The banks’ issuance of promissory notes

The other important form in which the banks utilize or sell their debts is that of bank-notes. A bank-note, like a bank deposit, is a bank’s promise to pay on demand. There are important differences, however.

The bank-note passes into general circulation; it passes from hand to hand without indorsement; it is engraved and printed in a way that makes it a convenient and a safe medium of exchange; in short, it really serves in hand-to-hand payments as part of the money of the community. Banks issue notes in very much the same way they make deposit credits, with, however, a few differences of detail. Some borrowers, as for example the manufacturer who has a large payroll to meet, may want cash rather than the right to draw checks. Or it may be that borrowers and other depositors are drawing so many checks upon a bank that its cash reserve is becoming dangerously low; in such a case, the bank may find it desirable to pay out its own notes over the counter in lieu of other money. In this case, what really happens is that a depositor who asks for cash is satisfied by having his deposit claim against the bank exchanged for another form of claim—the bank-note— which will serve his purpose as well as would any other sort of money.

The difference between deposits and bank-notes will concern us in other connections in later chapters. It is well that we should observe at this point, however, that, although they are alike liabilities or debts of a bank, the ways in which deposits and notes respectively are actually used creates problems peculiar to each. Thus, the depositor has an opportunity to acquaint himself with the bank’s reputation and with the character of its officials, and to learn what he can about its probable solvency before he intrusts his funds to the bank’s care. But if banknotes are to be in common use, if they are to pass from hand to hand, they must come into the possession of persons who have no knowledge of the particular banks which are responsible for them. It is for this reason more than for any other that certain governments, including that of the United States, have thought it wise to impose certain restrictions upon the issue of bank-notes while leaving the creation of bank deposits subject, within reasonable limits, to the discretion of the banks themselves.

Some of these matters we have been treating may be made clearer if the reader will glance for a moment at the statement of the condition of a typical national bank in a city of moderate size.

Table 33.1 Statement of the condition of a National Bank: September 12, 1925

Most of the stated resources and liabilities are self-explanatory. In the list of assets there will be noted United States government securities. Some of these this bank, as a national bank, is required by law to hold to cover its note issue of $100,000, which appears among the liabilities under the name “circulation.” In the cash the bank has on hand there is included its “exchange,” consisting of checks payable by other banks and other similar claims against them. Its “lawful reserve” under the present laws does not include all of its actual cash on hand, but consists wholly of deposit credit which this particular bank has in a federal reserve bank. Loans and discounts, it will be noted, constitute the most important item of the bank’s assets. This item designates the sum total of the bank’s holdings of the notes and bills of exchange of borrowers. Deposits, classified as demand and time, bulk as large in the bank’s liabilities as do loans and discounts in its assets.

Capital represents the original investments of the bank’s shareholders. The undivided profits are accrued earnings not yet paid out in dividends. For these, of course, the bank is liable to its shareholders. Profits come largely as the result of discounting and other lending and investment operations. Profits which the bank’s officials have not decided to pay out in dividends, thus reducing their cash or their other resources, but which instead they have determined to retain in the business as further investments of capital, are called “surplus.” Banks are required by our law to accumulate a certain amount of surplus. A large surplus is, generally speaking, a sign of strength. Where surplus is large the depositors’ claims are a smaller proportion of the bank’s liabilities than would otherwise be the case, and thus the depositor is better protected.

But sometimes a large surplus is a sign of weakness rather than strength. Bank officials, knowing that some of their loans are non-collectible, or that some of their other assets are not really worth the amount at which they appear on the statement, may be unwilling to put an increased strain upon the bank by paying dividends. The accumulated profits—really only paper profits because they depend upon an over-valuation of the bank’s assets—may be “passed to surplus” without arousing suspicion or without affecting the bank’s strength or weakness. A surplus as large as or somewhat larger than a bank’s capital is not uncommon and is, in general, an indication of sound banking. But a bank with an abnormally high surplus, four or five or even ten times its capital, is one that should be investigated rather carefully by a depositor before he intrusts his funds to the bank’s keeping. In general, however, we can congratulate ourselves that the standards of honesty in the conduct of the banking business are, as they should be, somewhat higher than the standards which prevail in most other types of business.

This is as it should be, we say, because the bank is in a very real sense a public trustee, performing an important and necessary public function.