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Operation Of The System
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Operation Of The System








The most noteworthy features of the working of this machinery may be
discussed under the heads: conflict of functions and laws; loan
operations; treasury operations; reserve system; absence of elasticity
in the currency.

(a) Conflict of Functions and Laws.--The two classes of banking
institutions which have been described (state banks and national
banks) and trust companies, described in a subsequent chapter, exist
side by side in many communities, and in the performance of certain
services compete for the patronage of the public. As has already been
pointed out, state and national banks differ little in their functions
except in their relation to real estate loans, and in some states
trust companies perform all the functions of these institutions and
many others besides. In the performance of these common services,
however, they are rarely regulated by the same laws or subjected to
the same kind or degree of public supervision. The competition between
them, therefore, is not always on a fair basis and the temptation to
violate restraining laws and administrative regulations is strong. The
supervising officers recognize the situation as a rule and go to the
extreme limit of leniency in administering laws and regulations which
operate to the manifest disadvantage of the institutions over which
they have jurisdiction, but even then it is often impossible to render
the basis of competition fair and equitable.

This condition of affairs has resulted in the devising of ways and
means of circumventing obnoxious laws and in some cases in practices
which are pernicious in themselves. As examples may be mentioned the
widespread practice of national banks, which are prohibited by law
from making loans on real estate security, of making loans to
customers who can offer no other collateral, on the security of their
personal notes only, or of making loans secured by real estate by a
three cornered operation utilizing a director or officer or some other
third party as intermediary. All three classes of institutions
compete in soliciting the savings deposits of the community, with the
result that the trust companies and savings banks, which often have
the advantage here, sometimes force upon their state and national bank
competitors a higher rate of interest on such deposits than they ought
to pay. The differing regulations in some places in force regarding
the amount that may be loaned to a single individual or firm has also
resulted in some cases in devious and uncommendable practices.

For the remedy of these conditions the first desideratum is the
careful differentiation of the various functions performed by all
these institutions, and the devising of appropriate legal and
administrative regulations for each one. These regulations should then
be incorporated into the legislation and the administrative practices
of the federal government and of each state, and any institution which
performs any of these functions should be obliged to submit to the
regulations pertaining thereto. The difficulties in the way of
securing such a differentiation of functions and such community of
action between the federal government and our states are too obvious
to require statement, but they should not prevent the formulation of
ideal conditions, and a conscious and persistent effort to attain
them.

(b) Loan Operations.--In making loans, a typical method of
procedure for a business man is to arrange with a bank for what is
technically called a "line," that is, the maximum amount he may expect
to be able to borrow under normal conditions. This "line" determined,
he borrows from time to time according to his needs, giving as
security his personal note, payable in one, two, three, four, or six
months. Sometimes an indorser is required, and sometimes the deposit
of collateral, mortgages on real estate, bonds, stocks, and warehouse
receipts being the most commonly used securities employed in such
cases. Ordinarily, when a note falls due, he expects the bank to renew
it, if its payment at the time is not convenient, the agreement on a
"line of credit" ordinarily carrying with it that implication, though
not legally, probably not morally, binding the bank so to do. Indeed,
the customer ordinarily counts the amount of his "line" as a part of
his working capital and expects to keep it in use a large part, if not
all, of the time.

In the determination of the amount of these "lines of credit," the
judgment of some one or more bank officers, assisted by a discount
committee and sometimes, though not as a rule, by a specially
organized credit department, rules. In forming these judgments, the
bankers of the United States as a class are not guided by any
universally recognized and well established principles. The best ones
require from their customers carefully prepared statements showing the
nature and volume of the business they transact, and a careful
classification of their assets and liabilities. Others, and these are
a large majority, rely upon the knowledge they already possess, gained
by general observation, and supplemented by verbal inquiries made from
time to time and by the voluntary statements of the customers
themselves.

The significance of the distinction between commercial and investment
operations in the business of banking is not generally understood, and
is consequently little regarded. The dominant question in the mind of
the average banker, both in determining the amount of a customer's
line and in making loans to him after the line is fixed, is how much
he is "good for," and on this point the total net worth, rather than
the nature of the business operations, of the customer is likely to be
decisive. Of course, the banker is also influenced by the customer's
reputation for both integrity and business ability.

This method of procedure has the advantage of rendering access of
people to the banks easy and of promoting their extensive use, but it
has the grave disadvantage of opening the doors wide to inflation of
credit. The majority of our bankers do not know whether more or less
than their savings deposits and their capital and surplus, the only
funds which can safely be invested in fixed forms, is so invested. The
promissory notes of their customers, which constitute the major part
of their assets, give no information on this point, and they have not
made the investigations necessary to determine with certainty the
destination of the funds they have loaned. They are satisfied with the
knowledge or the conviction that their loans can be collected, not at
maturity--they know very well that many, probably most, of them can
not--but ultimately. The result is that unconsciously and gradually
the banks create their demand obligations in the form of balances on
checking accounts against fixed investments in machinery, buildings,
lands, mines, etc., and, when the payment of these obligations is
demanded, the reserves fall below the danger point and they are forced
to require payment at maturity of paper which the maker had counted
upon having renewed indefinitely, and the payment of which is only
possible by the forced sale of the property in which the borrowed
funds were invested, or of some other property in his possession. If
only a single bank or a comparatively few banks find themselves in
this condition, relief may be found in the rediscount of paper with
other banks, in direct loans, or in the sale of securities on the
exchanges; but, if the condition is general, relief by these means is
impossible, and widespread forced liquidation becomes necessary. An
aggravated situation of this kind causes panic and results in a
commercial crisis.

(c) Treasury Operations.--The operation of our independent
treasury system produces arbitrary fluctuations in the reserves of the
banks and prevents that degree of prevision which is essential to the
most economical and the safest practices. The funds needed for current
purposes are withdrawn from the banks and kept under lock and key in
the treasury vaults, thus diminishing reserves to the extent of their
amount. Surplus funds likewise accumulate in the vaults with the same
result, until the Secretary of the Treasury sees fit to deposit, and
the banks find it possible to receive them. Even then the depository
banks alone are directly benefited, and no one of these knows long in
advance how much it is going to receive or when funds left on deposit
will be withdrawn.

Since the volume of the business of the government is very large, the
effects produced by the movement of its funds are of such magnitude as
to give them national importance, the ability of banks to loan and to
meet obligations already incurred being profoundly affected by them.
Among these effects must also be noted the inability of the banks to
calculate these movements in advance, as they to a degree can those
produced by the operations of their commercial customers, and the
relation between them and the Secretary of the Treasury, which
results. The relation between the receipts and the disbursements of
the government vary greatly from month to month and year to year, so
that, on the basis of past experience, it is impossible to predict
when the banks will gain from or lose to the treasury. The action of
the Secretary of the Treasury regarding deposits of surplus funds is
equally uncertain and unpredictable. No fixed policy regarding this
matter has yet been established by precedent or determined by law.
Each secretary follows his own judgment and is influenced by current
events and conditions.

The uncertainty which results creates a speculative atmosphere about
the money market and renders the banks dependent upon the secretary
and the secretary influential on the money market in a manner which is
unfortunate for both. Since they cannot be indifferent to the
operations of the treasury, and cannot predict them, banks are obliged
to speculate regarding them, and, if they err, they are likely either
to over-extend their credit operations or unduly to contract them. The
former will result when they expect an increase in their reserves from
treasury sources and do not get it, and the latter when contemplated
withdrawals of funds do not occur.

The Secretary of the Treasury is not in a position properly to
exercise the power conferred upon him. He is outside the channels of
commerce and industry, and must, therefore, secure at second hand the
information necessary for intelligent action. Such sources of
information are frequently unreliable and inaccurate and their use
subjects him to the charge of favoritism and to the danger of acting
in the interest of special groups or special localities.

(d) Operation of the Reserve System.--Each national bank now keeps
locked up in its vaults money to the amount of at least six to
twenty-five per cent of its deposits and a balance with banks in
reserve and central reserve cities sufficient to bring the total to at
least fifteen per cent of deposits in the case of country banks, and
twenty-five per cent of deposits in the case of reserve city banks. In
addition, it is customary for most banks to carry as a secondary
reserve high-grade bonds which can be readily sold in case of need.
The practice of state banks is practically the same as that of
national, and that of trust companies differs only in the amount of
reserves carried and in the proportion between the different items.

This system has many disadvantages. Among them the most obvious,
perhaps, is the withdrawal of enormous sums from the current use of
the agriculture, industry, and commerce of the country. That portion
of these reserve funds which is required to be kept under lock and key
in the vaults, amounting in the aggregate to a billion and a half of
dollars or more, is not available for use in ordinary times, and is
practically useless even in times of stringency, since according to
present law, when the reserves fall to the minimum prescribed by law,
banks must stop discounting, under penalty of being put in the hands
of a receiver. The other portions of these funds, namely, those
deposited with banks in reserve cities and those invested in bonds,
are likewise withdrawn from the uses of current commerce, since a
large part of the former is only available for use on the New York
Stock Exchange, and the latter are invested in railroads, mines,
factories, land, etc.

The explanation of the devotion of the redeposited portion of the
reserves to the operations of the New York Stock Exchange is to be
found in the fact that that exchange furnishes a regular market for
call loans on a large scale. Since these funds are held subject to the
call of the banks which deposited them, and interest at the rate of at
least two per cent is paid upon them, the depository banks are bound
to seek investment for them, and call loans on collateral listed on
the exchange under ordinary circumstances are best suited to their
purposes.

