Popular Science Monthly/Volume 49/July 1896/On our Banking System
By LOGAN G. McPHERSON.
IT is not to be supposed that many of the heads of the six million families in the United States whose incomes are less than six hundred dollars a year ever have in their possession more than a few dollars that are not required for immediate needs. A considerable number of those having larger incomes frequently are in possession of money which they are not obliged to spend at once, and merchants and manufacturers and others who direct on a large scale the efforts of many employees are frequently in possession of considerable sums which they do not immediately need to use.
Especially among English-speaking people has grown the custom of depositing such money in banks. Primary and elementary points of the banking problem are therefore the provision of receptacles for money that will withstand the forces of Nature and the assault of thieves; the securing of custodians who are honest and competent to receive and record deposits and to make payments with accuracy. That the strong and well-guarded vaults of modern banks meet the first of these points is evidenced by the decreasing list of bank robberies that are accomplished by physical force. The examination of bank employees' character, that has become the more searching and rigid as the operations of guarantee companies have extended, is causing defalcations through the direct stealing of funds to become constantly fewer.
As banks have become more numerous, the use of checks has increased. Between office and store, factory and warehouse, bank and bank, city and city, millions of these pieces of paper are continually in transit, furthering the exchange of human effort. The interlinking of banks as correspondents and the growth of clearing houses have formed a mechanism whereby their payment is effected with celerity.
But the actual deposits of a bank are increased by the proceeds of loans which it makes and which are frequently placed to the credit of the borrower the same as though money had actually been deposited by him. For example: A bank discounts a note from A to B at sixty days for one thousand dollars. The proceeds, amounting to nine hundred and ninety dollars, may not be instantly needed by B; the amount is placed to his credit for him to check against—that is, nine hundred and ninety dollars is placed to his credit on the books of the bank. As his checks come in he is charged with their amount on the books of the bank. In this way he obtains from the bank the use of nine hundred and ninety dollars; or, to speak more accurately, the bank is the guarantor of representatives of value issued by him to the extent of nine hundred and ninety dollars. He has deposited no money. What he has deposited has been a promissory note—that is, a promise to produce the result of human effort of which he can dispose for at least the value of the note. As a bank's profits are largely made by discounting notes, a very considerable portion of the checks issued against every bank, therefore, are not drawn against money deposited in it, but against credits in its books, which are based upon the assurance of the forthcoming of the result of human effort. And therefore a vast proportion of all the checks that flit between store and office, city and city, are based, not upon cash directly, but upon the guarantee of a bank that it will accept checks to the value of the result of human effort, the assurance of the production of which has been discounted or purchased by it and held as the basis for its guarantee.
In the case specified, the exhaustion of his credit by B might be somewhat as follows: At the end of the week, to pay his employees, he may draw two hundred dollars from the bank. In this instance the bank advances to him out of that portion of its deposits in actual money which it retains to meet current demands, coins, or circulating notes, to the amount of two hundred dollars, B may have employed C, a contractor, to make some repairs at his place of business, and he gives C a check on the bank for ninety dollars. C also has an account at the bank and deposits the check to his credit. The bank on its books charges B with ninety dollars and credits C with ninety dollars. B's debt to C has been paid without the use of money at all, the bank, in this instance, acting as a register of the exchange of human effort. B may have purchased goods in New York from X Y & Co. to the value of three hundred dollars. He delivers a check to his bank for that amount, and the bank delivers to him a draft on its correspondent bank in New York for three hundred dollars. B mails the draft to X Y & Co., who have an account at the bank on which it is drawn, and deposit it in that bank to their credit. This bank charges the original bank on its books with three hundred dollars, and credits X Y & Co. on its books with three hundred dollars. No money has been used in the entire transaction. Representatives of value based upon the note of A to B have caused the transfer of credits in the books of the original bank and in the books of the New York bank.
