When the customer discounts a note at his bank he parts with the property in it, just as when he sells any other article. The note becomes the absolute property of the banker and he may sell it again, or pledge it, or deal with it in any way that suits his own interests best.
The notes in the safe of a banker are exactly similar to the goods in the shop of a retail dealer. The retail dealer buys the goods from the wholesale dealer and sells them at a higher price to his customers; and, as he makes a profit by doing so, the goods are capital to him. Notes likewise are goods, or merchandise, which the bank buys from its own depositors at a discount, or bearing interest for a time, and as the bank makes a profit by so doing, the notes are capital to the bank precisely in the same way that the goods in the shop of the retail dealer are capital.
Now, lest we shall be misled, I want to call your attention to an error which is very common. Many persons not being aware that the word "Deposit" in banking language means the credit created in exchange for money, checks, drafts or notes bought, when they hear or read that a bank has such an amount of deposits conceive or suppose that the bank has that amount of cash on hand to trade with.
When it is said that a bank has $10,000,000, $50,000,000 or $100,000,000 or $200,000,000 of deposits, they are not deposits in cash at all; they are almost entirely pure credit, and are exactly equivalent to just as many "Bank Notes." They are nothing but an enormous superstructure of Credit built up on a comparatively small basis of reserves exactly like the note circulation. These figures do not show the quantity of cash at the command of the bank that can be traded with; but they show the quantity of business the bank has done, and the debts or liabilities it has created. These deposits, then, which so many think are cash, are in fact nothing but the credits the banks have created in exchange for the cash and notes which figure on the other side of the balance sheet as assets or resources.
This play of bank credit has been graphically described by Joseph T. Talbot, the Vice-President of one of our largest National Banks; he says: "A customer holding a bank note may present it for deposit and credit, instead of demanding redemption in cash. In this case, there is a conversion from the circulating form of credit, payable to bearer, back to a 'Book Credit,' payable to order, as was ordinarily the case. Thus it will be seen that all these forms of 'Bank Credits' are interchangeable, one for another, at the pleasure of the holder of the credit. The difference between these several forms of credit involves no changes whatever in the bank's liabilities. They amount to about the same difference which exists, let us say, between a coupon bond and a registered bond. The one is payable to bearer, the other is not. At one time a bank note may best serve a customer's needs; at another time he might prefer a deposit in the bank; or again he might prefer 'exchange.' All these interchangeable uses of credit actually and continuously take place. It will now be clear that a circulating 'Bank Note' in the hands of the public does not differ essentially from a 'Deposit Credit' on the bank's books.
"If one of your local bankers were asked how much he allowed his bank to issue in cashier's checks, he would tell you that he issued whatever sums his customers wanted; either against their balances, or against new loans. He would tell you the same in respect of the amount of exchange he issued; his sole rule and guide being the amount of such credit which his customers require, and which he is in position to lend afresh, and to maintain against, or to redeem in cash, if demanded. If asked how long these obligations were allowed to remain outstanding, he would tell you that he had no control whatever over the period of their circulation; that these obligations stood out just as long as the holders wanted to use them in that form, and no longer; that his only concern was in being prepared to redeem the obligations on demand in cash.
"Thus it is that the volume of bank credits, whether in the form of deposits, checks or notes, responds in a rise or fall according as there is legitimate trade demand; and over this the bank has no control, except by ceasing to make loans. This is why deposits increase as loans increase, and these increase as the volume of business increases."
Now, if we understand the real nature of these so-called deposits, the reason for their diminution is plain. Deposits fall because loaning stops. When you stop loaning, you stop creating credit. You can readily see that it is not a diminution of deposits in cash, but it is a contraction of credit, a refusal to make loans.
This erroneous notion of the real meaning and nature of deposits in banking language may lead to very great mistakes in estimating the stability of a bank. That a bank's stability depends on a due proportion being kept between the deposits or the liabilities and the cash; and it may very well happen that while the deposits are apparently mounting high, and might lead many persons to believe that the actual quantity of cash was increased, it might be nothing, perhaps, but a dangerous extension of credit. And if this were carried too far, the bank might be in the most dangerous position just when it was apparently most flourishing.
Now, let us consider how a banker who has purchased either money or notes from his customers by creating deposits or debts, may be used by his depositors. That is how the depositors may use these credits. Of course, every banker does business exactly in the same way, or practically so, and when their customers begin to use checks these different results may follow: