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THE VALUE OF A SECONDARY RESERVE

ADDRESS; BY HENRY H.^McKEE
President, National Capital Bank, Washington, D. C.
''

^at the

Eleventh Annual Convention of the

DISTRICT OF COLUMBIA BANKERS ASSOCIATION
Montauk Point, Long Island

June 2®, 1929.2
During the past eight years five thousand banks in the United
States have failed. Although new banks have been brought into
existence during that period the total number of banking units
today is 26,000 whereas in 1921 they numbered 30,000. A decrease
in the number of banks is desirable if the number can be reduced
through consolidations which result in larger and stronger units.
But the closing of banks through failure to pay their debts is a
matter of deep concern to the communities in which the failed banks
are located and to all of those who are engaged in business. Bank
failures do not inspire confidence.
When a bank offers its facilities, it appeals first to the confidence
of the community and then to its goodwill. Confidence is the basis
of all modern business. Enlightened selfishness, the mainspring of
human action especially in the domain of business, does not lead
one to turn over his property to another unless he believes he can
recover it or its equivalent for his own use when he needs it. Thus,
belief in the ability of a bank to return on demand to its owners
the deposits left in the bank is the basis of the bank’s relation with
the public. If a large number of banks fail to redeem their obliga­
tions, the cause is a matter of deep interest to all bankers because
it is, to some extent, a reflection upon the system of which they
are a part. In respect to fundamental principles all banks, whether
they be large or small, require the same kind of management to be
successful and all are subject to the same economic laws. The
banking public seems to have sensed this truth, perhaps because
standards of banking practice have been established by law, and
individual banks are regarded simply as units in a firmly established
system that is the outgrowth of the favorable experience of mankind


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and the result of careful thought and study by men who are familiar
with the principles of financial management.
This attitude of the banking public imposes an obligation upon
the bankers as a class. They cannot point with pride to their indi­
vidual achievements without, at the same time, making every reason­
able effort to place the business of banking as a whole upon a firm
basis, and through study, educational work, and co-operation remove
bank failures from the news of the day. That such an effort is
being made now by prominent bankers is evidenced by frequent
discussions of problems of bank management.
Although all bank failures cannot be traced directly to bad man­
agement, as occasionally some are the result of economic conditions
beyond the banker’s control, nevertheless, intelligent management
will go a long way toward reducing their number. In this con­
nection it might be helpful to use the term “intelligent banking
policy” as well as “intelligent management” because the work of a
bank is divided into three parts: First, the establishment by the
directors of a definite policy for the operation of the bank. Second,
the management, which is carried on by the officers within the
limitations of the established policy. Third, the detail work, which
is carried on by the junior officers and clerks. While all three of
these major divisions of the work of a bank are important, the
most important is the establishment and maintenance of an intelli­
gent banking policy that will tend to make the bank a strong and
efficient unit in the system of which it is an important part regard­
less of its size.
•
The mechanical work of a bank has been brought to a high degree
of efficiency through labor-saving devices and improved methods of
accounting. The managerial work is generally efficiently carried on
through departmental organization and a division of responsibility
among senior and junior officers. But it is a debatable question
whether all of those who are charged with the establishment and
maintenance of an intelligent banking policy have given sufficient
attention to what may be termed “the philosophy of banking” to
enable them to discharge their obligations fully.
“Philosophy” may seem to be a strange word to use in connection
with the prosaic business of receiving deposits and lending money.
Id plain words it means, when applied to banking, “the principles
of systematized knowledge of the business of banking derived from
human experience.” Some of these principles govern the purely
domestic relations of a bank with its customers; others govern the
inter-relationship of banks as members of one great system; others
govern the relationship of the system as a whole to the productive
and distributive process, otherwise frequently referred to as industry


