Full text of Bank Notes Secured by Commercial Assets : Address before the Banker's Club of Chicago

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BANK NOTES
SECURED BY

Commercial Assets

AN ADDRESS DELIVERED BY

J. LAURENCE LAUGHLIN,
Member of the Indianapolis Monetary Commission.

BEFORE THE

BANKERS’ CLUB OF CHICAGO,

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1898.

BOND-SECURED CIRCULATION.

The people of the United States have become accustomed to
the security of bank notes based upon the deposit with the
government of national bonds. For thirty-five years this has
furnished an absolutely safe bank circulation. There is good
reason why they should have come to regard this system as
highly satisfactory, and why there should be a strong belief
that no other kind of security would be acceptable.
It is well.understood, however, to be the. traditional policy of
the United States to pay offiits bonded indebtedness. Since the
close of the Civil War the reduction of the debt has gone on in
a way to surprise the debt-burdened countries of Europe. Twothirds of the debt existing at the close of the Civil War has
been paid off and the amount of bonds now available for na
tional bank circulation is not large. If we should return to the
policy of the past and begin the payment of our national debt
again, it is evident that United States bonds could not be used
to provide a permanent and increasing bank circulation. Cer
tainly, we may not seriously discuss the possibility that a debt
of the United States would be purposely contracted merely in
order that bonds might be provided with which to secure the
notes of national banks.
But, even if there were United States bonds in full and suffi
cient amounts to secure a proper volume of bank-notes, an ob
jection exists to this system which is fatal to the general plan
of a bond-secured circulation. It is well understood that the
market value of a bond fluctuates with the changes in the com
mercial rate of discount. If a 4 per cent. United States bond
which has a long time to run sells at par, it means that 4 per
cent, is the highest rate to be obtained in perfectly safe invest
ments ; but if the rate paid for such investments declined, say,
to 3 per cent., the bond which regularly returns four dollars a
year to its holder, pays a rate higher than can be got for other
equally safe securities, and consequently rises in its value be
yond par to such a figure (about $118) that four dollars of in
terest on this last sum is equal merely to the usual 3 per cent,
to be got in the money market; that is, the holder of the 4 per
cent, bond can sell it so much above par that the buyer can get
in the four dollars of annual return only 3 per cent, on the
amount paid for the bond. In this way, with the fall in the
market rate of commercial discount, the United States bonds
which were at first sold at par, or at a very slight premium,

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have risen largely in value. The price of such a bond, there
fore, is a measure of the market rate of interest on safe secu
rities. This explanation will serve to show that changes may
take place in the value of bonds due to changes in the credit
of the government or to changes in the -commercial rate of in
terest, both due to forces entirely outside of the control of the
banks.
If the premium on the deposited bonds rise from such causes,
it practically results that these bonds cost the bank just so much
more; for it has securities in the hands of the government
which it could at any moment sell for the increased value.
Moreover, the profit of a bank on its circulation is diminished
as. the price of the deposited bonds increases. Hence, changes
in the price of bonds may have a direct bearing upon the profit
of circulation, and hence upon the volume of the notes which
the banks will thereby keep outstanding.
The relation of the price of bonds to the market rate of inter
est produces still greater difficulties in regard to the probable
issue of bank-note circulation when it is needed. It may be
laid down as an undisputed fact that a system of bond-secured
circulation is. practically inconsistent with the automatic ad
justment of the quantity of notes to the demand of borrowers'
and the needs of trade. When the demand for loans is great,
there is little profit to be made in putting out notes; that is,
when the demand is urgent the supply is not forthcoming. As
already explained, the bonds are high-priced and bear a low
rate of interest; and yet, in times of financial stringency, the
rate of discount is sure to be high, and borrowers are in great
need of loans. As against buying bonds, in order to issue only
a fractional amount of their value in notes, on the other hand
there is the opportunity of loaning such funds directly at the
high market rate of discount. The situation, therefore, puts a
premium upon the direct use of banking capital, as against
that method of investment which leads to increasing the bank
note circulation. And in those communities where bank-notes
are essential to making discounts this is a serious obstacle. In
short, at the time of pressing demand under the existing system,
the supply of notes is not forthcoming. On the other hand, if the country is suffering from business
depression, if funds are accumulating in the bank, and if the
market rate of interest is low because there are few opportuni
ties of profitably employing capital) then it would not be impos
sible to expect the banks to use superabundant funds in buying
bonds of a low rate of interest. It results, therefore, that at a
time when the demand for loans is slight and the rate of discount
low, it would be easy for the banks to invest in bonds and thereby

