Introduction

A bank with low reserves may be disinclined to make a loan, but quite willing to accept a draft that is payable at a future date out of funds provided by the drawer. The accepted draft, being the obligation of a bank, finds a market wherever banks have redundant funds. The bank acceptance, therefore, works in the direction of a more nearly complete equilibration of demand for and supply of the purchasing power that banks make it their business to lend. The accepting bank buttresses the credit standing of the drawer, who then secures the funds desired from a lending institution. An acceptance credit has an important direct influence upon neither the deposits nor reserves of banks; actual advances affect both items directly. Hence, from the standpoint of banking theory, the acceptance credit is comparatively unimportant. Are Deposits Bank Credit? It happens, also, that borrowers extend credit to banks, when either cash or the proceeds of loans are lodged with their banks. Deposits are obviously closely related to loans, both in an individual bank and in a banking system, but that close relationship scarcely justifies the application of the term bank credit to deposits. Whether arising from the lodgment of cash or of the proceeds of loans in a bank, deposits represent INTRODUCTION 3 credit extended by the bank's customers to the bank.

However, partly out of deference to the reader who may insist that deposits also are bank credit, and partly because of the close relation of deposits to loans, a discussion of the deposit item in its relation to loans, surplus and cash is given in later pages. Bank Credit vs. Commercial Credit The fundamental factors affecting the question of security or safety are essentially the same in mercantile and bank credit. The banker and the wholesaler and jobber are about equally concerned with such matters as the ratio of quick assets to current liabilities, net worth, the moral hazard, etc. Both the banker and the business man who sells on credit, tap substantially the same sources of credit information. Methods of investigating the credit risk are substantially the same. In collecting credit information the trade relies heavily on the banks and the banks rely heavily on the trade. The essential difference between bank credit and commercial credit ües in the degree of certainty of payment. The banker's percentage of profit is so small in comparison with the profit of the merchant or manufacturer who extends credit to his customers that the banker is compelled to take greater precaution concerning repayment of a loan than is the business man in regard to payment for wares sold.

The mercantile credit man considers himself fortunate if the losses of his house do not exceed 1/4 or 1/3 of 1 per cent of his total sales. The banker, whose discount is small in comparison with the profits of the merchant, regards as serious the loss of even 1/100 of 4 BANK CREDIT one per cent of his turnover.1 It was estimated in 1892, by Mr. E. S. Lacey, a former Comptroller of the Currency, that the losses on loans and discounts made by national banks at that time amounted to 1/200 of one per cent.2 Another distinctive feature of bank credit is that a bank is commonly able to make loans in excess of the amount of cash received from shareholders and depositors. How much in excess is a question that is answered in chapter III. The Legitimate Scope of Bank Credit Extension It is not the most approved business of a bank to furnish the fixed capital of an enterprise. The fixed capital requirements of a business, as distinct from short time credit needs, must be met before banking accommodation can safely be extended, and borrowers should in general rely on banks for seasonal requirements only.

What the banker may most legitimately furnish will be made clear by an illustration. A clothing merchant proposes to set up in business. He expects to carry a stock of goods worth on the average about $25,000. If he, without capital of his own, should make application for a bank loan of that amount, the application would in all but the most exceptional cases be refused, because the banker, who handles chiefly the funds of 1 Norman I. Adams, Credit Department, Analysis of the Financial Statement, A lecture delivered before the Boston Chapter of the American Institute of Banking, February 4,1913, p. 4. 2 E. S. Lacey, Some Phases of Modem Banking, Proceedings, Second Annual Meeting, Bankers' Association of the State of Illinois, 1892, p. 50.

INTRODUCTION 5 others, cannot advisedly place those funds where so large a risk would obtain. The merchant might secure his capital through the partnership form of organization or,conceivably, through the issue and sale of corporate securities. In any event the bank would have to insist that the merchant commence business with a capital approximately as indicated. With those requirements met, the merchant would be in a favorable position to apply for a loan to finance his somewhat extraordinary needs in the buying seasons, the spring and fall. The capital invested would stand as a buffer between any losses that might occur in the conduct of the mercantile business and the interests of the lending bank. It is plain that if a borrower fully repays his bank loans seasonally it is presumptive evidence that the banker is not being required to furnish a part of the capital fixed in the business. Many banks insist on a "clean up" at least once a year.

The question naturally arises, why should the merchant,—and the same would apply to a manufacturer or other entrepreneur,—not have sufficient capital invested in the business to meet all needs, even those arising at the time of seasonal purchases or expansion? Relatively few concerns are so situated that borrowing from banks is unnecessary. The reason is that the possession of sufficient capital to enable a firm to follow that course would involve, ordinarily, an appreciable waste through loss of income on funds which, although available for use twelve months in the year, would be in active use only a fraction of that time. It is important that emphasis be placed on the di»6 BANK CREDIT tinction between fixed capital requirements and those credit requirements of a business which recur annually or seasonally. Separate and distinct methods ought to be observed in meeting each class of requirement.

