The bank and treasury; bank capitalization and the problem of elasticity

Front matter

Qass.

Book.

"... About twenty-five years ago, Lord Revelstoke, at the head of the great firm [Baring Brothers], was visiting a German watering-place, where he met one of our leading American bankers. Naturally, their conversation drifted into a discussion of the financial situation, and in the course of the talk, Lord Revelstoke remarked that he intended during the next ten or fifteen years to enter extensively into modern financial banking. From that time the character of the business of the Barings began to change, and from being the greatest merchants in commercial credits, they put their resources more and more into fixed forms of investment, into speculative ventures in securities and into the promotion of financial enterprises. What was the result? In 1890 the . . . world was startled by rumors reflecting upon the credit of this house, hitherto considered invincible, and its failure was only averted by the most strenuous efforts of the Bank of England, with the aid of the strongest bankers of London. . . .

Introduction

When, in the early months of 1902, Mr. Shaw took the Treasury portfolio, the country was passing through a period of marvellous financial activity. Four years of commercial and industrial consolidation, four years of trading in new corporate issues, "on margin," had absorbed hundreds of millions of banking capital in speculation. Moreover, this encumbering of current funds had taken place at a time when commercial and industrial expansion was multiplying its demands on our banks for credit accommodation. True, on May 9, 1901, an unexpected corner in Northern Pacific had brought speculation to a temporary standstill. But the quiet which followed had been utilized by the large banking interests to get together needed financial support with which to launch United States Steel and other new gigantic promotions. From two to three thousand millions of new issues had to be digested and assimilated by the investing public before our institutions of commercial credit could sufficiently relieve themselves from speculators' loans to meet the growing demands of trade.

After 1898 the financial situation was at all times pregnant with danger to business. So large was the proportion of new flotations carried on bank credit, that in the early months of 1902 conservative financiers became alarmed; serious question was raised as to what the outvi INTRODUCTION

come would be. The fear expressed was that the banking capital of the country was overloaded with credit obligations of a most dangerous sort. Within six years the national banks had increased their demand obligations to individual depositors more than $1,600,000,000, while during the same period their capital (both subscribed and earned) had increased only $135,000,000. That is to say, for every additional dollar put into the national banking business during this period, $12 of credit in the form of new deposit accounts had been issued against it.

At the time that the national banks were thus extending their credit obligations, similar expansion was taking place in the deposit obligations of state banks, private banks, and loan and trust companies. They had increased their demand credit over $2,000,000,000, while the new capital added to the business was only $235,000,- 000, making a total expansion in deposit accounts of $3,600,000,000, with a total increase in capital of $370,- 000,000. The amount of credit expansion in bank accounts alone — i.e., expansion in the forms of cash with which business is done — was equal to about two and one-half times the total money circulation of the country outside of the reporting banks, while the total increase in banking capital was only about one-seventh of the money stock of the nation.

To the end of aiding the banks to meet increasing money demands, Secretary Gage had used the customary methods of relief. He had refunded the bonded debt on a lower investment basis; he had made numerous purchases of bonds for retirement; he had made interest payments in advance ; he had added to the relief thus given

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by loaning to the banks some $80,000,000 in the form of revenue deposits. Such was the situation when Mr. Shaw came to the cabinet.

Panics Averted by Government Loans

Within the next few months pressure on the banks was extraordinary. The climax was reached in September and October. Then it was that Mr. Shaw broke away from all precedents and issued his famous order that savings bank investments be received as security collateral to additional revenue deposits. This first order was soon followed by another, which relieved the banks from the necessity of holding a twenty-five per cent reserve against the secured deposits of the government. The effect of these two orders was to increase loans of the government to the banks from $113,000,000 to $166,000,- 000 — producing a temporary result in financial circles much the same as if $50,000,000 of new capital had suddenly been added to the banking business.

During 1903 the financial stress of 1902 was gradually reduced. By concerted action of banks, by the continued aid of the government, by the imposition of high interest rates on bank accommodations and by demands for added collateral to margins forcing liquidation, the overencumbered capital of banks in financial centres was again somewhat relieved. These acts of conservatism were followed by months of wholesome trading, during which time speculation played the smaller part.

