Speculation Involved in the Issue of Notes
[259]When a banker takes out currency he engages in two distinct transactions and enters upon two different hazards. In one transaction he assumes the risk and holds the expectation of greater profit for taking out circulation. Since buying bonds and taking out circulation most of the time shows some theoretical profit over loaning direct, presumably if there were no other consideration, most of the time our bankers would keep outstanding all the notes they could. In the other transaction, however, the banker engages in a speculation in government securities. As a matter of fact, if the price of government bonds advances, the profit from taking out circulation declines; but our banker is pretty likely to view with equanimity the declining circulation profit when he considers the profit he is making in his speculation in bonds. On the other hand, as the price of government bonds declines, circulation grows more profitable. The banker is likely to view this with sour satisfaction when he looks on his loss in his bond speculation. Profit or loss in the bond speculation is likely to outbalance loss or profit in the circulation transaction.[260]
Let us examine the situation more closely. Just what is the profit or loss from taking out circulation? In the first place the bank gets the regular current money rates on the loans it makes through issuing notes. Also it gets the interest on the government bonds it buys. This, of course, means the real interest, or income on the investment, called basis, taking into consideration coupon interest, price paid, and date of maturity. Excepting for the tax of 1/2 per cent. on the circulation taken out (1 per cent. if taken out on the 3's or 4's) and for the expenses attendant on taking out circulation, which the government actuaries compute to average $63 on the $100,000, this interest on the government bonds looks like clear "velvet." It would be, too, if the banker did not have to pay more for the bonds than the amount of circulation he can take out against them. To figure his net profit he must deduct from the gain items just stated what he would have made if he had loaned his funds direct instead of investing in bonds.
Expressed as an algebraic equation the situation becomes much clearer. Let
x = current money rate;
y = basis rate at which government bonds are bought;
z = price of government bonds;
b = circulation received ($100,000 used as basis of calculation);
c = taxes, redemption, and other circulation expenses.
(As already stated, government actuaries have calculated that circulation expenses average to cost the banks $63 on the $100,000 of circulation taken out. Taxes depend on whether the 2's, in which case the tax is 1/2 per cent., or the 3's or 4's, in which case the tax is 1 per cent., are bought. Taxes, then, amount to either b(.01) or b(.005). We can take b as a constant in our calculations and base all our computations on taking out $100,000 of circulation.)
The equation of profit or loss on taking out circulation then reads:
yz + bx - xz - c = profit or loss.
But circulation taken out (b) can never be greater than the amount of money paid for the bonds (z).
If government bonds should be at par or at a discount, the nominal profit would always be just the basis interest on the bonds, less the tax and the cost of taking out circulation, or a constant advantage in the case of the 2's of 1.437 per cent. For the purpose of this discussion we will consider only the 2's of 1930.
In the regular case, then, the money paid for the bonds (z) is greater than the amount of circulation received (b). With that statement in mind we can draw certain very definite conclusions about our circulation direct from the equation we have formed; z is greater than b.
Repeating the equation in order to have it directly before us:
yz + bx - xz - c = profit or loss.
Then as the current interest rate (x) increases, if all the other quantities remain constant, the negative influence in the equation grows greater, or profit from circulation decreases. We can, then, make definitely:
STATEMENT I
If all other circumstances remain the same, circulation grows less profitable as the current money rate advances.
As business increases and the demand for both credit and money increases, as reflected in the rising interest rates, taking out circulation cæteris paribus, with the inexorability of a mathematical law, becomes less profitable.
Further, there is an intimate relationship between y and z. If the price of bonds (z) declines, the basis rate (y) must advance. As a matter of fact as z declines yz grows greater. If, then, x remains constant and z declines the influence of the negative quantities of the equation is growing less. Then follows:
STATEMENT II
As the price of bonds declines, if the current interest rate remains constant, the profit from taking out circulation increases.
That gives the absolute mathematical basis for such general statements as that "the price of bonds is too high to make circulation profitable."
These two facts set out in Statement I and Statement II place the banker who has taken out circulation between the devil and the deep, blue sea. If the price of bonds remains the same and the current interest rate rises, his circulation grows steadily less profitable. A decline in the price of bonds affords the only offset to an increasing interest rate. But if the price of bonds declines enough to offset the advance in the current interest rate, the banks must mark off enough profits to cover the loss on the capital value of the bonds.
Speculating in securities properly forms no part of a bank's business. It is an anomalous situation that in order to fulfil a proper function of note issue a bank should have to undertake such an improper speculation.