, St. Louis and New York. The form in which the borrower wishes to get his accommoda- tion from the bank is that which will be most acceptable as a means of payment to the persons he owes. In a city the borrower will generally make his payments by drawing checks upon the deposit account which the bank gives him as the result of the loan. In a sparsely settled country community where the number of banks is small and where the use of checks is not customary, the bor- rower will generally ask from the bank some forms of cash. The farm hands and others who are to receive the payments involved in gathering the crops prefer to have a medium of exchange which will pass current among them more easily than the bank check. This is usually satisfied by any form of cash. In short, during the crop- moving period, the banker must bear in mind that he must meet an serves 312 PEESSUEE ON EESEEVB CITIES urgent request for various forms of lawful money or bank notes. Some of this currency does not come back to the bank; the hired men may keep it until the end of their jobs, then travel on, and finally carry the money back to their homes. Hence, while the local bank may have paid out $10,000 a week in cash, only a portion of this amount will have returned to the bank in the deposits of mer- chants. Finding its supply of money running low, it sends to its reserve center — ^perhaps Kansas City, Omaha, or Minneapolis — for a shipment of currency. Hundreds of other banks are doing the same thing, and the city banks soon find their own supply of reserves decreasing. Thus they make requests on Chicago or St. Louis. There a demand is felt from thousands of banks over a wide area, and they consequently send to New York, where they keep a portion of their reserve funds, asking for large shipments to be sent from the Bast to the West. Thus the same pressure which is felt by the local bank is inevitably transferred with constantly in- creasing intensity to the banks of the central reserve cities of St. Louis, Chicago and New York. The seasonal characteristic in the agricultural regions is, as we have seen, not confined to the farm ; in such a community, the mill or the local buyer of grain also needs loans. During a period of about three months the mill must secure wheat and corn enough to insure a supply throughout the entire year. It is, of course, impos- sible for it to carry through the other months of the year actual cash for that tremendous expenditure. The management therefore borrows from the bank the funds for buying grain. A small coun- try mill may need as much as $20,000 to $40,000. Since the mill will be purchasing the farmers' grain, the mill must have the cash to complete the purchase; consequently the demand of the mill on the bank is likewise a demand which must be met in cash. The loan to the mill may have a maturity of several months — ^that is, for a period covering the grinding of the wheat, the shipping to a distant customer, and the return of the payment. A car sent to New York from the Prairie States may be eight weeks on the way. The mill is paying interest on the loan, and the amount of this loan, whether high or low, correspondingly affects the working ex- penses of the mill, and it must be met by a charge on the wheat producer or on the consumer — either in a lower price to the farmer for his grain, or in a higher price on the flour to the consumer. That is, a clumsy and expensive banking system inevitably lays its tribute upon the farmer or the consumer. EBB AND FLOW OF CUEEENCY 313 Farmers as Business The farmer, moreover, often appears as a business borrower. He may have harvested 40,000 bushels of corn; he may have had a large hay crop. If he could buy 200 head of range cattle to fatten he could make a fine profit on both his grain and stock. He may ask the bank to give him a loan on a note properly secured, and with the credit buy the stock. Or, it may be that the farmer has a Borrowers fine lot of young cattle, but has no feed for them. In that case he would wish to borrow the money with which to purchase hay and corn. Thus the bank must carry that loan until the cattle are fattened and sold — a period of perhaps three or four months. The seasonal characteristic of agriculture also influences the business of the local merchant. The small merchant who keeps a supply of farmers' necessities may carry a stock of goods worth perhaps $20,000; but a part of that is bought upon credit. He must, to hold his trade, frequently buy new supplies from the city. To obtain this added capital he needs a loan until he can sell the goods. ' This can be obtained either by a loan from the bank, or the wholesale house must give him 60 or 90 days' time. In the latter case, the wholesale house is itself probably the borrower from a city bank. In one way or another the banks collectively must meet this seasonal demand. It will be observed that the cash obtained by the farmer from his bank is soon paid out for supplies or labor. The money sent from reserve cities into country districts requires some period of time before it comes again into the local banks. In the autumn the farmer may not sell his wheat at once ; he may haul in one or two loads at a time, for, perhaps, $45 a load of 50 bushels. He takes a check for the money from the elevator or mill, and cashes it at the bank. The farmer's family may go to a county seat or a larger town at some distance where there are more pretentious stores and „ ^ Return distribute some of this cash away from home. In this case the small Flow of country bank feels the prolonged demand for currency, and may be Currency obliged to ship in considerable sums, even late in the autumn. Tak- ing the banks collectively, however, the expenditure by the farmers for goods will inevitably result in the return of the cash by the merchants to the banks. The farmer begins to prepare for winter ; tax-paying time arrives ; the holiday trade opens ; the farmer goes to town oftener and spends more freely. The local bank finds each day that it closes its business with more cash on hand than the day before; it ships a few thousand dollars to its nearest reserve cen- ter ; thence it is shipped to St. Louis or Chicago ; and in turn those 314 INELASTIC BANK-NOTE CUEEENCT cities send more or less on to New York, until the tide of currency is running back to the financial centers of the country from- which it was drawn early in the autumn. Thus there is an ebb and flow of actual currency from the financial centers to the agricultural cen- ters for several months. Then there follows a stationary period stretching on until the call of the harvest is repeated. Although more than 95 per cent of the wholesale transactions of the country is done with checks, actual money is demanded because of the sea- sonal characteristic of agriculture. Difficulty in Supply- ing Bank Notes §3. From what has been said, it is clear that banks in the agricultural parts of the country are expected to be able to provide notes, while the customers of banks in other parts of the country may do their business largely with checks. When the country banks are called on for loans, they should be able to provide notes of their own issue. Under our present system, however, they find them- selves obstructed by the limitations upon national bank currency, that is, the rigidity and inelasticity of our system works a direct injury to the country bank and to the borrowing farmers. They must first provide themselves with government bonds, then go through with the formalities attendant upon the issue of the notes. In very few eases where a bank in an agricultural region has a good trade, is it able to satisfy the wants of its customers by sim- ply lending them its own notes. This means that it must supply itself with funds from some other source. The only source from which it can obtain what it needs is the other banks of the coun- try. Hence, in order to have a resource upon which it can draw at crop-moving periods, it must build up a credit account with some bank elsewhere. This it endeavors to do. It is allowed by the na- tional banking law to place a part of its reserve with the banks in reserve cities and central reserve cities, and to the sum thus fixed it seeks to add by remitting such exchange on the cities as comes into its possession in the course of the year. When the crop-mov- ing period arrives, it draws on its correspondent bank in the city for actual funds. The correspondent bank ships the money, usually in the form of paper currency, to it by express, and thus it is able to supply the wants of borrowers. If the point is reached wher« it cannot further draw down its account with the city bank with- out danger or without violation of legal requirements, it must either stop lending or else ask the city bank for accommodation. The latter can be had by obtaining a straight loan or a rediscount from HIGHEE EATES OF INTEEEST 315 the bank — ^the result being in either case to increase its credit with the correspondent bank and hence enable it to draw on that bank for the resources it actually needs. Of course the process just sketched is not an isolated one. It is going on simultaneously in many parts of the country, and al- though the height of the crop season is not the same in all parts General of the Union, owing to the difference in the dates at which given Call for products mature and owing to climatic variations, there is enough o^^^n r^. of simultaneous demand to subject many banks to strain at about the serves same time. Therefore, all over the country there is likely to be a gen- eral call for funds which will take cash out of the vaults of the banks and keep it out for a certain period. This is a situation against which the city banks endeavor to provide by furnishing themselves with note issues, in many instances, which they would not other- wise take out. But, even when they have thus protected them- selves, the demand for loans is likely to be so irregular and sub- ject to such variation that the protection is inadequate. Eiven if it is sufficient, the cost of issuing the notes, as outlined in an earlier chapter of this volume, is so great that the expense of fur- nishing loanable funds for crop-moving is invariably high. Whether the city banks be called upon, therefore, to extend accommodation in the form of reserve money or in that of their own notes, they, must charge a tolerably high price for such accommodation. Consequently the borrower must pay a more than equally high price. If the city bank has to part with reserve money (or, what is the same thing, is called upon to extend a loan to a bank, know- ing that that bank will promptly call upon it for cash), it recog- nizes that the making of this loan will be a decidedly serious thing for it, since its credit-extending power in its own community will to'^gor-* ** be cut down in proportion to the amount of loans that could have rowers been supported by the reserve money with which it parts. If it has to get out notes expressly for the purpose of satisfying a borrower, it ties up a part of its fluid resources in the form of bonds, or else it borrows the bonds and pays their owners for the use of them. In any case, therefore, the operation is expensive. This expense is thrown upon the borrower in the form of a higher rate of interest. The home bank charges him whatever it has had to pay to the city bank, and in addition such a rate as will compensate it for its own services in acting as an intermediary and practically guaran- teeing the loan made by the city bank. Such action is inevitable, and of course involves no criticism upon the banks which thus 316 STRUGGLE FOE EESEEVES IN CRISIS 'charge a double rate for the accommodation they extend. But it makes the cost of supplying credit with which to move the crops abnormal. Inasmuch as the credit obtained is a part of the expenses of production in any economic operation, it is a part of the cost of placing agricultural products on the market. As the price of such products, in so far as they are staples, is a world price, they are necessarily less profitable to the producer than they otherwise would be. This means that there is an unnecessary burden upon the farmer as a result of our present system of agricultural loans. The method in which a stringency or panic affects the agricul- tural section may be shown by what happened in the autumn of 1907. As has been explained, farmers, crop-buyers and banks were drawing on the large reserve centers for currency. Suddenly, be- cause of financial disturbances, there came runs on certain New York banks which compelled caution on the part of all other bank- ing institutions of that city. This local situation, together with heavy demands for currency from the agricultural belt, made it impossible for the New York banks to satisfy all demands and also keep their currency reserve up to the point required by the bank- ing law. They were compelled to refuse currency shipments to Chicago, St. Louis, Memphis, New Orleans and other points ; con- sequently, the banks of those cities could not assist Minneapolis, Omaha, Kansas City and the cotton belt without illegally lowering their own cash reserves. In a day the entire country was alarmed ; everybody wanted his deposits in cash, and there was not enough to go around and no possibility of getting more. This account explains fully why the New York banks are equally interested in obtaining a measure of banking reform by which the cooperation of all the banks would relieve the pressure upon themselves as well as upon the small local bank. The local banks had the notes of merchants and fanners — all good commercial paper — ^but they had no cash to pay out and yet retain their lawful reserves. In such a case the bank of Wheatville, for instance, has $12,000 lying in its vaults, but it can not use it. It may have $300,000 of deposits and $25,000 of capital, but it may not be able to loan more than $160,000 to $170,000; it must keep as legal reserve $30,000, that cannot be used and, for safety, or in a moment of slightest alarm, it tries to keep its reserve in excess of the actual legal requirements. Like* wise, every other of the national banks in the United States has SUUJNJJiNiESS OF AGRICULTURAL PAPER 317 a portion of its reserve in gold or other cash, but under the present banking law it cannot be used. Depositors, therefore, are com- pelled to wait. Loans become expensive to the farmer. The essential need of the farmer or producer is a cheap source of credit that will enable him to send his product to market at a reasonable cost. This source must be one that can provide him with note currency, since, for the reasons already noted, that is a form in which he prefers to take his loans. He gets his accommoda- ^J^'g^ ^^^^ tion in the best shape when it is in the form that is most acceptable Need of to the people whom he has to pay and, as we have seen, that is the ^^"°" bank note, or actual reserve money of some kind. This kind of accommodation must be supplied him at as low a cost as is con- sistent with a fair return on bank capital and with the character of the paper the farmer has to offer. In the majority of cases the security offered by such farm product loans intended for crop- moving is of the best. The cotton bills of the South are well known for their reliability, and the same is true of similar paper based upon any staple crop, such as corn, wheat, oats, etc., in transit. As stated before, it is not a matter of much importance whether these bills originate with the farmer himself or not. Whether they originate with him, or with some factor or middleman, the cost of getting the accommodation from banks to cover the period while the goods are in transit or while they are being held to await a higher price is reflected back upon the farmer, in the form of a lower return. In so far as he can offer, therefore, paper of the very best description either directly or indirectly, there should be no reason why he should not get credit at the lowest going rates. His necessities call for a large, well-recognized market for paper of the kind he has to offer and an expansible or elastic medium into which his bank credit may be transformed. §4. Our antiquated banking system, which has remained prac- . ^ . tically unchanged since the Civil War, is obviously working in a Hampered destructive fashion upon the farming community. When the ^ Banking Bank of Wheatville has loaned to the farmers, elevator men and merchants all that its resources warrant, it must stop lending; under our present banking laws, it has no method of expanding either its credit or its currency. The farmer may offer his note secured by wheat or stock and the bank cannot accommodate him ; the mill may have 50,000 bushels of wheat in store, but it cannot 318 NEED OP COOPEEATIVE AGENCY use that as security to borrow from the bank. The bank's only resource is to send the paper elsewhere, trying to find, if possible, some other bank not loaned to its full capacity. It is not creditable to the intelligence of our country, more than half of whose 95 millions live in the rural districts, that there should be a perpetual and unnecessary struggle between the lending institutions and the borrowers. There ought to be some method by which the farmer, merchant and dealer in grain or stock can obtain credit when he needs actual currency. It has been made clear that any complication of the machinery by which it is made difficult to get credit means a lessened business opportunity for both the farmer and the merchant, and directly or indirectly results either in lower prices for the producer or higher prices for the consumer. The obvious remedy would be a cooperative agency by which all the banks of the country would be united in a national reserve association. Thereby the banks in any section where pressure arose would be able to bring the combined capital and credit of all the banks of the coimtry to the assistance of the region at the time when it was most in need. As a consequence, no bank would be obliged to CoSperation refuse accommodation to its customer, if it possessed good corn- Remedy mercial paper; because the local bank could take that paper to a branch of the national reserve association — ^free from dependence upon any city correspondent bank — and, with the proceeds of the loan, immediately increase its lawful reserves and its ability to lend to its constituents. When the Bank of Wheatville needed more currency at any time, it would change its credits with the national reserve association to notes, which would be sent to it without charge from the branch. Thus the notes of the national reserve association would automatically expand and contract, in accordance with the ebb and flow of the seasonal demands. Instead of each bank working out its salvation alone, all the banks would work together under a general policy. §5. The experience of other countries shows that it is not necessary to have a stringency, great or small, at periods of crop- moving, but that the seasons when agricultural products are be- ing sent to market can be financed as easily as any other pro- ductive period. This can be done by supplying .the two funda- mental necessities already referred to. In Canada, where the system CANADA'S ELASTIC SYSTEM 319 of production is very similar to our own, results are obtained by means of an elastic note issue which expands as the demand for agricultural loans expands. This note currency is supplied through a large number of branch banks which are thrown out into the agricultural districts by strong, highly capitalized institutions. The branch banks gets the notes from the head oflBces as fast as they are wanted, and lend them to farmers on the strength of the staple agricultural security which the latter have to offer. This system is often referred to as a flexible note currency system aj^nelps" for moving the crops. It is, in reality, a flexible system of bank the credit which happens to take the form of note currency. It ful- s'"'"*''^ fills the two requirements already mentioned in a preceding sec- tion. The large banks which establish the branches constitute the market for the paper of the agricultural communities. With their head oflBces situated in commercial centers, and with branches located in manufacturing regions, they are in position to draw idle funds from all sources and mass them where they are wanted at crucial moments. They thus afford a genuine market for agri- cultural paper. On the other hand, owing to their ability to issue large volumes of notes, they can supply the accommodation in that form and 'do actually do so. But while the branch system is desirable in many ways, it is not necessary, provided there be established such a system of cooperation among banks as to give to every institution which is called on for accommodation beyond its immediate means to Banks •grant, a certain and assured opportunity of marketing the paper which is offered to it and thus of getting the backing of a strong institution which will supply the support that is needed. Where this is done the result is to furnish exactly the same means of accommodation which are supplied under the Canadian banking system. If a cooperative institution were created, with power to issue notes as they were wanted, it could rediscount the paper presented by small banks. Having meanwhile obtained from other banks the surplus funds of other communities, it is able to use these as a basis for other loans and thus to afford genuine accom- modation to the banks that are in need of it. This accommoda- tion would naturally take the form of bank notes in the agri- cultural regions of the