The latter part of 1904 and the years 1905 and 1906 was another period of dangerous credit expansion. Durviii INTRODUCTION

ing 1904 clearing house transactions of the United States amounted to $102,000,000,000. The clearings for 1905 were $140,000,000,000. The following year, 1906, they reached $157,000,000,000. December, 1906, was a month of high tension at the financial centre, to relieve which call money sales were advanced to 36 per cent; the average of call rates for the month was about 14 per cent; thirty days money commanded from 9 per cent to 15 per cent. During a few days of the January following, as high as 50 per cent was paid for call money. This was followed by two months of comparative quiet. In March, 1907, however, speculative trading and holdings on margin had again reached such proportions that in efforts to protect themselves, the banks were forced to call, and in a single day the market price of securities dropped from 5 to 20 points. General prosperity and prompt relief from Washington alone saved our commercial and industrial institutions from distress similar to that recently experienced through the sudden contraction of bank-credit.

It was during this period of rapidly increasing business activity and rapidly expanding bank-credit, and in anticipation of a sudden need for increased support to bank-credit obligations, that Secretary Shaw rendered another signal service to the country. He saw the approaching storm and prepared for it by getting the Treasury in condition to come to the rescue of the country when the banks would be unable to meet obligations for payment without wholesale reduction of credit accommodation. In the first place, payment on the Panama Canal purchase was made by withdrawals of the deposits of the government.

INTRODUCTION IX

diminishing by this amount the demand loans of the Treasury to the banks, and the consequent inducement to banking extravagance. After making the Panama settlement — to provide for which a 20 per cent call had been made, — the Treasury deposits were about the same as when Mr. Shaw had been appointed to the cabinet three years before. Further than this, the Secretary gave notice to the banks that a call would be made, first for 25 per cent, and later for 50 per cent of the balance of Government deposits, and although these demands were not enforced to the letter, by November of 1905 the demand obligations of the banks to the Government were reduced to $50,000,000. Thus it was that, by the time the banks in financial centres had again reached the danger point of credit expansion, Mr. Shaw was able to come to the support of the money market; and during the latter part of 1906 and the early months of 1907, $120,000,000 in the form of additional deposits were loaned to the banks without embarrassing the Treasury, enabling them to maintain their money-reserves without seriously contracting business accommodations.

After the immediate need for collateral supports to the banks had passed, Secretary Cortelyou announced that he would follow the same general policy as had been pursued by his predecessor. But during the months from May to November the demand of the banks for money with which to maintain their reserves constantly increased. Protests were made against reducing the Treasury balances that had been loaned to the banks to tide over the stress which came earlier in the year.

Yielding to these importunities was a serious mistake.

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Instead of calling attention to the capital weakness of the banks, the Government permitted them to continue to use the large Treasury balance without interest. The banks found that it was not necessary to increase their own capitalization; in fact, the Government held out an inducement not to increase their capital, since the present stockholders were able to increase their income by the amount of the credit expansion supported by the Treasury balance, without being required to share their increased profit with new stockholders. Not only were the banks themselves weakened by continuing aid, but the Government was placed in a position where it could not lend a strong helping hand in future emergencies.

The October and November Panic

When in October and November, 1907, panic days again were reached, the Government at Washington could not respond with the liberality required. In May $170,000,000 had been reached. August 22, this amount had been reduced to $143,000,000. August 23, the Secretary began increasing Treasury deposits with the banks in response to urgent demands. November 11, $70,000,000 had been added to the Treasury loans and during the following month practically the whole available surplus of the Treasury was placed at the disposal of the banks. But even this did not suffice to support the weight of obligations that had been permitted to accumulate on the crumbling foundations of the credit institutions of the country.

The alternative was a violent credit contraction. The

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essential weakness, a first cause of credit collapse, is found in the changed relations of credit outstanding to capital supporting it. In 1897 the proportion of National bank capital to individual deposit obligations had been as 1 to 2.93; in 1906 their proportions reached 1 to 5.03. In 1897 the proportion of capital, surplus, and undivided profits to individual deposit obligations was as 1 to 1.92; in 1906 this proportion reached 1 to 2.79; in 1897 the proportion of money-reserves held by National banks to individual deposit obligations was as 1 to 5.35; in 1906, even counting all the money borrowed by the banks from the Government and from State and private banks and trust companies, this proportion had reached 1 to 6.71.

The institutions chartered by the Government to supply credit accommodations to the business public had been permitted to grow top-heavy. Worse than this; not only was it permitted that they issue a dangerous proportion of demand credit to capital and money supporting it, but as has been commonly asserted and not denied that the character of commercial assets purchased by the banks by means of this credit was even more dangerous — a large part of the demand-credit having been issued in exchange for paper secured by collateral which had been purchased "on margin," the market price of which was gradually depreciating. As fast as prices depreciated the demands of bankers for additional collaterals became more tense. The net result was to force sales, thereby further to depress the market. In cases where speculators reached their limit, they made special pleas to the banks for "time," till the market might change.