These instances indicate the manner in which, by the aid of the banking system, the exchange of the results of human effort is promoted to an extent far transcending the possibilities of exchange effected only by the use of coins or by the direct representatives of coins. By means of checks and drafts based on book credits in banks that are based on the assurance of the result of human effort as given by promissory notes, a very considerable portion of the commerce of civilization is forwarded, the proportion of exchanges effected by coins or the direct representatives of coins being in constantly decreasing ratio to the total value of exchanges. But, as when there is a scarcity of coin among the members of a race who have progressed to the use of coin, the exchange of effort between them is hindered and reverts to barter; as, when there becomes a scarcity of circulating notes among a nation accustomed to their use, commerce and manufacturing are restricted because, in the absence of other expedients, exchanges are necessarily conducted by coin, so in our banking development, when promissory notes and other securities are regarded with distrust by the banks upon which is devolving the most of the burden of directly or indirectly supplying the money needed in a community, there is a restriction of the exchange of human effort. Manufacture and commerce are retarded, and are forced to the exclusive use of coins or their direct representatives.
A most important point of the banking problem, therefore, is the regulation of discounts in such a manner that the commerce of a nation may proceed with regularity, and its development be continuous and orderly.
Suppose that the money actually deposited in a bank amounts to one hundred thousand dollars. The bank knows from experience that it will not need to keep more than fifty thousand dollars of this to meet current demands, and therefore discounts notes to the extent of fifty thousand dollars. It has received money to the extent of one hundred thousand dollars, promises to pay money to the extent of fifty thousand dollars, and made itself liable to the extent of one hundred and fifty thousand dollars—that is, it is responsible for the payment of checks to an amount fifty per cent in excess of the amount of money which it has received. A definite amount of money is made the basis of liability for an amount one and a half times as great. But a bank discounts not only from its actual deposits, but also from its surplus of accumulated profit, and such of its capital as is not invested in real estate, bank building and fixtures. Suppose that the money actually deposited in a bank amounts to a hundred thousand dollars, that it has a surplus of two hundred thousand dollars, and its capital in excess of the amount invested in bonds, real estate, and banking house is two hundred thousand dollars; its funds available for discount thus amount to five hundred thousand dollars. As the only legal restriction upon the extent of its discounts is the requirement that it maintain a reserve in actual money amounting to twenty-five per cent of its deposits, it is obvious that by keeping on hand a hundred and fifty thousand dollars in actual money, its statement of deposits may show six hundred thousand dollars. Of this a hundred thousand dollars is actual money received as deposits and five hundred thousand dollars the proceeds of discounted notes. And thus it is evident how it is possible for by far the greater portion of the exchanges of the country to be effected by representatives of value based upon the assurance of the production of human effort contained in promissory notes. It must be recognized that this furthering of the exchange of the result of human effort may be of vast benefit to the public as a whole. For example, a Southern planter, with ripening acres of cotton, may not have the means wherewith to pay for the picking, cleaning, packing, and freight to the place of market. The proceeds of a note discounted at a bank will provide him with the necessary means, and he pays the note with the money obtained from the sale of the cotton. Likewise with an elevator owner in Chicago purchasing grain for export; or a coal operator of Pittsburg who desires to send fuel by river to the Southern, or by lake to the Northwestern markets; or a merchant with store, clerks, and knowledge of the wants of his section may give his notes for needed goods which he pays from the proceeds of their sale; or a man, far-sighted, energetic, and careful, may perceive opportunity for profit if he could obtain the requisite material or the requisite tools or requisite help of other kinds. By having a note discounted, he obtains the requisite help and pays the note when the opportunity has been realized. In these instances, the discount of notes has contributed to the production and distribution of needed commodities. The producers have obtained profit, their employees have obtained wages; railways, vessels, and factories have been used with emolument to their owners and employees, and thousands of people have been placed in possession of food, fuel, and clothing.
