Rural Wealth and Welfare: Economic Principles Illustrated and Applied in Farm Life

Chapter XI. Banks And Banking.

Origin of banks.—Attention has been called to the banks of the country as a most important part of the machinery of exchange. It is proper to describe more fully the nature of the machine and its operations. A clear understanding of the character and process of banking on the part of all the people both extends its influence and diminishes its dangers. Banking, like everything else in civilization, has had a natural growth. The different steps in its growth have been devised for the sake of meeting the needs of a growing commerce, and banking can exist only where commercial transactions are frequent and constant.

The word bank, distinctly related to the English word bench, is supposed to have been adopted from the fact that early Jewish dealers in money sat by a bench in the streets of Italian cities. The commercial city of Venice is supposed to have been the seat of the first organization distinctly named a bank. This was a corporation of money lenders who handled their capital in the form of coin by exchanging it for notes of individuals. This was as early as the twelfth century. Since that time in every civilized community there has been experiment upon methods for quickening exchanges [pg 141] through such organizations, some of which have been of great advantage and some have brought disaster. The modern system of banking is the result of all these centuries of experience, a history of which cannot be given here.

Bank described.—A brief description of the most modern form of banks under state or national restrictions will help to understand how these institutions serve the world of commerce.

In simplest terms, a bank is a company founded for the sole purpose of dealing in coin and current certificates of credit of every form, the prime object being the convenience of people in making exchanges of any kind. Sometimes a bank is called upon simply to make change, or, as we say, to break a valuable coin or a bill of large denomination into smaller pieces. On the border land between two countries the banker serves a traveler by exchanging the coins of the country he leaves for coins of the country he enters.

Often the bank, equipped with safe protection against fire or robbers, receives the wealth of others in any form of money for safe keeping, with provision for its being paid when it is needed, whenever and wherever the owner directs. The same bank may be asked to exchange the money in its possession for notes of individuals payable on demand or at definite future time. It may even issue notes of the firm in place of the individual notes received, acquaintance of a community with the standing of the bank as a dealer in money making its notes circulate where individual notes would not. In this case the wider credit of the [pg 142] bank is exchanged for the limited credit of individuals. In the end a well established bank in close association with a system of banks is expected to do any service that has to do with either money or credit, so long as the credit approximates cash transactions, and has not drifted into overdue debts requiring courts and officials for collection.

So important are all these functions of a bank to the interests of society that distinct provision is needed in the law of the land for establishing the bank and maintaining its efficiency. The double system of government in our country known as state and national leads to two classes of banks, called state or national according as they are organized under authority of state government or under national laws.

State banks.—The independent laws of any state are supposed to provide such restrictions as the people desire for the management of banks. Any bank chartered by the state government is subject simply to the laws of the state pertaining to banks and is called a state bank, whatever the name under which it does business.

The laws of the different states vary indefinitely, but the essentials of a banking law quite recently established in one of the states may serve to illustrate the modern ideals as to safe, legitimate banking. Under this law a bank must be a corporation of not less than five persons who have subscribed for the entire stock and have paid at least 50 per cent of the value of this stock before beginning business, with provision for payment of 10 per cent each month until the whole of the capital [pg 143] stock is paid for in cash. Each stock-holder is individually liable to an amount equal to the value of his stock for any debts of the bank in excess of its original stock. Having settled upon a name distinct from all others, its application is made to a bank commissioner for a charter to do business in banking according to the laws of the state. Under the charter issued by the commissioner, the bank is required to be managed by a board of directors, from five to thirteen in number, which board elects the needed officers and appoints the necessary clerks. It cannot increase its capital except by fully paid stock, and can do no other kind of business, like buying and selling of goods and lands, or managing factories and railroads. It is authorized to receive deposits and make loans at interest not above legal rate, provided it keeps on hand available funds, including bank balances, amounting to 20 per cent of its total deposits, and never loans to one individual or firm more than 15 per cent of the paid up capital of the bank. A penalty of fine and imprisonment follows conviction of any officer for receiving deposits after general insolvency is known.

