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

ations 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.