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 purch
sed 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.