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Protection Against Unsound Practices

Commercial banks are an essential part of the machinery by which the
agriculture, industry, and commerce of a country are carried on, and
their proper conduct is, therefore, a matter of public concern. On
this account they have long been subjects of legislation and of public
supervision and control. The methods evolved for safeguarding the
public against abuses and unsound practices differ considerably among
different nations and to some extent among the different states of the
United States, and could only be adequately explained by a history of
banking in each nation. Only the more important and most widely used
of them will be described here.

(a) Capital and Surplus Requirements and Double Liability of
Stockholders.--A very common, indeed, almost universal, legal
requirement is that before beginning business the proprietors of a
commercial bank shall contribute a fund to be known as the capital
stock, and that an additional fund, usually called the surplus,
shall afterwards be set aside from profits. These funds are required
to be maintained intact, so long as the bank continues in business,
and to be used for the payment of losses in case of failure or
liquidation for any reason. In this country it is also customary to
hold the proprietors legally liable in case of failure for an
assessment equal to the amount of their capital stock. In foreign
countries it is a common practice to have the subscribed considerably
in excess of the paid-in capital, the balance being subject to call by
the directors at any time, and being available for the payment of
losses in case of failure.

These funds serve not only as a protection against loss to the
customers of a bank in case of failure, but also as a restraining
influence on the managers in the everyday conduct of the bank's
affairs. They constitute the proprietors' stake in the business, what
they are likely to lose if the management is imprudent, dishonest, or
inefficient. The absence of such funds would put a premium on rashness
and speculation and tempt into the business the unscrupulous and the

In the determination of the size of capital and surplus funds and of
the amount of the liability of stockholders for subscriptions in case
of failure, no well-founded principles have been developed for the
guidance of legislators. They should be great enough to cover
prospective losses and to induce conservatism, honesty, and efficiency
in management, and not so great as to prevent the free flow of an
adequate amount of capital into the business. Unfortunately, the
statistics of losses in cases of failure are not a sufficient guide.
In some cases they bear a large proportion to the volume of business
transacted and in others a very small one, and the number of cases
available are too small to give much value to averages. The amount
necessary to secure the best possible management is also purely

In lieu of well-founded principles, the practice has developed in this
country of making the minimum capitalization permitted depend upon the
population of the town in which the bank is located. This seems to be
a very crude and indirect method of proportioning capital to the
volume of business transacted. The fixing of such a proportion, or of
a proportion which no bank should be permitted to exceed, is probably
the best method of solving this problem, but it should be done
directly and not by the roundabout method which has been mentioned

A proportion of ten to one between capital and aggregate demand
obligations would probably be justified by American experience. The
present practice of fixing the surplus fund at twenty per cent of the
capital would be justifiable if the capital fund were properly
regulated in amount.

(b) Inflation and Means of Protecting the Public against It.--The
greatest abuse to which the business of commercial banking is subject,
and against which the public most needs protection, is inflation. This
is a condition difficult to diagnose, and not well understood by the
general public and even by bankers. The most easily recognized symptom
of its existence is the forced liquidation of credits; that is, forced
sales of property in order to meet maturing obligations to banks.
When, for example, the people whose notes or bills have been
discounted by banks default in large numbers, and the collateral
deposited as security has to be sold, or, in the absence of
collateral, the courts must order the sale of their property, the
presence of inflation may be suspected.

The chief cause of inflation is the issue by commercial banks of
demand obligations against investment securities. The means of
liquidating such securities are the profits of the enterprises in
which the investments were made and in the nature of the case several
years are required for the accomplishment of this end. Meantime the
demand obligations of the banks issued against them in the form of
balances on checking accounts or notes must be met and, the funds
regularly deposited with them as a result of the operation of such
enterprises being inadequate, other means must be found. The only one
available is the sacrifice, at forced sales, of the property in which
the investment was made or of some other property in the possession of
the persons responsible to the bank.

The banks usually protect themselves against such forced liquidation
by the requirement that the paper they discount shall mature at short
intervals, usually not to exceed four to six months, and accept the
long-time securities, such as bonds, stocks, and mortgages, only as
collateral. By this means they are able to force the liquidation on
their customers. Otherwise they would be obliged themselves to endure
it, with the result that their capital and surplus funds would be
impaired and perhaps exhausted; and, if they should prove inadequate,
failure would be inevitable.

The evil involved in the forced sales of property caused by inflation
is the readjustment of prices through which it is accomplished, and
the depression and, sometimes, panic which follow. When the prices of
many kinds of property must be greatly depressed in order to induce
their transfer to other hands, the machinery of commerce and industry
is thrown out of adjustment and is sometimes rendered temporarily
useless. This result is due to the fact that the relations between
costs of production and the returns from the sale of finished products
are so changed that profits are reduced or annihilated, and many
persons are financially ruined. Readjustments of the prices of raw
products, labor, and finished goods, and the transfer of plants to new
hands, are, therefore, necessary before industry, commerce, and
agriculture can again operate in a normal way, and during the period
of readjustment some enterprises must entirely stop operations, and
all must slow down. At such times many laborers are thrown out of
employment, many more work part time only, the wages of nearly all
are lowered, and most other classes of income are cut down. Depression
and, in extreme cases, panic are the result, and these have serious
consequences other than financial.