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obtain notes. In short, when there is no demand, the supply is
easily obtained. It needs no further comment, consequently, to
see that such a system of note-issues works at cross purposes
with the needs of the public. With a deposit of bonds for security
of notes, there is no supply of notes at a time when most needed
and an easy supply of notes when least needed.
*
So, too, at any given time, with bonds at a definite price, the
existing system makes the issue of notes profitable in those sec
tions like blew England, for example, where there is already an
abundance of both currency and capital, accompanied by low
rates of interest, and unprofitable in those sections such as the
West and South, where rates of interest are high and a real de
mand for more currency and capital exists.f The nature of the
*This has been clearly illustrated by the experience of the last half dozen
years. From 1882 until 1889 there was a pretty steady advance in the price of
government bonds; the 4’s of 1907 having risen from 103 in 1880 to 129 in 1889.
In 1880 and 1881, while these bonds were selling between 103 and 112, there was
some increase in the national bank circulation; but their price touched 120 in
1882, and for nine years thereafter, the bonds being high priced, there was a
steady decrease in the note circulation of the national banks. The financial
panic of 1890 caused a fall in the prices of government bonds, and thereby in
creased the chances of profit on the circulation of national banknotes. Asa
result there was a net increase in their circulation of $13,000,000 in 1891, and of
$8,000,000 in 1892. Now, in these two years, there was absolutely no demand for an
increase in the circulating medium of this country; on the contrary, the Treasury
Department in these years was injecting arbitrarily between $25,000,000 and
$50,000,000 of silver paper money into the currency of the country, as a result of
the Silver Purchase Act of 1890, and gold, in consequence, was being exported at
a rate which alarmed business men and finally precipitated the panic of 1893.
During 1893 the 4’s of 1907 sold down to 113, and the banks added to their circula
tion $37,000,000. During the months of June, July and August of that year there
was a most urgent need for an expansion of the currency; but during these
months the new national bank notes did not appear. Not until after the panic
was over and money was piling up in all the financial centers—a drug on the mar
ket—did the increase in the national bank note circulation take place. As a result
of the panic, business being depressed, the interest rate on prime commercial
paper during 1894, 1895 and 1896 was between three per cent, and 4 per cent. The
money supply of the country was in excess of its needs and gold was exported in
large amounts. The Treasury, embarrassed by the withdrawals of gold, was
forced to issue bonds in order to maintain the gold reserve. These bond issues
forced down the prices of bonds, and thus increased the profit which banks could
make upon new circulation. Therefore, considerable idle banking capital, which
could be loaned barely at three per cent, in business, was exchanged for govern
ment bonds and made the basis for bank notes, so that in 1895 and 1896 there
was a net addition to the bank note circulation of $32,000,000. Thus, the national
bank note helped to embarrass the government by inflating the currency at a time
when the government was doing its utmost to hinder inflation and prevent the
exportation of gold to Europe.
tit appears for example, that, in the New England'States, where the commer
cial rate of discount is not over 5 or 6 per cent., the national banks find it profitable
to issue. in excess of the notes on the required deposit of bonds, about half the
amount which they might so issue; while in the Western and Southern States, the
lanks issue, in general, only the amount of notes permitted upon their required
deposit of bonds, barely exceeding this by 1 per cent.

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bonds deposited is not important. The same objections hold,
whether the bonds are national, state, municipal or railroad
issues.
The explanations here briefly given sufficiently account for
the extraordinary fact in the history of the national banking
system that from December, 1873, when the note circulation
stood at §341,320,256, it pretty steadily diminished to October,
1890, when the amount outstanding was but §122,928,084. That
is, in the face of an expanding trade and industry, bank-note
circulation proved its maladjustment to the needs of the public
by shrinking at the time when there was more work to be clone.
These facts and the reasons above furnished, which explain
why these facts give us this result, make clear beyond perad
venture that a bond-secured circulation contains within itself
conditions warring directly against the automatic adjustment
of notes to the needs of the business world. We must choose
between a circulation, on the one hand, to which we have be
come accustomed and which is of undoubted safety, but which
is incompetent to meet expanding demands; and, on the other
hand, a system which, while providing perfect security to the
note-holder, will also furnish a volume of notes expanding and
contracting according to the needs of trade. The former we
now have; the latter is to be found in the plan proposed by the
Monetary Commission.

CIRCULATION SECURED BY COMMERCIAL ASSETS.

Assuming that the system of securing note-issues by the de
posit of bonds has not proved desirable, for reasons already
given, it is well to consider in-a practical way the various effects
of a system of note issues based upon all the resources of the
bank without the particular pledge of any one portion of the
assets for the notes. Under the plan proposed by the Monetary
Commission, the note issues may be considered from four points
of view:—
I. As affecting the note-holder;
II. As affecting the other banks in the system;
III. As affecting the depositor; and,
IV. As affecting the relative position of city and coun
try banks.
I.The only possible basis for consideration in a sytem of
bank-note issues, and one which must be regarded as funda
mental, is an absolute protection to the note-holder. This must
be accepted as axiomatic. Not only would a system which did