country. It would not matter whether the loans were made in the form of notes or in the form of credit de- posits, so far as the maker of the loan was concerned, but it would 320 UlflFOEM RATES OF INTEREST LOW Inter- est Rates In Remote Sections be a matter, of great importance to the individual borrower. The service of the note-issuer virould be merely that of converting into immediate means of payment assets which would be almost imme- diately wanted by the community and which had a certain market at' a definite figure. There would be no reason why any higher charge should be made for this kind of accommodation than for any other ; and as a matter of fact, there would not be. A comparison of the rates of interest charged in the "United States with those charged in Canada shows a very decided dif- ference. In the United States (see table of interest rates of na- tional banks given in Chapter III) the rates are uniformly high in outlying sections. In Canada they are little, if at all, higher there than in the commercial centers. Differences in paper, the length of the loan required, and other factors of the same sort, lead to some diilerences in rates of interest, but otherwise rates are uniform. In the United States the charge for accommodation at farming points in Texas may be 10, 12, or 15 per cent at the same time that in New York there is a plethora of idle funds which are being loaned at 3% and 4 per cent. Probably the rate on the loans in our country districts would never fall as low as this, for it often happens that the inability, under our system, to shift banking capital to different parts of the country as it is wanted causes a rate of interest which is as abnormally low in the cities as it is abnormally high in the country. With fluidity in banking capital and equality of adjustment between the two forms of bank credit, it would be found that a medium rate of interest some- what higher than the abnormally low rate of the present day and much lower than the abnormally high rates which prevail in the country at present would be established. There would, in short, be a general adjustment of supply to demand in the matter of bank loans and accommodations. Market for Agricul- tural Paper §6. The establishment of a regular discount market for paper originating in the agricultural communities, and the provision of a suitable note currency would be of great advantage in another way. The problem of the bank in the agricultural communiiy is two-fold — ^how to get additional means of accommodation at the crop-moving time, and how to dispose of its surplus funds at other times. The bank during a large part of the year now has dif- ficulty in disposing of the funds which are left with it. When farmers are paid for their crops and have liquidated their loans BEOADEE MAEKET FOE INVESTMENT 331 at the bank from which they borrowed, there is a surplus which represents their remuneration for their own labor and the use of their land during the producing season. This surplus is de- posited, while at the same time the demand for loans falls off heavily. The local bank tries to keep its funds active by buying commercial paper elsewhere, or by redepositing with other banks which pay it interest. When the funds are thus employed, the bank can afford not to seek loans of the less secure or less fluid character which may be offered in its own community — in other words, it can adhere closely to the actual business of banking from the commercial standpoint. The purchase of the outside commercial paper may thus be a good thing; and the redepositing of its funds with other in- stitutions, or the lending of such funds in distant markets, may be a good thing. Unfortunately, it frequently happens that the funds which are thus lent at a distance are lent upon speculative purchase security. Sometimes, although not so often, the commercial paper of Outside which is bought by the bank is bought unwisely and results in a ciaT'"*'"' loss to the institution. Under the most favorable circumstances. Paper there is probably a larger chance of loss, or of unwisdom in such use of the funds, than would exist if the bank could use them in buying paper which had been tested by a large cooperative insti- tution or by an existing bank that afforded a market for such paper. Thus, a discount market would be of great service to the bank, not only in marketing its own paper in times of special pressure, but also in keeping its funds active. At the same time it would be relieving the necessities of other communities which had a surplus of paper at times when the first institution had a surplus of funds. The effect of this discount market would be most obvious in the aid it would afford to banks in keeping their funds active and thereby enabling them to earn a good profit. But it would also have a favorable effect upon the borrower at the local bank. As we have seen, the local institution has to charge an exceptionally high rate because of the irregularity of business, which is abundant at some times and deficient at others. If it could be relieved of this irregularity, and enabled to employ its funds at about the same rate, and on about the same terms, throughout the year, it would be able to supply accommodation at a charge that was practically uniform throughout the year and that varied only as 323 ECONOMIZING USE OF BANK CAPITAL Discount Market Would Promote Uniformity of Inter- est Rates Present System Causes Bad Banking the general supply of, and demand for, loans varied throughout the country. In this way, a discount market would work in the interest not only, and not even primarily, of the banks, but to the distinct advantage of the borrowers at those banks. The local institution would be much better able to invest its idle funds as well as to get the use of idle funds from other places. In working out such a system, therefore, the business community would be pro- moting the interest not merely of the banks, but of everyone who was in the least dependent upon bank credit to facilitate his opera- tions. The plan suggested would really amount to a means of econ- omizing the use of capital throughout the whole agricultural com- munity. At present there is very great waste in the use of capital, owing to the necessity of holding it idle for long periods. The tendency of banks in some places has been to employ their surplus funds in long-period loans on real estate and similar security. This kind of business the national banks have technically been cut off from doing. Much of such business has, therefore, been taken over by state banks. This creates competition between different classes of banks. In not a few sections of the country, the effect of this com- petition has been to lead banks to undertake real estate loans by roundabout methods which violated the spirit of the national bank act, notwithstanding that they observed the letter of the law. Where this has been done, the effect may be to enable the banks to get better returns on their capital, but it is more than proportionately injurious to the community when the time comes for active short- period loans to be used in moving the crops. At such times, it is found that, in so far as the bank's capital has become involved in long-period security, it is unavailable for current uses. It is then so placed as to work a reduction in the active loaning power of the bank. This simply means that, in the attempt to get a full return on their investments and keep their capital actively employed, the banks have really reduced that portion of capital which is in a shape to furnish the basis for commercial loans. Under such circumstances, the banking capital of the community is narrowed by that amount. The community is then driven more and more to rely upon distant banks in time of stress. To the extent that it is thus obliged to look elsewhere for its short-period accommodations, it is without real banking capital. The function of banks as such in an agricultural community is not that of fur- PROMOTION OF GOOD BANKING 333 nishing farm loans, which are to be employed in the making of permanent improvements or the extension of farmer's equipment. That is a kind of business which should be performed by savings institutions, or by companies specially organized to do a mortgage business. The function should be kept quite separate from that of banking, as the type of organization which can be relied upon to furnish loans of the one class cannot be relied upon for the other. The adoption of a plan for rendering the crop-moving process efficient would aid the banking system as a whole, and through it would cheapen accommodations to borrowers in urban centers. Broader The discount market would be materially aided by the offering of ^^''^om- agricultural funds at slack seasons for the purchase of paper mercial originating in manufacturing regions or in retailing and jobbing ^P*"" centers. It would thus greatly tend to broaden the regular market for paper originating in either of these quarters. But it would also tend to create a new field for the exploitation of city bank capital. It has been noted how and why agricultural communities call for note credits rather than book credits. Conversely, we have seen, city communities demand book credits and do not care for many notes. At the present time, city banks take advantage of this con- dition of affairs, so far as the cramped conditions of note issue under the national system will permit them, to issue their own notes and to place these in the country when there is a demand for crop-moving "money." Very much more could be done in this way by an institution which was vested with a genuine note- issuing power. Inasmuch as the demand for the two kinds of bank accommodation is not interchangeable, it is usually true that a bank can maintain a considerably larger volume of outstanding credits where it has the power to make use of both classes of accommodation instead of employing only one. If a cooperative institution representing all the banks were thus vested with a large note-issue power, it would practically call into operation a large resource of credit which is now not employed at all. This kind of credit may be considered to have the same relation to the deposit form of bank accommodation as does the _. by-product in an industrial operation. If a manufacturing con- to Other cern is throwing away, or not utilizing, the material for the pro- Sections of duction of an important by-product, it is not in position to sell its chief output as cheaply as it could were it realizing something for its waste material. In a similar manner, the fact that the 324 BENEFITS TO UEBAN COMMUNITIES banks of the country were employing their pdwer of sustaining a note issue would call into effect a source of revenue which would enable them to supply credit by the other means at a lower rate. The steady call for note currency from the agricultural districts would, in other words, imply -a possibility of keeping the rate on ordinary loans in the cities and manufacturing regions considerably lower. This is the interest of the ordinary business man and manu- facturer in establishing a system of good agricultural credit. The desire for such a system of credit is not a purely altruistic one with him. It is coupled with the effort to make his own credit more secure by freeing the banks with which he deals of undue demand at periods of exceptional stringency. This makes it possible to re- duce the regular charge to him for the credit he needs, at all periods. Agricultural in a country like the United States is one of the basic industries of the nation. Whatever tends to render that industry more stable and regular in its methods, and at the same time to lower its cost of production, necessarily produces a beneficial reflex effect upon the rest of the community. CHAPTEE XIX THE MOVEMENT OF COTTON Financing Import and Export Business. — 2. New York Supplies Cash to Move tiie Cotton — 3. How Cotton Is Bought From the Pro- ducer — 4. Defects of Present Banking System in Relation to the Cotton Movement — 5. Cotton Movement and a Discount Market — 6. The Bill of Lading — 7. Acceptances. §1. The South, through its ports — New Orleans, Galveston, Mobile, Savannah, and Charleston — is engaged in the importation of such products as coffee, or bananas, from South and Central America; or in the exportation of such a main staple as cotton to Europe. In both cases, the transactions give rise to credit instru- ments by which shipments of actual cash are saved. That is, bills of exchange (or drafts) from different countries are offset against 'pterna- each other in international bookkeeping with much the same gen- Bookkeep- er al effect as are checks on different banks within our country off- '"9 '" set against each other at our clearing houses. To show the working import of a National Eeserve Association upon Southern business and Business banking, it will be well to discuss: (a) The matter of exports; and later (b) that of imports. Tinder (a), the points taken up will be: (1) A description of the present movement of cotton, and the bills of lading arising therefrom (2) The present financing of this movement by the banks (3) The evils of the present system (4) The remedies offered by a National Eeserve Association and acceptances (5) The bills of lading question §2. The total value of unmanufactured cotton exported from j^^^ York the Southern States in 1910 was $450,447,243.00 (or 6,263,293 Finances bales). Under present conditions, the main part of this move ^oveme*nt" ment of cotton is financed through New York, and the profits there- by gained are variously estimated at several millions of dollars. 325 326 DOMESTIC AND FOKEIGN BILLS First Steps In Moving Cotton to Market The question has been raised whether the Southern banks might not be able to do more of this business at home. Of course, it is a question, also, of the use of capital during the crop-moving season ; and the South itself does not possess the available capital to meet the need when it comes. In the technique of the cotton movement, it may be well to distinguish between (1) "domestic bills" and (3) "foreign bills," the former based on the operations within the country up to the arrival of the cotton at the port of shipment, the latter arising from the over-sea movement by ship. It is to be remembered that about one-half of the cotton produced is consumed at home. Hence domestic cotton bills between different parts of the United States are many; and they are also related to questions of warehousing, bills of lading, and the demand for credit. But times requires that this study should be confined to the cotton intended for exporta- tion. A cotton factor, or merchant, at some place like New Orleans, or Mobile, has cotton from various parts of the South sent him on consignment, or under some agreement as to price, to be sold. Or, a buyer sets out to purchase cotton in any part of the produc- ing area. In such cases, the cotton comes in on a railroad bill of lading, running only to the domestic port, or place of shipment; and if this cotton is sold to an American mill, or to another ship- per, only domestic bills of exchange arise. In case the factor sells any of this staple for export, he delivers it from the warehouse to the purchaser, who loads it on the ship and then obtains an ocean bill of lading. It may also happen that the foreign buyer himself may purchase cotton in the interior, and, wishing to see the actual goods, or collecting small shipments together at the seaboard, he may have the cotton sent to him on domestic railroad bills of lad- ing; then, afterwards, when he loads it on a steamer, he obtains a separate ocean bill. Thus, two sets of bills of exchange and bills of lading arise, a "domestic" and a "foreign;" but each covers an entirely separate transaction. If this distinction is kept in mind, much confusion may be avoided in understanding the financing of the crop. The method of handling cotton for export varies, of course, according to the conditions prevailing at the moment. At times the foreign buyer may find it advantageous to buy the cotton from the supply which is always accumulating at the seaboard. But, as is well known, there are throughout the producing area what COTTON IS BOUGHT FOE CASH 337 might be called inland cotton centers, such as Memphis, Dallas and the like, where the commodity is accumulated from the surround- ing country. Consequently, the purchaser for foreign account may buy cotton at these interior points and ship it direcly abroad on what is known as a Through Bill of Lading. This bill of lading Jhe 1 1^ 1*0 UQ n is issued by the railroad, and designates that the cotton is to be Bill of carried to the seaboard and thence by steamer to a specified for- Lading eign port. At the seaboard, such cotton is transferred without being touched by the shipper; but, when the cotton is placed on ship- board, the shipper obtains a document known as the -Master's Receipt. This document, however, does not control the shipment nor enter into the negotiation of drafts. The bill of exchange on Europe is negotiated on the through bill of lading, which controls the delivery abroad in the same manner as a simple ocean bill of lading. In this case, one set of bills covers the entire transaction. §3. Such being the usual course of the cotton movement, it will be the next step to indicate the present method of financing these operations during the months from September to January. In regard to the local cotton business, it is to be mentioned that the transactions are always in cash; hence a buyer, A, if of good standing, will arrange with his local bank to obtain funds if he wishes to purchase cotton. As is usual in this country, A will give his demand note, and secure it by warehouse, or compress, receipts, or by railroad bills of lading, covering a certain number of bales of cotton. Conservative banks will not advance on this piowof form of security more than their capital stock and surplus; but Currency this amount of credit is not adequate, and it makes the movement cotton is of cotton difficult. Moreover, if done, it is expensive. Payments Moving for cotton are demanded in cash. Consequently, when A buys 1,000 bales of cotton and gets the loan for, say $60,000, the bank knows without any doubt that within three or four days it will be called on for $60,000 in currency, which must come out of its re- serves, or must be shipped to the bank from the central reserve cities. When the cotton movement is over by January, this cur- rency comes in, and must be returned again, chiefly to New York. It is estimated that approximately $200,000,000 of currency is thus sent into the South, and again shipped back, during these four months, at a cost to country banks of possibly $40,000. In the thirteen cotton-growing states, including Kentucky and excluding Missouri, there are 1,461 national banks with a combined Financing Export Shipments 328 SOUTHEEN BANK CAPITAL INADEQUATE capital stock of $159,927,430. When this capitalization is consid- ered in connection with the value of the cotton crop it becomes im- mediately obvious why the South has to call on the North and on Europ,e for aid when the crop is to be moved. And, since the whole crop-moving period makes patent the insuflBciency of American cap- ital for all the demands — ^grain- as well as cotton-moving — put upon it, the inevitable resort is to Europe. And the ninety-day bill of exchange is the usual form by which this borrowing is carried out. In regard to financing exports of cotton and foreign buying, the operations are as follows: A cotton buyer, A, in the South- ern States, having borrowed as above described from his local bank, will now make a contract with a spinner abroad, or with a foreign cotton buyer (one who sells cotton to mills abroad), to sell him, say, 1,000 bales of cotton of a particular grade and staple, for shipment at a stipulated time and at a certain price. This price is usually what is known as "C. I. F. & 6%," i. e., cost, insurance and freight, and 6% tare deducted. Having assembled the requi- site number of bales, A takes out an ocean bill of lading for them, drawn to his own order, and stipulating that the steamship line shall notify the person abroad to whom he has sold them. He then makes up his invoice for the net amount which the foreign buyer should pay him and draws a draft (or bill of exchange), payable ninety days after sight to the order of himself, and en- dorsed in blank, which is called a documentary bill, because A at- taches to it the ship's bill of lading, or the through inland bill of lading (as previously described', covering both railroad and steam- ship transportation), and a policy of insurance covering the ship- ment. This draft, or bill, is drawn either upon the cotton firm to whom he has sold the cotton, or upon a mill which purchased the cotton, or upon some bank whose name has been given by the pur- chaser as one that will accept the bill by arrangement with him (the foreign purchaser) . The Southern cotton buyer. A, then pre- sents these documents to a bank, which offers him (for a commis- sion) the equivalent in dollars for whatever foreign money the bill may call for. By the proceeds of this sale of cotton to Europe, A has funds with which to take up his loan from a local bank, if he wishes. Of course, foreign cotton bills may not be sold to a local bank- in the South. A may sell through a broker in New York to some bank. Then the local bank, from which A first borrowed on his demand note, may draw a domestic bill of exchange, with the or- FINANCIAL DIFFICULTIES 329 iginal documents (warehouse receipt) attached, on the New York bank. Thus, in another way, the local bank will gain the sum neces- sary to liquidate A's obligation to it. Of course, the broker in New York gets a commission for selling the bill of exchange; and the New York bank makes a profit on the bill of exchange. Next, the bank forwards this bill, or draft, to its correspond- ent abroad, who presents it to the person upon whom it is drawn, Accept- and has it accepted — ^this acceptance being made by writing across Bills of the face of the bill the word "accepted," with the name of the Exchange firm, mill, or bank, and the date. The bill of lading and the insurance policy are thereupon delivered to the accepting institution, and the acceptance is held for the account of the American bank which forwarded it; and it may be carried until its maturity, or it may be discounted in the foreign discount market and the proceeds placed to the credit of the bank in this country. Finally, the American bank can sell a demand bill against the proceeds of the discounted ninety-day bill, and thus obtain the funds to meet the bill on maturity, or, in the meantime, to continue similar operations, §4. Having described the existing methods of shipping and financing the cotton crop, the defects of the present system may be here briefly mentioned. 