Another disadvantage of this reserve system is the dangerous situation
in which it places banks from time to time, and the tendency to panic
which it fosters. The demands made upon banks for both cash and credit
vary with the seasons. In the fall and spring they are much greater
than in the winter and summer. They also vary regularly through
periods of years, increasing during the up-grade of a credit cycle and
decreasing for a longer or shorter period after a crisis. Irregular
and unexpected events also cause variations. On account of the
rigidity of this reserve system and the lack of elasticity in our
currency, the means available to banks for meeting increased demands,
especially those of an irregular and unexpected character, are
inadequate, and their employment is often dangerous. These means are:
keeping in the vaults in slack times a large amount of unused cash, a
practice too expensive to be employed; keeping surplus balances with
correspondents at two or three per cent interest, not a sufficiently
remunerative practice to be employed on a sufficiently extensive
scale; rediscount with correspondents of some of their customers'
paper, or loans from them on the security of their own signatures or
on such security supplemented by collateral; and sale of bonds at such
prices as they will bring.

None of these expedients is certain at all times and under all
conditions, and some of them are precarious at all times. Surplus
balances with correspondents are most reliable, but they occasionally
fail on account of the inability of correspondents to realize upon
their call loans. When calls for the payment of balances are large and
general, it is impossible for brokers whose loans are called by one
bank to transfer them to another. The collateral deposited as security
must, therefore, be offered for sale on the stock exchange, and the
very stringency which resulted in their being so offered renders their
sale, even at slaughter prices, difficult and sometimes impossible.
The result at the best is a heavy fall in the prices of stock-market
securities, and at the worst a stock-market panic and a suspension of
payments by the banks.

Rediscounts and loans from correspondent banks cannot be depended on.
Correspondents are under no obligation to make them. They will usually
do so as a favor, if their condition warrants, otherwise not. Sales of
bonds on the stock exchange are difficult and sometimes impossible in
times of emergency, and are usually attended with loss.

On account of this uncertainty and the danger attending it, when new
and unusual conditions likely to result in increased demands upon them
arise, banks are likely to act "panicky"; to call in their balances
from correspondents; to sell bonds; to call loans; and greatly to
curtail or absolutely to cut off new discounts. This action spreads
the panicky feeling among their customers, and creates such pressure
at the reserve centers as to cause curtailment of accommodations and
panic there.

At the very best, this reserve system is accompanied by high discount
and loan rates and by speculation on the stock market. High rates
result inevitably from the hoarding of currency which it involves, the
supply of loan funds being abnormally diminished, and speculation
follows from the concentration in slack times of funds in New York
City, which can only be employed in call loans on stock-exchange
collateral. Stock brokers regularly take advantage of this situation,
speculate themselves and inspire speculation among their customers.
The mutual dependence of the stock and money markets thus produced by
this reserve system is disadvantageous to both, fluctuations in
values, uncertainty, and irregularity on both being the result.

(e) Lack of Elasticity in the Currency.--The money of the United
States consists of four main elements, gold and silver coin, United
States notes, and national bank notes, and none of these fluctuate in
volume in accord with the needs of commerce.

The gold element depends primarily upon the output of our gold mines
and upon the international movement of gold, increasing when that
output increases and when our imports of gold exceed our exports, and
decreasing under opposite conditions. These fluctuations, however, are
quite independent of our commercial needs. Silver dollars, which
constitute the major part of our silver currency, for several years
have been unchanged in quantity, and the volume of United States notes
has remained at $346,681,016 since the resumption of specie payments,
January 1, 1879.

National bank notes fluctuate in volume as a result of changes in the
number of national banks and in the prices of government bonds.
Whenever a new national bank is organized, a specified portion of its
capital must be invested in government bonds, which bonds are usually
deposited with the Comptroller of the Currency in exchange for notes;
and, when the price of government bonds rises, banks holding more than
the minimum required by law frequently retire a portion of their
circulation in order to recover their bonds for sale at the enhanced
price. When the price of government bonds falls, many banks purchase
additional quantities and increase their circulation.

Changes in the price of government bonds and in the number of national
banks, however, have no connection whatever with changes in our
currency needs, and no more do the fluctuations in the volume of the
currency as a whole, made up of these various elements combined. As a
result of this condition, rates on loans and discounts fluctuate
greatly on account of wide variations between the demand and the
supply of loan funds, and commerce is hampered at certain seasons and
overstimulated at others. As was indicated above, this lack of
elasticity in our currency aggravates the defects of our reserve
system and also aids in the production of financial panics.





Next: Plans For Reform

Previous: The Interrelations Of These Institutions



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