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


(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


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


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.

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