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The Capital Weakness of Central Banks Revealed by Commercial Demands from the Interior

The increasing demands from the commercial and industrial constituency of the vast interior forced the issue. When the country banks began to call the loans which they had made to the reserve banks, when the reserve banks, in turn, were forced to call their loans to the great central reserve banks that had used these loans for money-reserves with which to support credit accommodations to speculators, then it was that the mutual props in the form of " legal reserves" began to give way, and the whole business constituency which depended on bank-credit for cash was thrown into a condition of distress. The resulting condition was what Mr. Ridgley has referred to as the loss of confidence of banks in each other. To save themselves the central reserve city banks had to issue clearing-house certificates, which is a form of suspension of specie payments. This protective measure of the central reserve bank forced the banks the country over to do likewise. Mutual obligations within each community were settled by means of clearing-house paper.

Relief finally came in the only way possible, through added capitalization. This capitalization, however, was only temporarily supplied. It was furnished by a syndicate of which the house of Morgan & Co. was the head. The government also added all of its remaining surplus available. A broader basis for credit liquidation was established through the importation of approximately $65,000,000 in gold, a large part of which was procured

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by means of this new temporary capitalization furnished by the syndicate. But the reduction of the demand-credit used as "cash" in commerce and industry was far greater than either importation or money issue could supply — a contraction of the credit-circulating medium which resulted in reduction in prices, temporary receiverships, and wholesale stagnation of business. Never has there been a more tragic financial situation. Only the general prosperity of the commercial and industrial world saved us from the worst of business calamities.

By the end of the year 1907 the credit stress was in a measure abated. This was in part due to importation and in part due to the largely decreased business demands resulting from receiverships and liquidations forced on by the sudden withdrawal of hundreds of millions of dollars of banking accommodations which had been previously extended to legitimate enterprises. The remedy applied was drastic, wrecking the fortunes of thousands of persons engaged in useful employment. But the fundamental weakness of the system still remains to be dealt with. If collapse may come at a future time less prosperous than the present, failing credit may work still greater havoc.

Dangers in the Present Readjustment

The present readjustment is essentially a dangerous one. Not only is the added capital a temporary support, but in its method of application it is dangerous. Practically the whole Treasury surplus is tied up in the settlement. January 1, 1908, the banks were owing to the xiv INTRODUCTION

United States Treasury, either in the form of direct loans or as deposits of disbursing offices, about $256,000,000. A part of this the government needs at once to meet its current expenses. By a continued policy of loaning the Treasury surplus to the banks, without interest, by permitting the banks to retain a large part of the loan as money- reserves for the support of obligations to the depositors during times of credit expansion, by permitting the banks to find relief in added loans from the Treasury and in a temporary syndicate, a plan of reorganization is accepted which does not take care of a large floating debt, and which does not provide adequate working capital. Another element of weakness is found in the fact that while the syndicate loans bear a high rate of interest, the loans of the Government are without interest. The syndicate loans, therefore, will be paid as rapidly as possible, while the government will be further importuned not to reduce its balances. In case it may happen that the country banks may again loan their reserves to the reserve banks, and the reserve banks may in turn loan their reserves to the central reserve banks, in sufficient amount, then the government may be able to gradually call its loans. But with the first considerable pressure brought to bear on the system, the experiences of last March and of last November may be repeated.

Alternatives before the Government

As a result of the present adjustment the Government is placed in a position such that one of three courses is open to it: (1) It may demand payment of loans to the

INTRODUCTION XV

banks with the possibility of disrupting the whole fabric of private credit based on the present reserve : (2) it may permit the banks to use its funds without interest, and borrow money at interest with which to meet its own current expenses; (3) it may, by charges of high rates of interest to the banks for loans in the form of deposits and bank notes, issued on collaterals deposited with the Government (or by other effective measures) force the banks to add sufficient permanent capital to their business to enable them to meet all their present emergency capital obligations, and at the same time insure the safety and stability of their own credit-accounts. In this situation President Roosevelt has appealed to Congress urging that the last of the three courses be taken. His specific recommendation, however, is confined to note issues. It remains for some one in authority to seriously propose a measure which will effectively apply the same regulative principle to the loans of the government to banks in the form of " deposits."

