Now let us see how this huge debt from the banks to the public has been created. An examination of the assets side of the balance-sheet proves that most of it has been created by money lent to their customers by the banks, and that the cheque currency of to-day is, like the note currency of a former day, based on mutual indebtedness between the banks and their customers. For the assets side shows that the banks hold 43 millions in cash and at the Bank of England, 48 millions in investments, and 6 millions invested in their premises—the buildings in which they conduct their business—and that 180-1/2 millions have been lent by them to their customers, either by the discounting of bills or by advances to borrowers, or by loans at call or short notice. We can now reconstruct our balance-sheet, leaving out the acceptances on both sides, as follows:
| Millions of £. | Millions of £. | ||
| Due to shareholders | 28-1/2 | Cash in hand and at Bank of England | 43 |
| Due to customers | 249 | Investments | 48 |
| Premises | 6 | ||
| Due from customers | 180-1/2 | ||
| ———— | ———— | ||
| 277-1/2 | 277-1/2 |
And it thus appears that nearly three-quarters of the amount due from the banks to their customers are due from their customers to the banks, having been borrowed from them in one form or another. And this proportion would perhaps be exceeded if we could take the figures of English banking as a whole. But that cannot be done at present, because some of the smaller banks do not separate their cash from their loans at call in their published statements. The greater part of the banks' deposits is thus seen to consist, not of cash paid in, but of credits borrowed. For every loan makes a deposit, and since our balance-sheet shows 180-1/2 millions of loans, 180-1/2 out of the 249 millions of deposits have been created by loans.
To show how a loan makes a deposit, let us suppose that you want to buy a thousand-guinea motor-car and raise the wherewithal from your banker, pledging with him marketable securities, and receiving from him an advance, which is added to your current account. Being a prudent person you make this arrangement several days before you have to pay for the car, and so for this period the bank's deposits are swollen by your £1,050, and on the other side of its balance-sheet the entry "advances to customers" is also increased by this amount, and the loan has clearly created a deposit.
But you raised your loan for a definite purpose, and not to leave with your bank, and it might be thought that when you use it to pay for your car the deposit would be cancelled. But not so. If the seller of your car banks at your bank, which we will suppose to be Parr's, he will pay your cheque into his own account, and Parr's bank's position with regard to its deposits will be unchanged, still showing the increase due to your loan. But if, as is obviously more probable, he banks elsewhere—perhaps at Lloyd's—he will pay your cheque into his account at Lloyd's bank, and it will be the creditor of Parr's for the amount of £1,050. In actual fact, of course, so small a transaction would be swallowed up in the vast mass of the cross-entries which each of the banks every day makes against all the others, and would be a mere needle in a bottle of hay. But for the sake of clearness we will suppose that this little cheque is the only transaction between Parr's and Lloyd's on the day on which it is presented; the result would be that Parr's would transfer to Lloyd's £1,050 of its balance at the Bank of England, where all the banks keep an account for clearing purposes. And the final outcome of the operation would be that Parr's would have £1,050 more "advances to customers" and £1,050 less cash at the Bank of England among its assets, while Lloyd's would have £1,050 more deposits and £1,050 more cash at the Bank of England. And the £1,050 increase in Lloyd's deposits would have been created by your loan, and though it will be drawn against by the man who sold you the car, it will only be transferred perhaps in smaller fragments to the deposits of other banks; and as long as your loan is outstanding there will be a deposit against it in the books of one bank or another, unless, as is most unlikely, it is used for the withdrawal of coin or notes; and even then the coin and notes are probably paid into some other bank, and become a deposit again; and so we come back to our original conclusion that your borrowing of £1,050 has increased the sum of banking deposits, as a whole, by that amount.
The same reasoning applies whenever a bank makes a loan, whatever be the collateral, or pledge deposited by the borrower, whether Stock Exchange securities, as in the case cited, or bales of cotton or tons of copper; or, again, whenever it discounts a bill. In each case it gives the borrower or the seller of the bill a credit in its books—in other words, a deposit; and though this deposit is probably—almost certainly—transferred to another bank, the sum of banking deposits is thereby increased, and remains so, as long as the loans are in existence. And so it appears that the loans of one bank make the deposits of others, and its deposits consist largely of other banks' loans....
Relation Between Reserves and Demand Liabilities Again
[36]... a bank must so regulate its loans and note issues as to keep on hand a sufficient cash reserve, and thus prevent insufficiency of cash from ... threatening. It can regulate the reserve by alternately selling securities for cash and loaning cash on securities. The more the loans in proportion to the cash on hand, the greater the profits, but the greater the danger also. In the long run a bank maintains its necessary reserve by means of adjusting the interest rate charged for loans. If it has few loans and a reserve large enough to support loans of much greater volume, it will endeavor to extend its loans by lowering the rate of interest. If its loans are large and it fears too great demands on the reserve, it will restrict the loans by a high interest charge. Thus, by alternately raising and lowering interest, a bank keeps its loans within the sum which the reserve can support, but endeavors to keep them (for the sake of profit) as high as the reserve will support.
If the sums owed to individual depositors are large, relatively to the total liabilities, the reserve should be proportionately large, since the action of a small number of depositors can deplete it rapidly. Similarly, the reserves should be larger against fluctuating deposits (as of stock brokers) or those known to be temporary. The reserve in a large city of great bank activity needs to be greater in proportion to its demand liabilities than in a small town with infrequent banking transactions.
Experience dictates differently the average size of deposit accounts for different banks according to the general character and amount of their business. For every bank there is a normal ratio and hence for a whole community there is also a normal ratio—an average of the ratios for the different banks. No absolute numerical rule can be given. Arbitrary rules are often imposed by law. National banks in the United States, for instance, are required to keep a reserve for their deposits, varying according as they are or are not situated in certain cities designated by law as "reserve" cities, i. e., cities where national banks hold deposits of banks elsewhere. These reserves are all in defense of deposits. In defense of notes, on the other hand, no cash reserve is required—that is, of national banks. True, the same economic principles apply to both bank notes and deposits, but the law treats them differently. The Government itself chooses to undertake to redeem the national bank notes on demand.