But where there is a chance for profit, there also is a chance for loss. Flood may ruin the cotton crop, the markets may become so glutted that neither grain nor coal can be sold except at a greatly depreciated price; the merchant may be stricken in health; even the energetic, careful, and far-sighted man may have miscalculated his opportunity. In such cases, the result of human effort to the value of the notes may not be forthcoming; the assurance fail of performance; the notes can not be met. When representatives of value are based upon the promised result of human effort which does not materialize, they are worthless unless there is an ultimate basis of realized result. This realized result may be the property of signers or indorsers taken by the bank to make the value of the notes good; it may be of the capital or surplus of the bank or property of the stockholders who are liable for double the amount of their holdings; or, in the last resort, the loss falls upon individuals of the public in general.
Concerned, therefore, in the conduct of a bank are the stockholders, who profit by its prosperity and share its losses; the depositors, whose funds are in its custody, and the public in general; and an important phase of the banking problem is presented by three points: First, the necessity for a bank to keep on hand sufficient actual money wherewith to meet checks and drafts upon it that must be paid in actual money; second, the necessity for furthering the exchange of human effort and thereby making as large profits as possible by maintaining as large a line of discount at all times as may be prudent; third, to make no loans except upon adequate security.
When a bank discounts a note, its first consideration, of course, is the probability of the note being paid—that is, it desires to be reasonably sure that the transaction which the note covers will yield enough to cancel it. To this end it is obliged to rely largely upon the reputation for ability and honesty of the drawer and indorser, for it can not enter into the details of every transaction; but a general knowledge of prices and markets is useful, that it may not be overflooded with paper in any particular line of industry that may be offered by the oversanguine or the knavish. And the attempts to obtain discounts by the oversanguine and the knavish are not limited to the offer of paper in excess of the amount abundantly necessary to cover the movement in any particular line, but they frequently exchange notes, or in other ways obtain paper from a colleague which represents no legitimate business transaction, but by the discount of which they obtain needed funds.
As unpredicted circumstances may, at unforeseen times, cause unusual demands to be made upon a bank's deposits, it follows that a bank's loans should not be for long periods. In actual practice the average duration of notes is sixty days, and banks do not like to accept paper running longer than four months under any circumstances. Different notes corning due at different times bring into a bank day by day funds which it can use to discount new notes, or which it can retain in case of contingency requiring it to keep more money on hand than usual.
It is evident that a bank should not only be reasonably certain that the prospective exchange of effort which is the immediate cause of a loan should produce enough under ordinary conditions to cancel it, but that in case of contingency that is disastrous to the products immediately concerned the property of the signers and indorsers of the note not covered by other obligations be sufficient to liquidate it. But in these days, when a concern's property is not always visible and its incumbrances frequently concealed, a knowledge of its actual resources is difficult to obtain. It has happened that financial tricksters, by operations in several banks, knowledge of each of which has been kept from the others, have gained possession of funds far beyond the extent to which their resources entitle them, and in such a case, when any one bank suspects that it is being victimized, there is the temptation for it to conceal this knowledge from the other banks, that the unworthy customer may not be prevented from obtaining loans from them, wherewith he can repay the advances made by the bank which has begun to suspect him.
Perhaps the possibilities of unwholesome financiering which must finally result in loss to the banks and disturbance to all the communities concerned can best be illustrated by a definite example traced throughout its ramifications.