1. There is a lack of actual currency during the crop- moving period, and a plethora at other times. This lack Actual arises from the inelasticity of our currency: greenbacks and Money Is silver are issued in fixed amounts; and the bond-secured ®* * national-bank notes increase (they do not decrease) accord- ing to the prices of bonds, irrespective of the demands of the South or of any other community. To the extent that trans- actions are increasingly settled by checks rather than by actual cash, the conditions are changing for the better ; for, as more banks are established in the interior of the Southern States, there is a greater use of checks; but at present, and, as this condition may not soon be changed, the movement of the crop calls for many millions in circulating notes. 2. Even when it is possible for Northern banks to increase their note-issue, the annual requirement for currency to be sent in from outside during the movement of the crop brings with it certain expenses and difficulties. Since there is but' one agency, and that at Washington, there is great delay and 330 PRIMITIVE CONDITIONS OF EXCHANGE Inelasticity of Note Issues Felt In tlie South Cotton as a Basis of Credit expense attached to the forwarding of national-bank notes. Moreover, the banks find it impossible at any time to change large notes for small ones, and vice versa, and, in conse- quence their customers are seriously inconvenienced. In addition, there is a high charge — seventy-five cents per thou- sand — for telegraphic transfers of currency from the New York Subtreasury to New Orleans. 3. The necessity of shipping actual cash into the South in the autumn months, and the expenses involved in this operation, are, in themselves, only signs of causes lying deeper down. In the main, these are two in kind : (a) One is the retention of really primitive condi- tions of exchange. Cash is required where credit-off- sets might be more generally used. Because of the rigid- ity of our bank-issues, the inelasticity of our note system is painfully apparent. This is especially true in regions where checks are not generally used. No part of the country suffers more from the inelasticity of our note- issues than the South. (b) But the inelasticity of the notes is really traceable to a more fundamental cause. That cause is the patent insufficiency of Southern capital to meet the exceptional demands of moving a crop valued at from $700,000,000 to $900,000,000. It is absolutely necessary to obtain credit from centers where the capital of the world can be drawn upon; that is. Southern banks are obliged to call upon their large city correspondents for credit. In ordinary times, such credit is freely obtained ; but, in any serious emergency — such as a real stress or panic — credit is actually unobtainable. If credit were easily obtain- able, then the transfer by check, as a medium of ex- change, would be possible, even if notes were scarce. Hence, apart from the inelasticity of notes (which en- tails difficulties and expense), the fundamental difficulty is the inelasticity of credit.. Even though cotton in bales is as good a basis of credit as anything in the world, the banks of the South are restricted in their operations by an existing system, which, the moment a strain is put upon it, cuts them off from accommodation when it is most needed. As soon as a Southern bank's loans rise to a point where its immediate liabilities (in its deposit COTTON AS CONVEETIBLE WEALTH. 331 account) are no longer in the legal ratio to its lawful re- serves, it must cease to lend fo'r the moving of cotton. And, if large city banks are also restricted in the same way, they cannot lend to their country correspondents. And it is unfortunately true that when the country banks are "loaned up," the city banks are likely to be in the same condition and for the same reason. The absence of ?.""*'[', Handicap- any cooperative organization of credit, by which the re- ped More serves of all are put to the common service, hits the Than Any South in the cotton-moving period harder than any other section part of the United States. That is, in any part of the country where capital is as yet insufficient for its needs, the lack is not so much a lack of currency as it is a lack of credit; if the credit can be had, then a medium of exchange can be got, either in the form of checks or (with some delay and expense) in the form of notes. The remedy, therefore, must be suited to the need. §5. The plan of a National Eeserve Association, in the form of a cooperative agency for all the banks — which is not a central bank — ^would enable any bank having cotton paper, accompanied by warehouse receipts or bills of lading, to obtain a rediscount at any branch of the Association. The proceeds of this loan might be had either in a credit on the books of the Association, or in the note-issues of the Association; and in either form (under proper Cotton restrictions) the borrowing bank would be able to use them in its should reserves. The point of this operation would be that good cotton Finance bills would carry with them the power to finance themselves, with- '*s*'f out resort to the aid of banks in the Central reserve cities. That is, cotton could be immediately transmuted into current funds during the period between its purchase and its sale. Such an in- stitution could not be used for the promotion of syndicates, nor for carrying stocks and bonds, nor for providing funds to be used in speculation; because the only paper (in normal times) accepted for rediscount would be short-time commercial paper (such as ninety-day cotton bills). Such a plan, moreover, would be open to all banks, state or national, and the rates of discount to subscribing banks would be uniform throughout the Union. This National Eeserve Association would do no discounting with the general public, and hence would not compete for deposits with existing national and state banks and trust companies. Con- 333 PEEVENTING A MONEY STRINGENCY Amount of Business a Bank Can Do Wealth From the Soil Would Bring Prosperity Btituted in the common interest of all the hanks, it would make the credit of the whole Association available to the banks in that part of the country where the special need might arise. It is not always realized that the amount of business a bank can do is related, not to the volume of its capital and surplus, but to the quality of the paper it discounts. There is no possibility of undue expansion by a bank if its discounts are confined to credits based on cotton, in warehouse or in transit. Loans on such goods, by early sale for cash, carry within themselves the means of quick liquidation. Such paper is far and away safer than long-time bonds, which do not fall due for a considerable period, and do not possess any advantage over other property in being convertible into cash Such a cooperative agency as a National Reserve Association, there- fore, is, by its very nature and operation, adapted to meet the pe- culiar difficulties which confront the South during the movement of the cotton crop. 1. It has been seen that cotton dealings are uniformly settled, in cash ; that the enormous burden of moving cotton causes the shipment of hundreds of millions of dollars of cur- rency to and from the South in the, autumn; and that the in- elasticity of our note-issues makes currency scarce and high. Any demand for cash draws down the reserves of banks. When the surplus reserves are gone, the legal reserves cannot be paid out. In consequence, the banks cannot lend, even when good cotton bills are presented. This intolerable, hu- miliating, and rigid inelasticity of our currency would be entirely removed by a National Reserve Association. If a bank in Atlanta, Mobile, or New Orleans, during the crop- moving period, found its reserves down to the legal ratio, it could take cotton bills to the Branch (not to New York banks) and obtain notes of the Reserve Association which it could hold or put into circulation. That is, notes would come into existence just in proportion to the need for them as the cotton was moved. Instead of a big crop-movement creating a money stringency, it would hring a corresponding supply of notes. Instead of a production of vast new wealth from the soil causing a stoppage of credit, it would, as it ought to, en- large it, and bring prosperity with it. Then, since the notes of the Association would be redeemable on demand in gold or lawful money, their return for redemption should be forced by some provision which would make them costly to the banks BEDISCOTJNT OF COTTON BILLS 333 to hold in reserves. Consequently, there would be the neces- sary contraction, after the demand for them had passed, which is as essential to elasticity as a ready expansion in time of need. By such a cooperative association the South would be enabled to coin its own cotton into notes through its own local associations; and there would be no reason for the expensive shipment of cash to and from New York. ^° Reason Moreover, by making the South dependent only on itself, it Getting would be freed from its present dependence for credit on Cash From New York, or on other central reserve cities. More than that, under the present dependence, it is often not able to get the funds, even if it has the cotton paper to be rediscounted ; but, under a National Eeserve Association, it would be safely pro- vided with currency, if it so desired, just in proportion to the amount of cotton bought and sold. 2. Not only would the cooperative organization of banks in a National Eeserve Association provide elasticity of notes, but, more than that, it would provide an elasticity of credit. The one essential fact forced home on the South in the autumn is the inability to get credit. The value of the cot- . ton crop is too great for her banking system to handle. But credit must be had. The bill of exchange for ocean ship- ments is the instrument used to get funds. How can the South get these _funds, instead of feeling annually this ag- gi-avated constriction? Under a National Eeserve Association, aid would be given in a striking and effective way. Even if notes were not re- quired, a bank, when threatened by a shortage of cash, would need only to present cotton bills having a short maturity to the nearest branch for rediscount. A credit would thus be created on which the bank could draw; or, the Association would even ship to it notes free of charge. All the items of present expense, as above enumerated, would disappear. The main point of this result should not be regarded as the con- venience, or gain, to the local bank ; the real substance of the new order would be the ability of the bank to" accommodate its customers. Here is the crux of the whole matter: The persons to be benefited most are the borrowers, i. e., the cot- ton factors, the cotton growers, and the whole public depend- ent upon the industry — ^the farmer, the laborer, and the store- keeper. If they are enabled to realize on their crop, their 334 MOBILIZED EESERVES South Would Be Inde- pendent Financially purchasing power becomes evident at once. Now why could a National Eeserve Association work this miracle with the insufficient capital of the South? Simply because, as a cooperative agency, it would be enabled to call to its aid the mobilized reserves of the whole country to sup- port an intense temporary demand; and because, by dis- counting bills for the banks, it could draw upon the capital of the North and of Europe. This capital would be available to the South whenever necessary, without begging for it, with- out asking for it, but as a natural outcome of the operation of the system. Why the South has not demanded some such in- stitution long before is passing strange. Certainly there is no reason why it should remain content with dependence on New York, especially when, in times of emergency, that center re- eponds to requests for aid only with the greatest difficulty. It will be of interest to give here the opinion of a French banker, expressed to a friend in Atlanta, who is here quoted : "He Is manager of the second largest bank in France, and the fourth largest bank In the world. He said that he was in the South for the purpose of studying its banking methods, and, if possible, to obtain accounts for his bank; that, to his great sur- prise, he found that the banks in the South commenced to ad- vance money to make the cotton crop as early as January, by supplying the farmers with funds to purchase mules and fer- tilizer, and that such security as we took from farmers would not be considered good in his country; that we advanced a large amount of funds for labor in planting the cotton crop, which might never materialize, or be injured to a great extent, there- by making our collateral subject to weather conditions; that later on we advanced further large sums for the purpose of picking the cotton and preparing it for the market, and this he did not consider good security. After the cotton is picked and ready for market, the Southern banks advanced more funds, taking as security inadequate warehouse receipts. In fact, our entire system of banking was based upon the problematical se- curity of a growing crop, which is not always certain. He stated, further, that, to his great surprise, he found that when the cot- ton is shipped and the security put in the form of a sixty- or ninety-day bill on bankers in Europe (which is in every respect equivalent to a demand on the Bank of England or the Bank of France), that we Southern bankers will not advance a dollar on the security, and the only explanation he could get was that we did not know how to do it; and this is a simple truth. We take all the risk of growing the crop, and the poor warehouse system, and when we get a document on which there is absolutely no risk, we refuse to handle it, and let this gilt-edged security go to New York, where it is handled at a good profit." Further, by the instrumentality of a National Eeserve Association, the financing of the cotton crop could be accom- plished at home; the cotton bills could be drawn and sold by BANK ACCEPTANCES 335 Southern banks ; and all the profit on handling the export of cotton could go to them, rather than to New York. 3. It is to be remembered, also, that the National Re- serve Association should be empowered to deal in foreign bills of exchange, provided they arise from commercial trans- actions (as opposed to dealings in investment securities), and bear at least two responsible names. In such a case, with an agency in London, the gain from the transactions would ac- crue almost entirely to home institutions. A bank in tha South having bought a cotton bill on a firm in England could forward it to the London Branch, which would present tha bill to the acceptor. The accepted bills then in the hands of the Branch could be discounted in the open market in London, or in New York or Chicago. Thus the profit would be gained by the National Eeserve Association, rather than by a for- eign bank. Yet in this case, as elsewhere, the bill of ex- change would enable foreign credit to be used in and for the South. 4. In the proposals for banking reform, it is also intended to allow a;ll banks, under proper restrictions, to create accept- ances. That is, instead of borrowing in the form of a de- Instruments mand note, the borrower. A, would make an arrangement with "'Credit his bank to buy a bill drawn on A by B (the planter), or ac- cept one drawn by A on his bank. Thereby, when accepted, the bank would assume the risk of repayment, and give the paper uniform security wherever the bank was known. The quality of the paper would no longer vary with the standing of the individual borrowers, but would be as good as the bank that accepted it. Consequently, such acceptances could be sold to investors in any discount market, at home or abroad, where the bank was known. For instance, a cotton merchant at Greenwood, Mississippi, might arrange with his home bank, or with a bank in New Orleans, or in some other city, to grant him credit for $60,- 000. He would draw a bill of exchange, or draft, on the given bank at sixty or ninety days, to which would be at- tached the warehouse receipts. When this bill had been ac- cepted, the paper could then be sold in any open market; and the bank could obtain at any time funds for such bills. So long as the credits were based on actual warehouse receipts, there could be no over-expansion. Over-expansion could New 336 INCREASED LENDING POWER No Danger cf Over- Expansion Importance of Uniform Rate of Discount arise only if acceptances were granted without the actual security. Obviously, the introduction of acceptances, which would also be handled by the Branch of the National Reserve Associa- tion, would enable a bank to provide for a customer a credit instead of currency (or notes of the National Reserve Asso- ciation, if so desired). Hence, a Southern bank could with safety extend loans based on actual cotton receipts to two and a half or three times the amount of its capital and surplus. Consequently, the lending power of the Southern banks in the crop-moving period would be doubled or trebled, not only to their own profit, but to the advantage of their customers, and the whole people. 