379. SOME PRELIMINARY DEFINITIONS.—Money may be defined as anything that passes freely from hand to hand as a medium of exchange. Money is of two types: first, coin, including gold, silver, nickel, and copper coins; and second, paper money, including several kinds of certificates and notes. Both types of money, coin and paper, are called "cash." Credit refers to a promise to pay money or its equivalent at a future date. A bank is an institution which makes it its special business to deal in money and credit. A check is a written order directing a bank to pay a certain sum of money to a designated person. A bank note is a piece of paper money or currency which constitutes the bank's promise to pay in coin and on demand without interest, the sum named on the face of the note. A reserve fund is an amount of money or securities which a bank habitually keeps on hand as a partial guarantee that it will be able to meet its obligations.

380. TYPES OF BANKS.—Of the several types of banks, the savings bank is perhaps the most familiar to young people. A savings bank will receive deposits of one dollar or more, and will pay interest on these amounts. But the savings bank does not pay out money on checks drawn against deposits. Indeed, it may require a formal notice of several days before deposits can be withdrawn.

In many states there are trust companies. In addition to performing the function of a commercial bank, trust companies take care of valuable papers, execute trusts and wills, and sometimes guarantee titles to land.

The investment bank is usually a private institution, conducted chiefly in the interests of certain large industrial organizations.

A fourth type of bank is the commercial bank, with which this chapter is chiefly concerned. The commercial bank derives its name from the fact that it deals largely with business men. If classified on the basis of their charters, rather than on the basis of function, commercial banks may be either National, State, or private banks.

381. PRIMARY FUNCTION OF THE COMMERCIAL BANK. [Footnote: Throughout the remainder of this chapter the word "bank" should be taken as referring to the commercial bank.]—The primary function of a commercial bank is to receive the deposits of persons who have saved sums of money for which they have no immediate use, and to make loans to persons who desire them. Of course, those who have deposited sums with a bank may draw on their accounts at any time, either themselves demanding sums of the bank, or directing the bank, by means of checks, to pay specified sums to others. But experience has taught the bank that if it keeps on hand a reserve fund equal to from five to about thirty-five per cent of the sums for which it is liable to depositors, it will ordinarily be able to meet all the demands for cash which depositors will be likely to make upon it. The bank may then loan out to business men the remainder of the money deposited with it. This not only encourages production, but it allows the bank to secure a reward for its services. This reward is in the form of interest paid by those who borrow of the bank.

382. THE NATURE OF BANK CREDIT.—When an individual actually deposits with a bank $100 in cash, the bank becomes owner of the $100, and in turn writes down on its books the promise to pay to the depositor, as he shall direct, amounts totaling $100. The depositor receives a check book, and may draw part or all of the $100, as he likes.

Now it may happen that an individual may wish to increase his checking account at the bank, but that he has no actual cash with which to make a deposit with the bank. In this case he may give the bank his promissory note, together with stocks, bonds, or other forms of wealth, which the bank holds as security. In return, the bank credits him with a "deposit." This means that the bank extends its credit to the individual, by undertaking to honor checks for sums not actually received from the depositor.

The bank has received valuable security from the borrower and hence feels justified in extending him a deposit credit. But, why does a bank feel safe in undertaking to pay out sums of money which it does not actually have in its vaults? The answer is that the bank attempts to keep on hand a reserve fund sufficient to meet all demands for cash which may be made upon it. If the reserve fund is relatively large, the bank will ordinarily loan its credit freely. If the cash reserve is relatively low, the conservative bank may refuse further loans, on the grounds that its cash reserve is too low to justify the acceptance of additional obligations. The only safe alternative to this is for the bank in some way to increase its reserve fund, and then proceed to extend the amount of credit justified by this increased reserve.

