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Domestic Exchange

The accounts of a bank with its correspondents are a record of the
transactions of its customers with the outside world, the checks they
receive as a result of sales to outsiders of merchandise, real estate
or other property, or as a result of gifts by outsiders to them being
credited on such accounts, while the checks they draw or the drafts
they purchase in payment for merchandise, real estate or other
property purchased of outsiders, or of gifts made to them are debited.
When in a given period, say a day or a week, the receipts of the
customers of a bank from outsiders, as a result of current or past
sales and gifts, exceed the payments made by them as a result of
purchases and gifts, its credit balances with its correspondents will
increase, and under opposite conditions they will decrease. If the
payments should continue in excess for a considerable period, the
credit balances of a bank with its correspondents would be exhausted
and some means of replenishing them would have to be found, and under
the opposite conditions too large a portion of the bank's resources
would accumulate with its correspondents and some means of withdrawing
funds would have to be found.

When a bank needs to replenish its credit balances with its
correspondents, it may ship cash or purchase drafts from other home
banks, which it can send to its correspondents for collection like
checks deposited in the ordinary course of business. The latter
resource will of course be available only when these other banks'
balances with their correspondents are not exhausted. Should the
balances of all the banks of a town with their out-of-town
correspondents be nearly or quite exhausted, shipments of cash to
correspondents could not be avoided. If a bank wishes to withdraw
funds from its correspondents for home use, it may order cash shipped
or it may, perhaps, be able to sell drafts for cash to other home

The expenses involved in shipments of cash, loans, or purchases or
sales of drafts for the purpose of replenishing balances with or
withdrawing them from out-of-town correspondents, give rise to what is
called the rate of exchange. If, in order to make out-of-town
payments for its customers, a bank is obliged to pay the expense of
shipping cash to its correspondents or to pay a premium on drafts
purchased from other banks, the natural method of reimbursement will
be a premium charge on drafts sold equal to the amount of the expense
incurred. If it wishes to withdraw a balance with its correspondent,
since to order cash shipped will involve expense, it will be glad to
sell drafts for cash at a discount not to exceed such expense.

The rate of exchange, or the price of drafts on a given point, may,
therefore, fluctuate between a premium equal to the cost of shipping
cash to that point and a discount of the same amount. Beyond these
extremes, these fluctuations cannot ordinarily go, because customers
may demand cash of their banks in payment of checks against their own
credit balances and ship it to their out-of-town creditors at their
own expense, and would do so if the rates charged on drafts should
make such procedure profitable. The actual rate of exchange will not
ordinarily reach either of these extremes, on account of competition
either between the banks which are desirous of selling drafts on their
correspondents or between those which are forced to buy as an
alternative to cash shipments. If the aggregate balances of the banks
of a town with their out-of-town correspondents are large and
increasing, the pressure to sell drafts will be greater than that to
buy and the rate of exchange will go to a discount, the amount of
which, however, will be fixed by competition between the selling
banks. In the opposite case, the rate will go to a premium and be
fixed by competition between the buying banks.

In most towns in the United States there is little or no competition
between banks in the business of buying and selling drafts and
consequently no open market for exchange and no quotations of exchange
rates. In such cases each bank acts more or less independently;
shipments of cash to or from correspondents are the ordinary means of
regulating balances; and the cost of such shipments are charged to the
general expense account of the bank and taken out of customers either
by a fixed and more or less invariable charge on drafts sold, or in
other ways.

Since the balances of the banks of a town with their out-of-town
correspondents depend primarily upon the commercial and gift relations
of their customers with the outside world, it is pertinent to inquire
whether as a result of a long continued excess of purchases from
outsiders over sales to them and of gifts to over gifts from them, the
cash resources of a community might not be completely exhausted, and
if not, how such an outcome is prevented.

Bankers have no direct control over the purchases and sales of their
customers, but through the rate of interest they charge on loans and
discounts and their ability absolutely to discontinue such
accommodations they exert a very potent indirect influence. The rates
of interest and discount charged are an important element in the cost
of doing business and, if loaning and discounting is discontinued,
sales of property to meet maturing obligations are forced, with the
result of price readjustments between the town in question and the
outside world which speedily change the relations between purchases
and sales.

When the cash resources of the banks of a town approach the limit of
safety and their balances with their correspondents fall to an
ominously low point, the normal method of procedure is to raise the
rates on loans and discounts, and if conditions grow worse, to raise
them higher still and as a last resort to cease temporarily to make
them at any price. By increasing the cost of doing business this rise
in the rates will check purchases by diminishing or annihilating the
profits resulting, and will stimulate sales by rendering it more
profitable for some customers to secure funds by sales to outsiders at
lower prices than were formerly asked rather than by borrowing from
banks. Under ordinary circumstances this procedure will be sufficient
to change an unfavorable into a favorable balance of indebtedness with
the outside world, with the result that more checks on outside
institutions will be deposited with the banks and a smaller amount of
drafts purchased. Bankers' balances with their correspondents will,
therefore, increase, and with them their ability to command cash in
case of need. The demands made upon them for cash will also decrease,
since the volume of loans and of business transacted will fall.

If the banks stop discounting, a more or less violent readjustment
with the outside world results. Business men who have obligations to
meet, and most of them will belong to this class, are obliged to sell
their goods and property at whatever prices are necessary and to stop
purchasing entirely. The outcome, so far as the banks are concerned,
is as above indicated. If conditions are such that sales at any price
cannot be forced, a crisis ensues; that is, business operations are
temporarily suspended and transfers of property in settlement of
obligations are made through bankruptcy and other court proceedings.

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