Some aspects of banking theory

Preface

In the study which follows, an attempt has been made to select for detailed analysis certain aspects of the institution of banking which it is believed are of fundamental importance for an understanding of the role which banking plays in modern economic society. The aim has not only determined the general character of the topics discussed, but has also set definite limits to the scope of the study and to the problems which are considered. The operation of the banking system as a whole is of interest, rather than the question of its technical organization, while for the purpose at hand the reserve problem is of little consequence, and neither it nor the influence which the banking system may exert upon general prices has been discussed at length. The aim has likewise influenced the method of treatment. The analysis proceeds almost entirely upon the real as distinguished from the pecuniary level, and the psychology of credit has not been considered. At the same time, however, due attention has been given to the evolutionary character of the modern institution of banking, and the assistance obtained therefrom in arriving at a better understanding of the institution itself. Inasmuch as the purpose has been primarily constructive rather than critical, mention has been made of other writers only incidentally, in connection with the discussion of specific problems. No attempt has been made to indicate those who

8 PREFACE

originally formulated the various doctrines mentioned, and there is given merely the statement which is believed to be

best suited to the purposes of the particular discussion.

The writer is indebted to Mr. H. Parker Willis, Professor

of Banking in Columbia University, for reading tentative

drafts of several parts at an early stage of the work, as well

as for reading the completed manuscript, and making many

helpful suggestions. Acknowledgment is also due Dr.

H. R. Seager, Professor of Political Economy in the same

institution, for reading the first six chapters, and making

suggestions on certain points.

Chapter I The Evolution Of Hanking

PAGE

1. The institution of banking 11

2. The Middle Ages 15

3. Banking and the currency system 21

Note and deposit currency 24

4. Rise of commercial banking 26

5. Rise of investment banking 32

Chapter II

1. The definition of banking 34

2. Banking as commerce in capital 38

3. The economic process 40

4. Temporary and permanent capital requirements 43

Commercial banking and investment banking 45

5. The Pool of commercial financing and the pool of invest-

ment financing 46

Chapter III

1. The pool of commercial financing 49

2. Lower level of the analysis 53

Coalescence of capital supply and the currency system.. 54

3. Commercial banking as center of the commercial credit

system 55

4. Analysis of constituent funds on the lower level 58

5. Relation between the two levels 60

Extension and cancellation of commercial banking credit. 61

6. Veblen's doctrine of the loan fund 65

Chapter IV Some Further Aspects Of Commercial Banking

1. Guaranty function of commercial banking 68

Anticipation of the future 70

2. The collateral loan 72

3. The line of credit 77

CHAPTER V SOME FURTHER ASPECTS OF COMMERCIAL BANKING {Coflt.)

1. The extractive stage in the economic process: agriculture 82

2. Relation of commercial banking to an enterprise embrac-

ing several stages 87

3. The final stage: consumption good 89

Capital good 92

4. Financing of futures 94

5. Theory of commodity speculation 96

6. Volume of speculation 101

7. Summary 103

Chapter VI

1. The pool of investment financing 107

2. Service of security speculation 112

3. Investment banking types 116

Extension of investment operations 121

5. Commercial loan versus call loan 126

6. The theory of banking 132

Chapter VII

1. Banking as center of the credit system 135

2. Control in the pool of commercial financing and in the

pool of investment financing 136

3. Inter-system control 143

4. Price effects 150

War finance 153

5. Banking and the business cycle 155

Chapter I

1. The general economic conditions of the age mold the special economic institutions which exist The institution of banking is no exception to this precept. Thus it is necessary to trace what for us are the later stages in economic evolution in order to understand the evolution of banking. For evolution it is ; there is an organic process, not a mere series of disconnected events. Just as the life of an individual may be conceived of as a process of progressive selfrealization, so also does the life history of an institution reveal a progressive unfolding ; the process, apparently haphazard, its course often at present not discernable, is yet purposive. There are ends towards which the stream is flowing, although when the ends appear in a measure to be attained, perhaps even before, the ends themselves appear to fade, and a new goal, the child of the new conditions, peers above the horizon. Such is the story of the development of banking.