Each bank is required to report to the commissioner at least quarterly, and whenever called upon to publish its report; while failure to comply with requirements of the commissioner in report or otherwise brings immediate forfeiture of the charter. The commissioner or his deputy must visit each bank at least once a year and whenever occasion may require. If, upon examination, a bank is found insolvent the commissioner himself takes charge of the business for [pg 144] final settlement of its affairs. These important restrictions and careful inspection are thought necessary to secure the public interests in banking. The state through its bank commissioner gives guaranty to the public of legitimate and safe banking. The value of that guaranty, of course, depends upon the honesty, experience and executive ability of the bank commissioner, whose term of office and compensation should make him as independent as possible of any weakening influence. Under present arrangements no state banks issue their notes as currency because of a national tax of 10 per cent, which prevents a possible profit from its issue. Present state laws, therefore, make no provision for that function, unless by statutes existing before the organization of national banks. The states still have the constitutional right, apparently, to charter banks of issue, but the advantages of uniformity throughout the nation are so evident as to make such action very improbable.

National banks.—The so-called national banks organized under authority of United States government have been in existence since 1863, and have proved, so far as currency is concerned, such an improvement upon anything preceding in the way of bank issues, that few have advocated any return to former methods. The system as now existing places the authority of the United States in an officer called the comptroller of the currency. The law requires an association of five or more persons with a definite name and location, having not less than $100,000 capital ($50,000 in small towns) all paid within six months of beginning business. Share-holders are [pg 145] individually responsible for debts of the bank, aside from their stock, to an amount equal to their stock.

In banks having over $5,000,000 capital a surplus of 20 per cent may take the place of this individual responsibility. Not less than one-fourth of the capital stock, usually one-third, is deposited in the United States Treasury in the form of registered bonds of the United States, to be held exclusively for security of circulating notes. These notes are issued to the bank by the comptroller to the amount of not more than 90 per cent of the market value of the bonds deposited. These notes, printed by the government, signed, registered and sealed in the United States Treasury, in denominations from five dollars to one thousand dollars, become money when signed by the officers of the bank whose name they bear. The cost of these notes, together with the cost of restoring when worn out, as well as the expenses of the comptroller's office, are met by a tax of 1 per cent per annum, paid semi-annually, upon the average amount of notes in circulation during the previous six months. Such notes are not a legal tender, but are received at par for all dues to the United States except duties on imports, and for all demands against the United States except interest on the public debt and in redemption of currency. Any other issue of notes is prohibited, and worn out notes are cancelled and burned in the Treasury of the United States, being replaced by new.

The banks in sixteen principal cities are required to hold a reserve equal to 25 per cent of their circulating notes in lawful money of the United States, namely coin or treasury notes, and all other banks must have a reserve [pg 146] equal to 15 per cent of their circulating notes in the same form. This reserve is held for the redemption of the notes, provision being made for such redemption at the Sub-treasury of the United States in New York city, bank balances and clearing house certificates in the larger cities being counted as part of the reserve. The object of this is to secure ready redemption of any note in all parts of the nation.

The comptroller's office includes expert examiners, and to it each bank must report at least five times a year, with other special reports as called for. Each bank is subject to examination at the pleasure of the comptroller, and in case of failure to redeem bills or comply with the law, the comptroller has power to take possession of the bank and close its business. The usual banking business of any national bank proceeds according to the laws of the state in which it exists, the legal rate of interest of the state being compulsory.

Advantages and disadvantages of national bank currency.—The advantage of such a uniform system of bank notes is evident. The bills are secure beyond the possibility of doubt as to their final redemption, and therefore circulate freely without reference to the failure of the bank issuing them. In case of failure, all the banks form a ready machinery for collecting the bills for final redemption at the United States treasury. The frequent reports and expert inspection give as satisfactory means of maintaining safe management as can be secured by law. The possibility of connivance between examiners and bank officers is reduced to a minimum.

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At the same time, there are disadvantages from several sources. First, United States bonds do not form a permanent basis. Second, the market value of these bonds and the low rate of interest make the use of capital in the shape of circulating notes less profitable than other capital in the bank. This is especially true in the newer communities where interest is high, and banks so located are likely to surrender their circulating notes at times when money loaning is most profitable, and thus cause a fluctuating volume of currency in the country. Third, the national banks are easily made objects of suspicion as to matters of legislation with reference to money.