Within the first six weeks of the present Congress several bills were introduced which provide for an interest charge on the loans. In the House, Mr. Fowler (H. R. 12,677) an d Mr. Keifer (H. R. 208) proposed that banks be required to pay two per cent on government deposits. That such a measure would prove ineffective to cause banks to return government ''deposits" after an emergency was past, is amply proved by some forty years of experience with reserve loans. At such a rate, banks have never been known to return reserve deposits until "called." In the Senate two bills have been introduced which aim to make "deposits" emergency loans, but whose xvi INTRODUCTION

defects are apparent. Senator Culberson (S. 3026) would have banks pay two per cent from August 1 to November 30, four per cent from December 1 to March 31, and six per cent from April 1 to July 31 each year. This proposal assumes that money demands and credit disturbances regularly follow the seasons, an assumption which might do much to produce expansion and contraction at the wrong time. The banker is in the best position to know when money demands are such that he can afford to pay six per cent for government loans, and these are times when the credit circulation should be increased or when more money is needed to support that already outstanding. Senator Piatt's measure (S. 108) would make the rate discretionary. This might prove effective and without public danger if a minimum of about six per cent were established to insure the use of the government loans for purposes of steadying the market in time of extraordinary demand. If the banks had the opportunity of borrowing from the government on proper security at six per cent and the government had the option of supplying funds either in the form of gold or paper money to be issued by it, the money rate could never rise far above the established minimum. In such event there would be no limit to the possibilities of expanding credit when needed, except the limits of adequate security for the loans among prospective borrowers.

INTRODUCTION xvii

Our Hopeless Philosophy of Panics

Those who have expressed opinion concerning the cause of the recent panic used the same fatalistic philosophy as was employed centuries ago in accounting for ravages of "black death" and the scourges of smallpox and cholera. From time immemorial the same conclusions have been reached; after learned discussion, those in position to command respect for knowledge of financial situations have each time announced that sudden collapses of bank-credit have been due to an undefined, intangible, uncontrollable something called "lack of confidence." Comptroller Ridgley by a process of induction has given a new interpretation to this vague theory by asserting that the conditions which led to the panic of last October and last November were due "not to lack of confidence of the people in the banks, but more to lack of confidence of the banks in each other."

With such a diagnosis of the malady by those who are looked to professionally for prescription of remedies, question may be raised as to whether we may ever hope to find relief from financial ills. May we hope to correct a financial disease that is diagnosed as the result of a mental attitude of persons who may not be located and specifically treated? Congress is asked to pass remedial laws. What legislation will make business safe as against "what some people may think"? How may bankers be required to conduct their business to prevent "some people" from losing confidence? Does not such an analysis suggest that the philosophy of banking is still surrounded by the ignorance and mysticism of the dark xvlii INTRODUCTION

ages, and that public inquiry is still lacking in method of scientific research?

Time was when a land-slide was attributed to the mental attitude of an evil one; when the breaking of a bridge or the falling of a building was considered as the inscrutable act of some great destroying force. The remedy proposed for such calamity is similar to that at present urged to relieve business, viz.; self-sacrifice and prayer as a means of restoring lost faith in an influence for good — acquiring a belief which has the power to protect the people against the intrigues of the devil. Since the days of the South Sea Bubble, this same mystically vague remedy has been proposed for protection against the collapse of bank-credit. Let us have confidence! Restore our faith and we shall be saved!

A Plea for a Scientific Method of Determining the Character of Banking Legislation Needed to Protect the Public from Panics.

In the search for causes of structural collapse, we have come to apply scientific standards to judgment. Were the tower of the Capitol building to show signs of weakness during a storm, the Government would not rest content to set up props till the storm had abated. Were a great office building of New York to fall, no one would think of the prayer of faith as protection against future evils to be suffered from collapses of similar kind, or of importuning Omnipotence for justice to those responsible for loss of life and property. Inquest would immediately go to the character of materials and workmanship used in

INTRODUCTION xix

construction. Neither would there be mystery or fatalistic philosophy woven about legislation proposed for future safeguards to the community; nor would it be accepted as satisfactory defence of building management that those in control had yielded to the importunities of persons wishing accommodation, and as a consequence the building had been built too high or had been over-crowded, or had had a "run" on it that carried it and the tenants to destruction. If the structure had been used for purposes other than those approved, or if the owners had connived with officials, or officers of the law had permitted the superstructure to be carried beyond the point of safety, if the foundation had been overloaded and had crumbled beneath the weight, or if a superstructure had been erected of such physical parts as to endanger tenants or the public, under any and all of these circumstances tenets of scientific inquiry, premised on experience, would guide in determining responsibility for loss, as well as in the shaping of legislation for the correction of similar evils in other structures built or to be built.