5. Since these acceptances could be sold in the open dis- count market for prime bills, they would command a low rate of discount; and, if negotiating in Europe, the South would obtain its capital for crop-moving purposes at the low Euro- pean rate, rather than at the higher New York rate (as at present). If the Southern banks could thus borrow at low rates on acceptances, they could grant lower rates than now to the merchants and farmers who form their constituency. For a small bank could borrow at the National Reserve Asso- ciation at exactly the same rate as the large central reserve city bank. That brings out the democratic character of the proposed National Reserve Association. The importance to the South of this uniform rate of dis- count by the National Reserve Association cannot easily be exaggerated. As things go now, the idle funds of local banks go to New York banks, are there loaned on call, and used for stock speculation. If acceptances were made pos- sible, under proper restriction, and idle funds were directed to buying them in the open discount market at, say, 4 or 41^ per cent, instead of the 2 per cent obtained on New York deposits, the banks, as well as the borrower, would gain; the former getting a higher rate, and the latter a lower rate, than now. More than that, the flow of funds into call loans, as at present, makes the rate which the mercantile borrower pays depend upon the rates current on the stock exchange. But. with a National Reserve Association rediscounting only com- mercial paper, and with acceptances to be had in the open market, the mercantile borrower would be protected against VARYING INTEREST RATES 337 aberrations due to the excitements of stock exchange specula- tion. Not infrequently, in times of emergency — ^when a bor- rower is most in need — the rates in New York have advanced as high as 100 or 150 per cent. Likewise, the variation in the rates throughout the United States is wide, even in normal times : New York, 3%-3 per cent Chicago, 31^-4 per cent Atlanta, 5-6 per cent Macon, 6-7 per cent Greensboro, 8-10 per cent Smaller towns, 13-15 per cent Under a system by which mobilization of reserves was made small possible, the rates to banhs in the smaller towns, on the same Banks kind of security, would be as low as to the large bank in New Have York or Chicago. Advantages 6.. The effect of the National Reserve Association would be far reaching in many ways. At present, the central reserve city banks value the accounts of their correspondents accord- ing to the amount of their deposit accounts with them. The rules of the New York banks as to balances and discounts regulate the amount of credits to the Southern banks. And at some times in the year their funds in New York are avail- able to them only at a discount. But if bills and acceptances were made in the South and cuts Off forwarded direct to London by the Southern banks, the South Brokers' would have credits in London for sale. This practice would sions eliminate the commission of the New York broker, and the Southern- banks would retain for themselves the profit of the New York banker. Having cable advices as to rates of dis- count with their European correspondents, the Southern banks could make a price for exchange to the local cotton ex- porter. Having accounts in London, Paris, Berlin, or Bremen, the Southern bank could buy bills on Europe, forward them to its European correspondent, where the rate charged would be the European (not the American) rate ; on this account it could draw its clear demand bills, or cable transfers. That is, it could sell its European credits wherever in the world (New York, Chicago, Rio Janeiro, Buenos Ayres, Montreal, or Havana) credits on Europe were desired. For example, if Brazil were buying manufactured goods from London, and ex- 338 ARBITKAGE TRANSACTIONS London Accounts Have Advantages poiting coffee to New York ; and if the South were exporting cotton to London; then the Southern bank could sell a Lon- don credit (in sterling) to Eio; and the Eio bank could cable New York to place the sum (in dollars) to the credit of the Southern bank. This whole arbitrage transaction could be completed in twelve hours. As compared with a New York account, the London ac- count is more satisfactory to the Southern bank. It is not so much a question with the London banker what the amount of the balance with him is ; he is not rediscounting, as is the New York banker; he permits the Southern bank to draw on him, and he simply accepts the bills, charging for the period it is carried a rate of preferably li^ to 3 per cent — a rate much lower than that of New York. The London banker values the account according to the amount of acceptances he gets ; the greater the number and amount of bills, the greater his commissions. The credit is forthcoming in exact propor- tion to the need; while in New York it is dependent largely on the amount of balances held, or on the rigid system of re- serves. §6. Finally, we come out upon the bill-of-lading question, which has recently occupied so much attention since fraudulent bills were disclosed and efforts were made by foreign bankers to force a guaranty of the genuineness of the bills of lading before discounts were granted. The risk attendant upon such transactions to the American banker is primarily whether or not the cotton was actually sold by the buyer in this country to the buyer abroad; and secondly, whether or not the firm upon which the draft is drawn really authorized its acceptance. It is therefore incumbent upon the American banker to be thoroughly acquainted with the person from whom he buys, and to be satisfied of his integrity and that he would not offer for sale a bill of exchange drawn against cotton which had not been actually sold, nor draw upon a firm or bank which had not agreed to accept it. The American banker operates upon the theory that his responsibility as to the validity of all the documents ceases when the bill has been accepted; and the only responsibility he runs thereunder is by reason of his en- dorsement on the bill, in the event of the failure of the accepting bank of firm. THE FOEEIGN BTJYEES' EISKS 339 The risk to the foreign cotton merchant lies in whether or not the American cotton buyer from whom he has purchased the cotton is honest and responsible. He may be defrauded in various Ways of Defrauding Foreign (1) The foreigner may have purchased the cotton at a ivierchants stipulated price and the American buyer may never deliver it to him, if the market advances sharply and the transaction would show a serious loss; (2) The American may deliver him cotton of a lower grade than that which he purchased, and draw for the value . of the higher grade; (3) He may ship him cotton of less weight than that for which he draws; (4) He may make out a fraudulent bill of lading by signing the name of an interior agent, and draw against the cotton without ever having shipped it. It is therefore incumbent upon the foreigner to be thoroughly informed as to the firm or person from whom he buys, i. e., in the same manner in which it is necessary for anyone extending credit to be conversant with the aifairs of the person with whom he is deal- ing. The risk to the foreign banker who has agreed to accept such documents lies in whether or not the foreign spinner or cotton merchant for whom he has agreed to accept is financially respon- sible and able to pay the draft, even though the cotton may never have been shipped. He is, therefore, required to exercise his judg- ment in the same manner as when extending credit upon any other piece of negotiable paper. In the main, the risk arising from the possibility of fraudulent bills of lading is no greater than the risks which the banks assume every day in the chance of pay- ing forged checks. If the European methods, by which the buyer of cotton ar- Fear of ranges with his bank to accept bills drawn at thirty, sixty or Fraudulent ninety days against shipments of cotton, were generally introduced Lading into the South, much of the fear as to fraudulent bills of lading would disappear. The local Southern bank would be over-careful to see that the bills of lading were genuine, if it accepted the bill and assumed the risk; and its facilities for insuring genuineness are apparent. The main source of difficulty has arisen from the fact that the cotton bills now usually pass through New York banks, which obviously do not have the means of verifying the 340 VEEIFYING COTTON BILLS bills of lading, as do the banks in the cotton district. The attempt of the English bankers to force the responsibility home upon the New York bankers has its origin in the same general cause. Were cotton bills generally accepted by Southern banks, the risk wOuld be placed where there is the least chance of deceit, i. e., on the acceptng banks. If desired, the American banker could insist upon holding the bill of lading until the cotton arrived at desti- nation, and requiring that it should be placed in the warehouse, insured for his benefit, and paid for only when withdrawn from the warehouse by the mill. Such a procedure is usual in handling imports, such as coffee. Such a method could be successfully car- ried out by Southern banks, and they could transact a very much larger business than now, were there established a National Re- serve Association at which an accepting bank could rediscount, its own acceptances; or if there existed a general discount market for acceptances. §7. Lastly, we may briefly discuss (b) the relation of the financing of imports to the National Eeserve Association. A in New Orleans purchases coffee ($10,000) from B in Eio ^manc ng Janeiro. A wishes a time loan on this coffee in order to be able Imports in due course to pay for it out of the proceeds of its sale. A ap- plies to Bank X in New Orleans for a credit in London, which he can transfer to B's order; because, as Brazil buys its goods in Europe rather than in the United States, it wishes to use its pro- ceeds from exports of coffee to the United States in payment of its debts to Europe. Bank X grants this loan to A by instructing its correspondent bank, Y, in London to accept drafts (or bills of exchange), usually running ninety days ahead, drawn by B in Rio Janeiro on London to the amount of $10,000. Bank X guar- antees to Y the payment at maturity of this draft. The charge for this credit to A is made in the form of a commission of % of 1% ($50), of which 14 of 1% ($25) goes to the' London bank, Y. The London bank, Y, receives the draft from B in Rio ac- companied by the Bills of Lading and the Insurance Certificates of the coffee sent to A in New Orleans. Bank Y accepts the draft, but sends the bills of lading, etc., to its correspondent, X, in New Orleans. Then A must pay Bank X for the coffee: either (1) in cash, less the discount at the London rate to date of maturity; or (2) A may leave the documents with Bank X until the coffee ar- ECONOMIES PEOM BANK COOPEEATION 341 rives; or (3) A may take the coffee out on a Trust Receipt, place the coffee in a warehouse, and give Bank X the warehouse receipts as security; or (4) A may be given the coffee on Trust Eeceipt, and allowed to sell it, the bank arranging to be paid by A fifteen days before maturity of the bill in London. Thus A expects to get the means of payment for the loan by a credit based on the sale of- the coffee. If acceptances by national banks were legalized under the National Eeserve Association act, a national bank, X, could itself accept these drafts from Eio directly, without asking London Direct to do it. This paper would have on it the name of the Brazilian tions With exporting house, and of Bank X which accepted it, and it would ^°'"^'9" be guaranteed, also, by the importer. A, in New Orleans. If Bank X accepted the Eio draft, Bank X could provide A with a bill of exchange on London which A could transmit to Eio in pay- ment of the coffee. Then from the proceeds of the sale of the coffee A could pay off his obligation to Bank X. As is well known, such a use of credit instruments would prevent the needless ship- ment of actual cash. By this method the profits of accepting bills would be transferred from London to New Orleans. Of course, any state bank or trust company, not being under the jurisdiction of the National Banking Act; could do this business to-day; and it is coming to be understood by some enterprising state bankers in the South. The outcome of the whole matter is that the National Ecr serve Association would by evolution carry to a wider field of oper- ation the principles of the clearing house associations, and save the needless movement of actual cash, not merely between banks in the same city, but between different portions of the country. Thus the crop-moving period would no longer be a time of a great shifting of money reserves, and a time of stringency, but a season of prosperity and increased purchasing power. CHAPTEE XX THE DEPOSITOR 1. Relation of the Depositor to the Bank — 2. Guarantee of Deposits — 3. Shortcomings of Examination — 4. Bank Failures — 5. The Question of Rediscounts — 6. Segregation of Commercial and Other Banks. Both Depositors and Note- holders Must Be Considered Erroneous View of the Depositor §1. The relation of the depositor to the bank is often spoken of as if it were the principal problem to be dealt with from the side of the public in relation to banking. In former chapters, we have seen that the same point of view is also taken with respect to the note-holder. Neither view, in this exclusive form, is well found- ed. Both the note-holder and the depositor must be considered since both are holders of demand liabilities of the bank. But, while both are theoretically to be regarded as equal, the fact remains that in modern banking in commercial countries, the depositor has gradually assumed a much more important place than the note- holder because of the fact that the deposits which the bank has obligated itself to pay are so much larger than the notes which it has issued and which it has undertaken to redeem. A completely erroneous view of the depositor and his status is often taken and until this is eliminated, nothing can be accom- plished in analyzing his relation to the bank from a correct stand- point. The ordinary discussion of the depositor assumes that he has left something with the bank for safekeeping. This the bank is assumed to have received, and to be protecting, using it in the meanwhile for its own purposes as it is permitted to do. What the depositor is thus supposed to have "Iteft" is "money." The bank is conceived of as the guardian of the depositor's money and he is thought of as having placed money in the bank. This is practically the reverse of the ease. It is true that a few depositors bring actual money to the bank and leave it there, receiving in exchange a credit on the books of the bank, which is evidenced by a memorandum or by figures in a so- called "bank book." But this is not the wav in which the bulk of 342 DEPOSITS A EESTJLT OF LOANS 343 the deposits are made. Usually the deposit is made by asking the bank for a loan. A borrower goes to the bank and ofEers his note, with or without some additional protection. The bank agrees to grant him the desired accommodation and he gets a credit of, say, $1,000 on the books. Against this' he is allowed to draw; and, if he wishes, he may call for cash to that amount. The depositor who has actually left cash with the bank could not do more. Both are depositors upon an equal basis and are treated alike by. the bank. In fact, neither of them usually wishes to draw any money except, perhaps, in relatively small sums for current use. If they did so desire, they would not have become depositors at the 'bank in the first instance. The man who actually left cash there would not have done so but would have kept the cash in his possession. The man who got the loan would have taken it in the form of notes in- stead of that of a book credit. This gives us a new point of view as to the depositor. If he is not, in the majority of cases, one who has left money with the bank, but is one who has obtained a loan from the bank, what is Depositor the relation of the hank to him, and what ought to be the things Primarily a or conditions which he should be in position to exact from the bank ? What ought the institution, to be expected to do for him ? These questions can be tentatively answered by considering what it is that the bank agrees to do when it either accepts his money on deposit or grants him a credit on its books. The thing it Tindertakes to do is to liquidate, in current funds, all claims that may be presented to it up to the. amount thus credited, redeeming them in cash over the counter if actually called upon to do so. Of course, as everybody knows, no bank could redeem its outstanding deposits in cash if all depositors were to call upon it at once -to make good their claims in that way. It is assumed that they will not do so, but that only a normal amount of them will come ia. If the bank keeps itself in such condition that it can meet the normal claims of depositors that are regularly presented to it, and main- tains its assets in such condition that with a reasonable and aver- age notice it can convert them into cash and thus ultimately liqui- date the whole of its depositors' claims upon it, it has done all that can pi^operly be expected. Discussion of the relation of the de- positor to the bank must- therefore be an analysis of the way in which the bank has to proceed in order to get these results, and the nature of the precautions that must be observed in order that all 344 GUAEANTBE OF DEPOSITS banks may have an equally favorable chance of success in thus pro- tecting themselves and their creditors. Demand for Guarantee of Deposits Based on Mistaken Conception of Deposits An Efficient Guaranty §2. It is to be noted that in the foregoing analysis nothing has been said of "guarantee of bank deposits." In recent years there has been an outcry for legislation that would guarantee the depositor against loss through the failure of banks and would also guarantee him an immediate payment in the case of suspension. This notion was based upon the idea that the deposits in banks' were actual deposits of money and as such that their "return" could be "guaranteed." It was supposed that by establishing a "guaranty fund" contributed to by all banks in a certain percentage of their outstanding deposits, a resource would be created upon which all claims payable by failed or suspended banks could be made to draw. The trouble with this supposition was that (as we have seen) the deposits were credits in the proper sense of the term and the guarantee of bank deposits was therefore a guaranty of bank credits or, in other words, a guaranty on the part of banks that the loans they had all made would be liquidated at once if desired. Inas- much as bank deposits are several times the amount of cash in exist- ence at any given moment, and inasmuch as values depend entire- ly upon the continued existence of business as a going operation, the guaranty thus offered was impossible and imaginary. There was no assurance that the claims could be liquidated at any given moment and could not have been, since no one could know how many would be presented at any given time. Wherever the bank deposit guaranty system has been tried, it has been found ineffec- tive. The real nature of the guaranty which can and should be given to the depositors of the bank is not found in the furnishing of an assurance that the deposit accounts will certainly be paid. That merely prevents depositors from discriminating between banks and selecting their institutions wisely and carefully. It is found in the establishment of regulations which will give all the assurance that is humanly possible that banks are being carried on efficiently and safely, that their funds are being invested in properly secured loans, and that they are maintaining a due degree of liquidity in their assets. Part of this kind of assurance can be had from thorough and careful inspection of banks and the rigid enforcement of restrictions upon bank business which will prevent the institutions from en- INADEQUATE INSPECTION OF BANKS 345 gaging in hazardous or doubtful operations. If banks can be pre- vented from using their funds in directions which would not be approved by stockholders and creditors, all has been done that the government is in position to do, and there is no ground for de- manding that other banks stand behind the credits granted by the institution to depositors. If to this be added such arrangements as will insure the banks a means of liquidating their paper at those times when they desire to convert their assets into immediate funds, ■ there is little more that can be done. It has been supposed that, under existing conditions in the national banking system, the government was performing the first of these duties, that of thoroughly inspecting and examining the banks, although it was not performing the second. Even if it were true that the duty of inspection and examination were being fully performed by the government with respect to the national banks, the question of the state institutions would still remain. It is a notorious fact that, although there are some states whose bank examinations are as good as or better than those of the national governmeiit, there are numerous others in which the examinations are unsatisfactory. Since the state institutions outnumber the na- tional more than two to one, and since difficulty with banks in one system may communicate itself to the banks in the other, it would not be true that depositors were getting the proper protection to- day even if the national system of inspection and examination were sound or even if most of the systems of the states were also sound. But there is grave doubt as to whether even the national system of inspection is satisfactory. §3. Within recent years a very serious defect in the national banking system has been found in the difficulty of examining the different institutions. During the earlier years of the system when the banks were few in number the problem of examination was not very serious. It was then possible to send satisfactory and capable examiners with sufficient frequency to the different banks, and to obstacles ascertain with substantial accuracy what they were doing. Many to conditions intervened to change this situation. The very growth gxamina^ of the system has thrown serious obstacles in the way of examina- tion tion. Obliged to follow reports from more than 7,300 national banks, the officers of the Currency Bureau in Washington, find it far from easy to keep in mind the doings of each of the banks. But the growth of large systems of state banking and the development tions 346 NEED OF C05PEEATIVE CONTKOL of trust companies organized under state laws by the side of the na^ tional banking system has greatly complicated the problem. Many of these state institutions are affiliated more or less closely with national banks, while many more depend on the na- tional banks to hold their reserves and supply them with loans. The state institutions are subject to the oversight and control of the state superintendents or. supervisors of banking. Although '"**'■■ genuine efforts have been made by the Comptroller of the Cur- of state rency to improve the examining methods of the national banks ^"^. and to bring about cooperation and uniformity between the na- Examina- tional and state systems, his efforts have been only partially suc- cessful. Until very recently, a bank which was driven out of the national system for loose or bad banking promptly took out a state charter; and vice versa. This meant that it was impossible to get rid of the undesirable banking institutions of the country since they could always find a refuge, even though they had been obliged to give up their original charters on account of bad or_ doubtful practices, or the making of unwise loans. Under existing conditions, it is also very difficult to keep track of the paper which is outstanding and to make sure that it shall not be distributed by borrowers, who want more accommodation than they are entitled to, throughout a large group of banks none of whose members knows what the others are doing. The Comp- troller of the Currency has done what he could to bring about a greater diffusion of knowledge of this kind among the national bank examiners, and through them among the banks themselves, but his efforts are, of course, confined -to the system under his juris- diction. He cannot know of the conditions existing in the state systems, except by the courtesy or aid of state bank examiners, which they are not