383. DANGERS OF BANK CREDIT.—The integrity of these various operations rests upon the confidence which people have in the bank's ability to make good its promises. Confidence in the deposit credit of a bank exists when the past experience of depositors has taught them that the bank in question will habitually exchange either coin or bank notes for checks. Bank notes are ordinarily accepted in the place of coin, because people believe the credit of the bank issuing those notes to be so firmly established that the bank would be able and willing to exchange coin for its notes, upon demand. A bank is enabled to meet these obligations promptly, it should be remembered, because it keeps on hand, against the demands of depositors, a reserve fund of cash, or securities which by law it is allowed to count as cash. If all of the depositors of a bank suddenly and simultaneously demanded the full amount of their deposits in coin, the bank would be unable to accommodate them; as a matter of fact, business men normally leave in the bank that share of their deposits which they do not actually need. So long as men have confidence in a bank, they will prefer checks and bank notes to the less convenient coin, unless they need coin for some special purpose.

If properly managed a bank is a profitable business for everyone concerned. But even though properly managed, a bank may occasionally find itself in a precarious position. There are few matters which the average person comprehends as vaguely as banking, and few things which more vitally interest him than the safety of his money. These two facts combine to render banking extremely sensitive to every rumor of unsoundness. The careful regulation of banking by law is therefore necessary.

384. THE NATIONAL BANKING SYSTEM.—The Civil War plunged our government into serious financial straits. To improve the finances of the Federal government there was created, in 1863, a system of national banks. The original act of 1863 is still the basis of our banking system, though it has since been modified a number of times, notably in 1913.

We speak of a "national banking system," but as a matter of fact this term is inexact. From the beginning of their history, the so-called national banks were "national" only in the sense that they were chartered by the Federal government, and were subject to examination by Federal inspectors. These national banks constituted no definite system: they transacted business much as other banks did, they had no branches, and they had little to do with one another. There was little team-work, and no effective leadership, so that in time of a threatened panic the different parts of the "system" worked at cross- purposes instead of as a unit.

385. WHY A BANKING SYSTEM MUST BE ELASTIC.—A good banking system will be elastic, i.e. it will respond promptly to the varying needs of business. Money and credit constitute a mechanism by means of which business is handled, just as the labor force of a factory constitutes a means of handling the output of the factory. If the output of the factory increases, a larger labor force is needed; if the output dwindles, fewer laborers are needed. Similarly, if business increases in volume, an increased amount of money and credit is necessary to handle the increased volume of business. If, on the other hand, business declines, the volume of money and credit ought to decline also. Otherwise, there will be so much money and credit in circulation, relatively to the amount of goods, that high prices will result.

High prices will result for the following reason: Money and credit are used to exchange against goods. As a general proposition, all the available goods in a community are in a process of exchanging against all of the available money and credit in the community. If goods are relatively few and money and credit are relatively plentiful, a small amount of goods can command a large amount of money and credit, i.e. the goods will sell for high prices. A sound banking system, therefore, will allow an expansion of money and credit instruments when business is booming, and will permit the contraction of the mechanism of exchange when business is growing dull.

The old national banking system was inelastic in two ways: first, it provided an inelastic supply of deposit credit; second, it provided an inelastic supply of currency or bank notes.

386. INELASTICITY OF DEPOSIT CREDIT (RESERVES).—It will be recalled that the amount of loans which a bank may make depends upon the maintenance of an adequate reserve fund. From this it follows that the larger the reserve fund the more loans the bank will feel justified in making. Similarly, if the reserve fund shrinks, sound banking demands that loans be curtailed. Keeping these facts in mind, there were two reasons why the supply of deposit credit was inelastic before 1913.

In the first place, individual banks kept only a part of their reserves actually in their vaults. The remainder, and sometimes the larger part, of their reserves was maintained in the form of deposits in other banks. Banks in towns and small cities habitually kept part of their reserves in the form of deposits in the banks of large cities, and the latter in turn kept part of their reserves in the banks of New York City, the financial center of the country. Hence the cash reserves of the country tended to collect in New York, where they were utilized by New York banks as a basis for extending loans.

This was a dangerous arrangement. In the fall of the year large amounts of cash were demanded in the West, in order to pay farm hands and otherwise "move the crops." At such times the small western banks had to demand their deposits in larger banks, while these in turn had to call for their deposits in the New York banks. The New York banks were often embarrassed by these demands, because they made a practice of fully utilizing the funds left with them, as a basis for extending loans. The call in the West for cash meant a curtailment of these loans with a consequent demoralization of eastern money markets.

