Part I Quantitative Aspects of Bank Credit

PART I QUANTITATIVE ASPECTS OF BANK CREDIT CHAPTER II THE NATURE OF COMMEBCIAL BANKING The lending functions of a commercial bank are so radically different from those of the money lender, putting out only his own funds, that it will be desirable at the outset to consider carefully the nature of banking, the essence of which consists in the practice of extending loans far in excess of either the capital or cash holdings of the bank in question. A glimpse of the difference between bank loans and the loans of a money-lender will be gained if we examine the balance sheet of a bank as the institution expands on the basis of the cash paid in by the shareholders in exchange for shares of stock. Banking Transactions and Accounts Following the customary practice of setting down the assets and liabilities on opposite sides of the balance sheet, we note first that the payment of, say, $ 100,000 capital stock, one thousand shares of $100 each, will result in the creation of assets and liabilities as follows: Assets Liabilities Cash $100,000 Capital Stock $100,000 The balance sheet shows cash as an asset,—debt paying power,—and capital stock as a debt. Sometimes "capital stock" is shortened to "capital," in 13 14 BANK CREDIT which case the reader may have difficulty in bearing clearly in mind that capital really means, not the cash paid in by the shareholders, but what the bank as an institution owes the shareholders on account of their cash contributions to the enterprise. Capital stock or capital is always a liability of the bank.

It would be natural for many of the shareholders to transfer their accounts from older banks to the new, and we may suppose that cash amounting to $50,000 is deposited by shareholders. The balance sheet or financial statement will then read: Assets Liabilities Cash $150,000 Capital $100,000 Deposits 50,000 $150,000 $150,000 Local business men, friendly to the promoters of the new bank, also open accounts, depositing $5,000 in cash and $20,000 in checks on other banks. Our statement will now show: Assets Liabilities Cash $155,000 Capital $100,000 Due from Other Banks. 20,000 Deposits 75,000 $175,000 $175,000 During the early history of the bank, connection will have been established with one or more metropolitan banks, and a deposit balance created. The primary reasons for the maintenance of balances on deTHE NATURE OF COMMERCIAL BANKING 15 posit with banks in centers to which the locality of a given bank is commercially tributary are (1) that the local bank may be able to sell drafts on those centers, for the accommodation of its customers who may desire to remit drafts as means of payment, and (2) that the local bank may have agents in the centers to handle and collect drafts drawn by dealers or manufacturers who have shipped goods to distant markets, and (3) that the local bank may have collection agencies for the stream of checks deposited daily by its customers.

It would be reasonable for a bank having a capital of $100,000 to place $25,000, more or less, on deposit with one or more banks in commercial and financial centers to which the locality of the bank with which we are concerned is tributary. Cash would then be reduced $25,000 and "due from banks" would be increased to $45,000. The statement would stand: Assets Liabilities Cash $130,000 Capital $100,000 Due from Other Banks. 45,000 Deposits 75,000 $175,000 $175,000 Applications for loans amounting to $20,000 are received and approved. The average time is 90 days and the rate 6 per cent; the discount amounting to $300. The proceeds, $19,700, are left on deposit to be drawn against by check. This lending transaction introduces into the statement some new items. Loans and discounts, being valuable instruments in the possession of the bank, will take a place on the asset side 16 BANK CREDIT of the statement; deposits will be increased by the amount of the proceeds of the loans; the discount, which is profit undivided and belonging to the shareholders, will be recorded as a liability under the head of undivided profits. Assets and liabilities have grown to the following proportions: Liabilities Capital $100,000 Undivided Profits 300 Deposits 94,700 $195,000 Loans and Discounts .. $ 20,000 Due from Other Banks. 45,000 Cash 130,000 $195,000 The directors of our bank feel that the amount of cash lying idle in the vault is unduly large and vote to buy $30,000 worth of bonds and, confident of the future, also vote to invest $5,000 in a well located vacant lot on which, in the fullness of time, to erect a new banking house. The purchase of the bonds and real estate for cash is now reflected in the balance sheet.

Assets Loans and Discounts.. .$ 20,000 Due from Other Banks. 45,000 Real Estate 5,000 Bonds 30,000 Cash 95,000 $195,000 Liabilities Capital $100,000 Undivided Profits 300 Deposits 94,700 $195,000 An overdraft, which occurs when the bank allows an unbusinesslike customer to draw upon the bank for THE NATURE OF COMMERCIAL BANKING 17 a sum in excess of his balance, is a form of loan, an asset, but generally bears no interest. Short and Company having a deposit balance of $200 at the bank send a check for $210 to a New York wholesaler in order to pay an overdue bill. The check is deposited by the wholesaler in a New York bank, passes through the clearing house to the New York correspondent of the local bank, and then to the local bank itself on which it is drawn. The procedure makes several changes in the balance sheet. Deposits are reduced $200, i. e., Short and Company's balance is entirety wiped out; an overdraft of $10, a negative deposit, expressed in red ink on the individual ledger, is created; "due from banks" is reduced $210.

The bank has made no profit on the transaction but the balance sheet presents an entirely new item, overdrafts. Assets Liabilities Loans and Discounts.. .$ 20,000 Capital $100,000 Overdrafts 10 Undivided Profits 300 Due from Other Banks. 44,790 Deposits 94,500 Real Estate 5,000 Bonds 30,000 Cash 95,000 $194,800 $194,800 A traveling representative of a commercial paper house visits the bank, which buys, after investigation, one note of $2,500 each of four such open-market borrowers as the International Harvester Company and the Goodyear Tire and Rubber Company, The 18 BANK CREDIT average time of the paper bought is 4 months, the rate 6 per cent, and the discount $200. New York and Chicago drafts, drawn for a total of $9,800, are given in payment. Without reproducing the statement of the bank, we may indicate the changes which the purchase of the paper in the open market entailed. Undivided profits are increased $200; loans and discounts by $10,000; due from other banks is reduced $9,800.

A farmerj in order to add to his acreage, borrows $5,000 from the bank, giving a mortgage on real estate as security. The time is five years and interest at 6 per cent is made payable annually but not in advance. The amount of the loan is taken by the borrower in cash and paid to the seller of the land, who deposits it in a bank in a neighboring town. Cash is reduced $5,000 by this transaction; loans and discounts, increased by $5,000. Another customer of the bank pledges stock in a local corporation as security for a loan of $10,000 for 30 days at 5 per cent, leaving the proceeds, $9,958.33— $10,000 less the discount of $41.67,—on deposit. Loans and discounts are increased $10,000; deposits are increased $9,958.33 and undivided profits, $41.67. Stationery and supplies are bought at a cost of $65, an expense item that we may properly deduct from undivided profits. Cash is reduced $65. A customer deposits $500 in cash, and takes, in preference to a checking balance, a certificate of deposit bearing 4 per cent interest. Cash is increased $500 and a new item, certificates of deposit, for the same amount, appears among the liabilities.

THE NATURE OF COMMERCIAL BANKING 19 A local patron of a Chicago mail order house, pays cash for a Chicago draft for $88.60, for the issue of which the bank charges ten cents exchange. The draft is a check of one bank upon another. The small exchange charge is a form of undivided profits. The buyer of the draft pays $88.70 in cash, which includes the small charge for the services of the bank. Cash is increased $88.70. Due from other banks is reduced by $88.60 and the amount of the exchange charge, ten cents, is added to undivided profits. Furniture and fixtures, previously bought, are paid for by means of a cashier's check for $12,000. Furniture and fixtures will now be listed among the assets of the balance sheet as worth $12,000, and a new item, cashier's checks, for the same amount, will appear as a liability as long as the check is outstanding. Foreseeing the possibility of making a profit by doing so, the directors authorize the issue of $25,000 in notes, and, in accordance with statute requirements, forward $25,000 in United States bonds, which were on hand, to the United States Treasury as security. As the National Bank Act also requires the maintenance of a 5 per cent redemption fund in the United States Treasury, the cash of our bank will suffer a reduction of $1,250. We may conveniently suppose that the notes are passed over the counter of the bank in exchange for customers' demand notes aggregating $25,000. As demand notes bear interest, as distinguished from discount, no immediate profit will arise from putting the notes into circulation.

The condition of the bank now will be reflected by the following statement: 20 BANK CREDIT Loans and Discounts $ 70,000.00 Overdrafts 10.00 Real Estate 5,000.00 Furniture and Fixtures 12,000.00 U.S. Bonds 30,000.00 Due from Other Banks 34,901.40 Redemption Fund.. 1,250.00 Cash 89,273.70 Liabilities Capital $100,000.00 Undivided Profits.. $541.77 Less Expenses. . 65.00 476.77 Circulating Notes.. 25,000.00 Deposits 104,458.33 Certificates of Deposit 500.00 Cashier's Checks. 12,000.00 $242,435.10 $242,435.10 A glance at the statement shows that cash is equal to more than 50 per cent of the demand liabilities. A bank management eager to make a profitable record for its shareholders will be prompted to lend until demand liabilities, of which individual deposits are the main item, are from four to twenty times the cash or reserve. Expansion of Loans a Prelude to Loss of Cash Now as loans increase, in the case of an individual bank, cash tends to diminish. This is true partly because a few borrowers take all or part of the proceeds of their loans in cash. An attempt on the part of an individual bank to expand its loans is normally met by an immediate and positive reduction of its cash. The immediate contraction of cash is, however, almost negligibly small and is not the only restraining force affecting the execution of a liberal loan policy.

A second check on the loan expansion of an individTHE NATURE OF COMMERCIAL BANKING 21 ual bank consists in the fact that loans result in an increase in deposits, and as deposits increase a given reserve becomes less and less adequate to sustain their growing volume. Moreover, when the proceeds of loans are left on deposit with the bank, the balances created are soon reduced—funds are borrowed to be used—through checks drawn by the borrowers in connection with the payment of current obligations. Such checks are in most cases remitted to creditors who are not depositor-customers of the drawers' bank, which stands to lose cash when the checks are presented, directly or indirectly, for payment. As the deposit structure, i. e., liabilities payable in cash on demand or at short notice, rises as a result of rising loans, the cash base on which it rests becomes smaller and smaller. The liberal loan policy of an individual bank is opposed, then, in the process of its execution, by a double check: as loans are extended (a) cash tends to diminish; and (b) deposit liabilities arising from loans tend to swell,—the prelude to a further loss of cash.

A bank whose reserve is large in relation to its deposits or demand liabilities, as is true of the institution that we have been building up, will continue to expand its loans until, through a slight increase of deposits arising from loans and the decrease of cash resulting from loans, the ratio of reserve to deposit liabilities becomes what the bank management regards as normal or desirable. If the institution whose operations we have been handling were to continue to expand its loan and other activities until it became representative of our national 22 BANK CREDIT banks, its balance sheet would present an appearance about as follows: Assets Liabilities Loans and Discounts $540,760.28 Capital Stock $100,000.00 Overdrafts 120.16 Surplus 50,000.00 U.S. Bonds 50,000.00 Undivided Profits... 13,271.19 Other Bonds 20,200.00 Circulating Notes.. 12,500.00 1 Stock of Federal Individual Deposits. 504,365.58 Reserve Bank 4,500.00 U. S. Deposits 2,961.75 Real Estate, Furni-BillsRediscounted.. 5,000.00 ture and Fixtures.. 25,899.50 Due to Other Banks. 74,328.15 Other Assets 40,800.26 Certificates of DeRedemption Fund posit 18,441.37 and Due from U. S. Cashier's Checks... 468.00 Treasurer 1,250.20 Due from Other Banks 80,126.94 Gash 17,678.70 $781,336.04 $781,336.04 Protective Liabilities As our bank has grown, one new and somewhat puzzling item has made its appearance in the balance sheet, namely, surplus. Bank surplus is a liability of the bank to its shareholders which arises from and represents the excess value of assets over and above that required to meet all other liabilities, including capital stock and undivided profits. Surplus differs from capital or capital stock in not being represented by stock certificates, although the magnitude of the 1 Federal Reserve banks are banker's banks owned by national banks, state banks, and trust companies.

THE NATURE OF COMMERCIAL BANKING 23 surplus tends to be reflected in the market value of the relative stock certificates. Surplus also differs from capital in that it is commonly earned, whereas capital is commonly paid in by the shareholders. Bank surplus differs from the surplus of most business corporations in that it is sometimes, not infrequently, "paid in," wholly or in part. Perhaps the most important difference between capital and surplus is a legal one. Double liability attaches to the ownership of stock in all our national banks (except the National Bank of Commerce of New York) and in many state banks, but in no case does it apply to surplus. Reduced to simple terms, "double liability" means that a shareholder's maximum loss in connection with the holding of stock can not legally be made to exceed the amount of his investment (or the investment and an amount sufficient to make his shares fully paid, if the stock has not been fully paid) plus an amount equal to the par value of his stock. In general, a bank shareholder may be called upon, in the event of heavy loss or disaster to his bank, for a contribution in addition to the purchase price of his stock, proportionate to his shares held, but not in excess of their par value.

