386. INELASTICITY OF DEPOSIT CREDIT (RESERVES).—It will be recalled that the amount of loans which a bank may make depends upon the maintenance of an adequate reserve fund. From this it follows that the larger the reserve fund the more loans the bank will feel justified in making. Similarly, if the reserve fund shrinks, sound banking demands that loans be curtailed. Keeping these facts in mind, there were two reasons why the supply of deposit credit was inelastic before 1913.
In the first place, individual banks kept only a part of their reserves actually in their vaults. The remainder, and sometimes the larger part, of their reserves was maintained in the form of deposits in other banks. Banks in towns and small cities habitually kept part of their reserves in the form of deposits in the banks of large cities, and the latter in turn kept part of their reserves in the banks of New York City, the financial center of the country. Hence the cash reserves of the country tended to collect in New York, where they were utilized by New York banks as a basis for extending loans.
This was a dangerous arrangement. In the fall of the year large amounts of cash were demanded in the West, in order to pay farm hands and otherwise "move the crops." At such times the small western banks had to demand their deposits in larger banks, while these in turn had to call for their deposits in the New York banks. The New York banks were often embarrassed by these demands, because they made a practice of fully utilizing the funds left with them, as a basis for extending loans. The call in the West for cash meant a curtailment of these loans with a consequent demoralization of eastern money markets.
In the second place, individual banks were unable to extend loans to customers beyond the point justified by the amount of reserves in their vaults, or deposited to their credit in other banks. A bank with a total reserve of $10,000 might feel justified in loaning its credit to the extent of $100,000, but in case demands for additional loans were made upon it, sound banking practice would oblige it to refuse accommodation. Otherwise it might later find itself unable to get enough cash to pay out against claims made in the form of checks. This practice of curtailing loans when reserves were depleted was demoralizing to business, since the disappointed customer might find his entire business blocked, and this in turn would inconvenience or seriously injure all those who were connected with him in a business way. Before 1913, each bank stood as a unit, and when its reserves were depleted it could not secure temporary aid from other banks. There was no centralized control, and no method whereby national banks might secure help of one another.
387. INELASTICITY OF CURRENCY (BANK NOTES).—We have seen that an increased volume of business demands an increased volume of money and credit. In the previous section it was pointed out that before 1913 the volume of deposit credit in this country was inelastic. We must now notice that bank notes, or paper currency, are just as truly a part of the volume of money and credit as is deposit credit, and we must note, also, that just as deposit credit was inelastic before 1913, so the issue of bank notes was inelastic. Previous to 1913 it often happened that the supply of bank notes was smallest when business was expanding, and that the issue of bank notes increased during dull business periods. This statement requires some explanation.
The Act of 1863 provided that National banks might issue bank notes only after depositing in the Federal Treasury an amount of United States government bonds sufficient to render the bank notes absolutely safe. Naturally, the banks made heavy purchases of bonds when the bond market was depressed, and tended to purchase relatively few bonds when those securities were high in price. Since the only reason for purchasing bonds was to enable the b banks to issue notes, more notes were issued when bonds were low in price, and fewer were issued when bonds were high. Unfortunately, the same general conditions that stimulated business also tended to raise the price of bonds, while the causes of slack business often operated to lower bond prices. This means that when business was expanding, and more notes were needed, bonds were so high that few were purchased, and consequently few notes were issued. Similarly, when business was dull, more bonds were purchased, and more notes issued.
388. THE PANIC OF 1907.—The panic of 1907 attracted attention to these two great defects of the old national banking system, i.e. the inelasticity of deposit credit and the inelasticity of currency. In the fall of 1907, a bumper crop caused Western banks to make unusually large demands for cash upon the New York banks. Unfortunately, this depletion of reserves came at precisely the time when the demand upon New York banks for loans was greatest. There was thus increased pressure exerted upon New York banks for loans, but less justification for extending them. In response to the pressure for loans, some New York banks over-extended their credit. In October the inability of a few prominent banks to pay in cash all of the demands made upon them started a series of bank "runs." Even solvent institutions were unable to meet their obligations promptly and many failures occurred. A large number of banks were technically insolvent, that is to say, their assets were invested in forms which prevented their immediate conversion into cash, so that for the time being demands for cash could not be met. The lack of an effective banking system prevented these banks from securing temporary aid from banks more favorably situated.
389. REFORM.—The panic of 1907 stimulated financial experts to attempt to remedy the defects of our banking system. In 1908 a monetary commission was appointed to investigate banking experience at home and abroad. As the result of this investigation it appeared advisable to establish a system which should secure some of the advantages of such centralized banking systems as have long existed in many European countries. A single central government bank was at first recommended by experts, but this was deemed politically inexpedient. In view of this fact resort was had to a compromise between a centralized and a decentralized system. This compromise was effected by the Federal Reserve Act of 1913.
390. FRAMEWORK OF THE FEDERAL RESERVE SYSTEM.—The Act of 1913 is administered by the Federal Reserve Board, consisting of the Secretary of the Treasury and the Comptroller of the Currency, ex officio, and five other members appointed for ten years by the President. The country is divided into twelve districts, in each of which there is located a Federal Reserve bank. In each district every National bank must subscribe six per cent of its capital and surplus for stock in the Federal Reserve bank, and thus become a "member" bank. State banks and trust companies may, upon the fulfilment of certain conditions, become member banks. Each Federal Reserve bank is governed by a board of nine directors, six of whom are elected by the member banks of its district, and three of whom are appointed by the Federal Reserve Board. The Federal Reserve banks are bankers' banks, that is, they do not ordinarily deal directly with individuals, but with member banks only.
391. ELASTICITY OF DEPOSIT CREDIT (RESERVES).—The piling up of bank reserves in New York is impossible under the Federal Reserve system. The reserves of any member bank do not ordinarily move beyond the district, for a member bank may count as legal reserve only those funds which it has placed on deposit in the Federal Reserve bank of its district. There exists what may be called district centralization of reserves; that is to say, all of the legal reserves of all the member banks of a particular district are concentrated in the Federal Reserve bank of the district, and can be utilized as a unit by that Federal Reserve bank. If in time of stress the total reserves of the district are insufficient, the Federal Reserve Board may arrange for the temporary transfer of surplus funds from one Federal Reserve district to another. This secures one of the most important advantages of a central bank without actual centralization.