Government banks.—Similar institutions under direct management of government officers have often been thought of as bringing the banking machinery within the direct judgment of the people, and so best meeting the wants of the community as a whole. The advantages of unity and publicity in such a system seem evident, and yet in actual practice the safeguards against misuse of power have proved on trial less satisfactory in such methods than in several others. The history of debased coinage already referred to shows that men in power may easily disregard the interests of the people, and under popular government both officers and legal restraints are subject to changes in the interest of localities and parties. It is possible that a stable body of experts might manage such an institution under laws as stable as the Constitution with success. But the restraints of law are most effective upon institutions outside official circles.

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A government bank is subject to extreme pressure from popular demand under any financial distress to issue currency for general improvements in public buildings, parks, etc., which can bring no return and afford no means of redemption. Even the demand of unfortunate debtors for extended loans may push the bank into excessive issues, and finally lead to the scaling of debts and currency together in an effort to escape the results of over-issue.

Bank business.—Whatever the organization of a bank, its business must be essentially the same. It receives deposits from its customers for safe keeping and for convenience in use by means of checks. A check is simply an order to pay, and, if the receiver is a customer of the bank, amounts to merely a transfer of deposits from one owner to another on the books of the bank. A thousand dollars safely kept in the bank vault may thus change owners a hundred times by means of checks properly recorded. In large transactions the check, because of its economy, takes place of any other form of currency. The bank must also deal in drafts, by which exchanges can be made in different cities, and in bills of exchange, distinguished from ordinary drafts by special reference to foreign trade. It may also hold, as a part of its available machinery, clearing house certificates, which are statements of balances due in the daily settlement between the banks belonging to a clearing house association.

All these form a part of the machinery of every-day exchange, and together with a complete system of book-keeping make the utmost facility in the use of money.

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They also greatly economize in the use of money by saving cost of counting and of transfer, and by securing against losses. If the system offered no more advantages than this safe and ready use of good money, the banks would be practically indispensable. But they have a still greater use in a safe extension of credit. The perfection of system in banking makes it possible for one who habitually fulfils his promises to purchase anywhere in the world on the shortest notice with the simple guaranty of credit in the bank where he does business. A traveler wishing to have funds in safe-keeping, and yet available on a journey around the world, may obtain through a bank familiar with his business standing a letter of credit, upon which he can draw, wherever he may be, against the deposit in his favor, and his draft will be paid, through a series of banks, at the bank near his business connections. Thus the credit of the world is bound together by the banking system grown up to meet the necessities of trade.

The clearing house.—All forms of credit referred to above, where dealers are customers of a single bank, are easily brought together upon the books of that bank, and will practically cancel each other. The customers of many banks in large cities may have their checks and drafts brought into a single system of book-keeping through a clearing house, which is simply a bank of banks. At a certain hour each day, in the larger cities twice a day, each bank of the city brings to the clearing house all checks and drafts against any other banks. These are quickly sorted, charged to the several banks against which they are drawn, and credited to the banks [pg 150] from which they are brought. The balance of debit and credit is settled then and there, either by transfer of cash, or by issue of a clearing house certificate that a bank has a balance in its favor, and so only a small amount of cash is used in settling all transactions of an immense business. The clearings of a single day reach hundreds of millions of dollars, and form an index of the business prosperity of the country.

The system saves the risk and cost of transferring back and forth immense amounts of coin and currency, and brings the business men of the country into ready contact with each other. It is an essential part of the means of settlement between different cities and different countries. A debt in any part of the world can be paid through a draft on London, which by means of the clearing house and its associated banks can be purchased anywhere and paid without delay. Since the purchasing power of any part of the world is chiefly in what it has to sell, the constant motion of checks and drafts in opposite directions will balance each other. If there were no long time credits, the purchases of any city would essentially equal its sales; and so with perfect clearance all trade would be quickly adjusted with but little use of money except for retail business.