Banking represents basically a specialized technique in the supply of capital. In the struggle with nature, man has found it necessary to arm himself with certain technical equipment, which grows more and more elaborate with the passage of time. With the increase in the complexity of the equipment, the task of obtaining it assumes larger proportions. The individual must cease to rely solely upon his own efforts and his own resources; instead, a cooperative feature is introduced. Waiving discussion of possible hypothetical situations in a primitive economy, the development of this upon any considerable scale implies the use of what we generically term "money," as well as the institution of certain legal relationships, either express or implied. This cooperation may take a form typified either by the loan or by the partnership or company. The increase in the scale of enterprise, with its need of increased resources, at once creates a greater demand for service in obtaining funds, and at the same time increases the difficulty of the task. In consequence, specialization — a universal rule of economic life — develops. A specialized institution — banking — is gradually evolved. The purpose for which the intermediary is created may conveniently be considered as two-fold: either to assemble and transmit part or all of the permanent capital equipment required by the enterprise, or instead to assemble and transmit merely part or all of the circulating capital required,1 in which event both the operation to which the funds are applied and the length of the loan are relatively restricted. Gradually there arises recognition of the fact that cooperation of the second kind may be effected among the business community as a whole, which then acts both as recipient and as source of supply of the circulating capital required, rather than merely as recipient of capital supplied by a distinct class of investors. With economic advancement comes advance in the methods by which cooperation is effected, and the cooperation becomes more widespread, at the same time that it becomes more sharply differentiated from cooperation of the other variety. In short, banking itself becomes two-fold; the institution of

*The permanent capital equipment of course may consist of both fixed and circulating capital, as in the case of the manufacturing enterprise, or largely of circulating capital only, as in the case of the wholesale house. For a discussion of fixed and

circulating capital, cf. Ch. II, Section 4.

commercial banking must be clearly distinguished from the institution of investment banking.

But this is by no means the entire story. Banking as we know it today is a blanket term. Moreover, it is rather a modern conception. Certain of the technical methods have undergone great change, while new ones have been developed. True, the loan, the note and the deposit are with us yet, but the resemblance is in many ways more apparent than real. In their modern form they represent rather the result of the progressive adaptation of old devices to the needs of the modern situation as it has developed. In assigning to the term banking its modern connotation, we may say that under earlier conditions banking did not — could not — exist. It may be said to represent the historical time coalescence of several classes of business which have had a mutually more or less independent historical development. To employ the familiar illustration, commercial banking involves simultaneously supplying of capital and purveyance of currency. Moreover, the institution itself has become Janus-faced; in performing the one service it automatically performs the other. The details we shall see in the pages which follow. Suffice it to note at this point that the Janus-faced character is due in large part to the fact that this development has in general followed the line of social least resistance. With the rise of new social wants, it is often found that the simplest method of satisfying these wants is thru the adaptation of an existing institution, the interests of which are somewhat akin, rather than thru the creation of a new institution. At the same time that the process of integration goes on, a process of differentiation occurs. There is a sort of ceaseless ebb and flow; various strands are continually joining together, and just as continually otiiers are splitting off. Our study consists in carving out a period in time, commencing sufficiently prior to the present situation to enable an intelligent understanding of the conditions now existing. We consider how the various strands at present joined together have come to make up the current situation, at the same time that we take cognizance of the strands which have broken away. The central problem is to attempt to visualize the present situation; to understand what the institution of banking is, and what it is doing. But this involves a consideration of how it came to assume its present form; only by reference to its historic origins can it be understood. Hence the present chapter.