Such an arrangement, while affording a reasonable degree of security to depositors and other creditors, does not render the ownership of bank stock objectionable to men of great means and substance as did at one time the provisions of English banking law. Serious bank failures in the United Kingdom in the eighteen hundred and seventies spread circles of ruin among bank shareholders, who were liable on their 24 BANK CREDIT bank stocks to the full extent of their fortunes. Men shunned the latency of limitless debt, which "appalls the imagination and breaks the heart of effort," and the ownership of banks in the United Kingdom was rapidly passing from those who had much to lose to those who had little when the Act of 1879 was passed to prevent "the defection of the strong and the infusion of the weak." 1 The act, which legalized the principle of reserve liability, was accepted before 1885 by all but seven of the eighty-two unlimited banks in the three Kingdoms. The act enabled every bank registered under its provisions to increase the nominal value of each of its shares, and thus to enlarge its subscribed capital without increasing the amount paid up. It was further provided by the act that every bank that should register under it might place the whole or any portion of its uncalled capital in the form of reserve liability. Thus the liability of the shareholders of the London Joint Stock Bank, prior to its recent amalgamation with the London City and Midland Bank, was £85 per share in addition to £15 paid thereon.2 While the English system of reserve liability serves the same protective purpose as the double liability feature of our national bank stock, it is flexible and adaptable to the varying desires and views of share1 George Rae, The Country Banker, John Murray, London, 1885, p. 253.

2 Interviews on the Banking and Currency Systems of England, Scotland, France, Germany, Switzerland, and Italy, Publications of the National Monetary Commission, Senate Document No. 492, 61st Congress, 2nd Session, p. 60.

THE NATURE OF COMMERCIAL BANKING 25 holders and managements having widely different temperaments and policies. The English bank management is able to regulate the security underlying the ultimate payment of deposits and other creditor liabilities through the reserve liability as well as through the payment of capital and the accumulation of surplus, which the English call reserve. Surplus and undivided profits are of essentially the same nature. Each indicates that an excess value of resources exists on the assets side of the balance sheet. Surplus almost invariably stands as a round sum, and although sometimes owing its origin, like capital, to cash paid in by the shareholders, very frequently represents the accumulated earnings of the bank. The undivided profits item represents the accumulatmgr earnings of the bank and is scarcely ever a clean, round sum. Undivided profits feed surplus.

At intervals, the bookkeeper of a prosperous bank acting at the behest of the bank management will transfer a portion of undivided profits, $5,000, $10,000, or more, to surplus. Dividends, the expenses of the bank, and most losses come out of undivided profits, whereas surplus, like capital, stands as a buffer between the creditors of the bank and exceptionally heavy losses. It needs to be emphasized that surplus, like capital stock and undivided profits, is not something tangible that the bank examiner can place his hands on. Like all items on the liabilities side, surplus is a statement of debt. The assets available to cancel the debt represented by surplus, undivided profits, and all the remaining liabilities are listed in the opposite column of 26 BANK CREDIT the balance sheet. It is an egregious mistake to think of the surplus or capital stock or undivided profits as being normally invested in any one asset item or in any particular group of asset items. That such is not the case will be clear from an extreme, but legitimate, illustration. A bank has a surplus of $50,000 and cash of $40,000. If, as the result of a "run" on the bank, its cash were entirely withdrawn, deposits would be reduced $40,000 and cash reduced $40,000, with no change in the amount of the surplus. Any other item on the assets side of the financial statement might be eliminated in a similar way with similar results, in that surplus would be left undisturbed. Demonstrably, surplus does not stand for any one asset item, or even group of items, in the balance sheet. The shareholders have an equity in each of the resource items.

Writers on banking are probably responsible in no small measure for the general lack of clarity of understanding in connection with the nature and functions of surplus. Text books commonly in use either omit definition and explanation of surplus or fail to give a clear and satisfying exposition of this mystifying magnitude. Scott says with reference to capital and surplus: By the former is meant a fund contributed directly or guaranteed by the stockholders or proprietors, and by the latter an additional fund accumulated from profits. ... In case of failure, such funds' are available for" the payment of depositors and noteholders and other creditors, who are to this extent guaranteed against loss. Surplus funds may also be accumulated as a means of meeting temporary losses withTHE NATURE OF COMMERCIAL BANKING 27 out infringing upon the other resources of the bank, and for the equalization of dividends.1 Capital and surplus are represented as funds. The practice of so representing surplus and capital may have been prompted by the following provision (section 5199) of the National Bank Act: The directors of any association may, semi-annually, declare a dividend of so much of the net profits of the association as they shall judge expedient but each association shall, before the declaration of a dividend, carry onetenth part of its net profits of the preceding half year to its surplus fund until the same shall amount to twenty per centum of its capital stock.

White refers to both capital and surplus in terms of a guarantee fund. The capital of a bank is primarily a guarantee fund contributed by the shareholders to give it stability and to create confidence in its soundness. . . . The surplus is a portion of the bank's profits not divided among the shareholders but set aside as a permanent addition to the guarantee fund. . . . For all banking purposes the surplus becomes an integral part of the capital.2 Writers fresh from an examination of the surplus provisions of the National Bank Act have naturally employed its unfortunate terminology. The result 1 William A. Scott, Money and Banking, Henry Holt & Company, New York, 1916, p. 132. 2 Horace White, Money and Banking, Fourth Edition, Ginn and Gompany, Boston, p. 214.

28 BANK CREDIT has been confusion between surplus and cash or reserve which, in a strict sense, is a fund. Our frequent use of the term surplus reserve, i. e., the reserve held in excess of legal requirements, is not intended to sharpen the distinction current between surplus and reserve. Surplus is excess asset-value due shareholders. It is dollars' worth, not dollars. The balance sheet or financial statement last given should convey the fact that the bank represented would be able, in the event of liquidation, to meet in full all of its obligations to outside creditors and have sufficient funds remaining to pay shareholders $163.27, that is, $100,000(capital)+$50,000(surplus)+$13,271.19 (undivided profits) divided by 1000 (shares of stock), on each of the one tho`usand shares outstanding. The question naturally suggests itself, might not the loans and discounts or other assets prove to be worth more or less than 100 cents on the dollar? The question involves the subject of valuation. Although the value of the principal assets of a bank is free from fluctuation traceable to physical change, there is, nevertheless, occasion for re-valuation, for the scaling down or writing up of assets from time to time. While loans and discounts, which correspond roughly to a merchant's stock of goods, are not subject to physical deterioration, they do frequently include paper on which the face value cannot be realized. The value of bonds and other securities fluctuates constantly, and calls for more or less frequent value adjustment.

Furniture and fixtures also require re-valuation from time to time. Real estate is somewhat unsteady in value. The valuation placed on all these items will THE NATURE OF COMMERCIAL BANKING 2Ô depen*d appreciably on the temperament and disposition of the bank management. Where conservatism in valuation prevails,—as is probably true generally in banking, in contradistinction, perhaps, to ordinary business circles,—assets are likely to be undervalued, and the actual surplus larger than the book surplus. In such cases, assets are "concealed." Concealed Assets and Liabilities Concealment of an asset commonly represents concealment of profits and, whether partial or complete, may be accomplished in several ways. Securities that had not been listed among the assets and amounting to two and a quarter million dollars were uncovered by bank examiners at work on the affairs of a New York City bank. The officers of the bank were made to show the two and a quarter million dollars in their assets, "but in spite of that, shortly afterwards they increased their capital from one million to three millions without the stockholders paying in a cent or reducing their surplus or undivided profits. So they must have had a bunch somewhere that we did not know about." Under the old National Bank Act real estate could not be acquired and held beyond a certain time. A certain bank acquired a piece of real estate and not wanting "to be punched up by an examiner every day" the management "charged the entire thing off and let it go at that." When the real estate was sold later the money was thrown back into the profits of the bank. It has happened that a proportion of hidden assets has been credited to each of the different shareholders of a bank as a deposit, under an agree30 BANK GREDIT ment that the shareholders might not draw out the amount and that they should receive no interest thereon.1 Also, dividends have not been declared, by agreement among the stockholders, profits being concealed by issuing a certificate of deposit to some person as trustee for the stockholders.

The purpose of concealing assets may be to evade taxation, especially when capital items are assessed at a higher rate than real estate and other property. Again, concealing assets may discourage competition. Large profits shown might induce competition. When profits and assets are concealed from some of the stockholders, but not from others, the practice may be resorted to in order that officers or directors may be able to buy the stock of the ill informed shareholders at less than its value.2 Liabilities are also frequently concealed,—a practice that is even more seriously objectionable than that of concealing assets. Liabilities are generally concealed by dishonest and designing officers or employees in order to offset a shortage in the cash. It is assumed in our discussion of surplus and its role in commercial banking that book surplus accurately reflects actual surplus. However, it must be borne in mind that whether that reflection or measurement is accurate or not depends upon the valuation of the multifarious items that are embraced in the aggregates with which the balance sheet deals.

If we assume that the valuation of the assets in the 1 Proceedings, Ninth Annual Convention, National Association of Supervisors of State Banks, 1910, pp. 57-59. 2 Op. cit., pp. 56, 57.

THE NATURE OF COMMERCIAL BANKING 31 financial statement on page 22 is correct, it will be evident that the bank represented could sustain a loss of $163,271.19 and still pay its creditors in full, without levying an assessment on the shareholders in connection with the liability for the amount of the face value of their stock. If the bank had not built up a surplus and, instead of so doing, had paid dividends sufficiently liberal to absorb the earnings, any loss in excess of $113,271.19 (or of $213,271.19, if we include the possible levy upon stockholders provided for by the double liability feature of the National Bank Act) would cut into the amount available for meeting obligations to the creditors of the bank. The larger the capital, surplus or undivided profits, other things being equal, the less is the likelihood of loss to the creditors of the bank. Or stating the same fact in other words, the larger the surplus or other liabilities to the shareholders, the greater is the loss that a bank can sustain and still pay its deposits and other creditor liabilities in full.

CHAPTER III THE PHILOSOPHY OP BANK CREDIT The prime purpose of the present chapter will be to draw a sharp line of distinction between credit extension by an individual bank and that of banks taken in the aggregate. The accepted statements of banking theory, with scarcely an exception,1 have made no such distinction, with the result that confusion, obscurity, and error prevail with reference to the most fundamental principles of the subject. The explanation of the way in which banking institutions manufacture credit, i. e., make loans equal to several times the amount of their cash holdings, has been essayed again and again, but the traditional treatment appears to be marked by lack of insight into the heart of the problem, and the subject seems still to stand in need of exposition. The influence of bankers' banks on the manufacture of bank credit being taken up in chapter VI, it is in place to say that throughout this chapter cash is used in a broad sense synonymously with reserve, and no distinction is made between checks, drafts, etc., that are convertible into cash upon presentation and cash itself. It makes no substantial difference to the banker 1 Professor H. J. Davenport gives a fragmentary view of the theory here developed. See his Economics of Enterprise, The Macmillan Company, New York, 1913, pp. 263, 286, 287.

32 THE PHILOSOPHY OF BANK CREDIT 33 whether additions to his volume of deposits have their origin in the receipt of lawful money or in the form of various credit instruments, bank notes, checks, drafts, that are readily exchangeable for or convertible into lawful money. It has long been observed that the banks of a given credit area, e. g., United States, are able to extend credit, i. e., make loans, equal to several times their reserve and the inference has been made that what is true of all banks taken in the aggregate is true of each; and the inference has been supported by the observed fact that the balance sheet of any representative individual bank carries loans several times the amount of the reserve held. Observing that an individual bank, as well as banks taken collectively, commonly has loans equal to several times the reserve, the theorist has reasoned that a given addition to the reserves of an individual bank would place the receiving institution in a position to make a manifold increase in its own loans. If a bank holding cash of $100,000 has loans outstanding equal to $1,000,000, the receipt of another $100,000 in cash, the old theory runs, would enable the bank to add another $1,000,000 to its loan item.1 Such reasoning, however, leaves out of account certain consequences of loan expansion to which attention will be directed later in this chapter, and we may now state, as a thesis to be defended, that the acquisition of ad1 See E. E. Agger, Organised Banking, Henry Holt & Company, New York, 1918, pp. 31-33; H. G. Moulton, Surplus in Commercial Banking, Journal of Political Economy, Vol. XXV, December, 1917, pp. 1007-1009; W. H. Kniffin, The Practical Work of a Bank, Bankers' Publishing Company, New York, 1915, pp. 14-16.

34 BANK CREDIT ditional primary deposits enables an individual bank to expand its loan item by little more than the amount of such deposits.1 But how can a given amount of cash become the basis of manifold loans and deposits in a banking system if the acquisition of that amount by an individual bank has little or no multiplicative importance? That is the riddle of banking and to its solution this chapter is chiefly devoted. A statement and critical exposition of the time-honored theory, handed down consistently from the days of Alexander Hamilton to the present, will serve as an advantageous point of departure. A Critical Analysis of the Traditional Theory Horace White, who follows Macleod, has employed substantially the same explanation in the various editions of his Money and Banking, widely used as a text in our colleges and universities. The following passages from that work are typical of the traditional treatment.

An analysis of modern banking is substantially this: A man has $10,000 of his own money. He starts a bank. His neighbors deposit $50,000 with him. . . . The banker finds by experience that some of his customers will bring in as much money as others draw out, so that $60,000 is on hand all the time. He infers that if his own $10,000, in connection 1A primary deposit is one growing out of the lodgment of cash or its equivalent, and not out of credit extended by the bank in question. A fuller statement of the nature of primary deposits as distinguished from derivative deposits, which have their origin in loans extended to depositors, is given in later pages of this chapter.