Other clearing systems.—So evident are the advantages of clearing houses in banking that the system extends to many other interests. Railroad corporations balance accounts against each other by exchange of tickets issued by the different roads. Large combinations of dealers in implements or other goods find a similar service available where they can work together [pg 151] with confidence. Express companies sharing in a common service divide the final proceeds upon the same principle. So evident is the advantage that the growth has been rapid during recent years, and seems likely to extend still further.

Some effort has been made to establish farmers' exchanges upon a similar plan, but as yet with little success. The obstacles are chiefly in the want of business confidence in business habits among the farmers themselves. Since the system is strictly a credit system, exact promptness in meeting engagements and constant dealing in the same channels are absolutely necessary. Most farmers, having comparatively few transactions from day to day, are loath to attach themselves as constant customers in any association. With larger experience and more neighborly contact they are finding it possible to work in association for various purposes, and will doubtless enlarge their means of business credit as their progress in mutual understanding increases.

Government inspection.—The principal support of universal credit through banking is the assurance that uniform methods, honest in principle and accurate in execution, are followed. To secure these results a system of government inspection and guaranty seems absolutely necessary. If the public faith is to be maintained, the ground of that faith must be publicly established. The more complete the examination by trusted officials and the more frequent the publication of official reports, the better the public credit. It seems possible that even individual trustworthiness may become a matter of government record as it is now of private consideration in [pg 152] all business circles. One chief guaranty of credit through the banks is the strict inquiry made by the banks themselves into the business standing of their customers. If the record were perfect, the chief weakness of the credit system would be largely removed.

The balance of trade.—The bulk of trade between countries, that is of dealers in different countries, is settled in the usual routine of banking as has been indicated; but since under present systems the standards of value are given in different terms in different countries, somewhat more of friction remains in such trade. A greater attention is given to the fact of final settlement in coin or bullion. The price of exchange from a country whose dealers owe more than is due them, under the law of supply and demand, soon arises to an amount sufficient to cover the cost of transporting gold or silver. When these metals are used in payment by transportation from one country to another they are said to indicate the balance of trade; that is, they show that more of other property comes into the country than goes out. This balance of trade is supposed to show the relative prosperity of a nation, and is said to be against it when the nation buys more than it sells.

It is usually sought in the difference between the value of coin or bullion exported and of that imported. In two sets of circumstances a large correction is necessary to show the actual condition of trade. One is where a nation is buying on long credit, as in case of great enterprises like railroads or factories, constructed by sale of bonds in foreign countries or by sale of any other securities, government or individual, in a foreign land. The [pg 153] other is where a country like our own is a large producer of gold and silver by mining. In this case the products of the mines are as proper an article of export as the products of the farms or of the factories, and should be estimated as a part of the natural exports. For these reasons the balance of trade must be carefully scrutinized before being accepted as proof of a nation's progress in poverty or wealth.

Bank loans.—So far, in dealing with the subject of banking, no mention has been made of the function of extending individual credit by time loans. One of the original purposes of banking was to make a convenient office for the meeting of borrowers and lenders. The banks are still the go-betweens of those who have money to lend and those who have to borrow. In fact, every banking association is assumed to be a corporation of money lenders. Under ordinary circumstances this corporation is able to loan to individuals whose credit is good all of its capital not otherwise employed in the machinery of the bank, a considerable portion of deposits from its customers, and to a certain extent its own credit in the commercial world. In the case of a national bank a portion of capital is loaned to the government in the purchase of bonds, which are the basis of its circulating notes. The circulating notes, from 60 per cent to 90 per cent of the value of the bonds, are an extension of credit; that is, the capital already loaned on time to the government is partially loaned again to individuals. Again, the deposits of the customers, to be drawn as needed, in ordinary circumstances are not needed the same day. The bank soon learns by experience what portion it is [pg 154] safe to lend from day to day to individuals who are sure to make payments when promised. Double signatures, or endorsements, double the surety of prompt payment.

Thus the banks are enabled to provide safe keeping for money without charge, and even to pay a low rate of interest upon considerable deposits when times are good. In this way legitimate borrowers and legitimate lenders find a close connection in the bank. A legitimate lender is one who has property not needed at present for his own use. A legitimate borrower is one who can use capital to advantage in production. Any producer may at one part of a year be a lender and afterward a borrower to advantage of everybody. If the banks are thoroughly satisfactory the proceeds of the fall crops may serve the busy manufacturers as circulating capital during the winter. Again, the proceeds of the spring sales of goods and machinery may tide the farmers over the season of growth.

