The Banking System
Banks serve:
What Functions do Banks Perform?—Banks are established and maintained to satisfy certain needs which arise wherever men carry on extensive trade with one another. |1. As institutions of deposit.]| In the first place when money is accumulated by people in the course of their business some safe place is needed to keep it. Banks, therefore, serve as institutions of deposit. |2. As agencies for loaning money.| In the second place, as business develops, it becomes necessary for people to borrow money. Banks facilitate this borrowing. Their two primary functions are to receive deposits and to make loans. But in order that they may perform these two primary functions to the best advantage the banks have assumed other subsidiary functions as well. |3. Sometimes also as issuers of paper money.| Frequently they issue bank notes, or the bank’s own promises to pay, for use in general circulation. |4. To transfer funds from one place to another.| They sell drafts or bills of exchange, thus enabling people to transfer funds from one city or country to another without the trouble and risk of sending the actual money. As a rule they provide safe-deposit vaults in which customers, on payment of a small sum, are permitted to keep their valuables. These vaults are fire-proof and burglar-proof. Banks also collect money which may be due to a customer from someone elsewhere. They help the national and state governments to sell their bonds. Frequently they act as trustees, holding property for children until they grow up or for other persons who are unable to look after the property for themselves. Without banks it would be difficult, if not impossible, to carry on the operations of modern business.
The Early American Banking System.—The national constitution contains no mention of banks or banking. Hence it was assumed that the power to charter banks would rest with the states. The states assumed this authority but the national government desired to exercise it also, and during the first thirty years of its existence established two great banks, both of which became unpopular and ultimately went out of existence. The first Bank of the United States, established in 1791, ceased to do business in 1811; the second bank, chartered in 1816, incurred the wrath of President Andrew Jackson and went to the wall in 1836.[[203]] From this date to the Civil War the state banks, of which a large number were established in all parts of the country, had the field to themselves.
The National Banking Act of 1863.—During the Civil War, however, the national government encountered great difficulty in raising funds. When it issued bonds the people would not buy them readily. The state banks showed very little interest in marketing them. So Congress, in this emergency, decided to establish a system of national banks in order to facilitate the sale of war bonds. The National Banking Act, passed in that year, laid a heavy tax upon the paper money of all state banks, with intent to drive this currency out of circulation. It then provided that any bank chartered by the national government might issue untaxed paper money provided it bought United States bonds to a designated amount and deposited these bonds in Washington as security. In other words the Act of 1863 aimed to provide a uniform system of bank notes throughout the country, these notes to be backed by government bonds. The plan worked well and its main provisions have been retained to this day.
Present organization of the national banks.
National banks are owned by private individuals who subscribe the capital stock. These stockholders, or shareholders, elect the bank’s officers, who in turn manage the business. The profits go to the shareholders in the form of annual dividends. Each national bank must buy a designated amount of United States bonds and these bonds are deposited in Washington. In return the bank receives an equal amount of paper notes, with its own name engraved thereon, and these notes the bank pays out over its counters, thus putting them in general circulation. If the bank should become insolvent, the government would redeem the notes since it holds the bonds as security. |Their functions.| The national banks receive money on deposit, make loans, and perform the various other banking functions. They are strictly regulated by national law; they must make periodic reports and are frequently inspected by officials from Washington. |Their reserves.| One requirement is that they shall always maintain a certain “reserve” so that they may be in a position to make all payments which may be called for by their customers. The supervision of the national banks is in the hands of an official known as the Comptroller of the Currency, who is appointed by the President.
State banks and trust companies.
In addition to the national banks there are state banks and trust companies throughout the country operating under state charters. These institutions do not issue paper money but perform all the other banking functions.[[204]] Their business is regulated by the laws of the state in which they are located and they are supervised by state officials. The laws relating to state banks and trust companies differ considerably from state to state.
Defects of the national banking system due to the concentration of reserves and lack of flexibility.
The Federal Reserve Banks.—Although the national banking system worked pretty well for fifty years after its establishment, certain defects came to be recognized. One of these defects, in actual practice, was the necessity of always keeping available a “reserve” amounting to a certain percentage of each bank’s total deposits. It was not necessary to keep this reserve in the bank’s own vaults; a part of it might be placed upon deposit in larger banks where it would draw interest. As matters turned out, a considerable portion of the reserves was usually deposited with large banks in New York City. In times when business was good and money plentiful, this arrangement worked very well, but when periods of business depression arrived and money became scarce every small bank naturally drew upon its reserve deposits in the larger banks, which found difficulty in paying them all at the same time. Moreover, it was found from experience that during times of business prosperity the country needed a large increase in paper money while the national banking system, as established in 1863, proved too rigid to meet the business needs of the country.
How the Federal Reserve system remedies these defects.
In 1913, accordingly, Congress made provision for the establishment of a Federal Reserve system which does not displace but supplements the operations of the national banks. By an act passed in that year provision was made for the establishment of twelve federal reserve districts, with a federal reserve bank in each. The capital stock of each federal reserve bank is contributed by national or state banks within the districts, these contributors being then known as “member banks”. The national government also subscribes a part of the capital stock when necessary. |The Federal Reserve Board.| Each federal reserve bank is controlled by officials, some of whom are elected by the member banks and some appointed by the national government through a body known as the Federal Reserve Board. This board is composed of the Secretary of the Treasury, the Comptroller of the Currency, and five other members appointed by the President.