In the second place, individual banks were unable to extend loans to customers beyond the point justified by the amount of reserves in their vaults, or deposited to their credit in other banks. A bank with a total reserve of $10,000 might feel justified in loaning its credit to the extent of $100,000, but in case demands for additional loans were made upon it, sound banking practice would oblige it to refuse accommodation. Otherwise it might later find itself unable to get enough cash to pay out against claims made in the form of checks. This practice of curtailing loans when reserves were depleted was demoralizing to business, since the disappointed customer might find his entire business blocked, and this in turn would inconvenience or seriously injure all those who were connected with him in a business way. Before 1913, each bank stood as a unit, and when its reserves were depleted it could not secure temporary aid from other banks. There was no centralized control, and no method whereby national banks might secure help of one another.

387. INELASTICITY OF CURRENCY (BANK NOTES).—We have seen that an increased volume of business demands an increased volume of money and credit. In the previous section it was pointed out that before 1913 the volume of deposit credit in this country was inelastic. We must now notice that bank notes, or paper currency, are just as truly a part of the volume of money and credit as is deposit credit, and we must note, also, that just as deposit credit was inelastic before 1913, so the issue of bank notes was inelastic. Previous to 1913 it often happened that the supply of bank notes was smallest when business was expanding, and that the issue of bank notes increased during dull business periods. This statement requires some explanation.

The Act of 1863 provided that National banks might issue bank notes only after depositing in the Federal Treasury an amount of United States government bonds sufficient to render the bank notes absolutely safe. Naturally, the banks made heavy purchases of bonds when the bond market was depressed, and tended to purchase relatively few bonds when those securities were high in price. Since the only reason for purchasing bonds was to enable the b banks to issue notes, more notes were issued when bonds were low in price, and fewer were issued when bonds were high. Unfortunately, the same general conditions that stimulated business also tended to raise the price of bonds, while the causes of slack business often operated to lower bond prices. This means that when business was expanding, and more notes were needed, bonds were so high that few were purchased, and consequently few notes were issued. Similarly, when business was dull, more bonds were purchased, and more notes issued.

388. THE PANIC OF 1907.—The panic of 1907 attracted attention to these two great defects of the old national banking system, i.e. the inelasticity of deposit credit and the inelasticity of currency. In the fall of 1907, a bumper crop caused Western banks to make unusually large demands for cash upon the New York banks. Unfortunately, this depletion of reserves came at precisely the time when the demand upon New York banks for loans was greatest. There was thus increased pressure exerted upon New York banks for loans, but less justification for extending them. In response to the pressure for loans, some New York banks over-extended their credit. In October the inability of a few prominent banks to pay in cash all of the demands made upon them started a series of bank "runs." Even solvent institutions were unable to meet their obligations promptly and many failures occurred. A large number of banks were technically insolvent, that is to say, their assets were invested in forms which prevented their immediate conversion into cash, so that for the time being demands for cash could not be met. The lack of an effective banking system prevented these banks from securing temporary aid from banks more favorably situated.

389. REFORM.—The panic of 1907 stimulated financial experts to attempt to remedy the defects of our banking system. In 1908 a monetary commission was appointed to investigate banking experience at home and abroad. As the result of this investigation it appeared advisable to establish a system which should secure some of the advantages of such centralized banking systems as have long existed in many European countries. A single central government bank was at first recommended by experts, but this was deemed politically inexpedient. In view of this fact resort was had to a compromise between a centralized and a decentralized system. This compromise was effected by the Federal Reserve Act of 1913.

390. FRAMEWORK OF THE FEDERAL RESERVE SYSTEM.—The Act of 1913 is administered by the Federal Reserve Board, consisting of the Secretary of the Treasury and the Comptroller of the Currency, ex officio, and five other members appointed for ten years by the President. The country is divided into twelve districts, in each of which there is located a Federal Reserve bank. In each district every National bank must subscribe six per cent of its capital and surplus for stock in the Federal Reserve bank, and thus become a "member" bank. State banks and trust companies may, upon the fulfilment of certain conditions, become member banks. Each Federal Reserve bank is governed by a board of nine directors, six of whom are elected by the member banks of its district, and three of whom are appointed by the Federal Reserve Board. The Federal Reserve banks are bankers' banks, that is, they do not ordinarily deal directly with individuals, but with member banks only.