THE PHILOSOPHY OF BANK CREDIT 35 with his good reputation, is considered by the public a guarantee for $50,000, then the whole $60,000 will serve as a guarantee for a much larger sum. When he begins, his balance sheet reads in this way: Resources Liabilities Cash $60,000 Capital $10,000 Deposits 50,000 $60,000 $60,000 The banker now begins to buy promissory notes, or bills of exchange, due at a specified time in the future, paying the face value of the same, minus interest at a certain rate for the intervening time. This is called discounting commercial paper. When he discounts for one of his customers a note for $1,000 running ninety days, he deducts the interest (say $15), entering the amount under the head of profits due to stockholders, and writes the remainder, $985, on the credit side of the customer's pass book, entering a corresponding sum as a credit to that person's account in his own books. This credit is called a deposit, and properly so, since the net purport of the transaction is that the banker has bought an interest-bearing security and the seller has deposited the money he received for it in the bank, to be drawn out at his pleasure. If the customer had deposited $1,000 gold simultaneously with the foregoing transaction, his total deposits would have been $1,985. Yet there is a difference between the two kinds of deposits, the one being of money and the other a bank credit. In practice, the bank credits at any given time may be four or five times as large as the amount of cash in the bank.

The process of discounting commercial paper continues until the banker has $200,000 of bills receivable in his portfolio. Then his account stands thus: 36 BANK CREDIT Resources Liabilities Cash $ 60,000 Deposits $247,000 Loans and Discounts... 200,000 Capital 10,000 Profit 3,000 $260,000 $260,000 Thus the business venture called a "bank" owes to depositors and to the banker himself $260,000; and it has assets which will produce that amount, but only $60,000 of it is cash. It follows that the banker has manufactured something which serves as a medium of exchange to the extent of $197,000. This is credit. Goods can usually be bought and sold with it as readily as with money, since checks drawn against deposits are accepted in trade by the whole community. The whole $200,000 of bills are not discounted at one time, but gradually, so that some are always maturing and bringing in money to meet the banker's liabilities.1 Two questions arise at once concerning the explanation given. The first is, would not unfavorable clearing house balances preclude the possibility of the bank considered lending $200,000 on the basis of $60,000 in money? The second question is, would the gradual extension of loans of the bank enable the institution, without receiving additional primary cash deposits,—additional primary deposits, according to the traditional theory, would also serve to support manifold loans—to lend $200,000 on the basis of an undiminished reserve of $60,000?

The second question, relating to the content of the 1 Horace White, Money and Banking, Fifth Edition, Ginn & Company, Boston, 1914, pp. 194-196.

THE PHILOSOPHY OF BANK CREDIT 37 last sentence quoted above, may be disposed of at once. The error there involved is that small loans made today, January 1, will when they mature, April 1, bring in money with which to meet the banker's liabilities arising from heavier loans made April 1. If the funds received from the repayment of the early loans are sufficient to meet the banker's liabilities arising from the heavier loans made April 1, the funds first loaned would be sufficient to do the same.1 In other words, if loans amounting to $200,000 could be extended gradually on the basis of $60,000 cash, the same amount could be loaned at once. But the result of a loan expansion of the bank would be a loss of cash through unfavorable clearing house balances as the sequel will show. Let us suppose that the Hanover National Bank of New York acquires a deposit of $1,000,000 in gold imported and lends $10,000,000 to its customers, an amount suggested by the approximate ratio of 1 to 10 between reserves and deposits in our banking system at the present time. (The ratio of cash to deposits, one to four, in the statement quoted from White, which was taken almost verbatim from Macleod's work of a half century ago,2 is supposed to represent the ratio customary at that time.) The borrowing customers of the Hanover National Bank would withdraw little or 1 It is true that a small proportion of loans is customarily held on deposit by the borrower with the lending banker and that, as a result, the lending bank is able commonly to extend credit about equal in amount to "cash" deposits received.

! Henry Dunning Macleod, Theory and Practice of Banking (Fifth Edition), Vol. I, p. 324.

38 BANK GREDIT no cash over the counter but would certainly draw checks against the proceeds of their loans deposited with the bank. The checks would be sent to their creditors in New York and elsewhere. Checks for a relatively small amount would be deposited for credit at the Hanover National Bank, effecting the withdrawal of no cash; but the great bulk of the checks drawn by the borrowers of the $10,000,000 against the proceeds of their loans would reach the Hanover National Bank via the New York clearing house, many having traveled long distances from the points of deposit. Perhaps not more than $100,000 out of all the checks drawn against the $10,000,000 borrowed would be deposited at the Hanover National Bank. The remainder of the manifold loans supposedly extended on the basis of the imported gold deposited, except a small proportion, probably not more than 20 per cent, not checked by borrowers, would represent cash that the bank would lose through unfavorable clearing house balances, an amount that would be scattered widely among the banks of the system. It is clear that an individual bank attempting to lend greatly in excess of the amount of an addition to its reserves would do so at its peril.

Loan and Deposit Expansion within the Banking System It would be equally clear, however, if there were only one bank into which all of our banks were merged, doing the loan and deposit business of the entire country and maintaining a reservedeposit ratio of R, that the net deposit of a given amount of cash or reTHE PHILOSOPHY OF BANK CREDIT 39 serve, c, would enable the institution to lend, in addition to its normal amount of loans outstanding, cg· — c This is true because the deposit arising from the cash, c, would itself call for a reserve equal to Re, leaving c-Rc as reserve for deposits arising from additional loans. The amalgamated bank, i. e., the banking system, would tend to lose no cash as a result of its loan expansion, because all checks drawn by borrowers would be in favor of depositors of the drawers' bank, who would themselves place the checks on deposit.1 The total deposits expansion for the banking system, under 1 cthe conditions stated, would be -~-c or —.xt Jtv If the expansion of deposits were either more or less than s, there would be involved, obviously, a departureR from the cashdeposits ratio previously existent in the banking system.

Let the ratio of cash to deposits for the banking system, then, be represented by R, the new cash or reserve, by c, the expansion of deposits traceable to an addition to cash, by D, the loan expansion arising from the same source, by X, and the following equations stand forth: X=c(1~R)andD~¿R R 1 Some cash might be lost as a result of rising prices and a consequent increased demand for hand to hand money.

40 BANK CREDIT We have seen that the loan expansion in an isolated bank or in the banking system, as the result of the acquisition of a given amount of reserve, is several times greater than the loan expansion practicable for an individual bank acquiring the same amount. What is true for the banking system as an aggregate is not true for an individual bank that constitutes only one of many units in that aggregate. The sudden acquisition of a substantial amount of reserve by a representative individual bank, other things remaining the same, tends to cause that bank to become out of tune with the banks in the system as a whole. As the individual bank increases its loans in order to re-establish its normal reservedeposits ratio, reserve is lost to other banks and the new reserve, split into small fragments, becomes dispersed among the banks of the system. Through the process of dispersion it comes to constitute the basis of a manifold loan expansion.

Primary and Derivative Deposits Differentiated An explanation of the way in which new cash or reserve becomes the basis of a manifold and wide extension of loans by the banks of a system may be approached by distinguishing carefully between what, for lack of better terms, may be called primary and derivative deposits. A primary deposit may be defined as one that arises from the actual lodgment in a bank of cash or its readily convertible equivalent such as checks and drafts drawn on other banks, but not made in anticipation of the repayment of a loan. By a derivative deposit is meant one which arises directly from a loan or which is accumulated by a borrower in anticiTHE PHILOSOPHY OF BANK CREDIT 41 pation of the repayment of a loan. Whether springing from loan-proceeds left with the bank—which will later be largely, if not entirely, drawn out by check to serve the purpose for which the loan was made—or arising from the placement of funds in the bank in order to retire a loan at maturity, a derivative deposit is extremely variable in magnitude. A primary deposit, standing as it does for funds placed in the bank for safekeeping and to be currently checked against as well as currently replenished, is not marked by the extreme ups and downs to which a derivative deposit balance is subject. A primary deposit, it is true, may be large today and small tomorrow, but there is a strong tendency toward regularity and uniformity of volume. The primary deposit balance of a representative business concern moves generally within pretty definite limits, the lower limit never reaching zero. A derivative deposit, on the other hand, is superimposed upon the primary balance and, at the initial date of the relative loan, rises at once to a high point, falls away during the early period of the loan, then as the loan-maturity approaches rises more or less gradually to a peak and, when the loan is paid, drops precipitately to the initial and basic level. A primary deposit balance is roughly analogous to a flowing stream in the dry season of the year. A derivative deposit is, perhaps even more roughly, analogous to the added and quickly changing volume that comes with the rains of spring and fall.

A primary deposit tends, then, to be relatively stable in amount, while a derivative deposit, always "made" only to be "withdrawn," is subject, during its comparatively short and limited existence, to sharp and pro42 BANK CREDIT nounced changes in magnitude. The nature of primary deposits is easily understood. Derivative deposits, invariably tied closely to loans, require further explanation. A typical bank borrower does not at once check out the entire amount borrowed and, furthermore, for a short time just preceding the maturity of the loan he does not fail to accumulate a balance sufficiently large to enable him to retire the loan at maturity by means of check. Indeed borrowers are required by many city banks to maintain an average balance equal to a definite percentage, usually 20 per cent, of the maximum credit extended,—a circumstance that tends to prevent the withdrawal of the entire amount borrowed.

On the contrary, many country bankers affirm that loans made to a depositor have nothing to do with his balance. But even these country bankers admit that the typical borrower's balance is swollen for a few days after the negotiation of the loan, before checks, promptly drawn by the borrower, return to his bank, reducing his balance. They also testify that the borrower commonly increases his balance during the late days of the loan period, which may be lengthened by renewal, in order to be able to repay his loan by check at maturity. If we let diagram 1 represent a longitudinal section of the deposit account of a typical bank borrower, we shall be able to see the relation between an individual bank-loan and the corresponding derivative deposit balance. Time is measured and registered along the 0 P or horizontal axis, i. e., by distance from O toward the right. The amount of the total deposit balance of a THE PHILOSOPHY OF BANK CREDIT 43 typical depositorborrower is measured by the vertical distance above the 0 P axis.

Thus, before borrowing, the bank customer, whose account is pictured in the diagram, had a balance of O M. Just after leaving on deposit the proceeds of a loan, he had a balance of O M plus M' K of which M' K was "derivative." Funds are borrowed for use, Diagram 1 and we see that fact reflected in the downward course of the curve K L during the first days of the loan period. A short time before the maturity of the loan, preparation is made by the borrower looking toward repayment, and as time passes the vertical distance between the M N line and the K L line becomes greater. Derivative deposits rise in anticipation of the maturity of the loan, reaching a maximum on that day. When the loan is retired, the deposit balance drops to the level obtaining before the loan was secured. The reader, and especially the practical banker, who objects to the "ideal" character of the operations 44 BANK CREDIT represented by diagram 1, as invalidating the theory developed, is urged to peruse the exercises and problems bearing upon this chapter given in Appendix A.

The Ratio of Derivative Deposits to Loans The average magnitude of the derivative deposit balance, represented by the average height of the curve K L above the line M'N' in diagram 1, in relation to the amount of the loan, K M', varies decidedly from borrower to borrower and—less markedly— from bank to bank. The most extreme case of variation that the writer has found among borrowers is furnished by a bank at Sioux Falls, South Dakota. The cashier's own words are interesting. "Quite a percentage of our business is done with farmers who at most seasons of the year maintain only small accounts even though their borrowed balance is a good sized one. Then too at the other extreme we have had a few customers who borrowed good sized amounts and left a larger amount than the total amount borrowed on deposit all the time as an emergency fund in case of a sudden need. These are, in our case, men who deal in real estate, owners, not brokers, so that if they are at a distance and find what they consider a snap they shall be able to draw their check without stopping to negotiate for a loan."

The subjoined table, containing estimates obtained from the banks represented, throws light on the variation of the ratio from bank to bank and shows within what limits the average or typical ratio for American banks would fall.

THE PHILOSOPHY OF BANK CREDIT 45 Location of Bank Ratio of Derivative Deposits to Loans Boston, Mass 10 per cent Salem, Mass 20 " " Rockport, Mass 7.5 " " Claremont, N. H 10 " " Manchester, N. H 10 " " Milford, N. H 10 " " Newport, N. H.i 3 " " New York, N. Y 20 " " Erie, Pa.2 8 " " Baltimore, Md 10 " " Tiffin, Ohio 10 " " Medina, Ohio 20 " " Elkhart, Ind 8.75 " " Assumption, 111 12.5 " " Carthage, 111 20 " " Freeport, 111 5 " " Galesburg, 111 20 " " Frankfort, Ky 10 " " Scottsville, Ky.3 10 " " Greenvüle, S. C.1 18.5 " " 1 Detailed estimate is as follows: 10 per cent of loans result in an average balance of 15 per cent 30 per cent of loans result in an average balance of 5 per cent 60 per cent of loans result in an average balance of 0 per cent 2 Sixty per cent of loans are "out during the life of the obligation; and 40 per cent perhaps leave 20 per cent of the amount borrowed with us during the loan period."

8 Detailed estimate: 10 per cent of loans result in an average balance of 40 per cent 30 per cent of loans result in an average balance of 20 per cent 60 per cent of loans result in an average balance of 0 per cent 410 per cent of loans result in an average balance of 40 per cent 20 per cent of loans result in an average balance of 30 per cent 20 per cent of loans result in an average balance of 20 per cent 40 per cent of loans result in an average balance of 10 per cent 10 per cent of loans result in an average balance of 5 per cent 46 BANK CREDIT Location of Bank Ratio of Derivative Deposits to Loans Morgan City, La 10 per cent Corpus Christi, Tex. 15 Oskaloosa, la 2 Pierre, S. D 5 Denver, Colo 10 i Francisco, Cal.1 10 It seems safe to conclude that for our banks taken in the aggregate the derivative depositloan ratio lies somewhere between 5 and 20 per cent. Factors Determining the Ratio of Derivative Deposits to Loans The proportion of loans left on deposit is a function of many variables. In a community of farmers and stock men, relatively small derivative deposits would be maintained in relation to bank borrowings. "In a strictly farming community," says an Illinois banker, "loans are usually made for a definite purpose, such as buying stock or something of that nature and then paid off when grain or stock is sold in the bulk." It is evident that, under these conditions, deposits traceable to loans during the life of the obligations would be small.