Business men should first provide for the capital requisite to start business on a sound basis; then, should have banking accommodation adequate to enable them successfully to carry on that business.1 A maximum of profit to the borrower of funds and a minimum of risk to the lending bank,—these frequently represent conflicting considerations, and it would not be in harmony with the facts to suppose that business concerns confine their borrowing operations to strictly seasonal or temporary needs. The practice of business concerns selling notes through note brokers, described in chapter XVI, and the practice of maintaining more than one bank account militate, along with other circumstances, against the ability and disposition of bankers to limit the extension of credit to the satisfaction of seasonal needs only. It is well known that many wholesale, jobbing and manufacturing concerns now keep large amounts of paper afloat continuously.

That is, banks are supplying not only their short-time or seasonal needs, but a part of their long-time capital needs as well,—a circumstance that danger attends unless the proportion of liquid assets is kept ample.2 1 Cƒ. Charles Hall Davis, The Davis PL·n of Rural Banks, Proceedings, Seventeenth Annual Convention, North Carolina Bankers' Association, 1913, pp. 29-32. 1 Professor Harold G. Moulton has thrown a flood of light on the liquidity, or rather lack of liquidity, of American bank loans. See his articles on Commercial Banking and Capital Formation, Journal INTRODUCTION 7 It is also true that commercial banks customarily invest a part of their funds in long-time securities, especially bonds, a practice that carries with it a danger of shrinkage in value due to changes in the long-time rate of interest. Large cash holdings and other liquid assets in ample amount are designed to obviate the danger arising from advances made on renewable paper, even though the proceeds are invested in fixed form, but only large capital, surplus, and undivided profits will meet the situation if the prices of bonds held by banks shrink, as shrink they do, when long-time funds become scarce and the interest rate rises.

The disposition of borrowers to rely increasingly on continuous loans as against those of short and certain maturity is traceable in part to two facts or tendencies. In the first place the demand for "seasonal" loans of short-time duration, has fallen off relatively, owing to our improved facilities for distributing and storing. As it is almost always possible to obtain promptly any article needed for the consumers' trade there is no great advantage in heavy seasonal buying under ordinary conditions, and the need of seasonal borrowing is accordingly rendered less imperative.1 A second circumstance that has caused the demand for seasonal funds to decline relatively to that for fixed capital has been the tendency to use more and more capital in relation to labor in both production and dis¯ of Political Economy, Vol. 26 (1918), particularly article III, pages 705-31. 1 Cf. Asael E. Adams, As to the Efficiency of our Present System, Proceedings, Twenty-fourth Annual Convention, Ohio Bankers' Association, 1914, pp. 44,45.

8 BANK CREDIT tribution. Every new labor saving device introduced has involved an increase in capital needed in the line in which that device is used, relative to the amount of liquid or short time funds required.1 In one sense continuously floating paper, when marketed by note brokers, is liquid, and in another it is not. From the standpoint of an individual bank it is ordinarily very liquid, although in times of crisis the makers might experience difficulty in meeting their obligations. From the standpoint of the banks taken as a whole this paper, put on the market by brokers wherever buyers among banks can be found, is distinctly non-liquid. From the standpoint of the borrowing concern the floating of paper continuously in the market is almost tantamount to the issue and sale of bonds. From the standpoint of the banking system the floating of such paper is also almost equivalent to the sale of bonds to the banks; but from the standpoint of the individual bank the short time paper is liquid and mobile. In an ideal bank credit situation continuously floating paper would not be outstanding and borrowers would completely pay their obligations to banks at least once a year. The business or trade that has a season longer than a year is rare, perhaps nonexistent.

At the same time some lines of business, like that of the tanner, whose vats, always filled, impel him to borrow money "every day in the year," are nonseasonal and yet make heavy demands upon the loanable funds of banks. There is no good reason in such cases why banks should not lend, provided the ratio of quick assets to current liabilities is adequate, the INTRODUCTION 9 capital or net worth of the borrower ample, and the other elements in the situation favorable. What the commercial banker ought assiduously to avoid, even where loans are based on time deposits, is the unliquid condition of the loan item that exists when his funds are invested heavily in fixed form, in real estate, equipment, etc. Repayment then becomes a matter not of days or months, but of years, and may be extremely uncertain. In succeeding chapters we shall consider in detail the nature of the process involved in the manufacture of bank credit, the relation of loans to other magnitudes in the balance sheet in both individual and collective banking, the recent evolution of our bank credit arrangements, the bases of bank loans, and the influence of certain institutions and practices upon the quality of the contents of the banker's portfolio. A brief study of banking operations and accounts, designed to make clear the nature of commercial banking, is given in the next chapter as an essential preliminary to the development of principles attempted in the pages that follow.