Functions of the Federal Reserve Banks.
These federal reserve institutions are bankers’ banks. They do business with banks only, not with individuals. They receive deposits from banks and lend money to banks. The member banks now keep with them a portion of their reserves. In this way the reserves are mobilized at twelve different financial centers where they can be readily drawn upon.[[205]] The Federal Reserve Board has authority to increase or decrease the percentage of reserves which the member banks are required to maintain, thus giving the reserve system a large degree of flexibility. Whenever a member bank needs additional paper money for circulation it goes to the federal reserve bank of its district and deposits any sound “collateral”, that is to say, any acceptable security, and receives federal reserve notes of like value in return. This collateral may be in the form of government bonds or it may be, and more often is, “commercial paper”. |How they give flexibility to the whole banking system of the country.| By commercial paper is meant the notes or other obligations of corporations and individuals which have been given to the member banks in return for loans made to such corporations and individuals. The federal reserve banks are authorized to issue federal reserve notes, to an unlimited extent on the security of this collateral provided they also keep a gold reserve amounting to forty per cent of the total notes issued. In addition they are empowered to issue federal reserve bank notes secured by United States bonds in the same way as national bank notes are secured. It is expected that in time the national bank notes will go out of existence altogether, their place being taken by these federal reserve bank notes.
Value of the Federal Reserve system.
Since their establishment in 1913 the work of these federal reserve banks has been of great value. They have enabled the banking operations of the country to expand and contract in accordance with changes in business conditions, thus obviating serious danger of financial panics. In helping the government to float the various Liberty Loans they rendered great service. There is no doubt that the system has improved and strengthened the banking facilities of the country.[[206]] This will appear more clearly when the relations of banking and credit are discussed a few pages further on.
Commercial and savings banks distinguished.
The Practical Operations of Banking.—There are some elementary things connected with the practical operations of banking which everyone ought to know. Generally speaking, there are two kinds of banks, commercial banks and savings banks; or, in some cases the same bank may have two departments, a commercial department and a savings department. Both commercial and savings banks receive deposits; the former may or may not pay interest according to the amount of the deposit and the length of time it is left in the bank; the latter always pay interest if money is left on deposit a prescribed length of time. When money is deposited in a commercial bank the depositor is said to have an “account” and he may issue checks up to the amount of his deposit. |Bank checks.| A check is an order, addressed to the bank, and calling for the payment of a designated sum. This check may be cashed at the bank on which it is drawn, or the person who receives it may have it cashed at the bank where he has his account. Banks cash checks for their own customers no matter what bank the checks happen to be drawn upon.
One result of this is that every bank at the close of each day’s business will have on hand a large number of checks drawn against other banks. |The clearing house system.| It receives payment on these checks through the medium of the “clearing house”, an institution which is maintained by the banks in every large city. To the nearest clearing house a clerk takes each morning all the checks on other banks that have come in during the previous day. These are sorted out and exchanged for checks drawn on the bank itself which are held by other banks. Whatever difference there happens to be is paid in cash.
How bank loans are made.
When any person desires to borrow money from a bank he gives his note, which is a promise to repay the bank at a designated time. The bank may ask the borrower to obtain an endorsement upon his note, that is, to have some responsible person put his name on the back of it, which means that the endorser assumes liability for the amount of the note if it is not paid by the maker on time. Or the bank may ask the borrower to deposit “collateral” as security for the payment of the note. This collateral may be in the form of bonds, stocks, mortgages, or any other intangible property that has sufficient value. The bank holds this collateral until the loan is repaid.
The process of “discounting.”
When a bank lends money and takes a man’s note, with or without collateral, it is said to discount the note. It gives the borrower the face value of his note less the interest, whatever it is, calculated at the current rate. Thus if the rate is six per cent and the person gives his note for one thousand dollars payable in six months, the bank would hand him $970 in money. Business men obtain large sums of money from the banks by getting their notes discounted; they borrow money in this way to buy goods and then pay off their notes when the goods are sold. Such notes are called “commercial paper”.
“Rediscounting.”
Now the federal reserve banks help the member banks by “rediscounting” this commercial paper for them. Suppose a small bank has loaned on notes all the money it has to spare. Then it receives applications from its customers for more loans. What does it do? It takes a bundle of business men’s notes, or commercial paper, from its vaults and sends this to the nearest federal reserve bank. The latter does just what the member bank did in the first instance; it deducts the discount at current rates and gives the balance to the member bank in money, that is, in federal reserve notes. The member banks are enabled, in this way, to loan a great deal more money than would be the case if there were no way of getting their commercial paper “rediscounted”.
How the banks transfer funds.
Drafts or bills of exchange are used to make payments at distant points. If a person lives in San Francisco and wishes to pay a small bill in New York, he will probably go to the post office and buy a postal money order; but if the amount is large, he may find it more convenient and cheaper to go to a bank in San Francisco and buy a draft on some New York bank. This draft he then sends to New York in payment of his bill. A draft payable in a foreign country is usually called a bill of exchange. From any American bank one can buy a bill of exchange payable in Paris, Madras, Hong Kong, or elsewhere. When the money of one country is worth more than that of another, as is the case throughout the world at the present time, allowance is made for this difference. Bills of exchange are “cleared” through the great clearing houses in London or New York, and any balances are paid by the shipment of gold.