In engineering and architecture, as well as building ordinances, the guiding principle is : The greatest economy compatible with safety. But whatever the cost, foundation and materials must be of such strength and quality as to make the structure safe. In estimating the depth and breadth of foundation, or the strength of materials to be used in any part of a building, a liberal margin of safety is allowed to provide for strain greater than any that may ever be brought to bear. Should a bridge be under contemplation, then calculations as to the load or strain would depend on the character of use. After the

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bridge was completed traffic regulations would be framed to protect the public from danger of overloading, and the management would be held responsible for violations. Police control would also be exercised to prevent catastrophe.

Legislation Based on Ignorant Assumption may Increase

the Danger

Much of the legislation proposed to prevent collapses of bank-credit throws this kind of reasoning to the winds. The drift of opinion has been away from the theory of a coefficient of safety. The banking world is urged by public officials to make a still higher use of structural materials, i.e., to make such adjustments between themselves as will permit the same capital to carry a larger load. No attempt has been made to calculate what burden a particular credit structure may bear without endangering the business public from credit contraction. The argument has been further to reduce the capital cost of banking. In estimating this, no account is taken of the cost to the community of the periodical wholesale demolitions and the wrecking of other business which have been induced by the banks to depend on them for current funds. The banks may be safe. Yes! But what of the many business interests that have come to rely on bank-credit for "cash"? There seems to be an utter blindness to the public aspects of banking; no reckoning is taken of the fact that the forced contraction of the credit of even the smallest of banks may cause greater loss and suffering to a community as a

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whole than would the collapse of the largest of physical structures.

In the safety of a building structure the public is interested as a matter of physical protection to tenants and passers-by. Increased charges for rent due to capital cost required to obtain this protection is not accepted as reason for permission to build an unsafe edifice. At every cost, public safety is insisted on. In the safety of a bank it is not physical safety alone that is involved. The business, the fortunes, the life work, possibly the lives of all those who have made arrangements for their current financial needs, are directly at stake. Indirectly, a sudden contraction of bank-credit to protect the bank itself from collapse may unsettle well-founded business judgments, and produce conditions which may cause business concerns, not in any manner connected with the particular institution which institutes the measure, to topple to ruin. Indirectly, the business interests of a whole community or of a nation may be affected.

Is it not worth our while to proceed in the determination of questions of banking regulation on the theory that no capital cost is too great if it is necessary to protect the community against sudden contractions of bank-credit? May not the same principle of scientific inquiry be applied to the discovery of a margin of safety to prevent collapses of credit as has been applied to building structures? Of far greater importance to the welfare of the community is it that bank-credit shall not be constricted in time of need; of far greater importance that the capital foundation shall be adequate to support every dollar of credit issued by banks, so long as the credit may be needed xxn INTRODUCTION

by the borrower; of far greater importance that a liberal margin of safety shall be required as against extraordinary strain.

Would it not seem the part of wisdom for public men and public bodies to pass laws to prevent the overloading of the capital foundations of credit institutions, and overaccommodation, rather than that the Government shall be content to permit banks to extend their credit ad libitum? Is not legislation which requires the bank to do a safe business preferable to the administration of palliatives to the injured, or reliance upon the ability of the Treasury to prevent disaster by running to the support of toppling credit walls as a means of relieving financial institutions from the necessity of increasing the capital cost of doing business ?

Elements of Certainty in the Problem of Elasticity

In this relation it is suggested that banking and credit are just as susceptible to scientific analysis as are buildings and building materials. With all the mystery that has been woven about the subject, every feature and element in the problem of elasticity of bank-credit is as capable of exact determination as are the tensile strength of iron, the crushing resistance of stone, or the wind strain on an office building. In law there is none of the mysticism about credit which is commonly assigned. Credit is an unconditional contract for the payment of money, nothing more, nothing less. So clear is the law on this point, that it has been repeatedly decided that any other form of contract or transaction is not credit. In

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business practice there is absolutely no uncertainty about what credit is. Every business man knows that if he be creditor he can insist on the payment of the amount and kind of money contracted for, and that nothing else may be substituted except by his consent, which amounts to a new contract. If he be debtor, he knows quite as well that he must obtain and deliver the money in the amounts and at the time contracted for, or in default of such delivery the courts may be asked to intervene and sell his entire estate if need be to procure this money. In the common parlance of the street, credit is a " short sale" of money; this sale is governed by practically the same rules as a "short sale" of bonds or a " short sale" of wheat. The only alternative to " delivery" is "settlement," or the substitution of a new contract for the original credit contract.