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not provide absolute security to the note-holder have no chance
of adoption, but it would also be a distinct wrong to the business
community to propose it. The national bank note of the pres
ent system has earned a well-deserved confidence, because the
basis of its security has been unquestioned. Moreover, the
note of one bank should be so protected that it is as good as
the note of any other bank, no matter in what part of the coun
try it may be circulated. Perfect uniformity of bank-issues
throughout the length and breadth of the land is an essential of
a good currency The note of a bank in Maine must be equally
good if offered in Texas or Oregon. That condition exists un
der the present system, and the same result must be achieved
under any system which shall be devised to take its place.
It may be taken for granted, then, that the ends to be attained
in the proposed plan are not only (1) perfect security to the note
holder, but also (2) entire uniformity of issues by all the banks
of the system. In order to secure these ends, the Commission
have recommended a system by which they are confident that
uniformity as well as absolute security to the note-holder may be
obtained. This plan, in brief, authorizes the issue of notes by any
bank to an amount not exceeding its unimpaired capital, less
its investment in real estate; a first lien in favor of the note
holder upon all the assets of the bank; and, if the foregoing
should be insufficient, a prior lien upon the stockholders’ liabil
ity, which is for an amount equal to the capital of the bank;
and, finally the creation of a Guaranty Fund of 5 per cent.' on
outstanding circulation, contributed only in proportion as banks
issue notes. Moreover, a heavy tax of 6 per cent, is laid upon
any notes issued in excess of 80 per cent, of unimpaired capital;
so that we may go upon the assumption that notes will not,
under the proposed system, exceed, in ordinary times, 80 per
cent, of the capital. It is also provided that the notes shall be
receivable at par for debts due to all other national banks and
to the government. It is believed that such a system will pro
tect the note-holder beyond peradventure; and that, in practical
operation, no holder of the note of a failed national bank could
ever lose a cent.
It should be kept in mind that the Guaranty Fund is clearly
distinct from the Redemption Fund. The Guaranty Fund, con
tributed by each bank in proportion to its note-issues, is a fund
held in trust by the Treasury and reserved solely to provide for
the immediate redemption of notes of failed banks. It is in
tended that no period of time shall ever exist during which
there shall not be on hand a sum sufficient to redeem the note,
even of a failed bank. Without this fund, between the date of
a failure of a bank and the time when the receiver could have

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realized in cash upon the assets of the bank, there would be a
time when a note could not be redeemed, even though its ulti
mate redemption might be assured.* Under the plan of the
Commission, it is provided that a note of a failed bank in any
part of the country will be redeemed out of this common Guar
anty Fund without any delay in waiting for realization upon
the assets of the bank by a receiver. This provision perfectly
secures uniformity in the value of the note of every individual
bank in any part of the country. Any note, whether of a failed
or a solvent bank, will, at any time, be redeemed on demand at
the Treasury, or, at the discretion of the Secretary of the
Treasury, at any sub-treasury of the United States.
On the supposition that the present circulation may be in
creased from about $200,000,000 to $300,000,000, there would be
a Guaranty Fund of $15,000,000 always ready to meet the re
demption of notes of insolvent banks. At any one time this
would be fully sufficient to cover the notes of a failed bank or
group of banks. But it should be understood that this does
not necessarily imply an assessment upon other banks. The
Guaranty Fund will be used in the purchase of the notes of
failed banks to the full extent of those presented. But these
notes, for the time being, keep the fund nominally intact, at
least while the assets are in process of liquidation. As fast as
cash is realized this will be first sent to replace the notes held
by the Guaranty Fund; and so long as there are any assets yet
unliquidated to meet notes in the Guaranty Fund no assess
ment will be made on the other banks. An assessment can
take place, then, only for the fraction of notes for which no
assets can be realized at the close of the liquidating process by
the receiver.
In order to act as a brake upon excessive issues, it is provided
in the plan of the Commission that all notes beyond 60 per
cent., and less than 80 per cent., of the capital of a bank shall
be taxed, so long as they are outstanding, at the rate of 2 per
cent, per annum, but notes outstanding in excess of 80 per cent,
of the capital at the rate of 6 per cent, per annum. The inter
est on any portion of the Guaranty Fund invested by the Sec
retary of the Treasury and the taxes upon emergency issues,
just described, would, in time, furnish permanent additions to
the Guaranty Fund, and thereby establish public confidence in
the practical sufficiency of this sum for all possible protection
to the notes of failed banks.
The Guaranty Fund thus described provides for the immediate
redemption of the notes of any failed banks, while the prior lien
$In the Canadian banking system the notes of insolvent banks bear interest
until redeemed.

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on the assets and stockholders’ liability of the bank, together
with the operation of the fund in. case of deficiency, make up
the provisions for the ultimate and final security of its notes.
As distinct from this ultimate security (which is believed to be
full and more than sufficient), at the same time providing for
the immediate redemption of the notes of insolvent banks, the
plan of the Commission provides for the daily and immediate
redemption of the notes of all solvent banks by the mainte
nance of a 5 per cent. Redemption Fund, as now required by
law. As at present, each bank is required to redeem its' notes
on demand at its own counters, and also at Washington, or at
any sub-treasury which may be designated by the Secretary of
the Treasury. This Redemption Fund is a part of the assets
of the bank. As a matter of course, the banks must keep on
hand cash enough to redeem their own notes, and if a part of
this sum be placed in the Treasury it is only intended as a
matter of convenience to intercept in the commercial centers
the stream of notes coming in for redemption which would
otherwise be presented at the counter of the bank. The purpose
of a Redemption Fund is to make redemptions more easy and
rapid for the community. It is no added burden to the bank,,
which would be obliged to perform the same service at its own
counter if no Redemption Fund existed. To be required to
send notes home to each bank in remote parts of the country,
however, is an inconvenience which is obviated by the existence
of a Redemption Fund placed in those centers where notes are
most likely to be in circulation. The daily and immediate re
demption of notes at their own counters and through the Re
demption Fund, which must always be kept intact, provides a
constant test of the condition of a bank to meet immediate
demands. This system of redemption will be much more effect
ive under the new than under the present system. Notes will
constantly.be coming in for redemption to every bank audit
will be impossible for any one bank to keep its notes in circu
lation beyond the amount actually needed by the community.
Inasmuch as the Redemption Fund is intended only for daily
needs, it does not cover the case of possible failure and the pro
cess. of liquidation. That, as has been said, is provided for by
the Guaranty Fund.
Under, the proposed plan the resources behind the notes
would be much greater than is usually supposed. The present
capital of all national banks is $631,488,095 ; and if notes should
be issued by them all to the amount of 80 per cent, of their un
impaired capital, the aggregate would be the sum of $505,190,
476, for which the security in the form of total assets would bo