When a high rate of interest is charged, especially to farmers and stock men as is common in the West, the proportion of derivative deposits to loans may 1 Estimate of writer, based on information furnished by three banks of San Francisco,—where banking competition is very keen and requirements as to balances in relation to loans comparatively lax.

THE PHILOSOPHY OF BANK CREDIT 47 be whittled down still further. The higher the interest rate charged by the bank, the stronger will be the tendency for the borrower to make the inception of his loans synchronize with the initial date of the period for which he needs funds, and the maturity of the loans synchronize with sales or other cash receipts. A South Dakota banker estimates that a typical loan made by his bank is practically exhausted the day that it is borrowed and that very little deposit is made until the date that the note is paid. "The reason for this is as follows: Our rate of interest is high, 10 per cent, and when a customer makes a loan he does not do so until he has immediate use for the money and then only borrows what he really needs. Our loans," he continues, "are mostly made to stock men and are made payable at any time before maturity, so that usually the loan is entirely taken up from the proceeds of stock sales on the day the sale is made, or that the returns are received." High interest charges and meagre derivative dep_osits go hand in hand.

Conversely, where interest rates are comparatively low the desire of business men to maintain balances satisfactory to their bankers asserts itself and money may be borrowed in excess of actual or estimated needs. The good business man, it is well known, is jealous of his balance in his own bank. On general principles, he does not wish to see his balance run too low and he frequently asks for a loan, according to a Pennsylvania banker, with the remark that "I may need it." But even in communities where interest rates are low and business men are jealous of their bank balances 48 BANK CREDIT a considerable proportion of loans may be productive of no large volume of derivative deposits. When a large proportion of a bank's advances take the form of paper bought from paper dealers—notes of distant borrowers—the ratio of derivative deposits to combined advances made to depositors and non-depositors may be decidedly low. Essentially the same result is obtained when advances are made on mortgage security. The Indiana bank included in the table above reports that about 65 per cent of its loans are made on commercial paper and mortgages; and that on such loans practically no deposits are left with the bank.

The remaining 35 per cent of loans are made to local commercial borrowers, who are also depositors, and about 25 per cent of the amount loaned to these depositors remain, on an average, with the bank for the duration of the loans. With the six banks of Freeport, Illinois, there is no large local demand for borrowed money, and one carries over a half million dollars in loans secured largely by mortgages on farms in states farther north and west. A bank at Pecatonica, Illinois, with bonds and receivables totaling $410,000, loaned locally only $81,000. Banks of this character have a small volume of derivative deposits; the ratio of derivative deposits to loans is low. Collateral loans represent another class of advances from which small derivative deposits result. Funds derived from time or demand loans secured by marketable collateral tend to be drawn out immediately, as they are frequently needed for a specific purpose. At the maturity of such loans the collateral is usually sold by the holder, and the debt to the bank discharged; THE PHILOSOPHY OF BANK CREDIT 49 or, funds may become available from some other source definitely in the borrower's mind from the beginning of the loan, and the collateral may be freed by the application of such funds. Whenever a banker makes most of his advances on collateral, he may almost certainly count upon only a small percentage being left on deposit. Collateral loans as an element in the banker's advances tend to depress the ratio of derivative deposits to loans.

Whether loans are secured or unsecured, the time element will have its influence on the ratio under examination. Other things being equal, a short maturity favors a high ratio, and a long or deferred maturity a low ratio. The shorter the loan period the larger will the high balances of the early and closing days of a loan bulk in relation to the loan itself. Renewals are, accordingly, inimical to a high derivative balance in relation to loans and tend, therefore, to be less profitable to the banker than advances that are not renewed. The size of the loan, or rather the size of the borrower, may also be a factor bearing upon tne derivative depositloan ratio. A banker on the Pacific Coast points out that "among those who borrow, say $5,000, or less, the average balance would run close to forty per cent of the outstanding loan, over the larger period of the advance. As loans run into larger figures, the proportion of balance seems to reduce to around ten per cent." The argument of the large borrowers is that "they would prefer to sell their paper to commercial paper brokers and pay the additional commission than to lose the earning capacity of the money tied 50 BANK CREDIT up in compensating balances with their bank." The small business man, whose scale of borrowing operations is not large enough to arouse the interest of the commercial paper broker is apparently subject to a restraining influence in the withdrawal of borrowed funds that does not stay the hand of the big borrower whose access to the loan market through paper brokers is easy and economical.

Still one more determinant of the ratio under consideration is the firmness with which bankers are able to fix and enforce requirements as to the customer's balance in relation to accommodation extended. A bank having strict requirements as to minimum balances in relation to loans would tend to have relatively high derivative deposits, and vice versa. Requirements as to balances in relation to loans are in turn governed to an appreciable extent by such forces—conflicting, it may be—as banking competition, the rate of interest charged borrowers, custom, etc. A San Francisco banker agreeing upon a credit of $100,000 would ordinarily stipulate that the balances should run 15 per cent of the amount advanced, whereas a New York institution would commonly require 20 per cent. In each case, of course, the balances maintained when the account was not borrowing would be a consideration in determining the maximum credit.

Inasmuch as banks become comparatively strict with reference to balances maintained in relation to loans during periods of prosperity and expansion, when borrowers tend to strain their credit, the ratio of derivative deposits to loans may then rise decidedly higher than during less prosperous times. The heavy and THE PHILOSOPHY OF BANK CREDIT 51 insistent demands of borrowers for funds during a period of expansion, rising prices, and swollen profits, place the lending banker in an advantageous position to exact the maintenance of high balances in relation to loans. "You are straining your credit," says the banker to the credit-seeking customer, "and, with tight money staring us in the face, I shall have to ask you to keep a more liberal balance in relation to loans than previously, as a requisite to additional accommodation." A relatively high ratio of derivative deposits to loans is a part of the price that the borrower may have to pay for the use of funds during periods of expansion. We may, therefore, bring forward business conditions and the state of trade,—the business cycleL —as among the numerous factors determining the ratio of derivative deposits to loans.

In short, where loans are made mainly to merchants and manufacturers as distinct from farmers and livestock men, where the rate of interest charged to borrowers is low, where borrowers court the esteem and goodwill of their bankers against the time of financial need, where loans on collateral and mortgage security are of slender proportions, where lines of credit do not run into large figures, where maturities are short and paper seldom renewed, where the peddler of commercial paper is rarely seen, where requirements as to balances are strict and well enforced even in dull times,—there the ratio of derivative deposits to loans will be high, if not indeed at a maximum. Reverse the conditions and you reverse the result. Under typical conditions in the United States, the ratio, as we have seen, does not exceed 20 per cent.

52 BANK CREDIT Aggregate Derivative Deposits Tend to Remain Constant in Amount After a bank has struck its pace, so to speak, and its loans have begun to mature, aggregate derivative deposits tend to remain constant in amount. This is shown in diagram 2, which is a series of derivative deposits curves each similar to that contained in diagram 1. Here, as in diagram 1, time is measured along the horizontal axis and derivative deposits by the perpendicular distance above the line M N. Vertical axes erected at any two points between a and b would cut the derivative deposits curves in such a way that the sum of the vertical distances of the points of intersection above the M N line would be approximately equal in the two cases. Another and perhaps clearer way of saying the same thing is that if any given perpendicular axis, or vertical line, is moved from left to right or right to left between a and b along the time line M N, the vertical line will cut, at whatever point it may be, about the same number of derivative deposits curves—some going up, others going down—and at points approximately the same distance above the M N line. The perpendicular erected at c, a point of time, touches first a derivative deposits curve at a point so low as to indicate a derivative deposit balance of only about 3 per cent of the relative loan. The next two points of intersection, as we follow the perpendicular upward, indicate a balance of approximately 5 per cent of the corresponding loan in each case; then one of 8 per cent, one of 10 per cent and one of 14 per cent; then 20 per cent, 25 per cent, 30 per cent, and 80 THE PHILOSOPHY OF BANK CREDIT 53 Q 54 BANK CREDIT per cent; the average derivative deposit balance being 20 per cent. Whatever point of time is taken, the derivative deposits are substantially the same in amount.

If the diagram were drawn with derivative deposit curves asymmetrical and representing loans of varying maturities, irregularity would tend to offset irregularity, and substantially the same result as stated above would be obtained, as such a diagram, if drawn by the reader, would plainly show. Quantitative Determination of Individual Bank Loan Expansion Traceable to the Acquisition of Primary Deposits Our understanding of the nature of commercial banking operations and of the nature of primary and derivative deposits will enable us now to proceed with the development of a formula for the determination of the amount that any given individual bank in a system can add to its item of loans and discounts on the basis of additional reserve deposited with the bank. The magnitudes involved, with convenient abbreviations, are as follows: The additional cash or reserve (c); Overflow cash, i. e., what a bank tends to lose as the result of making the additional loans (ci); Loan expansion resulting from additional cash (x); The ratio of cash or reserve to deposits (r); The ratio of derivative deposits to loans (k).

THE PHILOSOPHY OF BANK CREDIT 55 Since (1—k) is equal to the percentage of loans checked against by borrowers, it follows that d = (l-k)x. Since the lending banker will make his loans of such an amount that the cash left in the bank after the overflow cash has been paid out will be equal to the reserve required for (1) the original cash deposit and (2) the derivative deposits arising from the loans, (rc+rkx) would equal the cash which the banker would have to retain as reserve, c being the amount of the cash deposit and kx being the amount of the derivative deposits, and r being the reservedeposits ratio. If (rc+ rkx) is retained by the bank, the amount of overflow cash, ci, may be found by subtracting (rc+krx) from c. Hence, ci=c— (rc+krx) or c—re—krx. Since ci is also equal to (1 —k)x, (1—k)x = c—re—krx. Transposing, krx+(l—k)x =c —re. or (kr+1— k)x=c—re, c—reand x = or kr+l-k c(l-r) kr+l-k The application of the formula to any given bank is simple. Take a deposited cash accretion of $1,000 in the case of a bank having a reservedeposits ratio of 56 BANK CREDIT 10 per cent and a derivative depositloan ratio of 20 per cent.

Under these conditions c =$1,000 r = .10 and k = .2O. Making substitutions in the formula, in order to ascertain the loan expansion practicable on the basis of the new deposited cash amounting to $1,000, we have The application of the formula indicates of course that the amount ascertained can be loaned in excess of what could have been loaned had the additional primary deposits not been obtained. If, owing to gold exports or other circumstances, banks were contracting their loans, the acquisition of additional primary deposits by a given bank might serve only to prevent or even check contraction of its loans by the amount ascertained by the application of the formula. It is evident from a glance at the formula that the higher the cashdeposits ratio, the lower will be the loan expansion: and the higher the derivative depositloan ratio, the greater the loan expansion. It is also observable that whenever (1—r) is equal to kr+1—k, the loan expansion rendered practicable by an additional primary deposit will equal that primary deposit. The following table gives combinations of cashdeposit and derivative depositloan ratios that admit of loan expansion equal to additional primary deposits.

THE PHILOSOPHY OF BANK CREDIT 57 CashDeposit Ratio 5 per centI¦T tt t( 10 " " 13 " " 15 " " 17 " " 20 " " and and and and and and and Derivative Deposil· Ratio 5.26 per cent 7.52 " " 11.11 " " 14.94 " " 17.64 " " 20.48 " " 25.00 " " Since kr is of very slight quantitative importance, being only a fraction of a fraction, it follows that if (1—r) in the numerator of the formula is matched quantitatively by 1—k in the denominator, i. e., if r equals k, the bank to which the magnitudes relate would be able to keep its loans moving upward in almost equal step with increasing primary deposits. Qualifications of the Formula The formula, x =,—: -V, calls for qualification. A kr+1 —k certain proportion of checks drawn by borrowers will be in favor of depositors of the drawers' bank and, to that extent, came no loss of cash by that bank. Overflow cash, it may be contended, particularly in a country having few banks, and especially in one-bank towns, would be reduced, and the bank's lending power made greater than would be indicated by the formula.

The importance of this contention is minimized, however, if we bear in mind that the ties and relations of trade and exchange between community and com58 BANK CREDIT munity, section and section, are so numerous and of such far reaching ramifications as to make certain the very early drawing of checks by customers of the bank that receives an addition to its primary deposits in favor of creditors that are not depositors in the drawers' bank. But we will not deny that the drawing of checks by borrowers in favor of depositors of the lending bank has almost the same significance to the lending bank as a higher ratio of derivative deposits to loans: instead of leaving borrowed funds on deposit in his own name, the borrower transfers them to some other depositor of the same bank. To this qualification may be added a second,* Any given bank, bank A, let us say, which has extended its loans on the basis of new reserve may become the depository for overflow cash lost by other banks in the system that have themselves loaned on the basis of cash received as a result of the loans made by bank A.