obliged to extend. It is, therefore, entirely pos- sible to float paper in the ways indicated, and thereby to secure ex- tensions of credit that ought not to be granted. Secretiveness and hostility among many of the banks greatly promote this condition of affairs, and it could be remedied only by some measure that would unite the banks more truly than now into a system, in the proper sense of the word. Until that shall be done, it will unavoidably be true that, owing to lack of knowledge and inadequate facilities for testing paper, the banks will suffer to a certain extent, and the soundness of the situation will be correspondingly impaired. This condition is seen at its worst during a period of credit in- flation. In such a period,- banks, perhaps throughout a given sec- NO CHECK ON BAD LOANS 347 tion of the country, become over-confident anJ extend loans on cer- tain classes of security either directly or indirectly beyond the limit to which they ought to confine themselves. Having thus exceeded the bounds of caution, there is nothing to cheek them such as would be supplied by a cooperative association to which paper would be carried for rediscount. Banks at a distance rediscount freely for the institutions which have been doing business with them in the speculative region, while other banks rediscount in the same way for still other institutions in this same area. That is, as things stand today, the capital of conservative districts is used to facili- tate loans in speculative districts. In consequence, credit is extended for certain purposes in a way that would not be followed if there were any general method of checking up what has been done. With the existence of such a method, there would be furnished a means of accurately estimating Difficulties the total amount of the available funds of the country which were [JJ^^me of being employed in certain classes of undertakings. Both the banks Inflation which originally made the paper, and those to whom it might be presented for rediscount, would thus get a far clearer knowledge than is possible at the present time. Present bank examinations cannot thoroughly reveal a condition of this sort because they af- ford no comparative test, or attempt such a test only in a remote and approximate manner. It is entirely possible that the assets of a bank at any given'time may be quite sound, considered by them- selves, yet be far from sound when considered comparatively with those of other institutions. Such a comparison reveals the fact that there has been undue emphasis upon certain classes of loans so that the liquidity of the paper is seriously impaired. This merely pre- sents one phase of the danger that exists in an incompletely organ- ized banking system, of diverting capital too largely into given channels and occasionally of making too largely extended loans upon given kinds of security. It is not a situation that can be cor- rected by any examination plan per se, however thorough. §4. It is a natural consequence of our incomplete and in- adequate system of examination that there should be a good many bank failures from time to time. The statement is frequently Failures ol made that such failures are not very numerous and that there is National no particular reason for fearing failures under the national sys- ^" ^ tern unless there has been dishonesty on the part of officers. The 348 FAILURES OP NATIONAL BANKS facts hardly bear out this assertion. According to the report of the Comptroller of the Currency for 1910, such failures have caused a loss of $150,000,000 and haye been as follows: Summary of Beports of Receivers of Insolvent National Banks, 1865 to October 31, 1910. Closed re- Active re- ceiverships, oelvershlps, Total, 514 459 55 Total assets taken charge of by receivers $296,406,777 f 45,399,194 $341,805,971 Disposition of assets: Offsets allowed and settled 23,696,964 3,417,858 27,114r822 Loss on assets, compounded or sold under order of court 107,773,294 4,448,160 112,221,454 Nominal value of assets returned to stockholde>-s 14,045,068 14,045,068 Nominal value of remaining as- sets 3,714,802 14,734,104 18,448,906 Collected from assets 147,176,649 22,799,072 169,975,721 Total $296,406,777 $45,399,194 $341,805,971 Collected from assets as above 147,176,649 22,799,072 169,975,721 Collected from assessments upon shareholders 19,498.142 2,089,868 21,588,010 Total collections $166,674,791 $24,888,940 $191,563,731 While it is true that the number of failures thus reported does not appear to be very great when considered in the aggre- gate, it is much greater than the failures reported from other coun- tries. The total number of banks failing in Canada during the past twenty-two years was only six, with a total amount of capital of less than $3,000,000. Their liabilities were about $12,571,000, Other most of which were paid. This was the experience under a corn- Countries petitive banking system, which numbered in 1909 some thirty-three banks, with a joint capital of $143,466,000. The losses in other countries have been even smaller, depending upon the degree of oversight and closeness of supervision accorded to the banks. No- where has a system of banks directly overseen and controlled by the governments of European countries proved itself liable to failure. It is thus evident that while the national banking system has not been peculiarly subject to insolvency, considering the great number of small units of which it is composed, it has, nevertheless, been- far from aflEording complete protection to its creditors. The losses to stockholders have, of course, been severe in those institutions where a receivership continued for some time or where assets were bad or doubtful to begin with. The fact often alluded to that no note-holder of any national bank has ever lost, owing to the fact that his notes are protected by RAISING THE BANKING STANDARD 349 gOTernment bonds, which the bank is compelled to buy in a specified percentage upon organization, is not a very important point. Clearly the benefit or gain to the note-holder thus secured is ofiEset by a corresponding decrease in the assets which might have been distributed among the other creditors. On account of the necessity of going through the legislation and regulations of so many different commonwealths, it would re- quire a much more elaborate treatment to show how inspection and examination work in the several states and what are the de- fects of these local systems, but it may be stated with truth that the evils present in the national system exist throughout the state fyg^^ systems, and in a magnified form. The state systems have buen Unsatisfac- thoroughly unsatisfactory in the matter of failures, while in so '"""^ far as concerns examinations, most states leave a great deal to be desired. All this urgently raises the question. What can be done to improve the situation regarding the safety and solvency of the banks of the country and thereby to put the depositor in the proper position with respect to the bank, the position to which his claims indisputably entitle him? Evidently the first step to be taken in this direction will be that of making all banks engaged in regular commercial opera- tions as nearly subject to one general kind of oversight or control as may be. This could hardly be done by any direct legislation Advantage under our constitutional system. But it can be reached by some °f ... Concentra- action that will unite the banks into a cooperative association for tion of the purpose of supplying one another with funds through a re- Supervision discount process whenever that may be found necessary. If a re- serve association, such as has been suggested in preceding chapters of this volume, were to be created, the effect would be to cause many banks to resort to it for accommodation as their needs might dictate. Probably every bank that owns stock in the association would at some time or other obtain loans from it, while those that did not do so would undoubtedly keep their spare funds with it on deposit. The result of establishing such an association, with its various branch oflBces, would be to create a general standard as to bank- ing operations and to enforce this standard in a way that is not now possible. Banks would seek, in the first place, to confine them- selves to such business as was recognized by the association as legitimate, and would attempt to have on hand at all times a fair amount of paper of the kinds that could be rediscounted with the 350 PANIC DEMANDS FOE CASH association. The effect of this would be to exert the same kind of wholesome influence that is now exerte^ by clearing-houses in the large cities. Such influence, however, would be extended to the smaller towns and villages, and there would be a general toning up of the banking system throughout the country. Bank paper would be standardized and bank operations subjected to a uniform mode of control. In these ways, depositors would be very greatly protected. They would run no such risk as they now run through the resort by banks to irregular methods of doing business, since it would be far easier to detect such methods under the proposed system. A genuine "guaranty" of bank deposits in the best sense of the term would thus be afforded, because the depositor would get the kind of protection he required, and the institution with which he dealt would be likely to fail only as the result of direct dis- honesty on the part of officers or directors. Demand for Cash in Time of Panic §5. While what has been said holds good of the banking system and of banking operations generally, there remains the question of the relation of the bank to the depositor in times of panic. It is this, and not the relation of the bank to the de- positor in ordinary tiqies, that has received most attention, not- withstanding the latter is probably the more important problem of the two. What happens in periods of panic, as we have previously set forth, is a sudden call on the part of depositors for the liquidation of the bank's obligation to them in spot cash. As we have seen also, this is not a demand that is likely to be made by depositors everywhere, or even at very many places. If it were, no means of meeting the demand could be devised. The demand occurs only at certain banks and in certain places, and the sole question in such cases is whether these banks have good assets. If they have, depositors should not be obliged to go without their funds, but should be enabled to get cash if they wanted it. This can be accomplished by means of a rediscount institu- tion which would enable such banks to convert their assets into immediate means of payment. Such an institution would be provided in the proposed Eeserve Association; and, if it were, the change in the present situation would simply amount to an assurance to all depositors that whenever the banks with INSTJEANCE AGAINST BANK RUNS 353 which they dealt had good assets, they need feel no doubt whatever- about their own capacity to secure cash at any time they desired it. The bank which held their accounts would be able to go to ^et by a Rediscount the Reserve Association, ask for a credit there, presenting its com- institution mercial paper of specified kinds for rediscount, and then either to use this credit as a reserve (thereby releasing the actual funds held in its vaults), or take it in notes of the Reserve Association which could be paid out over the counter, thereby substituting the note liability of all of the banks of the country (as federated together in the Reserve Association), for the obligation of the local bank itself, which for some reason had incurred the distrust of the depositors. The operation would be exactly the same that is performed by our clearing-house associations when they issue clearing-house certificates, except that it would be managed smoothly and efficiently, without any of the shocks to business confidence which are inevitably given under present "methods. It can safely be asserted that, with such a system in working order, funds would seldom be called for. They would never be asked for by depositors of banks which were recognized as un- doubtedly keeping their funds. in an available form through the Association maintenance of a volume of paper that was eligible for rediscount Would at the National Reserve Association. Doubtless, many small de- ^gn f^^ positors would know nothing of the practices of the banks in this Funds regard. Large depositors would have this knowledge, however, and would act accordingly. If small depositors, owing to some false rumor or market flurry, should lose confidence in a given bank and begin to draw out cash, it would be easy to check them promptly by obtaining abundant rediscounts from the National Reserve Association, and allowing the fact, if necessary, to be known. The consequence would be that large withdrawals of cash by depositors at times of panic or doubt would not take place, and the whole system would be put upon a much more satisfactory and normal basis than it is at present. As we have seen, this would save an immense amount of waste in the use of reserve money by avoidiug the maintenance of great sums of cash in the vaults of banks. It yu^g would also avoid the current necessity of obtaining actual cash Effected and paying it out over the counter in those instances where a run occurred. An issue of notes by the Reserve Association would avoid this necessity, while the notes would be equally acceptable to the depositors as cash, since they could" use them for practically 352 IMMEDIATE FUNDS FOR DEPOSITORS Rediscount Market Protects Depositors Guaranty of Deposits Does Not IVIeet Real Needs every purpose for which cash could be used. The conveniences of the banks and of the depositors, economy of the country's money supply, and avoidance of unnecessary strain on bank reserves would result from this method of meeting the ca,lls of depositors and the latter would be correspondingly aided. While this condition of affairs is sometimes spoken of as being of great advantage to the banks, inasmuch as they would be pro- tected against disturbance to business, loss of reserves, etc., the protection and advantage to the depositor would be vastly greater than to the banks themselves. Depositors who call for cash in times of loss of confidence do so, not because they want the cash, but because they have come to fear that the institution which is holding their deposits is not capable of maintaining payment. They recognize the serious loss to which they will be subject, if, as a result of the bank's suspension, they are prevented from drawing their funds as they need them. This loss is not merely the ultimate sacrifice of the value represented by the depositor. On the contrary, an analysis of bank failures shows that, in the long run, a very large percentage of bank obligations is fully liquidated, when the banks have had the time they need to convert their assets into cash and call in the proceeds of stockholders' lia- bility, etc. Meantime, however, the immediate need of the de- positor has not been met. His funds being tied up, he has been unable to meet claims upon him, or to take advantage of business opportunities,, or perhaps to liquidate pressing indebtedness, failure to meet which means loss of business credit and possibly, in ex- treme cases, bankruptcy. The return of his funds at some period far in the future is not a sufficient recompense to him. Guaranty of bank deposits, even if it succeeded ultipiately in making good to every bank depositor the total amount that was due him from banks, would not suffice to meet the real needs of the situation, since the most important requirement is not ultimate but immediate payment; and the latter, as we have seen, none of the familiar deposit guaranty systems can provide for. They would break down as soon as the immediate liability became large, and at best could merely succeed in subtracting some cash from the other banks, thereby weakening them to a corresponding extent without, as a rule, doing any good to the depositors. But by giving to every bank the power to convert its reliable assets into cash by rediscounting them as may be desired, the requirements of the de- positor for immediate payment are fully protected up to the point A PEEMIUM ON GOOD BANKING 353 that the bank with which he deals is in possession of good bank- able assets which it can with assurance present to the Eeserve Association for rediscount. Besides aiding the bank, the establishment of a discount mar- ket furnishes an accurate measure of the depositor's responsibility. Such responsibility is destroyed under a bank deposit guarantee system. As against that system, the proposed plan requires the depositor practically to keep his funds with those banks that con- fine themselves to strictly commercial banking, if his own business is such that his prime need is constant ability to draw. If a de- positor found that his bank, in a time of stress, was not able to system*""* meet his needs and could not liquidate the deposit accounts it Makes had become liable for, he could only conclude that the kinds of Dfs'i°^g*u|gh loans it had made were predominantly those which gave rise to Between paper which the Reserve Association could not recognize. It would ^" ' then be for him to choose whether he would continue to do busi- ness with an institution that accepted such business as thus re- ferred to. He might conclude that it was preferable to keep his account with a bank that loaned only on commercial paper of the highest type. Probably this would be his conclusion if that were the type of paper that was produced by his own operations. Of course, if the loans he himself had obtained were based upon security, which, although perhaps perfectly unimpeachable, was of a kind not recognized by the Reserve Association as furnishing a proper basis for loans, he might prefer to continue transacting business with an institution which engaged in operations not of the strictly commercial banking class. In this way a fairly sharp segregation of banks doing a com- mercial business, and of banks engaging in other operations, would be brought about. There is a strong tendency toward such segrega- tion today, as we have seen elsewhere, but this tendency would Promotes be very greatly strengthened and increased by the sharp distinc- of °Conv*'°" tion that would be drawn (under a discount system which was mercial ready to grant accommodation to banks presenting short-time live ^'"'*' commercial paper) between banks which could and those which could not offer security of this kind. §6. It should not be understood that such segregation would imply an inability on the part of banks doing a non-commercial business to get accommodation in case they were hard pressed. The savings bank which was being drawn upon by its depositors. 