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$4,011,403,513, or a protection of nearly 8 to 1. But it will be
*
said that not all banks will issue notes to this limit; and that
this will be done mainly by the banks outside of reserve cities.
The present capital of the 3,276 banks outside of reserve cities
(though including some cities of considerable size) is $401,302,
835; of which 80 per cent, would be $321,042,268 (while they
now issue under the present system $144,789,512); for which
the security in the form of total assets would be $1,956,216,503,
or $6.10 to every $1 of notes.
'
There can be no question, then, that in the aggregate the
security behind the notes would be ample. It is for occasional
instances where such would not be the case that the Guaranty
Fund is provided. And, finally, the power of the Comptroller
to levy assessments as they may be needed to keep the Fund
good for this purpose insures that these occasional failures will
cause no possible loss to the note-holders.
If it should be thought that the security of a prior lien upon
all the resources of a bank (instead of a part specifically invested
in bonds) is insufficient for the protection of the note-liability,
attention should be called to the fact that now over 90 per cent,
of large exchanges of goods are performed by the media of ex
change created on the basis of the deposit-liability of banks ; and
that the protection to this liability has always been the general
resources of the bank. An enormous volume of cheques, drafts
and bills are daily in circulation, expanding with expansion of
business, constantly coming home for redemption and payment,
always regarded as a safe medium of exchange—and this circu
lation is protected directly by the general assets of the banks.
When it is noted that deposit-accounts of about $2,000,000,000
do a work of about $50,000,000,000 (as exhibited in the clear
ings of the United States), while the note-circulation of the
banks is only about $220,000,000—it must be said that there is
nothing novel or unsafe in basing the smaller amount upon the
same security as that of the greater, and to which the community
has long been accustomed. Not only are the note-issues in the
proposed plan secured by assets of the same kind, but they are
given a prior lien on all this vast sum of resources. There is no
reason’why the note-issue of a bank should not be as good as
its cashier’s draft. On the one hand no greater obstacles, with
some obvious limitations, should be put in the way of the increase
in the quantity of the one more than of the other; and, on the
*With a note liability of $198,920,670, the actual assets now held by all the
national banks amount to $3,705,133,707. Should their note issues be increased
to $505,190,476, their assets would at the same time be increased by the same
amount—making the aggregate assets behind the $505,190,476 of notes, $4,011,
403,513, as stated. . .

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other hand, as rigid requirements should be exacted for the* re
demption and payment of the one as of the other. In that way,
notes will be used if transactions warrant their issue, and be
presented for redemption, just the same as a cashier’s cheque,
immediately their work is done, thereby operating with perfect
elasticity.
The people of the United States have become accustomed to
regard government bonds as the only safe security for bank issues. It should be clearly understood, however, that perfect
security to the note-holder has been obtained under the system
proposed herein, as proved both by the experiences of our own
country at other times and by practically the universal custom of
civilized nations on the continent of Europe to-day. It should
be kept constantly in mind, also, that many losses, due to the
inadequate security of bank-note issues in various parts of the
country before the civil war, came from a system in which the
notes were secured by the deposit of bonds. The bonds used,
however, were frequently State bonds, which, by repudiation or
bad legislation, had depreciated or become worthless. It is the
unmistakable testimony of our history before the civil war that
the security of bonds did not, by any means, protect the note
holder.
II.We pass now to the effects of the plan of note-issues, as
here proposed, upon the other banks in the system. The objec
tion might very naturally arise in the minds of bankers that,
under the system of a Guaranty Fund, supplied by all the banks
issuing notes, the well managed banks would be sustaining
badly managed banks, with the result that there would be no
penalty visited upon poor management. Clearly good bankers
might not wish to enter a system by which they became
responsible for issues of notes over which they could have no
control; and they might say that untrained and fraudulent
managers might put out excessive issues based on worthless
assets. It is therefore well to examine this objection in the
light of experience.
It is evident that the failure of a bank to provide .proper
assets to meet its note liability must depend upon either (1) bad
judgment, or (2) fraud. It should be said at once that these
two elements of danger can create no greater obstacles to suc
cessful management in banking than in any other business, and
that average honesty, as well as occasional dishonesty, must be
given its due weight. The possibility of fraudulent mismanage
ment of bank assets may possibly be magnified too greatly.
Nothing is more common and fallacious than to reason that
what is true in a particular case is true in general. For in
stance, if a single bank had been known to fail, and if assets