Such a back-flow of overflow cash would be tantamount to a correspondingly higher ratio of derivative deposits to loans. In a country like Canada or Scotland, having only a few banks, this consideration has great significance; in the United States, with more than twenty thousand commercial banks, it is of little quantitative importance. A third circumstance needs to be mentioned in this connection. Discount taken by a bank at the inception of an advance, making the proceeds thereof somewhat less than the face of the borrower's obligation, would add very slightly to the loan expansion as ascertained by the formula. The proceeds of the advance THE PHILOSOPHY OF BANK CREDIT 59 being less than the advance itself, overflow cash would be correspondingly reduced, and the loan expansion at the time somewhat greater than if the bank deducted no compensation. Perhaps we shall give due weight to the qualifying factors just mentioned, if we think of the derivative depositloan ratio of a representative American bank as approximating the maximum estimate of 20 per cent given on page 45 rather than either the simple arithmetical average or median, 10 per cent.

It is desirable in passing that attention be called to the use of the phrase "loan-expansion" (or "addition to loans"). On account of a lag between the time a loan is made and the payment of checks drawn against the proceeds, there tends to be an interval during which larger loans might be made than the application of the formula would indicate. It is equally important, however, to observe that the middle period of an advance witnesses a marked depression in the derivative deposits curve (see diagram 1) which offsets the high derivative balances at the first and last ends of the loan period. The phrase "loan expansion" encompasses the entire life-span of the advances made. The Distribution of New Reserve as the Foundation of Manifold New Loans So far we have been concerned with how great an addition an individual bank could make to its loans and discounts as a result of the net addition of a given amount of primary deposits. Let us turn now to the less difficult matter of the way in which new cash be60 BANK CREDIT comes widely distributed as the basis of new and manifold loans in the banking system.

It has been seen that the deposit of a given sum of new reserve typically admits of the extension of loans somewhat in excess of that sum by the bank receiving the deposit, and that the loan expansion in turn results in an overflow of cash, somewhat less than that deposited, to other banks in the system. The overflow cash in the banks to which it goes also becomes the foundation of loans somewhat greater than itself; and these loans in turn are productive of an overflow of cash somewhat less than the previous overflow. This chain of operations continues, each bank that receives a part of the overflow at any stage of the process retaining a fraction, but only a fraction, of what it receives, until the cash becomes very widely distributed, and the total loan expansion results in deposits sufficient to take up the slack in the reservedeposits ratio of the banking system. If the reservedeposits ratio is 1 to 10, the total loan expansion would be 9 times the amount of new cash, as already explained.

The nature and significance of the series of operations just described may be shown by means of diagram 3. The first rectangular area at the left, marked c, represents a given amount of cash or reserve lodged in bank A. The area p directly below the cash area, and equal to it, represents the deposit arising from the receipt of the reserve by the bank. It has been shown that an individual bank having a cashdeposits ratio of 10 per cent and a derivative depositloan ratio of 20 per cent may make new loans, in addition to its normal volume of loans, somewhat in excess of a given I3 I 62 BANK CREDIT addition to its cash. Accordingly, rectangle x, representing loans made as a result of the lodgment of the reserve, is somewhat larger than rectangle c. As a consequence of making loans represented by rectangle x, the bank loses cash, "overflow" cash, indicated by rectangle cl·, which is equal to the unshaded portion of area c. Rectangle x, new loans, minus rectangle ci, "overflow" cash, must give rectangle d, derivative deposits. Rectangle c minus rectangle cj gives residual reserve, i. e., that portion of the new reserve lodged in bank A which is retained by bank A. Retained or residual reserve is represented in rectangle c (and in all the "overflow" cash rectangles) by a small darkened area. Rectangle pi indicates deposits traceable to the receipt of "overflow" cash by bank, or group of banks, B. Rectangle xt represents loans made by bank, or group of banks, B, on the basis of the "overflow" cash received from bank A. Rectangle c2 represents "overflow" cash received from bank, or group of banks, B, by bank or group of banks C; rectangle x2, the consequent new loans made; rectangle P2, deposits arising from the receipt of "overflow" cash and d2, derivative deposits. The same circle of explanation continues with reference to the magnitudes remaining until "overflow" cash finally becomes a negligible quantity.

The sum of the series x, Xi, X2, . . . etc. is equal to X, the loan expansion traceable to c within the banking system, X being equal to .p The sum of the two series p, pi, p2, . . . etc. and d, d1; d2, . · . etc. is equal to D, the expansion of deposits within the system, which THE PHILOSOPHY OF BANK CREDIT 63 ft in turn equals =r-· (In this chapter r is used to indicatexí the reservedeposits ratio of the individual banks, and R, the reservedeposits ratio in the system as a whole. Since the system of banks is assumed, for the sake of simplicity, to be homogeneous, r=R.) Relation of Loans to Deposits An examination of the diagram will show clearly the relation of deposits to loans and of loans to deposits in an individual bank and in the system as a whole. It is evident that loans when made by a bank or group of banks rest chiefly upon primary deposits. An addition made to the loan item on the basis of a primary deposit may somewhat exceed that deposit in amount; but at the time the loan is made there is a foundation of reserve resulting from the primary "deposit"

only slightly L·ss than the new loan. The possession of reserve to an amount nearly equal to new loans is a prerequisite to making such loans. In order that a bank may add a given amount, $100,000 or $1,000,000, to its loan item it is essential that the bank secure new primary deposits approximately as great. Hence the struggle for primary deposits. In the case of an individual bank, additional reserve arising from primary "deposits" (not to mention cash arising from the payment of capital stock or surplus) conditions fundamentally the amount of additional loans. Moreover, the loans of one bank give rise to deposits —somewhat less than those loans—of other banks, the process continuing with the primary deposits approaching zero as a limit, as shown in the diagram. The loans 64 BANK CREDIT of any given bank, (bank A in the diagram, for example,) also result in derivative deposits for that bank of such magnitude that, if added to the primary deposits made in bank or group of banks B, as a result of the loans made by bank A, will equal the loans made by bank A. It follows that for the banking system deposits are chiefly the offspring of loans. For an individual bank loans are the offspring of deposits.

How the Withdrawal of Cash from an Individual Bank Effects a WideSpread Contraction of Loans and Deposits The explanation given of the way in which an increase in the cash holdings of a bank results in a general expansion of loans also enables us to understand the way in which the withdrawal of cash from a bank tends to effect a general contraction of loans. A depositor's withdrawal, for export, of cash of $1,000,000, let us say, from bank A in the diagram would normally require bank A to contract its loans, not by $1,000,000 but by $1,097,560.97; otherwise its cashdeposits ratio would be distorted. Since the loans gave rise, during the loan period, to a derivative deposit of 20 per cent, the loan contraction of bank A, amounting to $1,097-, 560.07, would draw in cash of only $878,048.78 from the other banks in the system,—in a fashion just the reverse of the way in which that cash became distributed; and bank A, after losing the $1,000,000 in cash would be in the same situation as before its receipt as a deposit and the consequent loan expansion. The difference between $1,000,000 that the bank would lose and $878,048.78 that would be drawn in through loan ÍHE PHILOSOPHY OF BANK CREDIT 65 contraction would be made up of cash held as a 10 per cent reserve against (a) the primary deposit of $1,000-, 000, now being withdrawn, and (b) the derivative deposit of $219,512.19.

If the deposit account of Barker, Brown and Company is transferred from the Chase National Bank of New York to the Chemical National Bank, the former will tend to contract its loans by an amount somewhat in excess of the deposit balance transferred, in order to meet the unfavorable clearing house balance arising from the loss of the account. The calling of the loan by the Chase sets in motion a circle of loan contraction, entailing a loss of cash by bank to bank,—the loss diminishing as the circle spreads. But the spread of the circle of contraction, with its concentric movement of cash will very soon be opposed by the spread of a circle of expansion incident to loan extension by the Chemical, based on the cash received from the Chase as a result of the transfer of the account of Barker, Brown and Company. In the circle of contraction set in motion by the Chase the force of the movement of cash is centripetal. In the circle of expansion set in motion by the expanded loans of the Chemical the force affecting the cash is centrifugal. The strength of the force in each case, speaking loosely, if not jocosely, would vary inversely with the distance. Let the reader observe again the darkened areas in the diagram.

It is important not to overlook the fact that the loan expansion of the Chemical National Bank as a result of acquiring a new deposit account was roughly equal to the loan contraction which the loss of the 66 BANK CREDIT account necessitated in the case of the Chase. Just as it was necessary for the Chase to contract its loans only slightly in excess of the amount of the balance transferred in order to meet the unfavorable balance arising from the transfer, so the loan expansion of the Chemical that was rendered practicable by the acquisition of the cash coming through the clearing house as a result of the transfer of the account would be only slightly in excess of the new cash received. Banks struggle to secure the accounts of their competitors' customers, not because the new cash arising from the new deposit balances will enable them to lend several times the amount of the deposits, but because it will enable them to lend approximately as much as the deposits,—and on the average probably a little more.

Why Banks Compete for Deposits Now the customary and current explanation of the theory of bank credit maintains that a bank can lend eight or ten times the amount of its cash deposits. "That explains," says Professor Agger,1 "why the bank can afford to maintain an expensive establishment, to supply stationery and to undertake free of charge the collection of checks, coupons, etc., for its depositors. In the banking business nothing succeeds like deposits." Apart from the demonstration already given that an addition to the deposits of a bank normally carries a power of loan extension only approximately equal 1 Eugene E. Agger, Organized Banking, Henry Holt and Company, New York, 1918, p. 33.

THE PHILOSOPHY OF BANK CREDIT 67 to the cash acquired, it should be pointed out that bankers would scarcely feel constrained to make so low a bid for deposits as they now make, if their lending power were enhanced by eight or ten times the amount of the deposit. If a banker were able to lend $50,000 as the result of securing a new primary deposit of $5,000, why would he hesitate to pay interest on the deposit? Would not competition force the rate paid on deposits above the nominal figures now obtaining? A representative bank with a cashdeposits ratio of 10 per cent and a derivative depositloan ratio of 20 per cent, securing additional primary deposits of $200,000 would be able to add approximately $220,000 to its loan item and would retain approximately $24-, 400 in cash as a reserve against the $244,000 deposits ($200,000 primary deposits and $44,000 derivative) owed by the bank after the proceeds of the loans had been drawn against by the borrowers. Its loans would be approximately nine times the cash on hand but the cash on hand would be only a fraction of the cash deposited. Primary deposits have almost no multiplicative importance as a basis for loans. A representative bank is able to pay reasonably large dividends, not because primary deposits can be made the basis of manifold loans by that bank, but because its total loans (and investments) are several times the amount of the bank's capital.

A representative commercial bank in the United States has loans and discounts equal roughly to ten times its capital. Its gross earnings from interest and discount therefore would be sufficient to pay a dividend of 50 per cent upon the capital, if the bank 68 BANK CREDIT charged its borrowing customers 5 per cent on their loans. The expenses of the business might absorb onehalf or three-quarters of the gross earnings and still leave an amount ample for dividend purposes. Banking is profitable, not because an individual bank can lend ten dollars as a result of receiving one dollar on deposit, which is not true, but essentially, because a bank can normally lend an amount roughly equal to its primary deposits. As primary deposits are a requisite to and (roughly speaking) a measure of loans, these deposits are eagerly sought as an indirect source of profit. How much more eagerly they would be sought if they conferred upon the bank receiving them the power to lend ten times their amount, as the current theory holds, is problematical.

The Assimilation of an Individual Bank to the System The way in which an individual bank during the early stages of its existence becomes assimilated to the system is now easily explained. Let us suppose that a newly established bank having a capital of $100,000, paid in cash, receives cash deposits of $200-, 000 and, further, that the bank invests $75,000 in government bonds, and $25,000 in building, furniture and fixtures. The balance sheet would show: Assets Liabilities U. S. Bonds $ 75,000 Capital SIOO,OOO Real Estate, Furniture and Fixtures 25,000 Deposits 200,000 Cash 200,000 $300,000 $300,000 THE PHILOSOPHY OF BANK CREDIT 69 How much can this bank lend without impairing its cashdeposits ratio, and without obtaining additional primary deposits, if a cashdeposits ratio of 1 to 10 is determined upon as affording a maximum profit consistent with reasonable security against a shortage of cash and if, also, the bank enjoys a 20 per cent ratio of derivative deposits to loans? Since the bank in question has a derivative depositloan ratio of 1 to 5 or 20 per cent and a cashdeposits ratio of 10 per cent, it would be able to lend, the application of the formula shows, approximately $220,000.00 and would lose approximately $175,000.00 in reserve to other banks in the system. Any additional loans would be conditioned by additional primary deposits, or to speak more accurately, by additional reserve acquired, the acquisition of which would give rise to primary deposits.

The application of our formula will show that the balance sheet of the bank under consideration, after unfavorable clearing house balances arising from the withdrawal of loan-proceeds have been paid, would present the following items. Assets Liabilities Loans and Discounts.. $219,512.19 Capital $100,000.00 U.S. Bonds 75,000.00 Deposits 243,902.44 Real Estate, Furniture and Fixtures.. 25,000.00 Cash 24,390.25 $343,902.44 $343,902.44 If, as time passes, the bank secures additional primary deposits of $400,000 it would be able to increase 70 BANK CREDIT its loans to $658,536.57. Its volume of deposits would then be raised to $731,707.30 and its cash to $73,170.73, and the statement would stand as follows: Assets Liabilities Loans and Discounts.. $658,536.57 Capital $100,000.00 U. S. Bonds 75,000.00 Deposits 731,707.30 Real Estate, Furniture and Fixtures... 25,000.00 Cash 73,170.73 $831,707.30 $831,707.30 For the sake of greater clarity in the development of all the formulas thus far given, slight cognizance has been taken of bank profits consisting of interest or discount. Although the inclusion of such profit was not necessary to establish the general principles developed, it will not be amiss now to say that undivided profits are invested without at any time being set aside as earmarked funds. If invested in loans and discounts, such profits remain in the bank only to the same extent as does cash which when lodged in the bank, matching primary deposits, justifies an increase in loans. There is one point of difference; no reserve needs to be maintained against undivided profits.