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and commerce. Many of these principles, having been tested and
found to be sound, have been incorporated in Statutory Law and
they form the basis of the high standard of banking practice estab­
lished by the Federal Government and by many of the States. But
not all of the sound principles discovered in the conduct of suc­
cessful banking can be incorporated in Statutory Laws for many
reasons. Thus, the law regulating banking is not a complete guide
to the successful conduct of that business and a strict observance of
Statutory provisions will not always save a bank that has been
weakened by the non-observance of vital principles, which, though
they are not expressed in law, are founded on prudence and common
sense.
If the practice of banking in this country were not controlled
by Statutes enacted by the Federal Government and the several
States, the law of natural selection would eliminate the weak and
unfit banks and in the course of time the business of banking would
get into the hands of comparatively few strong, able men who would
conduct their banks according to the principles of systematized
knowledge of the business and bank failures would be infrequent.
But under our system of government such a thing would be impos­
sible. We are not disposed to place obstacles in the way of those
who desire to enter the banking business if there is a reasonable
assurance that they will be successful. The intent of the law is
to keep the door of opportunity open and at the same time see that
those who engage in the business are fit to carry it on and that
the public is protected in its banking relations. If they invest a
reasonable amount of their own capital; if they are men of good
character; if they have a fair capacity for carrying on the business
they can get a charter from the Federal Government or from any
one of the States. The Sovereign power, however, establishes the
standards of practice instead of leaving such standards to be estab­
lished by the individual. But it must be remembered always that
no matter how high the standard thus established may be, there
are always principles not included in the law that must be observed
if the bank is to be successful.
Under our system of deposit banking a bank is debtor for the
amount of its demand deposits. It must keep in condition to meet
without hesitation at all times any demands that are made for the
payment of its debts. The fund that is kept for that purpose is
the reserve, the amount of which is fixed by law and when it falls
below the required percentage it must be replenished. The remainder
of the funds held by the bank, including its capital and surplus, may
be used in any way the directors and officers see fit to use it with­
out any legal restrictions except as to the amount that may be


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loaned to one borrower, the amount of securities issued by one cor­
poration that may be bought and the percentage of the value of
property that may be loaned upon real estate security. The use to
which this working fund is put indicates whether the banker is
prudent or careless, conservative or reckless, skilled in the proper
use of credit or ignorant of credit principles. The banker may elect
to keep all of his working funds in his own vault, but if he did he
would not make any money. He may keep them on deposit with
other banks. He may invest them in securities or lend them to
borrowers to, be used for various purposes. When he lets them out
of his possession to be used by others he does so for the purpose
of making a profit out of which to pay expenses and dividends and
create a surplus fund to meet losses and contingencies.
Banks are not charitable institutions. They are organized to
make money for their stockholders. It is the urge to make a good
showing, pay big dividends, and have the bank pointed out as a good
money-maker that creates unwise competition, often carries the
banker beyond the limits of prudence and common sense and brings
into existence many of the perplexing banking problems that con­
front us today. Although Statutory Law does not so provide, experi­
ence has taught us that in the establishment of a banking policy
it is prudent to provide for the creation of a strong and adequate
secondary reserve to supplement the primary liquid reserve to the
end that a bank shall be in a position to meet without strain all
demands for the payment of its debts.
A primary liquid reserve includes the legal reserve required by
law, cash carried in the bank’s vault and funds on deposit with
other banks that can be recovered on demand.
A secondary reserve may be defined as “earning assets” that
can be collected, sold, or used as collateral, to' obtain toithout delay
the cash necessary to meet withdrawal of funds and to keep the
bank’s legal reserve up to the percentage required by law.
It is a matter of record that if many of the 5,000 banks which
failed during the past eight years had maintained adequate second­
ary reserves they probably would have been able to weather the
unfortunate conditions which forced them into liquidation. There­
fore, with this lesson before us, is not the creation of a secondary
reserve a wise policy for all banks regardless of their size?
The amount and character of a secondary reserve cannot be
standardized. They depend upon the size of the bank, the char­
acter of its business, its relationship to other banks and the eco­
nomic condition of the community it serves.
If the working funds of a bank are used to purchase short-time,
self-liquidating obligations of merchants of undoubted worth, obliga-


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tions created by the production and sale of the necessities of life,
otherwise called staple commodities, a bank will need very little
liquid funds in addition to its primary reserve. It will have in its
portfolio prime commercial paper that can be sold or used as col­
lateral to get funds to restore its primary reserve and as such
paper is paid in full at maturity its earning assets will be turned
into liquid funds rapidly. When deposits begin to decline it can
meet that condition by refusing to purchase any more paper until
its reserve is restored and its deposits begin to increase.
If the working funds of a bank are used to make capital loans
and unsecured personal loans that have to be carried and renewed
for an indefinite time, or renewed upon the payment of small cur­
tails thus making the bank a silent and unwilling partner' in several
business enterprises, the working funds are frozen. While the bank
may be nominally in the banking business, it is really engaged in
several other lines of business by reason of its capital loans. If
deposits drop and the primary reserve becomes depleted the officers
and directors have many anxious moments unless their worth and
reputation enable them to get assistance from the outside to help
them to meet their obligations.
The two cases cited are extreme examples of banking practice.
The first one is the true bank of circulation and discount, so-called
because it helps producers and merchants to circulate their goods
among the people by discounting bills of exchange arising from the
sale and transfer of necessities, thus bringing into present and
immediate use the future or potential value of goods produced. We
call such banks “commercial banks” because they are the reliance
of industry and commerce and their operation accelerates the proc­
ess of production and distribution.
The second type of bank referred to is found in many small towns
and villages, particularly in agricultural communities, although cities
and towns in industrial sections have some of them struggling to
meet the competition of their stronger and better managed neigh­
bors. The reason for their existence appears to be two-fold. First,
the desire of a strong and self-reliant group engaged in the produc­
tion of staple products who make a living from the soil and those
engaged in small individual business enterprises to create and manage
for themselves the financial institutions on which they rely for credit.
The chief difficulty that confronts such banks is the lack of oppor­
tunity for diversifying their loans. Their funds are tied up in loans
to men who are engaged in one line of industry which may be
seriously affected by market conditions. Second, the desire of some
successful business man to pose as a financial genius and end his
successful business career as a banker. This statement is not


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intended and it should not be construed as a reflection on the char­
acter and ability of hundreds of able and successful men who have
been called from the business world to head banks because they
have the confidence and respect of the community. In such cases
the office seeks the man who is best fitted to fill it. The type referred
to is represented by the man who takes the lead in organizing a
bank in order that he may create a job for himself or use the bank’s
funds to further his own or his friends’ business ventures. The
depositors in such banks believe that because they have furnished
the deposits they should have preference in getting loans. They
resent having their money sent outside of the community through
its investment in bonds and securities or the purchase of commercial
paper and believe that the funds in a community should be used
for the improvement of that community especially for the improve­
ment of the individuals who own the bank. They proceed to tie the
bank’s funds up in long-time capital loans and unsecured personal
loans and expect the bank to carry them until the business for
which the money is borrowed is brought to a successful and profit­
able conclusion. If deposits drop, the absence of a liquid secondary
reserve is a serious matter.
Between these two extreme types of banks there are thousands
of other banks which are not as strong as the first type, nor as
weak as the second one. They represent the average of banking
in the United States. While all of them have some liquid assets
that can be turned into cash immediately to replenish falling pri­
mary reserves, they have "also slow and frozen assets.
Cash in bank, checks on other banks in the same place, and bal­
ances due from other banks that can be collected on demand consti­
tute the primary reserve. This primary reserve includes the legal
reserve which, in the case of members of the Federal Reserve System,
is carried on deposit in a Federal Reserve Bank.
What kind of earning assets are available for a secondary reserve?
If the bank is a commercial bank, with the larger part of its
deposits subject to withdrawal on demand and a smaller line of
savings deposits subject to notice of withdrawal, its secondary reserve
could be built up of the following assets in the order named:

1. Bankers Acceptances of the kind described in Section 613.
Federal Reserve Act.
2. Short-time, self-liquidating obligations issued by merchants of
undoubted worth covering the actual sale and transfer of
staple products.
3. Securities issued by the United States Government.
4. Securities issued by the political sub-divisions of the United


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States, provided they have a broad and ready market in which
they can be sold without delay.
5. Miscellaneous securities, including bonds, notes and debentures
issued by successful corporations engaged in supplying nec­
essary commodities and service, provided such securities have
been seasoned by several years’ successful operation of the
corporation which issue them and provided also they have a
broad and ready market in which they can be sold without
delay.