From a region rich in deposits of coal a railway extends to docks where coal is loaded into vessels for shipment to remote markets. A corporation controlled by a coal operator and the president of the railroad leases the docks, and engages in the purchase and shipment of coal. The railway is financially weak and the corporation without working capital. But the corporation buys large quantities of coal, giving four months' notes that aggregate thousands of dollars in payment therefor; it gives four months' notes to the railroad company, aggregating thousands of dollars, in payment for the freight to the docks. The coal producers, to obtain ready money wherewith to run their mines, discount the notes obtained from the shipping company in their banks. The railroad company, to obtain ready money wherewith to meet its expenses, discounts the notes obtained from the coal company for freight in its different banks. It is the intention of the coal-shipping company to pay the notes for coal and the notes for freight when the coal which it has shipped is sold, but, finding it easy to issue notes, it buys and ships more coal than it can sell at remunerative prices, or for immediate returns, and when its notes are due it can not pay them all. To retain its credit with the coal producers, it pays the notes given to them, but it then can not pay all the notes given the railroad company. To meet the situation, the railroad company and the coal company exchange notes—that is, for example, suppose there be notes amounting to forty thousand dollars of the coal company to the railroad company coming due, and the coal company can pay but twenty thousand dollars. To meet the other twenty thousand dollars, which may be in two notes of ten thousand dollars each, which have been discounted by the railroad company at the P National and the Q National Banks, the railroad company gives the coal company two notes each for ten thousand dollars, and the coal company gives the railroad company two notes each for ten thousand dollars. One note of the coal company to the railroad company is discounted at the R National and the other R,t the S National Bank, and the treasurer of the railroad company, by that part of the transaction, is in possession of twenty thousand dollars, less the discount, which he badly needs to help pay interest on an overburden of bonds and bills and long-overdue wages to employees. One note of the railroad company to the coal company is discounted at the T National and the other at the U National Bank, and the proceeds, amounting to nearly twenty thousand dollars, in connection with the twenty thousand dollars already in its treasury, enable the coal company to meet the maturing notes to the railroad company for forty thousand dollars. The bank in which they are paid and the P National and Q National Banks at which they have been discounted have their belief in the ability of the coal company to meet its obligations strengthened, because it appears that the coal company is paying its notes. But this is not really so, for only one half of its original notes has been paid, and the notes exchanged, representing a liability of forty thousand dollars, leave the amount of discounts in various banks the same as when the original notes of forty thousand dollars of the coal company to the railroad company were discounted.
Suppose a similar transaction to be undergone with each of three sets of notes given by the coal company to the railroad company, each set originally amounting to forty thousand dollars. Instead of the original indebtedness of one hundred and twenty thousand dollars of the coal company to the railroad company, there is created by the exchange of notes for half that amount a joint liability of the coal company and the railroad company for one hundred and twenty thousand dollars. The coal has all been sold, but how is it with the coal company? How is it with the railroad company? And how is it with the banks that have discounted their notes?
The coal company continues business, giving new notes to coal producers for coal purchased, and new notes to the railroad company for freight. It is responsible not only for these notes, but for the previously issued notes. Because of this burden, it is obliged to increase its shipments of coal, and therefore to extend its markets. To do this it is obliged to undersell other coal-shipping companies, and therefore to dispose of coal at prices that do not yield enough to pay the notes given coal producers and the notes given the railroad company. The coal producers must be paid; but such remaining funds as it can obtain can not pay the increasing mass of notes given the railroad company, which mature at shorter and shorter intervals. There is more juggling of notes through banks, and the mutual liability of the coal company and the railroad company rolls up, like a big snowball pushed by schoolboys. The coal company must stop business or its shipments must increase. To stop is to acknowledge its bankruptcy. To increase shipments necessitates still further expansion of markets. It builds docks at the places of market, and organizes another company to operate them.
Although the stock of this receiving company is controlled by the same men that control the stock of the shipping company, the shipping company sells coal to it, and takes notes of the receiving company in payment therefor. These notes the shipping company discounts at banks. Notes have therefore been given by the shipping company to the coal producers for coal, and notes for the same coal have been given the shipping company by the receiving company. But the shipping company and the receiving company are controlled by the same men, and neither have working capital. The notes can not be met. There is more juggling through the banks, and the snowball grows. The shipping company must sell coal; the receiving company must sell coal. They cut prices; their competitors cut prices to retain their trade. The cutting continues until the wages of the miners who dig coal are cut; they are cut and cut. Coal is piled up on the docks. A great panic sweeps over the country. The shutting down of mills and factories diminishes the use of coal. The traffic of the railroads falls off, and their locomotives do not burn so much fuel. There is an oversupply of coal, and the miners, whose wages have been reduced to a starvation basis, are without work even at those wages. All of them are poor, and the most of them are ignorant of the remote sources of the wrongs that are undoing them. Their discontent grows, and they strike. Their children are without shoes, and their stomachs are empty. Their discontent gives rise to mutterings. Here a coal tipple is burned, there an operator mobbed. The operators employ deputy sheriffs to protect their property, and threaten to call on the Governor for the aid of the militia in preserving peace. The miners are whipped and return to work.