Accordingly, cash that represents the payment of interest or discount or other form of undivided profits, constitutes a base for somewhat greater loan expansion by an individual bank than does the same amount of cash arising from deposits. Thus $10,000 net profit arising from banking operations and temporarily held by the bank in cash as surplus reserve would justify an THE PHILOSOPHY OF BANK CREDIT 71 extension of loans amounting to $12,195.12, if a cashdeposits ratio of 10 per cent is adhered to and 20 per cent of the funds borrowed are left on deposit on the average.1 As 80 per cent of $12,195.12 or $9,756.10 would be checked against on the average, a reserve would need to be held against derivative deposits of $12,195.12—$9,756.10 or $2,439.02; that is, $243.90 would be retained by the bank and $10,000—$243.90 or $9,756.10 would overflow to other banks. If we now incorporate in the balance sheet the item of $10,000 undivided profits, loans of $12,195.12, cash increase of $243.90, deposits increase of $2,439.02, the 1 The formula for the determination of the amount that a bankft can lend on the basis of surplus reserve is, x = ^¿·i_u> where x equals the loan expansion; c the surplus reserve; k, the ratio of the derivative deposits to loans; and r, the cashdeposits ratio.

The derivation is simple. Since k equals the ratio of derivative deposits to loans, the lending banker knows that (1—k) times the amount df the new loan will be withdrawn. Therefore, if we let ci stand for overflow cash, cj = (l—k)x. The lending banker will make his new loans of such an amount that after the overflow cash has been let go, he will still retain a sufficient amount of the surplus reserve to constitute a reserve against the derivative deposit resulting from the loan; that is, the banker will make his loans of such an amount that ci will equal c—kix. Since ¾ equals (1—k)x and also equals c-krz, 0—í)x=e—kra. Transposing, kra+(l—k)x=c. Or, (kr+1-k)a;=c, md' ¾=kr+l-k' If we substitute $10,000 for c, 20 per cent for k and 10 per cent for r, the loan expansion of $12,195.12 is obtained.

72 BANK CREDIT statement will reflect the condition of a bank assimilated to the system: Assets Liabilities Loans and Discounts. .$670,731.69 Capital $100,000.00 U.S. Bonds 75,000.00 Undivided Profits 10,000.00 Real Estate, Furni-Deposits 734,146.32 ture and Fixtures... 25,000.00 Cash 73,414.63 $844,146.32 $844,146.32 The reader can easily calculate the loan expansion that would be practicable in the case just considered, were the current and traditional theory a piece with the facts. Summary—The Old Theory and the New Contrasted It has been seen that the current theory of bank credit is predicated upon the contention that a bank would be able to make loans to the extent of several times the amount of additional cash newly acquired and held at the time the loans were made, whereas a representative bank in a system is actually able ordinarily to lend an amount only roughly equal to such cash. Writers in the past have assumed that the ratio of loans to cash on hand after the loans were made, as in the case of a representative bank thoroughly assimilated to the system, was an accurate measure of new loans that could be extended on the basis of new reserve. They have overlooked the pivotal fact that an addition to the usual volume of a bank's loans tends to result in a loss of reserve for that bank only somewhat less on the average than the amount of the additional loans. The reserve retained, what we have THE PHILOSOPHY OF BANK CREDIT 73 called residual cash or residual reserve, is only a fraction, on the average throughout the loan period, of additional loans made. The residual cash supports loans,—and deposits,—several times as great as itself, but the residual cash is only a fraction of the cash accretion, the possession of which prompts the banker to expand his loans. Manifold loans are not extended by an individual bank on the basis of a given amount of reserve. Instead, as a consequence of lending, the reserve of the individual bank overflows, leaving only the equivalent of a fractional part of the additional volume of loans extended, the overflow cash finding its way to other and still other banks until it becomes the "residualized," yet shifting, foundation of manifold loans and deposits.

The normal ratio of cash to deposits and to loans in an individual bank, in a word, is reached through the three-fold process of (1) cash acquisition coupled with an equal addition to deposits (2) loan expansion with the corresponding deposits heavily drawn against by check, resulting in (3) cash overflow or contraction. The same ratio in the banking system, which may be likened to a single great bank doing the entire banking business of the country, is reached through the twofold process of (1) cash acquisition offset by equal deposit expansion and (2) manifold loan and deposit expansion.1 The distinction already made between 1 As will be shown in the next chapter bank loan expansion in any given country tends to result in an "overflow" of cash to other countries, analogously to the individual bank, unless an offsetting credit expansion or other offsetting circumstances obtain in those other countries.

74 BANK CREDIT the manner of the loan expansion of an individual bank and that of the banking system is at once the foundation and pinnacle of the theory here advanced. Anticipated Criticism Answered It is anticipated that criticism of the theory developed in this chapter will center around the contention that an individual bank can lend as a result of a deposited accretion to its reserves, and without an impairment of its reserves, an amount roughly equal to the product of the reserve accretion and the depositsreserve ratio (not reservedeposits ratio) of the bank, the contention being based on the notion that the new loans would result in no loss of cash by the lending bank because checks drawn upon the lending bank by its depositorborrowers against the deposited proceeds of the new loans would be offset by the deposit in the lending bank of a corresponding amount of checks —received by its customers in the course of business —drawn upon other banks in consequence of loans made by those other banks to their depositorborrowers.

If all banks were expanding their loans at the same -?ate, in connection with simultaneous additions to their reserves, the contention would be valid. But additions to the reserves of a banking system, except in the most extraordinary case, are made, at any given time, not by the deposit of cash simultaneously in all the banks of a system but by the deposit of funds in only a small proportion of the banks, whence they are scattered throughout the system. In the usual case a bank receives additions to its reserves from either (1) other banks in the system or (2) THE PHILOSOPHY OF BANK CREDIT 75 from sources outside the banking system—imported or newly mined gold. If additional cash is received by any bank from sources outside the system that circumstance would not impel other banks in the system at once to expand their loans, thereby accommodatingly preventing a loss of cash on the part of the bank whose reserves had been augmented and whose loans had been consequently increased, even though later the other banks would tend to expand their loans, as soon as "overflow" cash fell into their possession, as has been explained.

Likewise, if the addition to the reserves of an individual bank, bank A, came from some other bank or banks within the system, that circumstance would tend to effect a contraction in the loans of the bank or banks losing the reserve, and instead of their depositorborrowers drawing more checks than formerly, as would be necessary if the swollen volume of checks drawn on bank A were to be offset, they would tend to draw less! Conclusively, if the claims of the Des Moines National Bank upon all other banks and the claims of all other banks upon the Des Moines National Bank balanced and cancelled before the acquisition by that bank of a certain addition to its reserves and prior to an expansion of loans consequent to that addition, those claims would not balance and cancel after the loan expansion had been made and the proceeds drawn upon by the borrowers, the checks drawn by the depositorborrowers and remitted to their creditors placing other banks in the system in a position to lay claim to cash in the vaults of the lending institution.

76 BANK CREDIT The old contention that no cash would be lost by the bank that increased its loans, under the conditions given, that counterclaims would still balance, was the fruit of confusing the operations of a bank with the operations of a banking system. Some serious, if not surprising, consequences of this confusion will be dwelt upon in chapter five, to which we may pass either directly or by way of chapter four.

CHAPTER IV INTERRELATIONS OF CASH, LOANS AND DEPOSITS CONSIDERED FURTHER The preceding chapter, which drew a sharp line of distinction between loans of individual banks and those of the banking system, has paved the way for further consideration of certain inter-relationships of items of the balance sheet in both individual and collective banking. In the present chapter the dynamic interrelations of cash, loans and deposits will be taken up; in the following chapter, surplus in relation to loans and the principal creditor liabilities will be discussed. Cash in Relation to Loan Expansion in Individual and Collective Banking It was pointed out in chapter II that there is a twofold check on a banker's impulse and ability to increase his profits by liberal lending. An expansion of loans by an individual bank tends to cause cash to fall and deposits to rise, the rise in deposits being the temporary forerunner of an actual loss of reserve—a loss of reserve, albeit, somewhat less than the loan expansion, as we have seen. But loss of cash as a result of increased loans, which is a powerful check on the loan expansion of an individual bank, tends to become inoperative if all banks within a credit area expand their loans with equal rapidity. If all the banks in a 77 78 BANK CREDIT system1 are increasing their loans and investments at the same rate, the cash of any one bank will tend to remain constant. This is true because (a) direct withdrawals of cash by borrowers from any one bank will be offset by the deposit of actual cash coming from other banks into the hands of that bank's depositors, and (b) the liberal loan policy of other banks will place their borrowing customers, who are at the same time depositors, in a position to draw more checks than previously, which in due proportion will be sent in payment of obligations to the customers of our given bank, where they will be deposited and used instead of cash to offset checks drawn upon that bank by its depositorborrowers and forwarded to it by the drawees through the established channels for payment. In the banking system as a whole where loans (less the discount allowed to accumulate as undivided profits or surplus) tend to result in deposits, the check imposed upon expanding loans by the direct or indirect withdrawal of cash from the institutions indulging in liberal lending is, therefore, inoperative. The cash that leaves one bank finds a resting place in another. If the reserve of one bank is reduced, that of another, or of others, is augmented. For the banking system as a whole, the only check on expanding loans is that represented by swelling deposit liabilities.2 1 By system of banks is meant not the banks operating under the authority of a given law or laws, as the national banks or state banks, but banks united by the ties of cash and credit relationships.

2 It is not overlooked of course that an over-extension of deposit liabilities would tend to cause a rise in prices and an exportation of gold—a fact that has little significance in this immediate connection, INTERRELATIONS OF CASH, LOANS AND DEPOSITS 79 Regulation of Ratio of Cash to Deposits in Individual Banking When a certain more or less normal or representative ratio of cash to deposits has been reached in the life history of a bank, that is, when the individual bank has become assimilated to the banking system of which it is a part, the ratio of cash to deposits is regulated and kept fairly constant through the banker's control over cash. If the banker's cash falls below what he regards as the line of safety in relation to possible cash demands of depositors, including both direct and indirect withdrawals, new loans are curtailed or discontinued until the inflow of cash coming from maturing loans has restored the ratio of cash to deposits to proper or desired proportions. If the demand for loans falls off locally and cash accumulates excessively, new outlets for the idle and redundant reserve are sought in outof-town loans or in investments other than promissory notes.1 If, on the contrary, the ratio of cash to deposits becomes too much attenuated, the banker, always eager to maintain and even to increase the volume of his deposits, will try to restore the ratio to normality however. The outflow of gold which would tend to check further loan and deposit expansion at home would tend, by the same token, to cause an expansion of the loan and deposit items in banks abroad.

Also see note, page 39. 1 The rate of interest is frequently lowered in order to equate supply and demand in the loan market, but the widespread practice is to maintain the over-the-counter rate on customers' paper rather inflexibly and to accept whatever rate can be got for funds placed in the outside market.

80 BANK CREDIT by adding to his holdings of cash through curtailment of loans rather than by seeking a reduction in deposits, for the withdrawal of deposits would tend to reduce cash correspondingly. Although the correction of the ratio of cash to deposits when cash is low in relation to deposit liabilities tends to cause a slight reduction in deposits, occasioned by the curtailment of loans, that reduction occurs against the will of the bank management. The banker tries to increase his cash, when it gets low, without causing a reduction of deposits, but his action, in spite of his desire and effort to avoid the result, inevitably tends to lessen the deposit item. Calling loans and refusing to make new commitments to offset maturing paper tends to cause the individual banker's cash to increase and his deposits slightly to decline. The individual banker's regulative or corrective power over the ratio of reserve to deposits is exercised, it is clear, through increasing or curtailing loans. The amount of his reserve in relation to demand liabilities at any given time will determine the advisability of lending more freely, thereby reducing cash and increasing deposits, or of lending less freely, thereby causing cash to accumulate and deposits to fall off.

The banker's control over the cashdeposits ratio passes through the loan item as a medium of transmission. The condition that is marked by the growth of cash in the vaults of a bank, and by declining loans and deposits when loans are being curtailed, and the condition that is marked by falling cash and rising deposits, when cash has become disproportionately large in relation to deposit liabilities and loans are consequently INTERRELATIONS OF GASH, LOANS AND DEPOSITS 81 being expanded,—both these conditions are constantlysubject to correction. One day or one week or even month the banker lends or buys commercial paper freely, and the next day or next week or month trims his sails. The banker's cashdeposit ratio at the close of business today dictates the contraction or expansion of his loans tomorrow. Through his loan item the banker regulates the amount of his cash and, to some extent, of his deposits. Adjustment and correction of the ratio of cash to deposits are almost continuous.

A pertinent question arises at this point. If the banker, finding his deposit liabilities dangerously large in relation to cash—as he sometimes does after paying an unexpectedly heavy balance to the clearing house—proceeds to replenish his reserves by calling or curtailing loans, do not the deposits of an individual bank regulate cash? The answer is that for the individual bank in question the ratio which the bank management regards as being in the highest degree prudent and profitable has become distorted or disturbed. The bank management, with no desire to reduce its deposits, deems it desirable to increase its cash. Curtailment of loans, which is productive of augmented reserve, inevitably tends to effect a reduction of deposits. The restoration of the ratio of cash to deposits entails, then, a reduction in deposits and loans as well as an increase in cash, mutual determinism existing between the reserve and deposits. The motive force underlying the restoration of the ratio under this condition is the banker's fear that he may be unable to meet his demand liabilities, or else an unwillingness to evade legal reserve requirements.

