382. THE NATURE OF BANK CREDIT.—When an individual actually deposits with a bank $100 in cash, the bank becomes owner of the $100, and in turn writes down on its books the promise to pay to the depositor, as he shall direct, amounts totaling $100. The depositor receives a check book, and may draw part or all of the $100, as he likes.
Now it may happen that an individual may wish to increase his checking account at the bank, but that he has no actual cash with which to make a deposit with the bank. In this case he may give the bank his promissory note, together with stocks, bonds, or other forms of wealth, which the bank holds as security. In return, the bank credits him with a "deposit." This means that the bank extends its credit to the individual, by undertaking to honor checks for sums not actually received from the depositor.
The bank has received valuable security from the borrower and hence feels justified in extending him a deposit credit. But, why does a bank feel safe in undertaking to pay out sums of money which it does not actually have in its vaults? The answer is that the bank attempts to keep on hand a reserve fund sufficient to meet all demands for cash which may be made upon it. If the reserve fund is relatively large, the bank will ordinarily loan its credit freely. If the cash reserve is relatively low, the conservative bank may refuse further loans, on the grounds that its cash reserve is too low to justify the acceptance of additional obligations. The only safe alternative to this is for the bank in some way to increase its reserve fund, and then proceed to extend the amount of credit justified by this increased reserve.
383. DANGERS OF BANK CREDIT.—The integrity of these various operations rests upon the confidence which people have in the bank's ability to make good its promises. Confidence in the deposit credit of a bank exists when the past experience of depositors has taught them that the bank in question will habitually exchange either coin or bank notes for checks. Bank notes are ordinarily accepted in the place of coin, because people believe the credit of the bank issuing those notes to be so firmly established that the bank would be able and willing to exchange coin for its notes, upon demand. A bank is enabled to meet these obligations promptly, it should be remembered, because it keeps on hand, against the demands of depositors, a reserve fund of cash, or securities which by law it is allowed to count as cash. If all of the depositors of a bank suddenly and simultaneously demanded the full amount of their deposits in coin, the bank would be unable to accommodate them; as a matter of fact, business men normally leave in the bank that share of their deposits which they do not actually need. So long as men have confidence in a bank, they will prefer checks and bank notes to the less convenient coin, unless they need coin for some special purpose.
If properly managed a bank is a profitable business for everyone concerned. But even though properly managed, a bank may occasionally find itself in a precarious position. There are few matters which the average person comprehends as vaguely as banking, and few things which more vitally interest him than the safety of his money. These two facts combine to render banking extremely sensitive to every rumor of unsoundness. The careful regulation of banking by law is therefore necessary.
384. THE NATIONAL BANKING SYSTEM.—The Civil War plunged our government into serious financial straits. To improve the finances of the Federal government there was created, in 1863, a system of national banks. The original act of 1863 is still the basis of our banking system, though it has since been modified a number of times, notably in 1913.
We speak of a "national banking system," but as a matter of fact this term is inexact. From the beginning of their history, the so-called national banks were "national" only in the sense that they were chartered by the Federal government, and were subject to examination by Federal inspectors. These national banks constituted no definite system: they transacted business much as other banks did, they had no branches, and they had little to do with one another. There was little team-work, and no effective leadership, so that in time of a threatened panic the different parts of the "system" worked at cross- purposes instead of as a unit.
385. WHY A BANKING SYSTEM MUST BE ELASTIC.—A good banking system will be elastic, i.e. it will respond promptly to the varying needs of business. Money and credit constitute a mechanism by means of which business is handled, just as the labor force of a factory constitutes a means of handling the output of the factory. If the output of the factory increases, a larger labor force is needed; if the output dwindles, fewer laborers are needed. Similarly, if business increases in volume, an increased amount of money and credit is necessary to handle the increased volume of business. If, on the other hand, business declines, the volume of money and credit ought to decline also. Otherwise, there will be so much money and credit in circulation, relatively to the amount of goods, that high prices will result.
High prices will result for the following reason: Money and credit are used to exchange against goods. As a general proposition, all the available goods in a community are in a process of exchanging against all of the available money and credit in the community. If goods are relatively few and money and credit are relatively plentiful, a small amount of goods can command a large amount of money and credit, i.e. the goods will sell for high prices. A sound banking system, therefore, will allow an expansion of money and credit instruments when business is booming, and will permit the contraction of the mechanism of exchange when business is growing dull.
The old national banking system was inelastic in two ways: first, it provided an inelastic supply of deposit credit; second, it provided an inelastic supply of currency or bank notes.