The means employed for the protection of the public against inflation
are crude and inadequate. They may be grouped under the heads:
regulations regarding investments, reserves, and note issues. Under
the first head belong in the banking legislation of this country
limitations on real estate investments and on the amount that may be
loaned to a single firm or individual. Our national banking act and
most of our state banking acts prohibit banks from holding real estate
except for their own accommodation, and as a means of reimbursing
themselves for defaulted loans, and our national banking act prohibits
the taking of real estate security for loans, and many of our state
banking acts limit the amount of such security that may be held. Our
national banking act limits the amount that may be loaned to a single
firm or individual to one-tenth of the bank's capital and surplus, and
similar regulations are common in state banking legislation.

The purpose of these regulations is to confine the investments of
banks to what are called liquid securities, but they fail to evince a
proper conception on the part of their authors of what really makes a
security liquid. Apparently legislators and their advisers have felt
that if the securities held by the banks mature in short periods, or
are listed on a stock exchange, they are liquid; but such is not
necessarily the case.

Commercial paper only is really liquid, since it represents a current
commercial process which will soon be completed and the completion of
which automatically provides the means for its payment. Such paper
usually matures in short periods, but the characteristic of liquidity
results not from the date at which it is made to mature, but from the
commercial process which called it into existence and will ultimately
retire it. In this country very often paper of short maturity is so in
form only, its makers expecting to renew it, instead of pay it, at

Bonds and stocks, even though they may be listed on a stock exchange
and daily bought and sold, are not liquid securities in the proper
sense of that term. An individual bank may be able to sell them in
case of need, but such sale is simply the transfer of the investment
to another bank or person, and not its liquidation. The security
still exists and must be paid, while its liquidation would take it out
of existence.

Foreign legislators have approximated more closely than ours what is
needed in the regulation of bank investments. In the case of their
central banks, many of them, notably those of France and Germany, have
recognized the fundamental distinction between commercial and
investment paper, and have required them to hold the former against
their demand obligations, especially their notes.

The regulation of reserves has become a subject of legislation in this
country only. Our national banking act classifies national banks into
three groups, called country, reserve city, and central reserve city
banks, and requires those in the first mentioned group to keep cash in
their vaults to the amount of at least six per cent of their deposits,
and balances in approved reserve city banks sufficient to bring the
total amount up to fifteen per cent of their deposits.

Banks in reserve cities are required to keep in their vaults cash to
the amount of at least twelve and one-half per cent of their deposits,
and balances in central reserve cities sufficient to bring the total
up to twenty-five per cent of their deposits. Banks in central reserve
cities are required to keep at least twenty-five per cent of their
deposits in cash in their vaults. When the reserves of a bank fall to
the prescribed minimum, all discounting must cease. Regulations
essentially similar are found in the banking laws of most of our

The purpose of these regulations is to set a limit to the extent to
which banks may expand the volume of their loans and discounts, in the
belief, apparently, that, if at least the prescribed proportion of
cash is all the time kept on hand, the banks will be able to meet
their obligations. As in the case of the regulations concerning
investments, the authors of these failed to recognize the
significance, from the point of view of the cash demands likely to be
made upon banks, of the kind of paper admitted to discount. If
discounts be confined to commercial paper, the demand obligations they
create will be met for the most part by transfers of credits on the
banks' books or by the return of the notes issued, and, as foreign
experience has demonstrated, the adjustment of cash resources to needs
can safely be left to the judgment of the bankers themselves, who,
through variations in the discount rate, rediscounts, and other means,
can regulate it with ease. If investment paper is admitted to
discount, reserves less than one hundred per cent of the demand
obligations thereby created are unsafe, since a less amount is likely
to force liquidation on the banks' customers, with the results above

The most elaborate regulations for the prevention of inflation have
been developed in connection with legislation concerning note issues.
The reason for this is the fact that commercial banking was at its
origin and for a long time thereafter carried on almost exclusively
through note issues, the conduct of checking accounts being a
comparatively recent development. The phenomenon of inflation was,
therefore, first observed in connection with note issues and
associated with them. Even now the essential similarity of note issues
and checking accounts as banking instrumentalities is not universally

The means of safeguarding note issues which have been incorporated
into legislative enactments are the prior lien on assets, the safety
fund, the requirement and sometimes the mortgaging of special assets,
and the limitation of the total issues. By the prior lien is meant the
provision that in case of failure the note holders shall be paid in
full before any of the assets are distributed among other creditors.
By the safety fund is meant a required contribution from each bank,
usually a percentage of the amount of notes issued, placed in the
hands of some public official and kept for the redemption, in case of
failure, of such of the notes of failed banks as cannot be redeemed
out of the assets of the banks themselves. Additional contributions
from the solvent banks are required for the replenishment of the fund
when it has been depleted.