In consequence, too, the historic problem before us shifts. For the problem in hand, the conventional discussion of the history of banking affords little aid. The most significant thing is by no means the etymologic derivation of the word "bank," whether from "bench" or from "pile" or "heap." Nor does detailed description of the methods employed by the Argentarii, the Fugger, the goldsmith bankers and others suffice. In short, the problem is not one of structure, but one of function.2 Banking then will concern us, rather than the bank. Attempted distinction along structural lines, while it has been the general rule in the treatment of economic phenomena in the past, due perhaps to the greater obviousness of structure as compared with function, is not only arbitrary, but misleading as well. Slight reflection will serve to show that the accuracy seemingly obtained must needs be specious. That human relationships and the institutions which express these relationships, are complex, is a truism. The theory of multiple correlation must be applied; linear correlation does not suffice. Social, and more particularly for one purpose, economic institutions are pro-

2 The functional concept is well illustrated by the problem of the shares in distribution as contrasted with both personal distribution and the ethical appraisal of the shares often attempted. Another instance is afforded by J. B. Clark's units of productive power as contrasted with the actual workers themselves.

ducts of evolution, and this, as just indicated, has been along the line of social least resistance. While a given structural product thus has a basic economic function, subsidiary activities, which later may attain coordinate rank, are often added, the outlines are blurred as a result, and soon lost. The economies of large scale operation, for example, may in certain cases render desirable the addition of a fiduciary department by a bank doing chiefly a commercial business, and vice versa. Or, again, the performance of the basic function necessarily implies certain methods of performing the same, some of which may be employed by other classes of organizations having vitally different basic functions. The structural cleavage, in other words, need not correspond to the functional.

The immediate problems before us are two-fold: in the evolution, how have the functions which are now performed by the institution of banking come together, and how have the detailed methods of performance, that is, the technique, involved therein, developed?

2. The modern institution of banking has its roots in the Middle Ages, and accordingly there our study must commence. With the cycle of economic life which had its culmination in the eternal city on the banks of the Tiber we need not detain ourselves. Likewise, for the purpose at hand the centuries preceding the Crusades may well be denominated the Dark Ages, though perhaps this is due to our lack of knowledge. But we accept the heritage which the twelfth century had from its predecessors, and at that point commence our contemplation of the factors in the everchanging situation which bear a more direct relation to the present situation.

The attempt has often been made, in particular by the members of the German historical school, to select one definite criterion by means of which to distinguish the various stages in the process of economic evolution.3 In genera, differences represented are primarily in the angle fro.n which the phenomenon is viewed. Each gives a partial picture. For the present purpose we may well recognize tie validity of the contentions of the partisans of each of tie divergent criteria. Banking, as we have seen, presents many phases, and in its development is related more closely now to this, now to that aspect of general economic development. In short, we require, not a choice from among, but rather a synthesis of, existing criteria. We must, however, select from the multitude of facts available, and have confined ourselves strictly to those most pertinent to the problem at hand.

For the student of banking, the outstanding feature of the earlier Middle Ages is the lack of structural differentiation between capital supply and commerce. Only later do we find business enterprises whose operations may be

3 Among more recent discussions of the problem may be mentioned that in the opening pages of Liefmann, Beteiligungs-u. Financierungsgesellschaften, Zweite vermehrte Auflage, Jena, 1913, where the author attempts to lay the theoretic foundation for his later study of financial organizations. In contrast to his view, which regards the problem as one of changes in capital forms, may be mentioned that of Commons, A Documentary History of American Industrial Society, Vol. Ill, Cleveland, 1910, Introduction, where the influence of markets upon the form of economic organization is stressed. In justice to the authors mentioned, it must be stated, however, that both represent rather an attempt to select a criterion believed to be of special significance for the solution of the particular problem at hand, and not an attempt to set up a general criterion of economic evolution. Mention need only be made, among older discussions, of the controversy raised by Bruno Hildebrand's attempt in his Natural-, Geld-und Creditwirtschaft, Jahrbucher fur Nationalokonomie und Statistik, Zweiter Band, 1864, pp. 1-24, to find the criterion in exchange, and thus dividing the stages into natural, monetary and credit economy.

termed purely financial. Perhaps the best known illustration of the transition is afforded by the Italian and Upper German merchants, which development, Ehrenberg tells us, had been practically completed by 1640.4 The same phenomenon, however, may be observed time and time again, principally according to the degree of economic advancement, though also according to the availability of the existing organization, as in the case of the goldsmith bankers or the London acceptance houses. In short, in point of time there is no absolute line of demarcation possible; each nation, we may almost say, has had its Middle Ages. As Dunbar has pointed out,5 a distinct hierarchy move across the stage — the Italians (and Germans), the later Dutch, and the still later English, each economically representing the same stage of development.

Simultaneous with this transition is the general development of the forerunners of various of the technical devices which are familiar today. Loan and deposit, as is well known, are two objective sides of the same phenomenon. The recognition of a class of deposit as distinct from loan marks an advance, in that it represents the recognition of a distinct organization which administers these deposits. In the early Middle Ages, the deposits received by the great mercantile houses, while all representing savings, originated from several sources — the shares of retired or deceased partners retained in the business, and in some cases funds obtained from relatives and friends of the house, both bearing a fixed rate of interest, also sums obtained from the clergy and larger capitalists, as well as from widows and orphans. These deposits were used in the ordinary course of the business, to a considerable extent in trading in goods

* Das Zeitalter der Fugger, Jena, 1896, Vol. I, p. 378.

5 The Bank of Venice, Quarterly Journal of Economics, Vol.

of various descriptions handled by the particular enterprise. In other words, these houses themselves obtained from other classes by means of the deposit principle part of the capital they required.6 The depositor may be said to have been a species of bondholder repayable on demand, though possessing no special security. An investment operation is represented. It is interesting to observe that this device was also employed in public finance as well as in private.7 Considerable risk is, however, involved in the procedure. The development was essentially empirical, and it is not surprising to find that the method of trial and error often led to serious difficulty.

The loans which were made in addition to direct employment of funds in ordinary business operations, were represented largely by advances to Government. From one point of view, such loans may be considered merely as the financing of one particular class of enterprise. Although of overshadowing importance at the time, this early relation of banking to the fiscal needs of the State may be dismissed briefly. What is now recognized as an evil, necessary, but nevertheless an evil, was then regarded as highly advantageous. As the potentate has given way to the modern State, so also have the fiscal needs of Government become subordinated to the general social welfare. The State now ordinarily takes its place in the loan market upon the same

VI, 1892, pp. 308-335. Reprinted in Economic Essays, New York, 1904, pp. 143-167.

6 Cf., e. g., Dunbar, Economic Essays, op. cit., p. 149. The best evidence .however, is afforded by a study of the balance sheets presented by Ehrenberg, op. cit., in his description of the operations of the various houses.

7Cf. Ehrenberg, op. cit., Vol. II, pp. 78, 274, 309, for instances of employment, both actual and contemplated, principally by the French crown.

basis as other borrowers ; except in times of great immediate need, it does not dominate the general financial situation. This has involved the disassociation of banking and public finance; the latter represents one of the shoots which has split off as increasing specialization has developed.

The other form of loan is typified in the bill of exchange, and in a two-fold way.8 From one point of view it represents a raising of funds by the process of the finance bill rather than through the deposit, and as such is a technical banking device ; from the other point of view, it represents the commercial transaction. By both these means, pooling of the circulating capital of mercantile enterprises is effected; the house with surplus capital at the moment relinquishes it in favor of the house which finds its capital insufficient for its present needs. But direct contact between borrowing and lending house is required. Through the absence of an institution of banking structurally distinct from commercial enterprise, and thus holding deposits of business enterprises, there is not effected the automatic application of the surplus of one business enterprise to the deficit of another which characterizes the modern situation. The surplus funds of another business enterprise must be obtained either through purchase from it on time, or else through the sale to it of a bill of exchange or other obligation. On the other hand, the dovetailing of circulating capital surpluses and deficits of business enterprises is ren-

8 The actual business and commercial practice of the Middle Ages with respect to these matters remains in considerable obscurity, principally because the problem is usually never raised. Possibly Japanese practice prior to the establishment of the present dynasty in 1868 might afford valuable data for a study of this kind, and be illuminating as to credit customs, etc., for this stage of economic development. The treatment in Goldschmidt, Universalgeschichte des Handelsrechts, Stuttgart, 1891, is by no means entirely satisfactory for our present purpose.

dered more difficult under an economic system such as then prevailed. In the absence of a regular economic process in which goods pass through a series of stages, yielding periodically a liquidating counter flow of funds as they emerge from one stage and enter the next, no regular automatic liquidation of loans is assured. In short, there is no pool of commercial financing operated in the manner with which we are at present familiar.9 The difference just noted in the character of the economic process is typified by the economic theory developed to explain the existing situation. Pre Smithian economics, in fact based upon the theory of the circulation of wealth, sharply differentiates earlier from present conditions, with the current conception of the production and distribution of wealth. Even where there is structural differentiation between capital supply and commerce, a narrower field only exists within which cooperative application of circulating capital may be effected, or to which the capital gathered from individual investors may be applied. That the doctrine of the Church concerning usury was due to the use of loans for purposes of consumption has become a commonplace,10 although the breaches made in the doctrine go hand in hand with the gradual development of commerce. The difference in the conception of the economic process is also reflected in the difference in the relative importance ascribable to industry and to trade. In the period considered, the handicraft system typified industry, while trade in its financial ramifications was concerned in large measure with Grosshandel, largely speculative in character, and the foreign trade. Both present con-

9 For a discussion of the economic conditions which are influential in determining the character of commercial banking, cf. Section 4.

10 The doctrine was due also to the lack of a theory of capital, confusion existing between capital, which was in large part circulating rather than fixed, and money.

siderable difficulty for the operation of the institution of banking.

During the period under review, the relation of banking to commerce should be approached rather from the point of view of the system of commercial payments. This system must surmount a two-fold difficulty, that of distance, and that of difference in currency systems. To the second is due the rise of the money changers, to whom Ehrenberg and Knies relate banking historically.11 Confined at first solely to the business of the house itself, later payments were effected in this manner also for others. The device then has become a means of economizing in the use of the existing monetary supply. In due time, this development was carried further in the fairs or Messen which arose, with their technical apparatus for the cancellation of indebtedness, and thus provided an approximation to the modern clearing system.

3. The failure often attendant upon the use of the trial and error method in the employment of deposits, which has been remarked above, has been long continued, and has led to the employment of various remedial devices. Among these devices, we may mention the creation in certain cases of organizations designed solely to act as intermediaries, and in many cases the prohibition of combination of active and passive credit business. Where such prohibition exists,

"Op. cit., Vol. I, pp. 48, 69; Der Credit, Zweite Halfte, Berlin, 1879, pp. 217 ff. As was pointed out in the preceding section, the many fold roots of banking make the question of choice between the various sources primarily a matter of emphasis, and in consequence no general agreement exists as to the basic source. Thus, e. g., Nasse and Lexis, Handworterbuch der Staatswissenschaften, Zweiter Band, Zweite Auflage, Jena, 1899, p. 132, state: "In diesem Geschafte (Kassenfiihrung) wurzeln die geschaftlichen Anfange alles Bankbetriebes."

it is felt that capital supply and the system of payments must be dissociated. Such organizations represent an attempt to grapple with the problem anew, by means of special organizations created for the particular purpose, rather than by means of adaptation of older existing bodies. Organizations of the restricted scope just mentioned, however, are of little importance from the point of view of the evolution of a technique for the supply of capital. Instead, they represent rather a development in the currency system — an application of the clearing principle — and in the administration of the funds of the individual business enterprise, in which character they act as a species of fiscal agent, performing what has been conventionally described as Kassenfiihrung.12 It should be noted that organizations so restricted in scope sooner or later enlarge their activities, engaging in loan operations.