82 BANK CREDIT But suppose the reserves of an individual bank are excessive in relation to deposits. Under this condition not fear or prudence or respect for banking law, but desire for greater profit becomes the motive underlying the correction or restoration of the reservedeposits ratio, and the bank will increase its loans until, as previously pointed out, the combined force of impaired cash and enlarged deposits calls a halt. The increase in the individual banker's loans is limited by both a reduction in cash, which tends to take place as long as his loans are increasing, and, to a slight extent, by the increasing deposits resulting from the rising loans. It is not merely cash in the vaults of the individual bank that impels the banker to expand his loan item, but cash in relation to deposits. Both terms of the cash-to-deposits ratio are variable in the individual bank and tend to be affected in opposite directions, but not necessarily to the same degree, when loans are expanded or curtailed. For the individual bank that has become assimilated to the system cash and deposits are mutually determinative, and both are regulated by loans. Increase loans, cash goes down and deposits go up. Reduce loans, cash increases and deposits fall off.

Ratio of Cash to Deposits and to Loans in the Banking System The relationship between cash and deposits and between cash and loans in an individual bank is very different from the same in the banking system regarded as an aggregate. In the banking system, at any stage of banking development, deposits and loans INl¾R-RELATIONS OF GASH, LOANS AND DEPOSITS 83 are a function of cash.1 An increase of cash in the banking system tends to be followed by a manifold increase in loans, the proceeds of which cause the deposits of the system to swell in approximately the same proportion as the loans. An increase in the cash of an individual bank, on the other hand, does not result in an increase in its loans and deposits equal to several times the amount of the new cash, but in a loan and deposit increase of scarcely more than the amount of the new cash. If an attempt were made by an individual bank to lend an amount equal to several times the cash newly acquired, unfavorable clearing house balances and, perhaps, withdrawals of cash over the counter, would in a short time reduce the cash of the bank below the line of safety,—a fact with which we are already familiar.

1 There is a measure of mutual determinism between cash and deposits in the banking system considered as a whole. An increase of cash in the banking system tends to cause loans and deposits to increase. An increase in deposits, whether induced by an expansion in the money metal mined or by a fall in the ratio of cash to deposits, tends to check the output of money metal through rising general prices. On the other hand, if cash were to fall off in relation to trade, or if the cashdeposits ratio rose, a consequent lower general price level would tend to stimulate the production of gold. Whatever the degree of mutual determinism between cash and deposits, in the banking system as a whole, the action of the forces there at work is exceedingly slow in comparison with the action of the forces that determine the relationship between cash and deposits in the individual bank.

CHAPTER V SURPLUS IN RELATION TO LOANS, DEPOSITS AND RESERVES Probably no phase of banking has been treated so inadequately and erroneously as has surplus, its nature, functions and relation to other items in the bank balance sheet. The defective treatment has been traceable measurably to factors already referred to in chapter II. Recently, however, in perhaps the most elaborate attempt at exposition and elucidation yet put forth, that of Professor Moulton,1 still other considerations, with roots running deep into a traditional and current but nevertheless erroneous theory of banking, invalidate the main doctrine advanced, namely, that the accumulation of surplus in commercial banking tends to weaken the position of depositors, to reduce the chance of the ultimate redemption of deposits. An examination of this doctrine, which Professor Moulton develops skillfully, will serve as an introduction to a positive statement of relationship between surplus and loans, deposits, cash.

A New but Erroneous Doctrine of Surplus Professor Moulton uses as an instrument of exposition a condensed balance sheet of a bank, reminding 1 Harold G. Moulton, The Surplus in Commercial Banking, Journal of Political Economy, December, 1917, Vol. 25, pp. 1003-1018. 84 SURPLUS IN RELATION TO LOANS, ETC. 85 us that deposits arise out of loans and that the two magnitudes are, in the banking system as a whole, approximately equal. The simplified balance sheet from which his argument proceeds is as follows: Assets Liabilities Gash $100,000 Capital Stock $100,000 Loans 600,000 Deposits 480,000 Interest and Discount Collected 20,000 It is correctly observed by Professor Moulton that The ratio of cash to deposits in the statement just given is 20.8 per cent. The ratio of assets to deposits, and hence the chance of ultimate liquidation, is $500,000 (loans) + $100,000 (cash) — a total of $600,000 — $480,000 (deposits), or 60 : 48 = 5 : 4.

As time passes the same bank accumulates a surplus of $20,000, which is assumed by Professor Moulton to be initially in the form of cash, accumulated from earnings.1 Whether it is admissible to proceed on the assumption that surplus is represented by cash is a question that will be answered later. We may now advantageously reproduce the following passages as containing 1 "Of course in actual practice," says Professor Moulton, "the amount set aside as surplus is not represented by a like amount of cash that is not utilized until semi-annual dividend date. The process of investing 'surplus funds' is a continuous one and not semi-annual. For clearness of exposition, however, it is better to assume that surplus is represented by cash and that its investment follows rather than precedes the formal setting aside of such a fund." Op. cit., p. 1011.

86 BANK CREDIT the kernel of Professor Moulton's contention that the accumulation of a surplus tends to impair the chance of the ultimate payment of creditor liabilities. The same bank (i. e., the bank whose balance sheet was last given) in time accumulates a surplus of $20,000. Let us assume that the $20,000 represented by surplus is initially in the form of cash, having been accumulated from earnings. On the basis of this new cash the bank now proceeds to expand its business by making additional loans. As a going concern it would then shortly present the following balance sheet. Assets Liabilities Cash $120,000 Capital Stock $100,000 Loans 600,000 Surplus 20,000 Deposits 576,000 Interest and Discount CoUected 24,000 The ratio of cash to deposits is still 20.8 per cent. The ratio of assets to deposits, and hence the chance of ultimate liquidation, is $600,000 (loans) + $120,000 (cash) — a total of $720,000 — to $576,000 (deposits), or 720 : 576 = 5 : 4, the same as before the surplus was created. Resources have increased, it is true, but since deposit liabilities increased at the same rate the chances of the creditors being paid in full are no whit different from what they were without a surplus.

In fact, the depositors have a smaller chance of being paid in full than was the case before the surplus was created, for the reason that our banking laws provide that shareholders are doubly liable on capital stock, but not on account of surplus. When measuring the ultimate security of creditors this factor must be included. Correcting the foregoing ratios of assets to creditor liabilities by including the double liability of shareholders on capital stock we have, before the creation SURPLUS IN RELATION TO LOANS, ETC. 87 of a surplus, $500,000 (loans) + $100,000 (cash) + $100,000 (double liability on capital stock) = $700,000 — to $480,000 = 35 : 24 or 1.458 to 1. In the second case it becomes $600,000 (loans) + $120,000 (cash) + $100,000 (double liability on capital stock) = $820,000 — to $576,000 = 205 :146, or 1.404 to 1 — less than when there was no surplus account at all. It may be concluded therefore that rather than strengthening the position of the depositor the creation of a surplus really tends to weaken it.1 It is granted that of the bank statements reproduced from Professor Moulton's article the first shows a greater degree of protection to depositors than does the second. Whether the accumulation of a surplus would result in the condition indicated by the second statement is the crucial question.

The Doctrine Disproved In what follows it will be shown that the accumulation of a surplus neither in an individual bank nor in the banking system as a whole results in such an increase in cash2 and deposits as to neutralize, to say nothing of outweighing, the enhanced safety that the accumulation of surplus affords to depositors. We may consider first the case of an individual bank. Let us assume, pro argumento, that it is practicable for an individual bank to set aside as surplus an amount of earnings represented specifically by a like amount of cash,—a basic assumption made by Professor Moulton,—and proceeding on that assumption, inquire whether a surplus thus represented by cash generates a 1 Op. cü., pp. 1011,1012. 2 Gash is used in this chapter synonomously with reserve.

88 BANK CREDIT several-fold expansion of loans and deposits in the manner described in the excerpts reproduced on pages 86,87. It was shown in a preceding chapter that the accumulation of surplus represented by an addition of a given amount of cash to the reserves of an individual bank would enable that bank typically to expand its loans by an amount approximately equal to, or somewhat in excess of, the new cash. It was also shown in the same chapter that new loans made tend to cause the bank extending the credit to lose, on the average, an amount of reserve only somewhat less than the amount of the loans. The addition of $20,000 to the surplus and to the cash would place the bank concerned in a position to add $24,39O.241 to its previous volume of loans, if derivative deposits of the bank average 20 per cent of its loans and a reservedeposits ratio of 10 per cent is maintained. Such an increase in loans would tend to result in the withdrawal of cash equal to $19,512.20, leaving $487.80 as a 10 per cent reserve to support derivative deposits of $4,878.05, i. e., 20 per cent of the additional loans.

It is important to observe that the surplus "represented by cash" ceases to be represented by cash as soon as loans are expanded on the basis of the cash. The surplus remains, but the cash largely leaves to meet unfavorable clearing balances. The very act of utilizing the cash as a basis of loans causes its fugitive character to assert itself, with the result that loans are increased appreciably, deposits are increased slightly and cash, the earmarked cash that stood for the surplus, is very decidedly reduced. 1 See page 71.

SURPLUS IN RELATION TO LOANS, ETC. 89 It must be clear that as long as the surplus was represented by cash it afforded additional protection to depositors and other general creditors. It must also be clear that when the surplus ceased to be represented by cash and that very cash, as a result of loan expansion, largely took flight to other banks, precluding the possibility of a deposits expansion equal to several times the amount of the surplus represented by cash, the surplus still remained intact. That is, the accumulation of a surplus represented by cash or not so represented does furnish additional protection to depositors, does improve the chances of the ultimate redemption of creditor liabilities in the case of an individual bank. Having shown that the accumulation of a surplus by an individual bank tends to improve the chance of the ultimate redemption of deposits, we have now to consider the way in which the accumulation of a surplus affects the safety of deposits and other creditor items in the banking system as a whole.

Is there anything connected with the action of bank directors in building up surplus—at the expense of dividend payments—that would swell the amount of cash in a banking system? Would the diversion of earnings from dividends to surplus accelerate the production of gold, or swell the volume of our legal tender notes, or even prompt the managements of our Federal Reserve banks to adopt a more liberal policy with reference to note issues? Would the accumulation of a surplus cause business men and concerns and the general public to substitute checks for cash in making payments ordinarily and conveniently made with cash, to such an extent as to effect a balance between 90 BANK CREDIT surplus accumulating and the additional reserve? What would attract the cash from circulation into the banks? Not surplus "represented by cash," because such surplus would not come into being until the corresponding cash had come into the banks! It is inadmissible to assume that surplus accumulated in a banking system is represented by so much additional cash, because there is no creative connection between the accumulation of surplus and the cash that is assumed to correspond to that surplus. If the newly created surplus is not represented by additional cash within the banking system, additional deposits within the banking system could not be built up without reducing the cashdeposits ratio of the system.

What actually takes place in a banking system when surplus is accumulated may be made clear by resort to the consolidated balance sheet of all our banks taken in the aggregate. The following simplified and condensed balance sheet represents roughly the aggregate condition of the commercial banks of the United States as given in the report of the Comptroller of the Currency for 1918. .ásseís Liabilities Loans $32 billions Capital $2.3 billions Reserve 3 " Surplus 2. " Undivided Profits.. .7 " Deposits 30. " $35 billions $35 billions If a surplus of 1 billion is now accumulated in the course of a year, let us say, that procedure would not cause bank managements to reduce deposits in relaSURPLUS IN RELATION TO LOANS, ETC. 91 tion to cash. Such a reduction, if it is assumed to take place, would be favorable to the ultimate redemption of creditor liabilities. The accumulation of additional surplus amounting to 1 billion would neither increase nor diminish cash—although cash might increase or decrease during a given period of time on account of other factors. If cash remains stationary and deposits do not fall off as a result of the accumulation of surplus, the cashdeposits ratio remaining unchanged, it is obvious that loans, in the simplified balance sheet, must increase by the amount of the surplus,1 and the statement of condition will now stand as follows: Assets Liabilities Loans $33 billions Capital $2.3 billions Cash 3 " Surplus 3.

Undivided Profits.. .7 " Deposits 30. " $36 billions $36 billions Since deposits have remained stationary and the excess of assets over liabilities other than those due shareholders has increased by 1 billion dollars, the ultimate chance of deposit redemption, as measured hy that excess, has been enhanced. Professor Moulton's contention that the accumulation of a surplus tends to weaken the position of de1A similar principle applies to surplus paid in or capital paid in. The shareholders in drawing checks with which to pay their subscriptions tend to reduce deposits in the system. But such a reduction of deposits is only temporary. Additional loans tend to result in a reëstablishment of the normal cashdeposits ratio.

