The guaranty of bank deposits

Preface

This series of books owes its existence to the generosity of Messrs. Hart, Schaffner & Marx, of Chicago, who have shown a special interest in trying to draw the attention of American youth to the study of economic and commercial subjects. For this purpose they have delegated to the undersigned committee the task of selecting or approving of topics, making announcements, and awarding prizes annually for those who wish to compete.

For the year ending June 1, 1919, there were offered:

In Class A, which included any American without restriction, a first prize of $1000, and a second prize of $500.

In Class B, which included any who were at the time undergraduates of an American college, a first prize of $300, and a second prize of $200.

Any essay submitted in Class B, if deemed of suflBcient merit, could receive a prize in Class A.

The present volume, submitted in Class A, was awarded second prize in that class.

J. Laurence Laughlin, Chairman

University of Chicago 3. B. Clark

Columbia University Henry C. Adams

Washington

Author's Preface

The guaranty of bank deposits is a part of the larger question of the guaranty of bank credit. Bank credit is an elemental thing consisting of purchasing power which a bank manufactures. This credit manifests itself in two forms, namely, bank notes and bank deposits. The first chapter of this essay deals with the nature of bank credit. In this chapter no attempt is made at an exhaustive discussion — the attempt being made simply to show the general nature of this phenomenon and its significance in the modern world. The second chapter deals with the guaranty of bank credit. In this chapter the characteristics of the two forms of bank credit are set forth and a description is given of the safeguards that have been thrown around each. With this broad view of the nature of bank credit and the relationship existing between bank notes and bank deposits, the way is cleared for a better understanding of the strength and the weakness of the foundation upon which bank-deposit guaranty rests.

In succeeding chapters a statement is given of the framework and the operation of the guaranty laws in the various states. The narrative endeavors to present what has occurred in each state. But attention is especially called to the fact that as each state is considered no attempt is made to weigh, in the light of the experience of that state, the much-mooted questions of bank guaranty. The discussion of these questions is deferred to chapter viii, where the testimony, gathered from all the states, is brought together and collated for the purpose of showing what light is thrown on these issues.

X AUTHOR'S PREFACE

Finally, the reader is warned that this subject is still surcharged with controversial heat. It yet gets "vitriolic attack or sublimated adulation." Time having not yet furnished a perspective, no one can be certain that he is free from that bias which is so fatal to scientific work.

In the preparation of, this little book I am deeply obligated to many persons. Most of all am I indebted to Professor Fred R. Fairchild, of Yale University, at whose suggestion the study was begun and whose advice has greatly influenced the general method of development. Professor R. B. Westerfield, of Yale University, has read the entire manuscript and I wish to acknowledge with gratitude his invaluable assistance with every chapter of the book. I am also under special obligation to Mr. Thornton Cooke, president of the Columbia National Bank of Kansas City, Missouri, for reading the manuscript. Mr. Cooke is well known as the closest and safest student of the guaranty movement, and he has given me many suggestions that I have incorporated bodily into the work. Finally, I am indebted to Professors A. B. Adams, Jerome Dowd, and J. R. Cable, of the University of Oklahoma, for going over my work and giving helpful criticism.

Thomas Bkuce Robb

Contents

I. The Nature op Bank Credit 1

II. Government Guaranty op Bane Credit 7

in. The Oklahoma System 20

Chapter I The Nature Of Bank Credit

Society is best served when its working capital is directed into the hands of those persons best fitted to use it. This is the transcendent service of a bank. A commercial bank collects the temporarily inactive funds of innumerable individuals, and, upon this as a foundation, creates its own superstructure of credit which it places at the disposal of other individuals seeking short-term loans. These lenders and borrowers can get together effectively only through the instrumentality of a bank. Borrowers want substantial sums for certain periods of time; but the surplus capital of a community is in small amounts scattered in many hands. In this shape it is utterly useless to the borrower wanting large sums for stated periods. The commercial bank does much more, however, than simply come between these two parties and bring them together; it marshals these innumerable driblets collected from lenders, and, using them as a basis for its credit, multiplies manyfold the purchasing power that may be placed at the disposal of borrowers. A bank thus not only economizes the capital of a community, but also at the same time performs the inestimable service of selecting those persons best fitted to use it. Society has recognized this service, and the bank, holding its commission in common with other corporations from the government itself, is permitted the profits of the business as a remuneration for its services.