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had proven insufficient to cover the note-issues of that hank, it
would be fallacious to assume that the same would be the case
at once with many or all banks. Failures due to dishonesty
and mismanagement will sometimes happen, but it is undoubt
edly true that these are only sporadic cases. Under the pro
posed system a special loss in cases of individual banks is dissi
pated over the issues of the whole number of banks, and
thereby falls lightly upon any one. It is, in short, the opera
tion of the general law of averages well known to actuaries.
Therefore, the objection to the proposed scheme from the fear
that bank assets would be often or generally insufficient is
based on the erroneous assumption that fraud will be general
and chronic on the part of the issuing banks. An objection
based on this general assumption can certainly have little real
value. It moreover proves too much. To assume that fraud
in regard to banking assets would be so general as feared by
timid persons presupposes a condition of morals in the commu
nity such that fraud would be so prevalent in all forms of
business as to make it impossible for ordinary trade and ex
change to go on as it does now. Business as it exists to-day
would be impossible. On such an assumption it would not be
practicable to obtain a proper number even of book-keepers or
officials who could be trusted. But the supposition on which
such an objection to this scheme is based is every day and hour
contradicted by the fact that we do go on, in banking as in all
other business, on the actual belief that fraud is the exception
and not the rule. The objection to the plan of the Guaranty
Fund as thus stated on the ground of any general prevalence of
fraud is hypercritical and largely imaginary.
Since the note-issues go out only as the result of a transac
tion based on the transfer of exchangeable property, the notes
are as sound as the property on which they are based, and bank
ing assets in general reflect quite accurately the character of the
business transactions of a country. Consequently notes based
on general assets are as sound as the business transactions of
the country. Bankers, moreover, are as honest as the average
man in other branches of business. The banks, therefore, enter
ing into this system run no great risks, owing to the require
ment of contributions to the Guaranty Fund, since their respon
sibility extends only to losses determined by the average honesty
of business men. That is, the losses they will be obliged to
meet from fraud will be exceptional, and the amount of these
will be very small in comparison with the total circulation, and
will be no serious burden to the Guaranty Fund. It is founded
on the theory of insurance by which a very small premium
from each participant is sufficient to provide a considerable sum

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to cover individual losses; and thereby the Guaranty Fund,
which ties all the banks together, produces that uniform value
of the note-issues in all parts of the country, which is essential
to a desirable bank-note circulation.
It is well known that in the whole history of our national
banks, bank failures have been greatest in the years 1893-1896.
In 1893, if all the banks in the system had issued notes to the
full amount of 80 per cent, of their capital (as contemplated in
the proposed plan), the sum would have been $548,000,000. The
aggregate circulation issued by the banks which failed in 1893,
on the same basis would have been only 1^ per cent, of the
aforesaid possible circulation under the plan proposed. That
is, if upon the failure of these banks all their notes had been
presented for redemption before a dollar had been collected
from their assets, only about one-third of the Guaranty Fund
would have been invested in such notes. During the process
of liquidation, however, it appeared that the amount which
would not have been returned to the fund from the assets of the
banks formed only one-eighth of 1 per cent, of the proposed
circulation. Hence, a fund of one-eighth of 1 per cent, of the
notes outstanding would have met the losses to banks which
caused assets to fall short of their note liability.
The facts are more conclusive if, instead of one period of fre
quent failures we pass under review the whole period of exist
ence of the national banks. Of the 352 banks which have
failed in the national banking system from 1863 to 1897, the
total capital was $58,802,420 (80 per cent, of which would have
been $47,041,936); but the net collections from the assets of
these 352 banks had already been $65,239,554 at the date of the
last report of the Comptroller of the Currency; while even in
the case of the banks where the net collections, under the plan
proposed, would have been less than 80 per cent, of the capital,
the aggregate deficiency would have been met by an average
annual assessment upon the remaining banks of about one
fortieth of one per cent, of their circulation (assuming that the
circulation would have risen to 80 per cent, of their capital).
And as the larger part of this apparent deficiency arises from
the failure of banks whose affairs are not yet closed, it is prob
able that subsequent collections from the assets of these banks
would reduce the net loss to date to an amount so insignificant
that it might almost be left out of account.
Therefore, on the basis of banking assets, as disclosed in the
history of the present system, it is beyond question that all
losses upon the note-issues of failed banks, after recourse to the
general assets of the bank, and to the stockholders’ liability,