354 COMMEECIAL AND INVESTMENT BANKS Would Not Deprive Non-Com- mercial Banks of Aid In Need Segregation Protects Depositors the trust company which found its deposits leaking away, and other institutions in diflBculties, owing to the urgent nature of the demands made upon them, would always be able to request other banks to grant them assistance with as good a prospect of being listened to as their securities warranted, and their depositors would benefit accordingly. The extension of such accommodation would, of course, depend upon the condition of the other banks of whom the request was made, and the arrangements that had been made with them beforehand, but their capacity to aid would be greatly strengthened by the creation of a discount market. It is a fact that in European countries today there are many such banks which succeed in getting abundant accommodation from other institutions when they need it. They very seldom suspend or fail as compared with banks in the United States. But the distinct recognition of two classes of banks, one deal- ing predominantly in live commercial paper and confidently look- ing to a cooperative association comprising the banking power of the country for aid when needed, the other making loans of a less stereotyped character and getting assistance only in proportion as that might be granted by other banks of the community, places the depositors in a very much stronger position. They are able to select the banks with which they are to do business, with far greater discrimination and intelligence. A savings depositor, for example, who does not need his funds currently, but who merely wishes to be certain of their ultimate return, is safe in leaving his funds with a savings bank, although he knows that this bank may, if hard pressed for funds, require a notice of sixty days before he draws any cash. On the other hand, the holder of a trust fund may prefer to deposit this fund with a perfectly solvent trust company which will pay him a rate of interest, even though it would not be possible for him to draw the cash at any moment in case of stringency. This may be due to the fact that he would rather get the interest than be able to draw his money certainly on demand. At the present time, these functions are far too greatly confused, many banks having both savings and trust de- posits as well as their regular commercial deposits growing out of loan and discount operations. The distinct segregation of the banks by classes aids materially, not only in rendering possible an effective system for keeping commercial discounts liquid, but in enabling depositors to make definite choice of an institution whose business practices are suited to their special or peculiar needs, and then to exact from it the proper methods of operation. CHAPTER XXI THE RESERVE ASSOCIATION AS FISCAL AGENT OF THE FEDERAL GOVERNMENT 1. Banks as Government Depositories and Establishment of the Inde- pendent Treasury System — 2. Workings of the System — 3. Ex- change Functions of the Treasury — 4. Foreign Experience — 5. Plan of National Reserve Association — 6. Contrast With Present Sys- tem — 7. The Question of Safety of the Government Funds — 8. Pub- lic Function of National Reserve Association. §1. An integral part of the proposed plan of banking reform is found in the transfer of government funds from the Treasury of the United States to the banks of the country. The depositing of public funds in banks was the policy of the United States gov- ernment from the adoption of the Constitution down to 1846 when oeposi- the present independent Treasury system was created. Shortly tories after the adoption of the Constitution, Alexander Hamilton, then Secretary of the Treasury, recommended the establishment of a large institution to be known as the Bank of the United States. This was finally chartered in 1791 with a twenty-year franchise. From 1811 to 1817 public funds were deposited in private banks. Then the second Bank of the United States was chartered and it continued in operation until 1837, when it went out of existence, and public funds were again deposited in the state banks. This plan continued to be followed until 1846, as already noted. While the first and second United States Banks were, in the main, ably conducted, and were at all times sound financial institu- tions, handling the funds of the government with economy and despatch, there was much complaint of their operations on the ground that they were influenced by political considerations. On the other hand, the placing of public funds in state banks was not satisfactory, because these institutions were small and often in- efficient. Frequently they suspended payment or failed, and as a result the government was either kept from the use of its funds for a long time or unable to get them back at all. 355 356 THE GOVBENMENT POCKETBOOK The Inde- pendent Treasury System The consequence was the adoption of a plan whereby payments and disbursements were to be made in actual money, and whereby the government was to keep its funds in its own vaults. To this end so-called sub-treasuries were established at convenient points in which the receiving ofi&cers of the Government were directed to deposit the funds coming into their hands and for which disbursing ofiScers were supplied with funds through properly drawn warrants. Modifica- tions of the System Essential Features Remain §2. A rigid adherence to the notion of having all payments and disbursements made in money has not been possible, and to- day various modifications of it are in effect. Perhaps the most im- portant is that which permits the Government to deposit Treasury funds with national banks on condition that these banks shall turn over to the Government approved bonds to an amount equal to the sum of deposits left with them. In this way it has sometimes oc- curred in recent years that all of the available funds of the Gov- ernment except a small working balance were parcelled out among banks. There have been times when the amount thus distributed was as much as $250,000,000 and the number of depositary banks nearly 1,400. Moreover, it has not been found possible to keep the Govern- ment entirely separate from the machinery of modern banking. Today the independent Treasury System consists of the Treasury itself, and nine independent or sub-treasuries located at as many different places. These sub-treasuries are members of the local clear- inghouses in the places where they are situated and clear their claims with the banks through this means. When it has debts to pay, the Treasury pays them by means of a Government warrant (the equivalent of a check, which it resembles in form), upon a con- venient sub-treasury. Such warrants are deposited with the banks by the persons who receive them and thus the banks come into pos- session of claims against the sub-treasury. On the other hand, the Government at times finds it desirable to draw on the depositary banks, and thus the banks and the sub-treasuries have occasion to interchange their claims by the usual clearing process. But in spite of these modifications in the system, its essential features remain. It is substantially a plan for drawing the funds of the community by taxation out of the pockets of the people, keeping them locked up for an indefinite period in government DOMESTIC EXCHANGES 357 vaults, and finally paying them out in whole or in part to other persons. This set of operations has a serious and important effect upon the business of the community. §3. On account of its possession of large quantities ot cash funds and its refusal to let these funds go back into circulation, the Treasury Department has been forced to accept still other bank- ing functions. It now supplies exchange at current rates by al- lowing sub-treasuries in the various places to pay out cash upon telegraphic order when an equal amount of funds plus exchange has been deposited elsewhere. Thus payments at New York may be offset by disbursements at San Francisco, if New York banks de- sire to supply currency to others in the latter city. The function of providing exchange in this way is not properly a governmental duty but should be exercised in conjunction with the function of discounting and of buying commercial paper. When divorced from the latter function, it tends to disturb the exchange market, although it may serve a useful purpose at the time it is per- Domestfc formed by obviating the necessity for shipments of ciirrency back Not a and forth. The same end would be gained, and gained much bet- Government ter, if the funds upon which the Treasury bases its operations were in actual commercial use the country over. Yet how can this end be attained, and the exchange function be entirely relegated to the banks, so long as the government is the holder of so large a per- centage of the country's circulating medium ? It is not possible to turn this work over to the banks while the funds of the country are partly in the Treasury; nor would it be practicable to entrust them with the work of supplying exchange in this way without giving the profits to a relatively small number of them. The problem raised by the independent Treasury system is therefore not only that of meeting the demand for a better dis- position of the actual funds of the country, but is that of affording some means whereby the public may get the benefit of the banking mechanism, operating upon these funds in connection with its com- Independent mercial transactions. This merely amounts to the statement that vvithd'raws the essention evil in the independent Treasury system today is its Funds from withdrawal of current funds from banking uses and its consequent ^"^'"®®® infringement of the functions which are, and can be, successfully performed only by the banks. This may be re-stated by saying that the United States Treasury is not a bank and cannot successfully 858 AN ANTIQUATED SYSTEM perform the services which banks render, yet that it takes to itself the funds of the community without giving any return in the form of aid to exchange and business. §4. The facts which have thus been briefly stated are so well Un'i^^^**'" understood throughout the world that the independent Treasury system is today almost if not wholly unique. No important coun- try today hoards money or currency or declines to accept the properly authenticated checks and notes of solvent banks in liquida- tion of claims due to it. Nor is there any which fails to employ the solvent banks of the country and their credit mechanism in making its payments to individuals, corporations, and other countries. In most European countries today, there is a close official rela- tionship between the financial department of the government and some great banking institution. Familiar examples of this kind are seen in the case of the Banks of England and France, and of the Eeichsbank of Germany. These great banks hold the funds belonging to the public and in return are closely supervised, in- spected and controlled by the governments with which they are affiliated. The fact that government funds constitute everywhere so large a sum and could be used for the purpose of earning an enor- mous profit were they freely entrusted to the banks in which they are deposited, has led to the adoption of methods for assuring to the public powers their due share of the profits which may be obtained Distribution j^ ^jjjg ^^y Various ideas have existed with reference to the of Profits •' from Use best method for reservmg to the government its proper share of of Pubiic ^jjg proceeds of the banking business under such conditions. In the first and second United States Banks, the government of the United States, which had chartered the institutions, was a large stock- holder, and received the dividends upon its stock as did other own- ers of shares. In Germany at the present time the government obtains its share of the proceeds partly by means of taxation and partly by a division of profits. In France a similar system though with different details is adopted. The general opinion in the ad- vanced commercial countries of the world is that, while it is abso- lutely essential that some institution shall act as a connecting link between the government and the financial system of the country, it is necessary that the profits derived incidentally in this way shall go in large measure to the government. Probably the best opinion PROFIT m USE OF PUBLIC FUNDS 359 at present supports a plan whereby all income above a mere com- mercial rate of interest on the capital invested is taken by the gov- ernment in return for its grant of a franchise to the institution which holds its cash, as well as for the advantage given by the use of the immense deposits of current funds made by the government itself. §5. This is the arrangement which is aimed at in the National Reserve Association proposal. It recognizes the essen- tial necessity of leaving the funds of the country in the hands of Excess the community and of reserving to the government the profit which Profits would come from their use by a private agency. It contemplates covern- placing in the hands of the Reserve Association, as that institution ""«"* has been described, all of the current funds of the Treasury. It is intended that the government shall regularly place its receipts on deposit with the Association except in those cases where it may be desired to put funds into national banks in cities where no branch of the Reserve Association exists. Disbursements, however, would be made entirely through the National Reserve Association. It would be the duty of that association to make payments without charge at those points where the government had obligations to meet. The notes of the Reserve Association would be received at par in payment of aU dues to the United States and would be pay- able by the United States to all of its creditors except those who held obligations specifically payable in gold. In return for this relationship to the government and the pos- sible profit which might be made out of it, the Reserve Association would turn over to the government all earnings at the start in ex- cess of 4 per cent. Of these earnings a division would be made, one-half going to surplus of the Reserve Association until that surplus amounted to 20 per cent of the paid-in capital, and one- fourth to stockholders, while one-fourth would go to the government. When the stockholders' dividends reached 5 per cent and when the surplus of the Reserve Association had reached 20 per cent of its capital, the whole balance would be given to the government. This would mean that, however large the earnings made by the use of the government's funds might be, they would revert to the government after the stockholders had received a moderate interest of 5 per cent on their investment. At the present time the aver- age earning upon all capital invested in national banks is very 360 WEAKENING OF BANK RESERVES Average Earnings on Bank Capital Effect on Our Reserve System illustrated by Case of New York Importer nearly 10 per cent. Besides getting whatever profits were thus earned from the use of its funds, the government would make a large saving in running expenses. It would no longer have to man- age exchanges, see to the transfer of funds hither and thither, and pay the charges arising out of these duties. The Reserve Associa- tion would do this work and would do it without charge. In our earlier discussion we saw that the fundamental ques- tion to be considered in connection with national banking was the effect of any change that might be introduced upon the reserve system of the national banks. This was because the reserves are the fundamental element in the banking system and upon them de- pend the solvency, economy and efficiency of the whole. It is im- portant, therefore, to consider first of all what would be the change in our reserve system arising from the designation of the proposed National Reserve Association as the fiscal agent of the government. The effect of the change can he briefly stated. It would abolish all of the artificial disturbances which arise from the present Treasury system, and would leave business conditions and relation- ships practically the same as they would be, from the banking standpoint, if the government never exacted any taxation. When taxes were payable, when customs duties were collectible, they would be paid to the government either in notes of the National Reserve Association or in checks upon it, or, of course, if the payer wished, in actual money. Suppose the case of an importer at New York who had a large consignment of goods which he wished released from the custom house. If his customs payment was $20,000 and if he did not wish (as he would not) to make payment in actual money, he would go to his own bank and would obtain from it a draft on the National Reserve Association, or, if he desired, notes of the National Reserve Association. He might pay for this draft or the notes in a check drawn upon a previously established credit in the bank itself, just as today, if he wished to buy a draft on Chicago or San Francisco, he would get it from his bank and pay that bank with a check on itself. If his account with the bank was not large enough, he would have to obtain from it a discount, the bank plac- ing to his credit such a sum as he desired and thus enabling him to buy from it a draft on the National Reserve Association. Of course the effect of issuing such drafts would be to reduce the bank's bal- TEEASTJEY HOAEDING OF CASH 361 ance with the Reserve Association. This would be built up again either by the depositing of claims on the Eeserve Association trans- ferred to it by other banks or by rediscounting, perhaps, the very paper left with the bank by the importer. In any case — and this is the important point — there would be no displacement of current funds. No money would have had to be drawn from bank vaults in making the payment. §6. This transaction shotdd be studied in comparison with the management of a similar transaction under the present sys- tem. Suppose that this importer today wishes to pay $20,000 in duties. Knowing that the payment is to be made, he has usually spoken to his bank in advance and the bank has sent to the sub- treasury gold or legal tender money to the amount of $20,000. Then when the importer appears, he is allowed to pay the gov- ernment in a check on his own bank, because that bank has the actual cash in the vaults of the government. Or the importer may draw actual money from his bank and physically carry it to the sub-treasury, depositing it there at the time when he liquidates his customs duties. What is the effect of either of these transactions ? In the first place, the withdrawal of the money from the reserve of the bank means that so long as the funds are taken out, that particular bank finds its reserve weakened to a corresponding extent. If these Weaken- funds went promptly into some other bank, little harm perhaps Reserves would be done, although even in that case, the effect of the transac- tion would be to withdraw the funds temporarily from the banks while the transfer was being made. It would be better even in such a case to have the payment made in the form of a check or draft which would stand a chance of being offset against other checks or drafts, so that only a small balance in money would have to pass in order to settle the transaction in the last analysis. But the sum withdrawn does not go into the vaults of other banks at the time. It goes into the Treasury, and must therefore be con- sidered lost to the banks of the country so long as it is tied up there. Will not the Treasury let the cash out almost immediately and _ will not the withdrawal therefore be only temporary? This de- Hoards pends upon the state of government revenues. Evidently, in order *'^®'^ to have such an adjustment as would thus be produced, it is neces- 363 MOVEMENT OF PUBLIC FUISTDS Distribu- tion not According to Needs Conse- quences of Hoarding sary that (1) disbureements shall be made by the Treasury about as fast as incomes accrue, and (3) they shall be made at about the same places as those at which incomes are received. Neither of these conditions exists. At present there is a very great difference between the rate at which funds come in and that at which they go out. Often for a series of years there is a regular Treasury surplus of incomes over expenditures. Funds come in much faster than they are spent. Even in years when the total outgo is about the same as the total income, that is not true throughout the year. Funds will be re- ceived largely at certain seasons and will lie idle for some months, when they will rapidly go out again. Moreover, the points where cash is disbursed are quite differ- ent from those where it is received. The government now gets its income chiefly at a few large ports through which goods pass into the country, and at a few points in the interior where whisky and tobacco taxes are paid. The corporation tax and a few other kinds of payment are more widely diffused, but they are minor items. The payments of the government are made largely at Washing- ton, at those points where bodies of troops and ships of war are stationed, at the post oiBces and other government offices through- out the country, and at points where supplies have been pur- chased. In making payments, as we have already seen, the Treas- ury may either pay cash or issue warrants on the sub-treasuries. Whichever it does, the effect of its disbursements is to draw cash from the points of collection to the points of disbursement. If the payment were made in a claim upon such an institution as the Na- tional Eeserve Association, this would not be the case, but the claim would go through the ordinary mechanism of banking, would be offset against other claims, and would in the long run give rise only to such a movement of cash as might be necessary to settle bal- ances between different places. The present consequences of the Treasury system of hoarding are very serious. It is an unfortunate fact that the payments to the government under the present system of taxation are likely to be heaviest at those seasons when funds are most needed in reserve. We have seen in earlier chapters that the crop-moving season in the autumn is a period of special demand for accommodation. But that is also a time when payments for customs are likely to be heav- iest. Throughout the late summer and early fall merchants are TKEASIJEY DEPOSITS WITH BANKS 363 receiving goods from abroad, releasing them from the custom house and paying duties. To do this they are withdrawing funds from banks and transferring them to the Treasury. Just at this same juncture, the banks are feeling the demand for large accom- modations in the interior. Of course the effect of thus diminishing reserves is to make it more expensive for producers to get accommodation, while the banks are embarrassed by the necessity of having to let go of the funds they need to sustain their credit. If it should happen that the surplus reserve of the country is very low at any time, the effect is to curtail the banks' power of lending very materially. There is no reason why government payments should be excep- tionally large contemporaneously with these large receipts. In fact, they are not, for the greatest disbursements are made on the first of January and of July, when interest is paid, during the early months of the fiscal year, July and August, when new appropriations go into effect, and at other times of exceptional de- mand, due to payments for labor or supplies as determined by conditions of construction on public works and the like. The situa- tion is therefore exceptionally embarrassing and diEBcult. The Treasury has, as briefiy noted heretofore, attempted to apply a crude means of relieving this situation. Whenever funds have tended to accumulate too rapidly, by virtue of its power under congressional enactment, it has redeposited with the banks, of Relief In so doing,, it has, however, had to select the banks with which C''ut'e it would place its funds. Wisdom would have dictated the placing of the funds as near to the points from which they were drawn as possible. That would have been difficult at the best, but political exigencies have rendered it impossible. Congress has made it mandatory upon the Treasury in mak- ing deposits to distribute them as nearly as possible in propor- tion to