More important for our purpose is the gradual rise of a distinct institution of commercial banking as contrasted with an institution of investment banking, and the gradual recognition of a distinctive character appertaining to each. This tendency is accompanied by a tendency towards structural cleavage corresponding broadly to the functional demarcation. The process, however, is one of slow evolution, and presents few outstanding features. Continuing throughout the period under review, it is also found in the succeeding period, and in increased degree. In fact, the recognition of a distinct institution of commercial banking may be regarded for our purpose as one of the two outstanding features of the nineteenth century.

12 Ferhaps the best known illustration is afforded by the Bank of Amsterdam. Mention should also be made of the Italian banks centuries before, likewise of the goldsmith bankers in their early days, though the last named were of course of a strictly private character.

A characteristic of the modern institution of commercial banking, found also in certain cases in investment banking, is the application of the credit principle to the currency system — concretely, the use of credit instruments as currency, and more particularly for our purpose, the use of banking obligations in this fashion. This acceptance o£ banking credit as currency is but the logical outgrowth of the recognition of a distinctive position occupied by banking, which was previously remarked. The evolution of credit currency and the control thereof by banking is the outstanding feature of the period under review. Highly significant for our purpose, too, is the fact that the currency system thus at the same time has become a means whereby capital is loaned.13 Were this feature absent, the technique of capital supply might conceivably be far different than it now is. Viewed merely as a process whereby capital is supplied, banking is entirely possible where money, and not credit currency supplied by it is in use. Money would then be received, credited to the depositor's account, and loaned to another, who took it away. This is in fact the original form, and provides the older conception.14 The modern process, however, is far subtler, as will be indicated

13 The place of this development in currency evolution may be indicated as follows: In the evolutionary process four stages (abstracting from inconvertible paper money) may be roughly recognized, each marked by the appearance of the form noted, in addition to those previously in existence, (1) commodity money (2) government representative and convertible paper money (3) bank notes (4) bank deposits. The cleavage of great significance for the student of banking appears between the second and third stages, due to the change in the issuer. It is here that we remark the coalescence of capital supply and currency.

"Subsequent to the deposit for safe-keeping only. For a statement of this well known point, cf. Wagner, Beitrage zur Lehre von den Banken, Leipzig, 1857, pp. 49-50.

at greater length below. Suffice it here to point out that in the use of banking obligations as currency, the bank relinquishes its rights to another party before control over any capital whatsoever is actually transferred to it, and a reversal of the time sequence in the loan operation appears to result. We see here clearly that only through consideration of historic origins and development may we arrive at a proper understanding of the interrelations of the three C's — credit, capital and currency — in the modern economic order.15

The further question arises of the form which the credit currency shall assume. To the student of banking at the present day, the substantial indentity of notes and deposits is practically a truism, the clearest method of proof of the same treating the difference between the two forms as one of accounting technique, in that with the one form merely one general account — notes outstanding — is written on the ledger, instead of separate accounts with each of the individual creditors. Changes in the aggregate amount alone are noted. From this point of view, the difference between notes and deposits is substantially similar to that between coupon and registered bonds. In view of the well-known fact that the deposit represents the earlier form historically, it becomes interesting to inquire into the reasons for the less

15 The customary approach is illustrated in the following quotation from J. M. Keynes, in his review of Hobson, Gold, Prices and Wages, Economic Journal, Vol. XXIII, 1913, p. 396. "The second confusion ... is between the two senses of the word 'credit,' the sense in which it stands for the method by which the control of liquid wealth is temporarily transferred from those who have less need of it to those who have more, and the sense in which it stands for methods of making payment and effecting exchanges without the use of actual coin. There is, of course, no necessary connection whatever between these two."