391. ELASTICITY OF DEPOSIT CREDIT (RESERVES).—The piling up of bank reserves in New York is impossible under the Federal Reserve system. The reserves of any member bank do not ordinarily move beyond the district, for a member bank may count as legal reserve only those funds which it has placed on deposit in the Federal Reserve bank of its district. There exists what may be called district centralization of reserves; that is to say, all of the legal reserves of all the member banks of a particular district are concentrated in the Federal Reserve bank of the district, and can be utilized as a unit by that Federal Reserve bank. If in time of stress the total reserves of the district are insufficient, the Federal Reserve Board may arrange for the temporary transfer of surplus funds from one Federal Reserve district to another. This secures one of the most important advantages of a central bank without actual centralization.

Elasticity of deposit credit is also provided for in the "rediscounting device." A bank discounts commercial paper when it loans an individual, say, $980, on the security of a $1000 promissory note. The $20 represents an amount which the bank counts out, or discounts, as payment for the service. A further operation, long known in Europe as rediscounting, was authorized by the Act of 1913. When the reserves of a member bank are too low to justify further extensions of deposit credit, the bank can send certain types of discounted paper to the Federal Reserve bank of its district, and receive in return either a deposit credit or a special form of paper currency called Federal Reserve notes.

392. ELASTICITY OF CURRENCY (BANK NOTES).—When, in return for discounted commercial paper, the Federal Reserve bank extends a deposit credit to the member bank, the deposit credit of the member bank is rendered more elastic. When, on the other hand, the Federal Reserve bank sends the member bank Federal Reserve notes in exchange for discounted paper, the result is a certain elasticity in the currency.

The Federal Reserve notes are a new type of currency. They are secured by the maintenance, in the vaults of the Federal Reserve banks, of a forty per cent gold reserve for their redemption. Since these notes are issued to member banks in return for rediscounted paper, the expansion of business and the resultant tendency of member banks to send discounted paper to the Federal Reserve bank for rediscount causes the volume of Federal Reserve notes to expand. When the need for additional currency has subsided, there is an arrangement whereby a certain amount of the Federal Reserve notes may be withdrawn from circulation. This is important, for if the amount of money in circulation continues to be enormous after business has declined, inflation and high prices result. A truly elastic banking system necessitates contraction as well as expansion.

393. THE OUTLOOK.—On the whole, it would seem that the Federal Reserve System is a happy compromise between the centralized banking systems of Europe and the highly decentralized system existing in this country prior to 1913. The Federal Reserve system allows us to secure the main benefits of a great central bank without the political difficulties attendant upon the existence of such a bank. It does a great deal to make elastic our supply of money and credit. The Federal Reserve Board can mobilize the entire banking strength of the country in time of stress, so that the strength of one member bank is the strength of the whole system. Since it controls not only a substantial proportion of the bank reserves of the country, but also the privilege of note issue on the security of rediscounted paper, the Federal Reserve Board can administer the member banks as a unit. The system may not eliminate panics, but it is fair to expect that it will reduce their number and lessen their violence.

QUESTIONS ON THE TEXT

1. Distinguish between money and credit.

2. Name and distinguish between the four types of banks.

3. What is the primary function of a commercial bank?

4. Explain clearly the nature of bank credit.

5. If the cash reserve of a bank is low, and the bank is confronted with demands for loans, in what two ways may it dispose of these demands?

6. What dangers attend the extension of bank credit?

7. Describe the national banking system.

8. Why should a banking system be elastic?

9. Explain the inelasticity of deposit credit before 1913.

10. Discuss the inelasticity of bank note issue under the old national banking system.

11. What was the significance of the panic of 1907?

12. Outline the framework of the Federal Reserve System.

13. Explain in detail how the Act of 1913 provides for elastic deposit credit.

14. Explain the "rediscounting device."

15. How does the Act of 1913 provide for an elastic bank note issue?

16. What is the present outlook with respect to our banking system?

REQUIRED READINGS

1. Williamson, Readings in American Democracy, chapter xxxi.

Or all of the following:

2. Ely, Outlines of Economics, chapter xv.

3. Fetter, Modern Economic Problems, chapter ix.

4. Seager, Principles of Economics, chapter xx.

5. Guitteau, Government and Politics in the United States, chapter xxx.

QUESTIONS ON THE REQUIRED READINGS

1. Outline the financial powers of Congress. (Guitteau, page 361.)

2. Describe the First and Second United States banks. (Guitteau, pages 369-370.)

3. What were the main functions of the national banks? (Guitteau, pages 371-373.)

4. What are collateral loans? (Seager, pages 346-347.)

5. What are the limitations upon the use of bank credit? (Seager, pages 352-353.)

6. In what ways are depositors in national banks protected? (Seager, pages 358-359.)

7. What is the Independent Treasury system? (Ely, pages 297-298.)

8. Explain the relation of "moving the crops" to bank credit. (Ely, pages 298-299.)

9. How does the Bank of England secure elastic reserves? (Ely, page 302.)

10. What was the Aldrich-Vreeland Act? (Ely, pages 305-306.)

11. Enumerate some of the powers of the Federal Reserve banks. (Fetter, page 121.)

TOPICS FOR INVESTIGATION AND REPORT

I

1. Write to a number of banks in your vicinity asking for literature describing the varied services which they offer the public.

2. Outline some of the more important banking laws of your state.

3. What are the limits of the Federal Reserve district in which you live? In what city is the Reserve Bank located? Why do you suppose it is located in this city?

4. List the banks in your vicinity that are members of the Federal Reserve system.

5. Interview an official of a bank belonging to the Federal Reserve System upon the advantages of such membership.

6. Interview a friendly official of a bank which does not belong to the system. Try to ascertain the reasons why this bank does not belong to the Federal Reserve System.

II

7. Nature and function of money. (Ely, Outlines of Economics, chapter xiv; Fetter, Modern Economic Problems, chapter iii.)

8. Functions of a bank. (White, Money and Banking, part iii, chapter i; Fetter, Modern Economic Problems, chapter vii; Fiske, The Modern Bank, chapter iv.)

9. The bank statement. (White, Money and Banking, part iii, chapter ii.)

10. The clearing house. (White, Money and Banking, part iii, chapter iii; Fiske, The Modern Bank, chapter x.)

11. The credit department of a modern bank. (Fiske, The Modern Bank, chapter xvii.)

12. Bank reserves. (Fiske, The Modern Bank, chapter xxii.)

13. Greenbacks. (White, Money and Banking, part ii, chapter iii.)

14. The check system. (Dunbar, Theory and History of Banking, chapter iv.)

15. Colonial finance. (Dewey, Financial History of the United States, chapter i.)

16. The First United States Bank. (White, Money and Banking, part iii, chapter vi.)

17. The Second United States Bank. (White, Money and Banking, part iii. chapter vii.)

18. The national banking system. (White, Money and Banking, part iii, chapter xiv; Dewey, Financial History of the United States, chapter iv; Fetter, Modern Economic Problems, chapter viii.)

19. The panic of 1907. (Coman, Industrial History of the United States, pages 335-337; Noyes, Forty Years of American Finance, chapter xv; White, Money and Banking, part iii, chapter xviii.)

20. The Bank of England. (Dunbar. Theory and History of Banking, chapter viii.)

21. The Bank of France. (Dunbar, Theory and History of Banking, chapter ix.)

22. The German bank. (Dunbar, Theory and History of Banking, chapter x.)

23. Organization of the Federal Reserve System. (Annals, vol. lxiii, pages 88-97.)

24. The Federal Reserve act and foreign trade. (Annals, vol. lxiii, pages 132-141; Kemmerer, The A B C of the Federal Reserve System, chapter ix.)

FOR CLASSROOM DISCUSSION

25. Should we adopt a centralized banking system such as exists in England, France and Germany? (See the Debaters' Handbook Series.)

26. Should all State banks and trust companies be required by law to become members of the Federal Reserve System?

27. What would be the best method of acquainting the general public with the fundamental principles of banking?