population throughout the states and territories. Un- fortunately, the amount of business and credit performed and needed by different communities is not proportionate to popula- tion, and therefore the distribution has, in most eases, been pro- ductive of much incidental harm. It was much better to get the money out of the Treasury than to have it accumulate there, but it has never been distributed in such a way as to facilitate the needs of the country. Very often a large government deposit in 364 PAYMENT OF TAXES , Payment of Taxes Should not Disturb Money Market a town has resulted in the unwise extension of credit to enter- prises which could not otherwise have obtained it. In other cases, when there was no local use for the funds, they have been shipped direct to New York, and have there been reloaned on call to speculators. It has been felt that, since the government might de- mand the deposits at an early date and since there was no profit- able use for them at home, the bank might as well make the most out of them by lending them as a basis for speculation. Consequently, such deposits have not infrequently become a stimulus to speculation in securities. The payment of taxes ought not to be an unnecessary dis- turbing influence to commerce. It should, in its essential nature, be nothing more than the transfer of a portion of private wealth to the public authorities. It should therefore cause no more dis- turbance than a similar transfer from one private individual to an- other. The transaction should be effected in the same way in which such transactions are effected in the commercial world. "Whatever the ultimate economic result of taxation may be, there would then be no incidental effects. The operation of paying taxes would be merely that of establishing a suitable balance with the bank and then transferring the title to that balance to the government in the same way that the individual would pay any other claim upon him. At present this is not the case with federal taxation which, as we have seen, exerts a seriously annoying in- fluence upon the mechanism of credit practically throughout the country. With a proper banking system in close harmony with the public treasury, no such danger would exist, but the transfer would take place mechanically and the government would simply come into possession of a certain share of the wealth of the country as the result of its laws. So far as the banking mechanism is concerned, it would not matter whether this exaction were made at one time of the year or at another. Since no movement of money or currency would be necessary, no change would take place in the volume of reserve funds held by the institutions of the country, and no local readjustments in the supply of funds avail- able at one point as contrasted with those available at another would be requisite. While the effect of the substitution of the banks for the Treasury as a fiscal agent, through the medium of the Eeserve SALES OP NEW BONDS 365 Association, would thus be desirable from the standpoint of taxa- tion and of its effect upon the producing and exchanging mechan- ism of the country, the change would be equally as desirable from another standpoint. At present the Treasury Department exerts a disturbing influence upon the reserve supply of the country, ^f ^^,^ not only through its receipts and disbursements of the proceeds q"^''" of taxation, but through its handling of the public debt. The floating of bonds at the present time is effected by advertising for bids, which are subsequently opened in the Treasury Depart- ment, the bonds being then awarded to the highest bidder. Such bidders are usually banks and other financial institutions. With their bids they submit, as a rule, a certified check covering the percentage of their offering which is required by the department. Then, on getting an award, they pay in a certain percentage of the amount of bonds assigned them. Later they complete their payment by a specified date. The Treasury may either take the proceeds of its sales in cash or it may leave the funds on deposit with the banks, in which case it merely accepts a claim on the banks in liquidation of the loan. There have been occasions within the past ten years when the Secretary of the Treasury let it be known that he would leave the funds on deposit for a time with the same banks which received the awards of bonds, so that these banks would make payment to the Treasury merely by crediting the government with a cer- tain sum on its books. This, however, is a rare case. Ordinarily, cash must be taken out of the vaults and turned over to the de- partment, or else, even where funds are left on deposit, they must be shifted from the banks which get the bonds to the banks which are to receive the deposits.. In either case there is a tend- ency to tie up the cash of the country and to place it in institu- tions remote from the points at which it originated. The harm is similar to that which was found to exist in the present method of paying taxes. It would be far better if the government obtained its payment for bonds in the form of a transfer to it of a credit on the books of How it a National Eeserve Association representing the banks of the coun- Managed try acting as a unit. Then, if bank A, an institution of, say, by Reserve $35,000 capital, at some point in the interior should bid for and secure a block of, say, $5,000 in government bonds, it could pay for these bonds by giving the government a check on the Na- 366 ECOlSrOMY OP FISCAL OPERATIONS tional Reserve Association. This association would have granted to the bank the right to draw on it either in return for a deposit of cash, or a deposit of its own notes, or as the proceeds of a dis- count of commercial paper offered to it by the bank in question. Usually the interior bank would have built up its credit with the Reserve Association by offering such paper for rediscount. This would mean that there had been no disturbance of the reserve money of the country or of its distribution, but merely that the government had obtained a title to a certain amount of the fluid wealth of the country in exchange for its own long-time obli- gation. If it then paid out this wealth by giving to its creditors claims on the National Reserve Association, the whole transaction would have been settled by means of a mere transfer of title. Suppose, for example, that the proceeds of the bonds were to be used in the irrigation of arid lands and that the govern- ment had a payment of $5,000 to make in the same general region, perhaps in the same county where the bank which got the bonds was located. In that case, the wealth would be expended in the same place where it originated. Not a dollar would have moved out of the community necessarily. The bank would have paid the government in a claim on the Reserve Association and the government would have paid the contractor in the same way. Very probably the contractor would have deposited the claim he re- ceived from the government in the bank which had bid for the bonds. Thus, in the last analysis, the bank would have obtained the bonds and turned over the payment for them to persons in the same community. If it had bought the bonds as agent of certain investors in the community, the investors would pay it by drawing cheeks in its favor on their bank accounts. The wealth of the country would have been invested to the extent of $5,000 in the irrigation system, and the local investors would have received bonds backed by the government to an equal amount. The task imposed on the government at the present time of furnishing exchange would be entirely eliminated by the use, as Government a iiscal agency, of a banking institution of the kind described. Would ijijjig institution, having close connections with banks in all parts Furnish of the country, would serve as a means for equalizing the supply of Exchange funds throughout the whole country, and would find the successful performance of this duty one of the chief tests of its eflSciency and satisfactoriness. A SAVING TO THE GOVEENMENT 367 Probably very much less demand for the movement of funda from one part of the country to another would be felt with such an institution at work than without it. It would tend to act as a great clearing-house for claims offered by one part of the country against another, and vice versa. When there was a demand for funds in one region, it would be met by the Eeserve Association, which would create credits available there. These credits would later be canceled by others resulting from the sale of goods, and business would be financed without the movement of money. This alone would be a great saving to the community. It would also be a great saving to the government, which is not now able to take advantage, save in a minor degree, of the banking mechanism of the country, in facilitating its payments. The Treasury would not only cease to furnish exchange for commercial applicants, but it would also, cease to need exchange on its own account. Not only disturbance to business, but actual expense would thus be economized. It is impossible to say how large a saving in the routine operations of the Treasury could be made by the transfer of its funds to a fiscal agent in the way described, until details had been more fully worked out, but it is certain that the saving would be very substantial and that much work now done in the Department would be rendered entirely unnecessary. §7. An objection which is frequently heard with reference to the adoption of this fiscal agency idea is that under it the government "would not be .able to get its funds when it wanted Association them." This appears to mean either that the banks would be un- 1'^^*,'?^ . IT. iTTn, ,« Combined able to pay on demand and would have to ask for time before meet- Banks ing. the request of the government, or else that there would be ^ ^^^ danger of failure. The latter question may be considered first. Certainly it would be an unfortunate situation if the proposed Eeserve Association were to fail or suspend payment and thereby prevent the government from getting the use of its resources. In this connection, the real question is the strength of the Eeserve Association. Constituted as it would be, as already explained, it would be practically equivalent to an agency representing the united banks of the country. It would therefore have the same strength that is possessed by the combined banks of the country. The government cannot expect to be stronger in its resources than 368 NO DANGEE OF PUBLIC LOSS the commercial community. If all the banks of the country were to fail, it would not be remarkable if the government should fail also. In fact, it could not collect taxation and might as well suspend eiforts at making payment. This is merely a reductio ad dbsurdum, inasmuch as it shows the impossibility of the assump- tion that the reserve association organized as already suggested would differ in its strength from that of the combined banks, and inasmuch as it emphasizes the fact that a financial strength greater than that of the combined banks is neither attainable nor perhaps desirable. There is no case on record where a large European institution acting as the fiscal agency of the government under which it is organized has failed. Such a failure would imply careless, if not criminal, oversight on the part of the officials en- trusted with the supervision of banking, and would besides be evidence of the complete instability and decay of the general busi- ness conditions and institutions of the country. The question of a suspension or temporary inability to pay on the part of such a reserve association is a matter which in- volves somewhat different considerations. It might be sufficient to say on this point that under no conceivable system, reserve The Ques- association or other, could conditions be worse than they have Suspension ^^^^ under the national banking system. It can be stated with absolute certainty that at all times when the government has had large and widely diffused deposits in national banks it has had the very greatest difficulty in getting them back, even in times of prosperity and public confidence. During the past ten years it has been customary when the Treasury wanted to draw in some of its deposits to issue what was termed "a call" for deposits. This was habitually given out from 15 to 30 days in advance of the time when the deposits were wanted, and amounted to a notice to the banks that they would have to pay at a certain date. Very often banks sent representatives to the Treasury to beg for more time. It was a difficult matter to get them to liquidate under any conditions. In times of panic and stringency, the Treasury, instead of calling for deposits, has habitually placed more funds with the banks, if it could command them. Thus, during the panic of 1907, Secretary Cortelyou went so far in the pursuit of this policy as to deposit with the banks practically everything that the Treasury owned in the way of cash, outside of its trust funds, so AS SOLVENT AS THE COUNTRY 369 that probably there was hardly a week's supply of actual cash in the Treasury at the time when it was in greatest straits. Other instances of the same kind could be cited. The whole trouble comes from the fact that when the Treasury calls for deposit, it asks for actual money. To give this the banks must cut down their reserve by a corresponding amount, and that usually implies a curtailment of commercial credit. If the funds of the government were regularly on deposit with a reserve asso- ciation and if the government never "called" for its deposits ex- Due to cept in so far as it needed cash for immediate disbursement, just T'^f^^'i^^ as would be done by any large business house, there would be no Cash occasion for difficulty, but the institution would always be able to meet its obligations so long as it was in a solvent condition. It would never have to contemplate the problem of turning a portion of its reserve over to the Treasury Department. The government would build up its account with the Reserve Association by de- positing there the proceeds of taxation and of bond sales as they came in, and it would transfer these claims to its creditors. The capacity of the Reserve Association to meet the demands would be merely a question of its solvency, a question already sufficiently discussed. Of course, the whole fallacy in the views of those who speak of the danger of turning over government funds to a private in- stitution lies in the attempt to draw a distinction between the gov- ernment and the community which it represents. The government cannot be stronger than its subjects. If the latter are represented by an institution which acts as the joint agency of the banks of the country and in that way practically stands for the whole of Government the business community, the government cannot hope to put itself No stronger in a more powerful or solvent condition than the institution which peopie thus has at its disposal the fluid resources of the nation. Its sole anxiety must be that of seeing that the institution in question is properly conducted, and that it does not fall into the hands of selfish persons who may pervert its purpose for their own object. That is a question which is met by the provisions governing or- ganization and management. These have already been discussed, and it has been shown how such an institution can properly be managed in the public interest. If the government has done its share in directing the policy of the institution by appointing able directors to present its views on the controlling board, and if it 370 A PUBLIC INSTITUTION has properly performed its function of inspection and oversight there is no more to be said. The safety of the institution is equivalent to that of the nation as a whole, and the government could not do better than to trust the public funds to the institu- tion vrhich thus represented the public in its financial aspect. Reserve Association a Public Institution §8. The proposed Reserve Association is to be, in fact, a public institution in the highest sense of the word. It would be conducted in the interest of the public, for the good of the public, and its profits above the moderate rate of 5 per cent on capital invested would go to the public authorities. Under those condi- tions the employment of the Eeserve Association as the fiscal agent of the government would in no sense be the turning over of the funds of the government to private individuals. It would be simply the substitution of an effective public institution possessing banking functions and working in close harmony with the banking institu- tions of the country for another public institution, the Treasury, possessing no equipment for this service, having no necessary rela- tion to the banking mechanism of the country and in every way lacking the equipment that would render it a satisfactory means to the accomplishment of the fiscal purposes of the government eign CHAPTEE XXII INTERNATIONAL POSITION OF THE UNITED STATES 1. Readjustment of the Banking System to Meet Foreign Trade Con- ditions — 2. Uniterm Discount Rate and the Flow of Specie — 3. United States Not Considered as a Center of Finance — 4. Pur- chase and Sale of Exchange — 5. Reserve Association to Do Banking Business Abroad — 6. International Flow of Gold — 7. Foreign Ex- change Banks. §1. An important element in the plan of banking reform, proposed by the National Monetary Commission, is found in the provision it contains for a new adjustment of our banking system to foreign trade conditions. Such readjustment has long been con- sidered a necessary feature of any plan of reform in banking, peadjust- The national banking system was established at a time when for- men* to eign trade was small and when little or no heed had been given to popej, the peculiar credit requirements of export houses. Since that Trade time, the export business of the United States has greatly expanded. Simultaneously, competition with foreign countries has become much more severe. In this competition, we have found ourselves exceptionally handicapped, owing to the circumstance that foreign banking systems were so much better equipped to furnish the credit needed in financing these international operations. It has been found that our peculiarly subdivided and inde- pendent system of banks (1) entirely lacks the power to control international gold movements by changes in the rate of discount; (2) is unable under the terms of the national act to establish branches in foreign countries capable of supplying American ex- porters with the funds they require in order to meet the peculiar credit, conditions there obtaining; (3) could not with entire success develop the mechanism needed for dealing in international ex- change; and (4) lacks the unity of policy required to properly finance export movements of commodities. 371 373 CONTEOL OVEE GOLD Practical Defects When a Silver Standard Was Threatened Gold Imports in 1907 These defects in the national system have at times been ex- emplified in a striking way. This has been true at critical periods of stringency and panic. Less conspicuous, but perhaps more im- portant, has however been the fact that the national system has suffered -continuously from these evils and weaknesses, and was unable to supply the necessities of the trade of the country in such a way as to support and encourage its business. The most notice- able feature of the situation has been seen when the gold reserves have been reduced below normal necessities, without any serious action on the part of the banks intended to check the outflow or restore the depleted supply. It has occasionally happened that the gold resources of the country fell far below normal requirements, reserves were allowed to run down, and danger to solvency and liquidity was encountered. This was the case during the three years just after the Sher- man Silver Purchase Act of 1890, when it appeared that foreign countries were sending back to the United States the securities of American enterprises -which failed to command confidence because of the threat then current in American politics that the country would pass to a silver standard. It would not have been possible on that occasion for the banks to prevent the withdrawal of cash funds in payment for the securities, since the real cause of the out- flow was entirely beyond their control. A suitably organized sys- tem of banking would, however, have managed the operation with far less suffering and stress, would have been able to give earlier and more effective notice to the country of what was occurring and of its causes, and would have been able to rectify and restore the normal supply of gold, after proper legislative action had been taken. In this way the crisis of 1893 might have been prevented, or greatly mitigated. During the panic of 1907, when reserves were being drawn down by depositors and by small banks which feared that they would become unable to pay cash, a suitably-organized banking sys- tem would have succeeded in drawing gold from abroad much more readily than was actually done. There were many banking houses during the panic of 1907 which imported large quantities of gold and placed it at the disposal of their correspondents. The same was true on previous occasions when similar, although less urgent, needs made themselves felt. But there was no general or concerted at- tempt to rectify the situation by raising rates of discount, or by STITOY OF TEADE BALANCES 373 offering foreign countries the inducements necessary in order to get them to part with their specie in favor of the TJnited States. Throughout the whole period of our foreign trade develop- ment during the past 20 years, it has been necessary for exporters to rely upon accommodations at foreign banks or at private bank- ing houses, which, although efficient so far as their operations ex- tended, necessarily worked upon a limited scale and without refer- Broader ence to the broader needs of the country. There has been constant "^^Z*?