92 BANK CREDIT positors is centered around the balance sheet of an individual bank, even though his own injunction is to emphasize the banking system as a whole as distinct from individual banks as units in that system. It will therefore be well to observe that the creation by an individual bank of a surplus "represented by cash" would tend to necessitate a reduction of cash somewhere else in the banking system. The loss of cash by other banks in the system would correspond roughly to that gained by the bank creating a surplus "represented by cash." Expansion and contraction in the loans and deposits of a banking system are regulated by the cash reserve of the system. If the cash is shifted from bank to bank, or from center to center, the expansion and contraction of loans and deposits also tend to shift. If the creation or accumulation of a surplus represented by cash takes place at one point in the banking system some other point or points, ceteris parïbus, will have been forced to curtail their operations, reducing their loans in order to keep their ratio of cash to deposits within the customary limits of banking prudence. A swell in the cash, loans, and deposits in one quarter where surplus represented by cash was being built up would be offset by a corresponding depression in loans and deposits in other quarters whence cash was being withdrawn.

If within a banking system surplus goes up at a point gaining cash and down at the point or points losing cash, the net result would be, obviously, no change in surplus. If, within a banking system, surplus goes up at a point gaining cash and does not go down at the point or points losing cash, the net result would SURPLUS IN RELATION TO LOANS, ETC. 93 be an increase in the ratio of surplus to deposits. In one case the surplus in the system does not increase; in the other, surplus in the system increases but deposits do not. Evidently, if surplus increases in the banking system as a whole and deposits and other creditor liabilities do not, the chance of the ultimate payment of creditor liabilities is enhanced. Whether the accumulation of a surplus is considered in connection with an individual bank or in connection with the banking system as a whole, it is now plain that the chance of the ultimate redemption of creditor liabilities is improved by accretions to the surplus item.

What then is Professor Moulton's fundamental error? It is twofold. In the first place, he assumes that an individual bank can increase its loans by several times—five times—the amount of its surplus reserve without losing cash to other banks in the system,—a mistaken contention that is traceable to his failure to distinguish carefully between the operations of an isolated bank, that would not lose cash as a result of loan expansion, and the operations of a bank that is only one of many units in a banking system, where loan expansion tends to result in a loss of cash by the bank whose loans are expanding.1 This lack of clearness of distinction between individual and collective banking lies at the root of the fallacy that permeates his discussion. The second error, namely, his assumption that the accumulating surplus of a banking system may be represented by cash, dovetails with the first and is scarcely less subtle and misleading. If the accumulation of i See pages 37, 38.

94 BANK CREDIT surplus in a banking system1 brought into being a corresponding accretion to the cash of the system, deposits in the system would tend to expand as indicated in the statements quoted on pages 85, 86 and the accumulation of surplus would tend to lessen the chances of the ultimate redemption of creditor liabilities. But the accumulation of a surplus does not bring into being any corresponding accretion to cash, as we have seen. The Relation of Cash or Reserve to Surplus There is a causal connection between cash or reserve and surplus, but the direction of the connecting forces is from reserve to surplus through deposits, and not from surplus to reserve. An accretion of cash or reserve to that of the banking system tends to be followed by a several-fold increase in deposits in the banking system, as we have seen; and an increase in deposits tends to be followed by an increase in surplus.

The larger the deposits in any individual bank, the larger will be the loans and investments and, therefore, the earnings from which surplus may be accumulated. Not only do larger deposits make it feasible to accumulate surplus, but they also make the accumulation desirable from the standpoint of the management and shareholders. As surplus strengthens the assurance 1 Although Professor Moulton employs the balance sheet of an individual bank as an aid in exposition, he enjoins the reader to emphasize the banking system as a whole. "This emphasis," he says, "is necessary, for it is only by a study of the whole rather than of the individual parts that one can obtain an adequate understanding of banking organization." Op. cit., p. 1011.

SURPLUS IN RELATION TO LOANS, ETC. 95 of the ultimate convertibility of deposits in the case of any given bank, a large surplus in relation to creditor liabilities should and does prove attractive to both actual and potential depositors. A relatively large surplus is probably more influential in determining the choice of correspondents by banks than in connection with the choice of a bank by a business house. Banks that borrow from their city correspondents, as do many of our institutions, particularly in the South and West, are able to borrow more liberally and, perhaps, at more favorable rates when the shareholders' equity in the assets of their bank, as represented by capital, surplus and undivided profits, is large. Large loans, which are almost invariably associated with large deposits, then, make the accumulation of a surplus easy and the dictates of sound and profitable banking make its accumulation desirable. The larger the deposits the larger tends to be the surplus. In the banking system as a whole, cash regulates deposits and deposits regulate surplus. Cash, therefore, regulates surplus. The relation of cash to surplus in the banking system may be represented accurately by the following simple diagram.

Cash —> deposits —-> surplus The regulatory relation of cash or reserve to surplus is loose and elastic, but of such a nature that in no case would an increase in surplus result in an increase in cash. If the ratio of reserves to deposits and that of surplus to deposits (which constitute the bulk of creditor liabilities) remained constant, an increase in cash would be accompanied by an increase in surplus 96 BANK CREDIT in direct proportion. Also if both ratios changed at the same rate and in the same direction, any change in cash would be accompanied by an exactly corresponding change in surplus. In American banking during the last generation the two ratios have changed in the same direction, but not at the same rates. The ratio of reserves to deposits in our national banks was 23.6 per cent in 1885, 17 per cent in 1910, and 10.4 per cent in 1918. The ratio of surplus and undivided profits to creditor liabilities was 12 per cent in 1885, 11 per cent in 1910, and 7.5 per cent in 1918.x The two items, cash and surplus, including undivided profits, were roughly equal in 1875 and a considerable degree of parallelism has continued to the present time.

The Ratio of Cash to Deposits and of Surplus to Creditor Liabilities If surplus—and we might also include the other protective items, capital and undivided profits—is not represented by reserve, how can we explain this strong tendency toward direct variation between the two items? The explanation lies in the fact that substantially the same or similar forces effect changes in both ratios. One of these forces, affecting both ratios, consists in the banker's conservatism. If a representative bank management becomes more conservative concerning the immediate convertibility of deposits, that same management would scarcely be expected to become less so with reference to the ultimate convertibility of 1 Reports of the Comptroller of the Currency, 1885, 1910, 1918.

SURPLUS IN RELATION TO LOANS, ETC. 97 those deposits and other creditor liabilities. Increasing conservatism and prudence as to cash tends to be matched by increasing conservatism as to surplus. Individual cases of increasing caution and prudence as to cash and the reverse as to surplus are probably rare and fully offset by cases of dwindling caution and prudence as to surplus and the reverse as to cash. Conservatism is a factor, then, that affects the ratios of cash to deposits and of surplus to creditor liabilities unequally, nevertheless in the same direction. It is, of course, not denied that the maintenance of a surplus, always represented largely by productive assets, would seem to go less strongly against the grain of a typical bank management, whose prime aim is always profit, than would the maintenance of a large and "barren" reserve. Besides the banker's prudence and conservatism or caution there is a group of forces, arising out of the economic and banking organization, that tends to keep the ratio referred to on an even keel. Certain changes taking place in the evolution of our economic organization, such as improvements in transportation facilities, quickened means of communication, the centralization of banking reserves and the creation of improved rediscount facilities admit of a certain reduction in the percentage of reserves without any impairment of immediate convertibility of deposits. If improvement in means of communication and transportation takes place, facilitating quick and speedy movement of cash from place to place, the banker can safely allow his reserve to fall off in relation to deposits, knowing that additional cash may be got promptly in 98 BANK CREDIT order to meet extraordinary needs. The centralization of reserves and the creation of assured facilities for rediscount enable the representative banker to conduct his business on an appreciably lowered reserve with even greater assurance of an unfailing adequacy of cash.

Mr. E. D. Hulbert in an address before the American Bankers' Association, September, 1918, gave point to the way in which the Federal Reserve System favored the certainty of meeting all demands of depositors easily and promptly, although that system has rendered practicable a decided reduction in the ratio of reserves to deposits: After four years of trial the Federal Reserve Act stands as one of the most successful and beneficent pieces of legislation ever enacted by Congress. What it has done for the country in promoting war finance cannot be computed. ... It can safely be said that the banking business of the country has been carried on during the past four years, notwithstanding the unprecedented world disturbance, with less worry, foreboding and fear than the bankers of the United States have experienced in any other four years of their lives. . . . I cannot remember any four years since I have been a responsible officer of a bank when I had less anxiety as to the possibility and certainty of meeting all calls from depositors and borrowers as I have during the last four years.

It has been demonstrated that financial panics can be nipped in the bud and normal conditions restored with rapidity under the operation of this system. There is no doubt that on at least one occasion since the system has been in operation we would have been forced to issue Clearing House Certificates under the old regime, and we all know that recovery from that kind of shock is slow. As it was the SURPLUS IN RELATION TO LOANS, ETC. 99 banks converted over $200,000,000 of commercial paper into reserves in one day and met the emergency. No one, outside of the banks in the central reserve cities, knew that a crisis had occurred. Most of this loan was repaid to the Federal Reserve banks inside of ten days and as a shock absorber the efficiency of the system was demonstrated perfectly.1 Such changes in the economic and banking organization as have been mentioned admit of a reduction in the ratio of cash to deposits without impairing the immediate convertibility of deposits. It has so happened in the evolution of our economic order that certain other developments have occurred that permit a reduction in the ratio of surplus to creditor liabilities without an impairment of the chance of the ultimate convertibility of those liabilities.

Any institution or condition that reduces business losses, as for example, the growth in the extent and thoroughness of the work of the credit departments of business concerns, is favorable to the enduring and unimpaired value of bank loans,—on which the ultimate convertibility of creditor obligations of banks largely depends. The rise and development of the bank credit department has also had an extremely salutary effect upon the uniform soundness of bank assets. New and stricter forms of bank supervision have done much to eliminate poor investments by banks. A more equable distribution of fire losses through an enlarged utilization of insurance tends to reduce 1E. D. Hulbert, 2VMSÍ Companies and the Federal Reserve System, iTrust Companies, October, 1918, Vol. XXVII, No. 4, p. 325. ~' 100 BANK CREDIT business failures, supporting and stabilizing bank assets underlying the ultimate convertibility of creditor's claims. Such an improvement in banking facilities as was effected by the establishment of the Federal Reserve System is calculated, through a reduction in commercial losses and failures due to money stringencies and crises, to make the value of loans and discounts, bonds and other investments less subject to fluctuation and depreciation. Improvements in economic organization and underlying conditions during a given period may fully offset a marked reduction in the ratio of surplus to creditor liabilities, leaving the likelihood of the ultimate convertibility of those liabilities unchanged or even favorably affected.

The striking reduction that has occurred in the ratio of surplus to deposits and other creditor liabilities in our national banking system since its inception may not, and apparently does not, represent declining prudence on the part of our bank managements in safeguarding their customers against loss due to a shrinkage of bank assets. The improvement in economic organization and in fundamental conditions, if we look at the period as a whole, may have more than counter-balanced the relative decline in surplus. Our banks could not now withstand such large losses in relation to their creditor liabilities and still pay their creditors in full as they could have withstood forty or fifty years ago, but the creditors' interests are conceivably just as safe, even safer, today because losses corresponding in volume to those of the sixties and seventies are less likely to occur. Perhaps no better evidence can be found that a SURPLUS IN RELATION TO LOANS, ETC. 101 declining ratio of surplus (and the other protective items) to creditor libilities may be outweighed by improvement in the conditions underlying bank solvency than the declining percentage of loss to the amount of all deposits in our national banks since 1880. During the 33-year period, July 1, 1881, to June 30, 1914, the average annual percentage of loss to the amount of all deposits in national banks was .628. During the 3-year period, July 1,1914, to June 30,1917, the annual average percentage of loss was only .003 of all deposits in national banks.1 In the two succeeding years the percentage of loss dwindled and disappeared, there being only one national bank failure in 1918 and none in 1919, a circumstance not untouched, however, by the favorable influence of flush times.

In brief, surplus tends to vary with reserve because forces are at work which cause the ratios of reserve to deposits and of surplus to creditor liabilities to vary in the same direction, if not to the same extent. Banking conservatism tends to affect each ratio in the same way. Changes in the economic and banking organization that admit of a reduction in reserves without any reduction in the chance of immediate convertibility of deposits are paralleled by other changes that have a similar influence and effect upon surplus in relation to creditor obligations. What has been said should not, however, be allowed to obscure the sharp line of distinction that lies between the nature of the relation of cash to deposits and that of surplus to creditor liabilities. 1 Report of the Comptroller of the Currency, 1917, Vol. I, pp. 66, 67 102 BANK CREDIT The Relation of Cash to Deposits vs. the Relation of Surplus to Creditor Liabilities The dependence of immediate convertibility of depositors' claims upon the provision of a cash reserve is of a different order from the dependence of the ultimate convertibility of creditors' claims upon the provision of a surplus (or even capital). The dependence of the immediate convertibility of deposits upon cash is both absolute and relative, whereas the dependence of their ultimate convertibility upon surplus (or even capital) is only relative. The creation of a surplus simply enhances the chance of the ultimate convertibility of deposits, that ultimate convertibility having been already reasonably assured.

The existence of a cash reserve on the contrary is essential to any chance whatsoever of immediate convertibility, while an increase in cash, other factors remaining the same, simply enhances the chance of immediate convertibility, once a reserve has been established. The banker is not so constantly and imperatively concerned with the ratio of surplus to creditor liabilities as he is with the ratio of reserve to deposits. Without the provision of a cash reserve a bank cannot continue to function, except during a period of suspension of cash payments. But a bank may do business indefinitely without a surplus. A bank may even be insolvent over a long period of time and still perform all the banking functions if it has a cash reserve.1 1 For the case of a Canadian bank that was probably insolvent for forty years before its failure, see Interviews on the Banking and Currency Systems of Canada, Publications of the National Monetary Commission, 1909, p. 14.