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will in fact be easily met by a Guaranty Fund of 5 per cent, as
proposed.
Having shown that the losses which will fall upon the Guar
anty Fund will not in any case be serious, it should also be
borne in mind that, in the plan of the Commission, responsi
bility for the notes of other banks affects only those that issue
notes, and even then only in proportion to their note-issues. It
may be possible that great city banks which are now able to do
a very large business and earn their profits without the use of
any notes whatever, may continue to do their business without
resort to note-issues at all. So far as this takes place these
banks would be entirely unaffected by the requirements for the
Guaranty Fund. In case need should arise for the temporary
issue of notes, when the need for the issue had passed, and
measures had been taken to retire their notes, their contribu
tions to the Guaranty Fund would be withdrawn and their
responsibility for the issues of other banks would thereupon
cease and determine.
If it be taken into account how small in fact the losses from
failed banks might have been, as previously discussed, it will be
found that only a very small part of the Guaranty Fund would
have been called upon to meet the sporadic cases of bad manage
ment. How small this amount would be, as determined by the
character of the assets held by the banks, during the last thirty five years, is surprising to those who may not have investigated
the facts. The banks have, moreover, been able under the pres
ent law to pay a tax on circulation of 1 per cent.; and yet the
average annual assessment on circulation for the Guaranty Fund,
as already shown by the experience of thirty-five years, would
amount to only one-fortieth of 1 per cent. Attention in this
connection should be called to the recommendation of the Com
mission that the expenses of the banking system should not be
provided by a tax on circulation, but by a tax on capital and
surplus. Hence, if there should be no other tax on circulation,
the insignificant contribution for the Guaranty Fund can not be
s'aid to be seriously heavy.
.
Resting the security of the notes on the general assets of a
bank gives direct importance to the fact that good or bad bank
ing depends entirely upon the kind of discounts made. Hence
it is proposed under the new plan to obtain so far as possible an
improvement in the methods of examinations and reports upon
the character, of the resources of the banks. The mere fact that
banks have a responsibility no matter how slight, for each
other’s notes, will induce a habit of vigilance and watchfulness
over the character of other banks which will not only make

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each more careful as to the discounts it makes, but will con
stantly tend to drive to the wall mismanaged institutions. Banks
showing bad judgment or fraudulent intentions under this sys
tem would be so hard pressed by other banks to meet their
obligations that they could not long exist.
It should also be kept in mind by other banks in the system
that the method of rapid and constant redemption which is
likely to take place under the proposed system would make it
impossible for the mismanagement of banks to go on long un
observed. Hence the system of redemption affords a protection
of great practical importance to the other banks in the system
as a means of detecting the condition of their banking resources.
The character of the assets of each bank will be' constantly
tested by the requirement to pay its notes on demand.

III. It is necessary next to discuss the provisions in the pro
posed plan for the protection of the note-holder so far as they
affect the depositor. Attention should again be called to the
fundamental assumption upon which any system of bank-note cir
culation must be based. This assumption is that the note-holder
must be given absolute safety. It is useless to discuss note-issues
on any other basis. Under the present national banking system
the note-holder has absolute security; and it is believed that
also under the new system, as already fully described, the note
holder is given absolute and perfect security. This is as it
should be. Inasmuch as the note moves to a distance from the
issuing bank; as it is in a form usually accepted by innocent
holders as good money; and inasmuch as members of the com
munity should not be obliged to investigate the individual char
acter of each bank whose notes are in circulation, the security
for each and every note must be thoroughly established inde
pendently of the management of any particular bank. The
position of the depositor is necessarily different from that of the
note-holder. The former is usually one close to, and able to
inform himself about, the bank in which he deposits. He is in a
position, moreover, where he may be expected to choose his de
pository bank for himself, and very properly to face all risks of
his own judgment in this matter. It is instantly to be seen that
the State could not possibly undertake by regulations to protect
a depositor in the exercise of his own voluntary judgment in
regard to good or bad banking management. It is clear, there
fore, that the depositor stands in a different relation to the bank
than that of the distant and innocent note-holder. The depos
itor, it is true, may be protected in general by regulations
peculiar to his case—by publicity, by frequent examinations.

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and by vigilance of the Comptroller against loose and fraudu
lent methods. Beyond that banking regulations can not go.
We now approach the question first raised as to the effect oi
the proposed plan on the depositor with two clearly defined
propositions which all must accept: First, that the depositor
holds a different position relatively to the bank than the note
holder; second, that the note-holder under any practicable
scheme must be made absolutely safe. With this understanding,
it may be well to discuss the effect on the depositor of the prior
lien on the assets of the bank in favor of the note-holder. It is
well understood, of course, that for the notes issued, the bank
has received an equivalent amount of resources. Under the
present national banking system, that part of the assets equal
to that received in return for the issue of notes is, in the begin
ning, taken irrevocably away from the depositor; and in order
that it should not possibly fall into any other hands, is invested
in bonds and deposited with the Government. Under the pres
ent system, therefore, the note-holder has a claim upon the
assets of the bank prior to all other claims. The new system
proceeds upon the same principle. Although the method of af
fording the protection is different, only the same amount event
ually goes to the note-holder under the proposed as under the
present system. Consequently, in either system the assets cov
ering the note issues are necessarily so placed that they can not
go to the depositor.
A national bank which, under the present law holds in its re
sources, say $500,000 worth of bonds, as a protection to its notes,
which are but (we will suppose for simplicity) to an equal amount,
would, under the new system, hold $500,000 more of general
resources (instead of bonds in the Treasury) to cover an equal
amount of notes. The resources behind the depositor are thus
not affected by the change of the bond resources into the form
of other general resources. On this additional amount of
$500,000 of general resources behind the notes, the depositor
would have no more claim than if those resources existed, as
now, in the form of bonds. In the case of mismanagement and
fraud, under the present national bank system, the depositor
would suffer directly by the effect on the resources lying behind
his deposits. Merely because the additional resources corre
sponding to the bonds are held in the possession of the bank
and not by the Government, the depositor has no right to as
sume that that fact gives him any moral precedence on what
lies behind the notes. The only way in which the depositor
can be protected from mismanagement is, that directors should
direct. Good management will inspire confidence and insure