The practice of different countries regarding the requirement of
special assets to be held against note issues, as well as regarding
the mortgaging of such assets, is not the same. Germany and France,
for example, require their banks to cover their note issues by
designated proportions of commercial paper and coin, while the United
States requires its banks of issue to cover their notes by government
bonds and to contribute a five per cent redemption fund in addition,
and England requires the Bank of England to cover a designated amount
of its issues by government and other securities and the remainder by
coin. Unlike the others, the United States mortgages to the note
holders the securities, that is, the government bonds, required to be
held against the notes, by providing that in case of failure these
securities shall be sold and the proceeds used for the settlement of
their claims.

In all of these provisions, the protection of note holders against
loss in case of failure has been an influential consideration, and in
the cases of the prior lien and the safety fund, the only one. The
prevention of inflation may have entered into consideration in the
other cases, but among the states mentioned the regulations of France
and Germany alone are efficient in this direction, since they alone
prohibit note issues against investment securities. The above
mentioned regulations of England and the United States tend rather to
promote, than to prevent, inflation, since they require the holding of
investment securities against note issues.

The limitation of the aggregate amount of notes that may be issued is
a common legislative regulation. In the United States the limit set is
the amount of the capital stock, and in France it is an arbitrary
figure from time to time changed as the needs of the bank seem to
require. As a safeguard against inflation, the value of such
limitation depends upon the basis of the issues. If it is investment
securities, as in the case of the United States, limitation to a low
figure, not in any case to exceed the capital stock, is desirable,
since such limitation keeps the inflation within such bounds that the
banks themselves may be able to withstand the effects of it by selling
upon foreign markets, without great and perhaps without any loss, the
securities in which their capital and surplus funds are invested. If
the basis of issues be commercial paper, such limitation is
unnecessary, since inflation in such a case is improbable, and
pernicious, unless it be placed above the point which the volume of
issues is likely in ordinary cases to reach.

(c) Other Means of Safeguarding the Interests of the
Public.--Experience has shown that publicity is a valuable safeguard
against bad bank practices, and legislation has, therefore, provided
for it by the requirement that statements of banking operations shall
be published from time to time. The national banking act of the United
States and many of our state banking acts, for example, provide for
the publication five times a year of bank balance sheets, drawn up
according to prescribed forms.

The inspection of banks by public examiners and the requirement of
detailed reports to public officials are also provided for in our
federal and state legislation. Canada requires the reports but not
the inspection by public officials, on the ground that the latter
cannot be thorough and efficient, and is, therefore, likely to mislead
the public and cause it to be less vigilant than it otherwise would be
in the use of other means of safeguarding its interests.

Legislation in this country has also concerned itself with the duties
of bank directors and the enforcement of their performance, and with
the relations of bank officers to their banks, particularly those
involved in borrowing for their own uses or for firms or corporations
in which they are interested.

A recent legislative experiment along quite a new line has been
undertaken in this country in the form of laws providing for the
mutual insurance of depositors. Oklahoma started this experiment, and
her example has been followed by other states. The essence of the
experiment consists in the provision of a fund out of which is paid to
the depositors of failed banks that portion of their claims which
cannot be met from the liquidation of the assets of the defunct banks,
such fund to be contributed by the other banks belonging to the

The protection of depositors against loss is a commendable aim of
legislation, but this method of attaining this aim is open to the
serious objection that it removes from depositors all concern
regarding the proper management of the bank with which they do
business, and thus gives the unscrupulous, dishonest, and plunging
banker an advantage. Attraction of depositors is the chief field in
which competition between banks is carried on, and when the power of
good management in this direction is removed, high rates on deposits,
high lines of credit, low or no rates of exchange, extravagance in
equipment, etc., remain the only attractions, and in the offer of
these the unscrupulous and plunging banker will always outdo the

It is impossible to overcome this objection by public supervision, and
more frequent and rigid examinations. No public officer can equip
himself to pass judgment on the relations of a bank with each
customer, or to detect secret contracts and unwritten understandings,
or to keep unscrupulous people out of the banking business. There can
be no doubt that a reputation for conservatism, good judgment, strict
integrity, and careful management is, at the present time, the most
valuable asset a banker can have, because customers know that they are
in danger to the extent that these qualities are lacking. To
substitute for the present basis of competition between banks that
established by mutual insurance laws is to undermine the foundations
of our credit system and to invite disaster and ruin.

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