In this way labor of every kind is sustained by labor of every other kind. In all these ways the banking power of a country is extended to several times the coin money in circulation, and that with perfect safety. But it is possible for banks to be tempted through the very perfection of their own credit. The note of an individual has no established market value. A deposit in the bank is valued as cash. It is possible to secure the credit of having a bank deposit by discounting an individual note. If that note is a time note the bank has increased its immediate liabilities by the amount of a nominal deposit, with only a promise to pay in the future to rest upon. To lend to an individual is practically [pg 155] to enter into partnership with his fortune. The fortunes of the group of individuals representing the bank is less doubtful than that of any one person. The borrower in this instance pays in the discount of his note the difference in risk between his fortune and that of the combination. Such deposits purchased upon credit must be distinguished from deposits of cash, lest the bank should nominally increase its power to lend while in fact it has already lent up to its ability. Sometimes such nominal deposits are maintained by persons deeply in debt for the sake of paying a larger rate of interest than is allowed by law.

Safety of banking.—In times of business prosperity a bank with usual business caution as to customers, is safe for all concerned. And yet, in the very nature of extended credit, it has promised to pay on any particular day, if demanded, far more than it has cash in hand. Its liabilities embrace the whole of its deposits except a small portion made for a definite time, and all its issues of currency subject to redemption. To meet these engagements its immediate resources are whatever currency in any form of coin or bills it may have at hand. This amount, since its profits are made from lending, not from holding, must be small in proportion to its liabilities. The bulk of its means of payment is in notes not yet due, and to be collected when due. Of other property it is likely to have bonds of municipalities or of great corporations, and these are supposed to be a more available form of resources than individual notes, because they usually have a definite market value and can be sold or used as security for loans in any [pg 156] money market. If real estate forms a part of the capital, it can never be made available for immediate use. Hence any bank dealing in mortgages on real estate invests its funds where they cannot be had when wanted. All banking schemes based upon security in land have necessarily failed, because land has no current use in trade.

Under the pressure of panic, from whatever source, each depositor is sure to demand every cent due him from the bank, and just as certainly the bank's own resources are insufficient to meet those dues without the sale of bonds and notes in other markets. For these reasons in any great period of distrust the banks are obliged to suspend payments. Since all the banks of the community are in similar circumstances they cannot help each other, and time must be given for the collection of loans, according to agreement, that the gradual accumulation of ready cash may return to the vault, and so to the depositors, all that has been loaned. Because of this necessary instability bankers watch most carefully the tendencies of the money market, and necessarily reduce their loans for safety when any anxious pressure begins. For the same reason legitimate banking is limited to short time loans—on demand, thirty, sixty, ninety days—the shorter being the safer. Laws sometimes prohibit a bank from dealing in any other business, where a stock of goods must tie up funds, or from speculation in real estate, which confines capital more certainly.

In most banks the amount to be loaned to a single individual or firm is limited to a small portion, one-tenth [pg 157] to one-fifth, of the total capital. The principal causes of failure in banking are defalcation of officers, misuse of funds in speculative enterprises, dealing in speculative securities or on boards of trade, careless loaning to poor paymasters, investment in long time securities not readily marketable, or sacrifice in hurried sale of stocks and bonds under the pressure of panic.

The better the customers of a bank understand its condition and management, the less is its danger, for the basis of banking, as of the credit of the world, is the public confidence. Farmers who acquaint themselves with the workings of neighboring banks by making use of their aid in business benefit both themselves and their neighbors. The progress of the world demands of every farmer a closer contact with business and, therefore, a greater familiarity with business methods. Even the burden of debts will be lessened when farmers understand and appreciate the advantage of systematic credit. The dangers from over expansion of credit are lessened when all the people clearly understand the essential conditions for maintaining credit. The final perfection of a banking system depends upon the interest of the whole people, with a fair knowledge of the growth already made.

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