® complaint, therefore, of the difficulties connected with the obtain- country ing of credit in the proper form and amount for the conduct of Not foreign trade operations. For these reasons, the question is al- ways, and properly, asked, in connection with any proposed system of banking legislation, how far and in what way it will meet the evils which have developed in the ways already described. §2. The most important change iu our relation to foreign countries in regard to the international flow of specie would be found in the introduction of some element of cooperative or com- bined control over such movements, exerting itself by the establish- ment of a uniform rate of discount which would be raised or low- ered as circumstances might demand. One of the most important Discount of these circimistances would be the condition of our foreign trade Rate and and the state of our international balance. If conditions had de- of Specie veloped in such a way as to create tendencies toward the outflow of specie, a properly-organized banking system would do what was needed in order to moderate and control this tendency. In foreign countries, such work is performed by the great banking institutions which act as representatives of the combined banks of the nation. Thus the banks of France, England, Germany, etc., find a large part of their activity directed toward the regulation of rates of dis- count in such a way as to prevent the gold stock of their clientele from being unduly depleted, or to build it up when circumstances call for such steps. 'No such policy is possible in a country where there is no cooperative agency to regulate the rate of discount. It is impos- sible to expect banks, acting on their own initiative, in competition with others, and controlled primarily by a desire for profit, to pur- sue a policy which would merely reduce their own earnings and would not result in conserving the gold supply of the country. If they could act as a unit, there would be many cases in which they 374 AMEEICAN MARKET IS ISOLATED No Force rn this Country to Conserve the Gold Supply would agree to raise the rate of discount to customers in order to check borrowing, reduce exportation of gold, and put a brake upon lines of business which were going too far for the general good of the country. Acting alone, they cannot be expected to sacrifice themselves for such a purpose, particularly as such self-sacrifice would be of little or no use where it was not practiced by others. Fundamentally a great service to our foreign trade which would be performed through a cooperative reserve institution would be that of controlling the specie movement. The knowledge that a banking mechanism of such a kind, comparable in strength and vi- tality to those existing elsewhere, had been established here would greatly strengthen the financial position of American borrowers and American enterprises abroad, and would immensely improve our general position in the world community of finance. Position of the United States In the World of Finance Isolation of the American Market §3. At present, the United States does not receive the con- sideration as a center of finance and industry to which its rank in wealth entitles it. International enterprises prefer to establish their headquarters in countries whose banking systems are upon a more stable basis. They do not care to run the risk of such oc- currences as the panic of 1907, suspensions of payment, shortages of accommodation, and general financial disturbance. They find it more advantageous to operate where they are free from such un- necessary dangers, and where at the same time they can be assured of any amount of accommodation for which they can show good and sufBcient security of the proper kind. All these considerations make against our status in the international financial market and tend to drive enterprises away from our shores when the high char- acter of the management is such that it can select the place of prin- cipal operation at will. The effect is to cut us off from much de- sirable business and in a measure to isolate the American market. The lack of cooperation among our banks prevents the estab- lishment of any uniform system or standard for financial trans- actions, such as exists in the principal countries abroad, and it is partly due to this fact that American securities are looked upon with doubt by many foreign investors and are listed only with hesi- tation by foreign exchanges. The establishment of a cooperative institution would bring about a great change in these conditions. It would establish here a mechanism which is not a central bank, BANKS AND INTEENATIONAL BUSINESS 375 but which would be comparable in power and prestige with the great banks of Europe, would ensure suitable supplies of credit when they were needed, and would thereby prevent the recurrence of bank suspensions and difficulties similar to those of 1907 and preceding panic years.^ Precisely how the proposed plan would work and by what mechanism it would bring about the results indicated may now be pointed out. At present, banks of the United States are for the most part too small in capital to engage in large international transactions. This is true both of national and state institutions. Partly as a result of law, partly in consequence of the dictates of ^h B k sound business policy, it is not wise for them to tie up their funds Mechanism in the long-term operations needed in international trade. They co^untry are not able under existing conditions to be sure of rediscount ac- .Needs commodations that would suffice to give them the assurance they need in dealing with applicants for loans on international paper. Such new mechanism as may be established must therefore have large capital. It must further be able either to "carry" enter- prises for such periods of time as they may require in international operations, or to secure through foreign banking institutions the aid necessary to do so. Further it must have power to operate in foreign countries and to adjust its methods to those of the credit Uarge systems which there prevail. None of these things is now practic- Capital able. The problem is how to supply them. Prom another point of view, the proposition assumes a twofold form — (1) that of chang- ing our banking organization so as to supply the amotmt of capital and the type of credit needed; and (2) that of standardizing local paper so as to, make it pass current in world markets. §4. The fundamental operation in financing foreign trade transactions is the purchase and sale of exchange. This amounts practically to the making of loans by the general methods already described (see Chapter V on "Commercial Paper"), but in such 'The National Monetary Commission says of the plan: The National Reserve Association Is given ample power to protect its own reserves, in order that it may be able at all times to exercise its most important func- tion — that of sustaining the commercial and public credit of the country. For the purpose of strengthening its own reserves It may, first, attract gold from other countries by an advance in its discount rate; second, purchase and borrow gold and give security for its loans, including the hypotheca- tion of government bonds; third, buy and sell foreign bills of exchange. Short-time foreign biUs have been found elsewhere most effective as a means of replenishing a gold supply, and of preventing the exportation ot gold at critical times. 376 EBDISCOUNTS AN AID TO FOEEIGN TEADE Purchase of Bills of Exchange Why Banks Avoid Foreign Business How a Discount Market Woi^ld Work a way as to finance transactions involving exportation and importa- tion. An exporter sells a bill of goods to a buyer in Eio Janeiro. He wishes to have the returns for the goods immediately, and so draws at a specified number of days upon his correspondent in that city. This draft, accompanied by the necessary documents, is taken by him to a bank and is there presented for discount. The bank examines the draft and the attached documents. Finding all satis- factory, and being certain of the solvency of the customer who asks for the discount, it grants the accommodation desired. Thereupon, it stands possessed of the claim upon the buyer in Eio Janeiro, the exporter who discounted the draft being meanwhile under obliga- tion for the amount of the loan only in case there should be a default at the other end. Such loans are necessarily longer in their period than ordinary commercial paper, and the business probably could not be done in many instances upon the narrow margin of time which is usual in domestic trade. This has prevented national banks from engaging actively in this kind of operation notwithstanding that such loans are among the best and safest that can be found. Banks do not care to have too great a proportion of their funds tied up in loans that can be realized upon only with possible difficulty. A large proportion of this business has, therefore, gone in the past to pri- vate institutions, and has been dealt with by them only sporadically and in many instances unsatisfactorily. One fundamental necessity in the case is that of providing some method that will permit a rediscount of such paper. ' This function would be performed to best advantage by a Eeserve Asso- ciation such as has been spoken of. If such an institution stood ready to advance funds upon paper arising out of foreign trade operations, several desirable effects would be brought about. The trade itself would be greatly facilitated, because of the increased possibility of getting current accommodations at the reasonable rates needed in the business. The plan would render material aid also, because of the encouragement afforded by it to ordinary banks to take up such paper when offered to them. This would tend to keep the rate of discount at a low fig- ure since it would ensure the banks' power to hypothecate the bills of exchange upon terms as favorable as those accorded to any kind of paper originating elsewhere. It would undoubtedly bring MAEKET FOE IDLE MONEY 377 about a more friendly attitude on the part of the banking public toward export enterprises in general. On this point the National Monetary Commission says : A wider domestic market for the commercial paper we have described will be found in the changes which are likely to take place under the provisions of the bill submitted, in the Investment of the surplus funds of the hanks, and by surplus funds in this connection we do not refer to moneys deposited with reserve agents, but to funds for which there may be no legitimate local demand. The surplus funds referred to are now deposited perhaps through correspondents in New York at 2 per cent interest. The New York banks are usually obliged to loan them on call on stock exchange collaterals, inducing at times dangerous speculative conditions, with the probability that when the money is with- drawn the necessary calling of loans may cause disturbances in reserves and in the market and sometimes lead to panics. We propose by the provision of the bill submitted to enable the banks to invest their surplus funds of the character we have described in notes or hills of exchange representing the indus- tries or the products of the United States. It may be that they will not be able in making these loans to obtain the full rate cur- rent for discounts of commercial paper, as they will have to com- pete with foreign banks for a portion of the business, but they will certainly receive more than 2 per ceut for their money, and they will have in their portfolio commercial paper created for legitimate purposes which they can take to the district branch and have transformed into cash or a cash credit at any hour of any business day of the year. §5. In order to facilitate this foreign business, the proposed plan of the National Eeserve Association, one form of which has been presented by the National Monetary Commission, proposes to give power to the' association to open banking accounts in foreign Banki'ncf countries and to do business there along lines that are appropriate Accounts or necessary to the carrying out of this branch of its operations. Countries" The Monetary Commission's bill says : The National Reserve Association shall have power to open and maintain banking accounts in foreign countries and to estab- lish agencies in foreign countries for the purpose of purchasing, selling, and collecting foreign bills of exchange, and it shall have authority to buy and sell, with or without its indorsement, through such correspondents or agencies, checks or prime foreign bills of exchange arising out of commercial transactions, which have not exceeding ninety days to run, and which bear the signatures of two or more responsible parties. 378 FOREIGN BUSINESS CONNECTIONS An Inter- national Banking Mechanism Special Authoriza- tion as to Inter- national Business It is evident that this provision would furnish the association vrith the power needed to establish close business connections with foreign countries. The limitation by which the paper is to run not more than 90 days and to bear the signatures of two responsible parties is intended to prevent the use of the funds of the associa- tion in financing very long period loans, and has the same object as the limitation of domestic loans to 28-day transactions under all except very carefully safeguarded conditions. The provisions just quoted would merely furnish the basis for the extension of the business of the National Reserve Association beyond the confines of the United States. It would thus be fundamental because it would permit the creation of an international banking mechanism with headquarters in the United States. This is now entirely lacking in our present national banking system. The National Reserve Association is intended to do business only with banks and is not to be permitted to undertake any inde- pendent operations, in domestic trade. Communication with the public of the United States, therefore, is to be had solely through the constituent banks which have taken stock in the Reserve Asso- ciation.^ We have already seen how carefully it is intended to limit the operations of these banks in order that they may not succeed in securing the use of funds of the association for purposes that might be dangerous or that might result in inflation. A special ^Considerable difference of opinion on the question whether bills should be bought only from the banks still exists among expert students. With reference to this subject, Mr. Frank B. Anderson, president of the Bank of California of San Francisco, says: "The power to make its rate effective would be the Association's great- est weapon of offense and defense. It will, if efficient, give the elasticity to our banking system which is so desirable — elasticity means contraction and expansion, not expansion alone. In normal times the influence of the Association's rate would be practically nil. Under the plan the Association would be a beggar at the doors of Its depositors, dependent upon them for the investment of Its funds; falling there, all of Its funds would have to go abroad for investment. On the other hand, when the banks were loaned up and actual stringency existed, the banks would have to go to the Asso- ciation and accept such terras as it Imposed; that is, the Association rate will be effective only when the banks have to borrow. In other words, the Association can only act on the defensive and Its Influence will not be felt until inflation has got under pretty full headway. V^orld conditions might be so settled that the Association felt that the business public was entitled to lower rates, and that there was no danger in allowing business to ex- pand. It certainly would not be wise to encourage the banks to borrow the Association's money at such a time. On the other hand. It would be conservative for the Association to let some of its money out by purchas- ing bills In the open market, because it would be In a position to control the situation when necessary. The purchases of the Association would be only of the highest grades of short-time paper, and the competition with the banks would be practically negligible; the Association would certainly be able to serve the nation and the banks more Intelligently and with more safety if it could purchase and sell in the open market. If the Association is to be charged with the responsibility of guarding the reserves of the banks and the gold supply of the country, It should be given the power to make its rate effective. If the lessons of history are worth anything, the Association will not be fully successful unless It can make its rate effec- tive." NINETY-DAY FOKEIGN BILLS 379 provision would, therefore, be needed to expand the, scope of the National Reserve Association's work in connection with interna- tional trade. Were this not done, the purchase of paper growing out of foreign trade transactions would be forbidden to the Reserve Association. The following section of the plan proposed by the National Monetary Commission shows what authority it is intended to give to the National Reserve Association in this connection : The National Reserve Association shall have power to pur- chase from its suhscribing banks and to sell, with or without its indorsement, checks or bills of exchange arising out of commer- cial transactions as hereinbefore defined, payable in such foreign countries as the board of directors of the National Reserve Asso- ciation may determine. These bills of exchange must have not exceeding ninety days to run, and must bear the signatures of two or more responsible parties, of which the last one shall be that of a subscribing bank. While this provision would give a large degree of discretion to the Board of Directors of the Reserve Association in limiting the classes of paper in which they were willing to trade in inter- national business, it would not permit any discrimination between different institutions. The different banks would be guaranteed the same access to the Reserve Association as any other of their number and the association would be able to limit itself only in regard to certain specified classes of transactions. By requiring that each bank offering paper for rediscount shall place its signature upon the paper offered to the Reserv i Associa- tion for rediscount, the plan makes it certain that each piece of Tests paper will have been tested by the bank to which application is ** '''P*'" originally made, and that nothing will have been done except upon the request and with the approval of some bank which so strongly backs its judgment in the matter as to make itself liable by placing its signature upon the paper. §6. A power incidental to, and correlative with, the author- ity already granted in the provision referred to is that of attracting gold coin and bullion from foreign countries whenever necessary Inter- to rectify the balance of trade and to supply needed reserve resources ptow"^' in the United States. On that point the plan of the National of Gold Monetary Commission provides as follows : Sec. 34. The National Reserve Association shall have power, both at home and abroad, to deal in gold coin or bullion, to make loans thereon, and to contract for loans of gold coin or bullion. 380 THE DEMAND FOE EESEEVE GOLD Banks Would Not Be Concerned About Gold Supply Dealing in Bonds of Otiier Countries giving therefor, when necessary, acceptable security, including the hypothecation of any of Its holdings of United States bonds. The effect of this provision would be to permit the association at times when the currents of international trade had gone against the United States, thereby depleting our gold supply, to obtain gold abroad, practically by purchase, and to arrange for its im- portation into the United States. This at times is a necessary function in order to avert stringency and supply actual gold to meet demands for reserves. In times past, when stringency has occurred, there were no means of obtaining gold by united action on the part of the banks, but it was necessary to rely entirely upon the sporadic activities of large banks in order to secure the import of gold. The new plan would place the power, and therewith the responsibility, for such work upon the National Eeserve Associa- tion. The banks themselves would thereby be relieved of the neces- sity of concerning themselves further about the general question of gold supply as compared with that of foreign countries, and would be enabled to look directly to the National Eeserve Asso- ciation for such accommodation as they might deem necessary. By the side of this provision may be set another, which, although not absolutely required, is likely to be of distinct service in the management of foreign trade relations. This is the power to deal in the national bonds not only of the United States but of foreign countries. The Monetary Commission plan makes the following provision on that score : The National Reserve Association may invest in United States bonds; also in obligations, having not more than one year to run, of the United States or its dependencies, or of any state, or of foreign governments. Foreign Exchange Banl