Mobilizing banking credits
The drastic reform of the banking system of the United States
Possibilities of the federal reserve
In considering the factors responsible for the creation of the national wealth, statesmen and the public have often been far too prone to overlook the indispensable services of those institutions which assemble and distribute the credit resources of the country. Too often has the nation been depicted as merely a vast workshop in which the technique of physical production alone demands the thoughtful and continuous attention of the country’s best brains. But without an adequate mechanism of exchange, production cannot function to its fullest capacity. General Francis A.Walker wrote indeed without exaggeration that it was much more important to the people of London to possess stable exchange relations with other countries than to keep in repair its largest bridge across the Thames; and a contemporary American economist has remarked that if the world were stripped of its telegraph wires it would not suffer more than if business should be obliged to conduct its operations without the use of credit.
In a previous chaptera we have noted the condition of credit in the days of “wild cat” state banks, days in which the country was flooded with currency in the form of the promises-to-pay of banks, promises too often disregarded. When the national banking system was established, a remedy was found in the impositions of so heavy a federal tax on the issues of state banks that they rapidly disappeared from circulation. But despite the admitted service of the national banking system, one cannot but wonder at the calm subordination of banking requirements to temporary political considerations at the time of its establishment.
Except for the financial difficulties of the government in consequence of the Civil War, the national banking system would probably not have been born. In its extremity, the nation was prepared to accept a banking system organized primarily to strengthen the market for government securities. A bill fathered by Salmon P.Chase, Secretary of the Treasury, provided for the creation of a set of banks chartered under federal law; and, as security for their note issues, required to purchase bonds of the United States and deposit them with the Treasury at Washington. The successful banking system of the State of New York was taken, in a number of important respects, as a model. In this manner the government hoped to increase the market for its bonds.
But many of our institutions, illogically established, have in practice worked admirably. How was it with the national banking system? Before passing final judgment, it will be helpful to review the most prominent features of the act. In what respects did it build upon, and in what respects depart from the experience of earlier systems?
First, and of foremost importance, the act accepted the “currency” rather than the “banking” principle. These opposing viewpoints took root in earlier English banking experience. The currency principle stresses the analogy of banknotes to government paper money, while the banking principle emphasizes the similarity of the bank-note and the deposit. From the standpoint of the banks’ liability the banking principle secures its justification, for the note and the deposit are but different forms in which the banks extend their promises to pay.
But, on the other hand, advocates of “currency” principle argue that notes are apt to remain longer in circulation, and that harmful inflation of the currency was more likely to result from excessive issues of notes than from an expansion of deposits. In other words, the note possesses a greater currency function than the deposit, and its issue, it is accordingly argued, is attended with greater danger. The world had suffered in recent memory greatly from the irredeemability of government paper money. If, then, bank currency possessed the same inflationary possibilities, should it not be as strongly regulated by law? Should not the note issues of banks be more stringently restricted and guarded than their deposits?
This question was answered affirmatively in the National Bank Act. The amount of a bank’s note issue was made to depend upon the amount of government bonds deposited with the Treasury. Furthermore, note issues were limited to the amount of the bank’s capital stock. Finally, in case of insolvency, the government would assume responsibility for the redemption of the notes, but to safeguard itself, was given a prior lien on the assets of the failed bank. That is, in case of liquidation, the bank’s resources would first be made available for the protection of the noteholders.
A second significant feature of the new system lay in the fact that nowhere was there to exist a central board of directors able to exercise a control over credit conditions throughout the country. In this respect, the United States departed from the experience of European countries where cash reserves were centralized in great central institutions. When further funds were required, a local bank would secure them by turning over some of its holdings of debtors’ paper—their bills and notes—to the central institution. By raising or lowering its interest or discount rate, the directorate of the central bank can render it difficult or easy for the smaller banks to extend credit to their clientele. General credit conditions may thus to a large extent be determined by the single central institution. In the First (1791–1811) and the Second (1816–1836) United States Banks our country was fairly on the road to develop such dominating institutions, but these banks so aroused the fears and the hostility of the state banks and of the general public, that they were shipwrecked in the sea of politics. Public opinion in 1863 was not yet ready to sanction the reestablishment of any such all-powerful institution; nor was it willing to accept the dictation of any single central directorate. A federal officer, the Comptroller of the Currency, was at the head of the national banking system, but his duties were primarily administrative.
But even though it was not felt that the expansion of deposit credits should be restricted so rigidly as note issues, the national government was unwilling to leave the control of deposits entirely to the judgment and the discretion of the various individual directorates. Accordingly reliance was placed upon the unwieldy device of establishing by law certain minimum reserve requirements. That is, the upper limit of deposit credits was made to depend upon the amount of each bank’s reserve of cash.
But ought not some banks to hold larger proportionate reserves than others? Country banks customarily kept funds on deposit in near-by city banks; these in turn made deposits in the larger financial centers. Should not the banks which held in greatest measure the deposits of other banks be obliged to hold the largest reserves? Clearly such institutions would be subjected to the greatest strain in any period of credit collapse.
Accordingly by law the national banks were divided into three general classes. Banks in New York, Chicago and Saint Louis, the central reserve cities, were required to hold a 25 per cent cash reserve. That is, they had to have on hand an amount of legal tender money equal to one-fourth of their liabilities to their own depositors. Banks in other large cities of the country, designated as reserve cities, were also required to hold a 25 per cent reserve, but half of this might be in the form of deposits with banks in central reserve cities. All other banks, the “country banks,” were required to keep only a 15 per cent reserve, and deposits in banks in reserve cities or central reserve cities might count for three-fifths of this amount.
Editors’ note
a Chapter 32 of the Grolier Book of Popular Science entitled “Monetary System of the United States” (included in this selection as Chapter 34).