The railroad company and the shipping company and the receiving company push the growing snowball of their indebtedness before them. By juggling, twisting, scheming, and the manipulations through the banks they are kept afloat.
What finally happens? The railroad company, overburdened with debts, and robbed by its officers, goes into the hands of a receiver.
The great snowball of indebtedness rests upon the coal company; its notes are scattered far and wide in the banks that have discounted them. What can the banks do? Get judgment on the notes and take the property of the coal company. But the coal company owns next to nothing. Its docks are leased, its cars are leased, its coal land is leased; the lessors have the first claim, the banks would get nothing. What can the banks do? Allow the coal company to issue bonds, take bonds to the value of the notes which they hold, and allow the coal company to continue? If it has so lamentably failed in the past, what can be expected of the future? The banks are between the devil and the deep sea.
How did they get there? Because they discounted notes assuring the forthcoming of the result of human effort to the extent that the signers and indorsers failed to produce. Had the banks been fully alive to the conditions of the coal markets, they certainly would not, in the first place, have discounted notes covering supplies of coal that far exceeded the demand, and the sale of which affected the prosperity of other coal companies to such an extent that cutting of prices finally reacted upon the prosperity of every community concerned in the coal industry. But, if it be urged that it is asking too much of any bank to keep track of the intricacies of every business, that a bank is safe in discounting the notes of concerns that always pay their notes, there is the reply that these concerns did not pay their notes. By manipulation they apparently paid them, and therefore the system under which such manipulation is possible is fundamentally wrong.
Under the Canadian banking system, with its large banks, each having enormous capital and branches throughout the Dominion, it is practicable to enforce the rule of "one concern, one bank"; each customer must render a confidential statement to his bank from time to time of the exact condition of his affairs, of his assets and liabilities, and it is to the interest of his bank to accord him the fullest accommodation that his business will justify. Its enormous resources enable it to thus accommodate all its customers. It is evident that under such a system such juggling as that instanced in the foregoing illustration could not have been carried on. Many of the banks of the United States have blank forms which they submit to offerers of paper for discount, the filling up of which completely discloses the condition of their affairs, the extent of their assets and liabilities in every shape and form. Had such statements been required of the coal company and the railroad company by each of the banks before discounting their notes, the possibility of ruin entailed by their reckless procedure would certainly have been averted; but men, shrewd, plausible, and unscrupulous, have a way of quieting the fears of banks and evading inquiries that are searching.
Under the Canadian system the few banks, each with large capital and many branches, find it to their interest to employ as managers men of character, foresight, and ability, and they are not allowed to participate in any way in the borrowing of money from their banks. In the United States each city has its numerous banks, no one of them firmly connected in management with any other bank. The officials often are men of minds not of the broadest and judgment not of the most accurate, who have attained their positions, perhaps, through influence of one kind or another, and sometimes they are in direct partnership with the men who have offered paper to the bank for discount, the recommendation of action upon which comes within their province.
Under the Canadian system there are restrictions upon the amounts which directors of a bank can borrow, and their heavy liability for losses incurred by their bank leads them to exercise much caution in accepting paper. In the United States many bank directors seek their positions almost exclusively because of the facilities they thereby obtain for borrowing, and by their accommodating each other the legitimate business of the bank and the community is prone to suffer.
Under the Canadian system there is an examiner for each large bank, who inspects its operations from time to time to ascertain not only that its status is sound from a bookkeeping and arithmetical standpoint, but that it grants discounts on sound principles, and that the discounted paper held by it is good. In the United States there are national bank examiners, but their duties do not embrace a thorough and rigid scrutiny of the soundness of notes discounted.