As suggested in the foregoing paragraph, the object of the bank is primarily not to reloan the collected funds, but rather to use a part of them as a reserve on which to extend . its credit. This reserve, of course, is not the real basis of bank credit, but because of legal requirements it serves rather as a limit to the credit-manufacturing process. The bank makes its credit greatly enlarge the efficiency of capital; but by skillful banking it is able to make one dollar in its reserve support many dollars in credit. In this way it greatly increases its loans and so its profits and at the same time multiplies the productive forces of the community. Thus a bank is commonly described as a manufacturer of credit. Macleod says that the mystery and confusion of banking is cleared away by simply observing that a bank is merely a shop for the sale of credit.* It now remains to show more fully the nature of this bank credit.

When a customer pays in money to his account with his banker, he cedes the absolute property in the money to the banker and receives in exchange for it a Right of Action, or Credit, or Debt, to demand an equivalent sum of money at any time he pleases, but not the identical money.^

As this quotation shows, from the legal point of view the banker gains a property right in his customer's deposit, but the depositor retains the right to draw on demand. The depositor, by putting his money in the bank, admits by implication that he is not going to use it at once; otherwise he would never have deposited it in a bank. The banker finds that daily his depositors are drawing checks against their accounts. But at the same time others are bringing in money and depositing. By actual experience he finds that this inflow and outflow of money practically cancel each other, while his cash account stands almost untouched. "The banker's cash is, therefore," says Macleod, "like a column of gold with a slight ripple on the surface." ' The banker is quick to see the possibilities of this situation — possibilities greatly enhanced by the modern check system.

1 The Theory of Credit, p. 606. ' Ibid., p. fi94. ^ Ibid., p. 691.

THE NATURE OF BANK CREDIT S

It is evident that in loaning a large part of these accumulated funds there is a source of profit for the bank. But the bank can do even better yet by using such of the funds as are cash as a reserve for the extension of its credit. Farmers, merchants, and manufacturers come to the bank seeking loans. The prospective borrower gives to the bank his note, possibly secured by a mortgage on personal property or other collateral, for the loan. What he really does is to sell this credit instrument to the bank, and the bank, instead of actually giving him money to the amount stipulated, gives him a book credit with the right to draw that amount. This, of course, is a deposit, but instead of being occasioned by the customer depositing money with the bank, it was in fact occasioned by a creation of bank credit which the customer accepted from the bank in lieu of cash when it purchased his note. The bank continues this loaning process until its deposits are, say, five or six times its cash account. Thus an insignificant part of the commercial deposits is created by the deposit of money; the great majority of them is created by the granting of loans. It is patent that if the borrower demanded cash over the coimter, the bank's loaning power would soon reach its limit. But in the large majority of cases, especially where large sums are involved, a checking account is much more convenient to the borrower and it is infinitely more profitable to the bank. To the bank the checking system is largely a transfer of the right to draw from one account to another. If the bank cannot effect this operation on its own books, the banks among themselves accompUsh it through the clearing-house. In this way the checking system, by economizing the bank's cash accoimt, greatly extends the field of bank credit and thereby enhances the profits of the business.

Such is the manner in which a bank manufactures credit. Back of this credit is a small percentage of cash and the tangible assets of all those persons to whom the bank has granted loans. The bank draws interest on the individual credit that it has bought, and as it generally exchanges therefor its own credit, it thus in effect draws interest on its own credit and consequently finds the credit-manufactiu-ing process a lucrative business. Since the manufacture of credit is not an expensive process, there is naturally a temptation to extend the operation as far as possible. The question at once arises, how far can this operation go? The answer to the question is found in the nature of the deposit. A deposit is a right to draw on demand and the bank cannot extend its credit transactions beyond the point where it is able to meet them on demand. It is here that the technique of banking appears. Since a banker must hold himself ready to meet his deposit-liabilities on demand, it is evident that he must not permit his assets to get beyond the point where he is able to supply cash. Short-term loans are therefore dear to the heart of the cautious banker and it is his constant concern to keep their dates of maturity well distributed. Thus the banker will find his depositors presenting checks, many of which must be satisfied with cash, but by skillful marshaling of his assets he brings it about that his maturing loans furnish him a stream of money for this purpose.

So much as to the natiu-e of bank credit. It is now possible to see the service a bank performs as an insurer of individual credit.

The borrower took his own credit to the bank and exchanged it at a discount for the credit of the bank, namely a bank deposit. The borrower took to the bank his own promise to pay money; he bore away from the bank the bank's promise to pay money.^

The reason the borrower was willing to exchange at a discount his own credit for that of the bank was the fact that the bank's credit enjoyed a wider acceptability. As Professor Fisher says:

I Johnson, Money and Currency, p. 45.

THE NATURE OF BANK CREDIT 5

Through banking, he who possesses wealth difficult to exchange can create a circulating medium based upon that wealth. He has only to give his note, for which, of course, his property is liable, get in return the right to draw, and lo! his comparatively unexchangeable wealth becomes liquid currency. To put it crudely, deposit-banking is a device for coining into dollars land, stoves, and other wealth not otherwise generally exchangeable.'

The bank thus makes a business of studying individual credit and one of its great services to the pubHc is its ability and willingness for a given remuneration to substitute what White calls its well-known credit for the individual's lessknown credit.^ President Hadley calls this operation the insurance of credit:

It [the bank] may be said to insure credit. If it discounts a three months' note and allows the maker to draw checks upon the sum with which it credits him, it protects the public, which accepts such checks, from the risk of subsequent insolvency on the part of the maker. It is because this insurance is effective that the public will accept checks where it will not accept promissory notes.'

Bank credit touches intimately the life of every individual. As civilization becomes more differentiated, the production and distribution of goods on which it rests become more intricate. Bank credit is the unguent which lubricates this ponderous machine by which society is sustained, for "the banking system of the country stands at the center of the market," and "it is the market that holds the center of the industrial field and gives to business, however specialized, its unity of purpose." * It is evident, ) therefore, that anything which gives stability to bank credit is at the same time giving stabiUty to the foundations of society itself.

The development of bank credit has proved a great boon

' Elementary Principles of Economics, p. 173.

' Money and BanHng (5th ed.), p. 202. ' Economies, p. 245.

* H. C. Adams, Description of Industry, p. 154.

to mankind, but it is a blessing that cannot be abused with impunity. As abeady indicated, commercial banks build their credit on a community's deposits. In a sense they become the trustees of this capital, and when this trust is abused either through dishonesty or incompetency, the public is the large sufferer. Dishonest bankers may build up large deposit accounts, make a wrong use of them, and rob the conmiunity. Incompetent bankers may be the victims of dishonest and reckless borrowers with the same result. Bank credit, extended to assist in a productive process, is sound and wholesome only when that process ripens into goods which will liquidate the loan. Crop failures, fires, interrupted transportation, and other unforeseen calamities may intervene and upset the best of calculations. The banker, after all, is only a human being, and speculation in its various degrees is his most insidious temptation. This is a situation fraught with great pubhc danger, and nowhere has this danger been greater than in the United States with its adherence to the democratic principle of free banking. Bank notes and bank deposits are the two forms in which bank credit manifests itself, and since the bank as a corporation holds its commission from the government to engage in this business peculiarly affected with a public interest, the government attempts to guard the public from the dangers of these two credit instruments. With this view of the nature, the importance, and the dangers of bank credit, we pass on to a consideration of the safeguards that have been thrown around bank notes and bank deposits.

CHAPTER n

GOVERNMENT GUARANTY OF BANK CREDIT

The world's representative banking systems are in agreement that note issues must have adequate security. The Bank of England, with a few unimportant exceptions, has a monopoly of note issue. It is permitted to issue up to about $90,000,000 in notes which must be secured by government bonds. Beyond this, notes can be issued only on gold which is held in the vaults of the Issue Department of the Bank.' In Canada the notes of the banks are secured by a prior hen on the general assets of the banks plus a five per cent guaranty fund.^ The Bank of France enjoys a monopoly of note issue which is regulated by the law of Napoleon, namely, that notes must be covered either by coin held by the Bank, or notes secured by collateral and two signatures, or by notes signed by three responsible persons.^ The German Imperial Bank and other German note-issuing banks are required to hold in their vaults gold or government gold certificates to the amoimt of one third of their circulation. The balance of their circulation must be covered by discounted notes that bear the names of two good solvent parties.^ In the United States, under the old national banking system, the national banks alone were permitted, without the burden of a prohibitive tax, the privilege of note issue. These banks were required to purchase United States bonds, and upon depositing them

* White, Money and Banking (5th ed.), p. 372. Of course this statement regarding the Bank of England as well as the other foreign banks refers to normal pre-war conditions.

' Interviewa on the Banking Systems of Europe, National Monetary Commission, p. 195.

' The Reichsbank, National Monetary Commission, pp. 69-70.

with the United States Treasury were permitted to issue notes upon them. In addition to this a gold deposit equal to five per cent of the note issue must be made with the Treasury. With these bonds and the five per cent redemption fund to protect it, the United States Treasury redeems on demand the bank notes that may be presented. The federal reserve notes, issued under the federal reserve system, are covered by an equal amoimt of collateral f lu-nished by the member bank desiring these notes. This collateral must also bear the endorsement of the member bank furnishing it. The federal reserve bank issuing the notes must hold back of them a gold reserve of not less than 40 per cent. In addition to this the notes are obligations of the United States Government.* Thus the leading governments of the world secure note issues either by the deposit of gold, the deposit of other unquestioned collateral, or by a prior hen on the general assets of the issuing bank. From this it is seen that the universal practice is to guard the note issues so strictly as almost to preclude the possibiUty of loss to the individual.

As regards deposits, on the other hand, the policy is quite the reverse.^ In foreign countries governmental regulation is the exception rather than the rule, and the whole matter of reserves, capital, and other banking regulations is left with the banks, working under the law of self-preser-

^ The Federal Reserve Act, section 16.

^ "Publicity is alone sufficient, in the case of the great monopoly banks of issue, to aSord reasonable safeguards against unsound banking and undue reduction of reserves. The cash reserves of these banks, their loans, and their relation to their deposit liabilities are promptly telegraphed around the world and have become a barometer of monetary conditions which is eagerly awaited from week to week in every financial center. They ,are scanned constantly by the most expert financiers and economic students as well as by business men and officials of the government. Government supervision of the monopoly banks of issue is practically limited to the requirement that these reports shall be made, since the reports themselves afford the evidence that the reserve and the character of securities held are in accordance with the character of the bank." Couant, The Principles of Money and Banking, vol. ii, pp. 102-03.

vation, to adjust as their needs demand.' The United States has gone much farther than foreign countries in this respect, the necessity for this action being well stated by Professor LaughUn:

Where the business of banking is not a monopoly, but is thrown open to any group of persons who may wish to enter it, that is, under a regime of so-called free banking, there will probably be a few failures from time to time. Under a system where the business is concentrated in a few hands, risks are less and those which exist are met by larger resources. Above all, the best of experience and business judgment is in charge of affairs. There is little more likelihood of the failure of the strong financial institutions of the world, such as the banks of France or England, than there is of the failure of all, or a large proportion of, the banks in the national banking system — an occurrence scarcely more to be anticipated than the breakdown of the whole business commimity itself. This absolute security, obtainable by committing the business of banking to one or to a few large financial institutions, is sacrificed under a system of free banking like our present one. This is the price paid for freedom of opportunity to engage in the business.^

As this quotation indicates, the United States, in her zeal to preserve freedom of opportunity in the banking business, has greatly increased the danger to the depositing public. All through American history this danger has been a very real one. Here almost every section of the country has experienced a phenomenal growth in its day, and the activities of banking have been intimately connected with this rapid expansion. A spirit of optimism and speculation is always present in such boom times, and when the banks become infused with this spirit, the public is exposed to great danger. At times heavy losses have caused much pubhc hardship, and there has been much state interference in behalf of the depositor.

* Belgium seems to be an exception to this statement. "In Belgium a reserve of gold and gold bills equivalent to one-third of note issues pius deposits is required." Barker, The Theory of Money, p. 40.

' Report of the Monetary Commission, 1898, p. 237.

In this country the law has erected a formidable and complicated system to protect, either directly or indirectly, the depositor. Under the old National Banking Law, the law regulating reserves divided the banks of the country into two groups, namely, the reserve city banks and the country banks. The reserve city banks were divided into two classes. Those in the central reserve cities — New York, Chicago, and St. Louis — were required to keep a reserve equal to twenty-five per cent of their deposits. The banks in the other reserve cities had also to keep a twenty-five per cent reserve, but one half of this might be kept with the central reserve city banks. The country banks had to keep a reserve equal to fifteen per cent of their deposits, but two thirds of this might be deposited with the central reserve or reserve city banks. The new Federal Reserve Act has reduced considerably these percentages, but has centralized the reserves in each reserve district instead of concentrating them in one or two large cities. Much the same reserve regulations for state banks are found in the various states. This complicated reserve requirement is a direct legal safeguard to protect the depositor. Stringent laws regulate the size of loans which may be made to individuals, directors, or other bank officials. National and almost all state governments maintain highly trained corps of bank examiners, who periodically examine the condition of the banks.* Publicity of statements is required, so that he who runs may read. In case of failure each stockholder in national banks and in many of the state banks is liable to double the amount of his stockholdings. Professor Laughlin has estimated ^ that the capital, surplus, undi-

' "The American system of examination is the most thorough in the world. This has been a natural and almost necessary outgrowth of the fact that the system is the most widely extended and contains the largest number of small independent banks. Safety, therefore, could be less easily seciu-ed by reliance upon the action of the banks themselves than in the countries where the number of banks of issue is comparatively limited." Conant, The PriruAples of Money and Banking, vol. ii, pp. 104-05.

* Banking Progress, p. 118.

vided profits, and stockholders' double liability alone constitute a cash insurance fund of forty-five per cent of individual deposits. This fund, in connection with the legal reserve requirements, and other banking regulations, has built up such a bulwark around deposits that, since the establishment of the national banking system, the average annual loss to depositors in national banks has amounted to only one twentieth of one per cent of their deposits.*

However, the smallness of this average rate of loss cannot be accepted as a criterion by which to measure the amount of suffering caused to the public from losses occasioned by bank failiu-es. This rate represents only the loss in national banks. Undoubtedly, if a composite rate could be made from the losses occasioned through state banks, it would be much greater. But whatever this rate may be, the fact remains that these losses have not been distributed over this long period of time and among all the depositors of the country in proportion to this average rate, but have fallen at certain times upon certain individuals and communities and have been matters of much serious concern. The fact remains that the government does not give the depositor the same protection which has been given to the note-holder, and the possibility of loss is such a nightmare to the public that a banker's reputation for safe and conservative banking is prized more by him than silver or gold.

One reason for the different policy pursued as to the security for bank notes and for bank deposits is that legislators and the public have regarded the two activities as being essentially different in nature. This confusion is probably due to the different historical development of the two phases of banking. Banks and note issues have always gone together in American history. From early colonial days there was a great scarcity of specie, and it was the crying need of a medium of exchange which prompted the establishment of the fijst banks in the colonies. The old land 1 Report of the Comptroller of the Curreney, 1907, p. 27.

12 THE GUAKANTY OF BANK DEPOSITS

banks of Massachusetts and similar banks in Pennsylvania confined their activities exclusively to the issue of their notes. When the abuse of this power prompted an act of Parliament suppressing the issues, this action was made one of the grievances of the colonies against the British Government. At that time banks issued their credit almost exclusively in the form of bank notes.* The fact that these bank notes were a medium of exchange, and that any insecurity in them was fraught with great public danger, early impressed itself upon legislators.

In 1829 the Safety-Fund Banking System was inaugurated in New York State. It provided for a special fund to guarantee all the debts of the banks. The intention of the law was to provide security for note issues. At that date deposit banking was so little developed that the framers of the law apparently overlooked the fact that bank debts might also be occasioned by deposits.^ It was in the period immediately following the enactment of this law that deposit banking began to assume its modern proportions. In New York between 1836 and 1860 the notes of the banks increased only fifty per cent, while in the same period the deposits increased over seven hundred per cent.^ The panic of 1837 caused widespread bank failures, and the debts of failed banks were such that the safety-fund system broke down imder the strain. The New York legislature then realized that the growth of deposit banking had made "all the debts of the banks" consist of something besides those

' "The abuse of banking led, of course, to a condemnation of the forms most in evidence; this accounts for the fact that down to the Civil War statutes regulating the excesses of banking related chiefly to note issues, as if they were the only forms of currency created by banks; while the deposit currency has been wholly ignored. In fact, to the present day in our country, there is a prevalent belief — which has come down to us from the earlier decades and from radically different conditions — that the operations of a bank can be effectively controlled by regulations applied to note issues." J. Laurence Laughlin, The Principlea of Money, p. 140.

2 Safety-Fund Banking System, National Monetary Commission, pp. i7i, 385. Also, Knox, History of Banking, p. 409.

' Safety-Fund Banking System, National Monetary Commission, p. S85.

occasioned by note issues. It immediately amended the law specifying that the fund should cover only losses arising from note issues. The New York legislature seemed to regard note issues and deposits as essentially distinct in nature. It seemed to feel that note issues must be sacredly guarded by law, but that deposits were solely a matter between the individual and the bank. The same philosophy appeared at the creation of the national banking system in 1863. Note issues were so guarded as practically to preclude the possibility of loss, while the safety of deposits was left to depend on the partial security abeady described.

But this distinction between bank notes and bank deposits has little justification in fact. Writers have repeatedly pointed out the similarity of the two instruments. Says Professor Fisher:

Besides lending deposit rights, banks may also lend their own notes, called "bank notes." And the principle governing bank notes is the same as the principle governing deposit rights. The holder simply gets a pocketful of bank notes instead of a credit on his bank account. The bank must always be ready to pay, on demand, either the note holders — i.e., to "redeem its notes" — or the depositors, and in either case the bank exchanges a promise for a promise.'