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large deposits under either system of banking; and under
either they will be equally safe.
In most cities there now exists keen competition between na
tional banks, on the one hand, and state banks and trust com
panies on the other hand. It may be said by state banks to
depositors, that it would be desirable for them to deposit with
the state banks, because, if they deposited with a national bank
under the new system, the note-holder of the national bank
would have a prior claim upon the assets of the bank in case of
failure, and that consequently the deposits would be safer with
the trust companies and state banks. We have already shown
that on entering the new system, a national bank would have in
its possession more resources by exactly the amount of its present
bond-holdings kept for security of its notes. Under the present
national bank system, by which the portion of the assets intended
to secure the notes are placed with the government, in order that
mismanagement can, in no possibility, reach them, losses from
bad banking can still fall upon the resources behind the deposits.
Under the new system the depositor would be worse off only on
the supposition that the resources behind the notes, being in the
hands of the bank, were thereby liable to mismanagement. On
the assumption of bad banking—such that this one part of the
resources (behind the notes) is invalidated—it is certain that no
other part (such as that behind the deposits) will be any better
off; and the risk to the depositor resolves itself, as in every case
it must, into a question whether the bank is well or badly man
aged as a whole.
Such statements as the above, however, may be used by the
state banks and trust companies to influence depositors at a time
of distrust in the money market. At a critical time depositors
might be induced to withdraw large deposits from national
banks for fear that in case of failure the note-holders, having a
first lien, might exhaust the resources of the bank. Among
unthinking depositors this might be selfishly used to the disad
vantage of the national banks. It should be observed as to this
point that the national banks have a remedy in their own hands.
To a timid depositor, instead of a deposit they can offer their
own notes, which would be a first lien upon the resources of the
bank, and the depositor would then be even better off with the
national bank than if he held a deposit in a trust company or a
state bank; for, as before explained, the notes would be abso
lutely safe.
■
'■
In fact, it is apparent to every one that the unimpaired capi
tal, which necessarily appears in the resources, furnishes • an
amount of assets which act as a buffer to receive losses before
they reach the depositor.' If the note-holder has a prior lien

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17
"before the depositor, it is equally clear that the depositor has a
prior claim before the shareholder, and the capital must be
totally impaired before a loss can fall upon the depositor. No
other precedence of claims is defensible under any banking law.
It might be remarked in passing that if a national bank found
itself pushed by the competition of trust companies under state
laws, it might create a situation under the new system which
would give the depositor exactly the same protection as now
under the system of a deposit of bonds to secure the note-holder.
That is, if a bank wished to guard against any objection to the
position of the depositor under the new system, it might take
that portion of its resources which was equal to its note liabil
ity, deposit these resources with a trust company as trustee for the
note-holder, and then the bank would stand in exactly the same
position relatively to depositors as a national bank does now.
It is not believed, moreover, that depositors would prefer a
trust company under state laws .as against a national bank under
the proposed plan, or vice versa, upon any such analysis of bank
accounts as has here been given. It will be found, in fact, that
depositors place their accounts with banks quite irrespective of
such considerations as have been advanced above. Depositors,
as a rule, deposit where deposits are already large. A well
managed bank, having the confidence of large interests, and
already having large deposits, thereby attracts. other deposits.
Smaller depositors naturally reason, that, if men in charge of large
estates select a certain bank for the deposit of large sums, they
must have good grounds for their confidence, and they follow
their example without more examination. The banks obtain de
posits on the principle of “ to him that hath shall be given.” The
accumulation of deposits by a bank in any place depends so
entirely upon its reputation for good management, that it is
quite independent of the particular system under which the
bank is doing business. A trust company or state bank will
obtain deposits, not because it is acting under a state law, but
directly and solely because of the confidence of the depositors
in the reputation and management of the bank. And the same
holds true of a national bank to-day; it will accumulate large
deposits, not merely because1 it is a national bank, but because
it is a well-managed bank. Under the proposed plan, the de
posits of the community will be distributed undoubtedly for
the same reasons as now, because of the' confidence of the de
positors in the relative management and reputation of the
respective banks. Objections, therefore, to the proposed scheme
on the above mentioned grounds of its effect upon depositors,
must be, without doubt, largely fictitious.
(2)

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18
IV. It is important also to examine into the effect of the
plan of the Commission upon the relative positions of city
and rural banks. Of course, any one familiar with the opera
tions of banking perfectly understands that the profit to a bank
does not necessarily depend on its power to issue notes. On
this point, however, a widespread misapprehension exists. It
is supposed that by granting to banks the privilege of issuing
notes, there i.s conveyed to them a means of making large c
profits and of monopolizing the market for loans. This belief
is largely erroneous. At the very outset we are met by the
fact that the largest city banks in our country, almost without
exception, make very little, or absolutely no use of their right
to issue notes; and yet these great banks make a profit from
banking and pile up a huge surplus. How can this be, if the
note-issues are so important a privilege ?
■
A bank in reality makes a profit by buying and selling. In
making a loan, or discount, it buys the right (duly secured) to
receive money in the future, and it pays for this by creating a
liability on its resources to pay the borrower on demand. The
profit arises from giving the borrower a claim for immediate
payment less the bank discount or profit. It follows that the
gain to a bank is settled by this discount operation, and resides
in that. And this profit is the same to the bank whether the
demand liability is issued to the borrower in the form of its
notes, or in the form of a deposit-account to his credit. Whether
one or the other form of liability is actually used depends not
upon the will of the bank, but upon the choice of its customers.
In the great financial centers the banks adapt themselves to
their constituents, who do not wish to carry notes about, but
who find it much safer and most convenient to pay entirely by
checks or drafts on deposit accounts. This explains why the.
richest city banks with enormous deposits, do a profitable busi
ness without issuing any notes.
It is quite otherwise in rural districts: there the small bor
rower calls for notes, and seldom uses a deposit account. On
proper collateral being presented, and a loan being asked for,
the bank can not grant it, unless it is able to provide that kind
of bank currency—that is, notes—which the habits of the com
munity force the borrower to choose. If, as under the present
national banking system, the small banks of the South and
West find it unprofitable to issue notes, then it often happens
that, even where banking capital exists, it can not be used in
the particular way which would be of most advantage and con
venience to the community in which it is placed. How true
this is may be seen by the following statement:

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19
,3

A , .... j

Groups.
<1

a
3

■

o
a
East.

N. H.... '
Vt............
RI.........
(Outside
Prov.)

a
w
a "
|
"m3

•A
nd
. a

..S nd

(2)

■

nd .S

' g S'
■ co

34 O'S
•H ®

A fl
"5
O'

A ' "-

34
5 3 S

8
O
<y "7!

§ O'S

I gw ■

(3)

(4)

3 o g ..
(5 ®’A
fl w
I"5 A
(5)

$1,457,500 $1,816,675 $3,734,500
1,471,250 1,568,460 4,857,750
1,175,000 1,729,435 3,239,725

a
a

3
3 ti
^

o !>
s .^ 5
o f o
3
to
toAW
® 'o 5
5 V 5

^ o o

MWH

(6)

$3,274,175
3,039,710
2,904,435

$5,292,000
6,309,000
4,414,725

■ 520,190
658,700
215,045

1,966,500
3,637,440
774,000

546,240
712,500
215,000

26,050
53,800
45

1,420,260
2,924,940
559,000

None
None
.009

259,190
234,587

1,098,000
760,500

180,000
215,000

79,190
19,587

918,000
545,000

.08
.003

513,705

1,735,200

424,500

89,205

1,310,700

.06

.49
.32
.53

West. '
N. D ....
Mont....
Wyo...;.

South.

Ark.........
La..........
(Outside
N. 0.)
S. Car.....

As will be seen, returns for three groups of states are given,
one a typical Eastern group, one Western, and one Southern.
The first column displays the returns for circulation actually
outstanding, the second gives the maximum circulation which
under present laws it would be possible to issue, i. e., 90 per
cent, of the par value of the capital stock of the banks. Col
umn 3 represents the circulation corresponding to the minimum
amount of bonds required to be deposited by the banks accord
ing to law. The differences between the circulation actually
outstanding (1) and that corresponding to the' required deposit
of bonds (3) represents the amount which, under current condi
tions, the banks are induced to issue over and above actual legal
requirements, and is given in column 4. The differences be
tween the possible maximum (2) and the circulation upon the

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legal minimum of bonds (3) is given in column 5, and repre
sents what the banks might issue if conditions made it suffi
ciently profitable to induce them to do so. The percentage of
column 5, to column 4, indicates what proportion of this possi
ble surplus above legal requirements the banks are actually in
duced to issue.
.
The plan of the Commission will work in the interest of the
rural communities, and of small borrowers in those regions.
Indeed, the plan is only carrying out equal justice and fairness
to all classes and to all parts of the country. The large city
banks do their business and earn a profit mainly without the
use of note-issues. They create a form of currency, of a highly
efficient quality as a medium of exchange, by which profits are
obtained. But mark this point: this medium of exchange is
untaxed (while the currency of country banks, that is, note
issues, is, taxed), and it is based on the security of the general
commercial assets of the banks. Kow, would it not be fair and
just to allow to other parts of the country, where the note
liability is the only convenient form of completing the discount
operation, an equal right to an untaxed medium of exchange,
and to one also based upon the general commercial resources of
the bank? That is no more, no less, than justice. The recom
mendations of the Commission, therefore, concern mainly the
small producers and borrowers in districts other than the finan
cial centers.
It is true that if the method of issuing notes is made less bur
densome and expensive, the city banks may issue more notes
than now. They would do this, however, provided they could
supply other (and generally rural) communities with notes, in
default of sufficient local banking facilities. At present, for
reasons illustrated by the figures given above, the country banks
borrow of the city, and thereby obtain the currency which they
do not row issue themselves. Under the plan of the Commis
sion, the main demands of rural districts for notes will be sup
plied by the country banks, and they will not bo obliged to de
pend so largely on the cities.

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