Bankers acceptances and trade paper are put at the head of the
list because the demand deposits of merchants represent the credit
of commerce and it should be used for commerce instead of invested
in capital loans. Such paper has a short maturity and it can be
rediscounted without loss, whereas capital loans represented by bonds,
notes and debentures, may have to be sold in an emergency for less
than their cost.
If the principal business of the bank is receiving savings deposits
and the commerial feature is secondary, securities of the three other
classes named should head the list with United States securities first,
because the savings of the people represent Surplus Capital with
which the tools of production and distribution and the instruments
of service are purchased.
Some may not approve this list and its arrangement with respect
to the relative importance of the different classes of assets as a sec­
ondary reserve. They may insist that call loans to brokers secured
by stock-market collateral should head the list for the investment
of both commercial and savings deposits. There is no doubt that
up to the present time the stock-market call loan has been the most
liquid of all loans and under normal conditions no superior form
of secondary reserve can be found. But as we are attempting to
discuss fundamental principles the call loan situation deserves brief
attention.
Stock-market collateral consists of bonds and stocks, notes and
debentures that have been issued to provide funds to buy the tools
of production and distribution, to make permanent improvements and
to provide working capital. Generally there is a broad and ready
market for such securities and loans made to borrowers on such
collateral are well secured by large margins. The borrowers know
the rules of the game and when payment is demanded it is forth­
coming. If the volume of such loans can be kept within reasonable
bounds to the end that industry and commerce are not robbed of
their rightful share of credit at reasonable prices, the balanced con­
dition on which prosperity depends is not disturbed. But if the


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reverse occurs production and distribution are slowed up and in the
end all business is adversely affected.
The call loan situation today is a manifestation of a basic cause
that has not been sufficiently studied and analyzed to enable us to
determine whether it is a constructive and helpful force in our
economic development or merely a gambling scheme. Some able
students and thinkers contend that it is pure gambling, that it is
a game of chance for immediate profit in which those who buy do
so merely for the sake of selling again in order to bring into pres­
ent use for their own advantage the future value which estimated
earnings of corporations five or ten years hence may give to the
stocks which they have issued. Others just as able contend that it
is an indication of the desire of thousands to become partners in
corporations that are making money through the rendition of valu­
able service and that the wide-spread interest in the stock-market
represents legitimate buying for investment.
Others point out that the new era of mass production has devel­
oped new methods of financing and that many corporations in addi­
tion to getting their capital directly from the people through the
issue and sale of securities without the intervention of banks are
also getting the commercial credit they need to circulate their goods
and services in the same way.
A public service corporation, rendering a valuable and growing
service, needs new capital. It issues $10,000,000 of new stock which
is sold to the public and the money is turned over to the corporation
to be used either as capital or commercial credit. If bank credit is
used in any way to effect the transfer of new capital from the people
to the corporation and the distribution of the corporation’s stock
among the people, bank credit has performed a valuable service
w'hether it finds expression in the usual type of secured call loan
or in any other form. It has helped to create or renew the tools of
production or service and at the same time provide a good invest­
ment for the savings or surplus capital of a number of individuals
who become partners in the business and receive in the form of divi­
dends income on the capital they have invested.
After the new issue of stock has been absorbed the earnings of
the corporation increase. A rumor is started that increased divi­
dends may be expected and soon, as a result of that rumor, the
quoted price of the stock advances until there is a well-defined move­
ment in all of the corporation’s issues and the stock changes hands
in large volume very rapidly.
What is the motive of those who buy the stock under such con­
ditions? Who can look into the mind and heart of another and
sell what is there? The only clue is some act committed or the


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spoken word, so none can tell why all who buy part with their
money in return for the stock. Perhaps some are convinced that
they are getting a good investment. But there is no doubt others
buy only to sell again at a profit. The use of bank credit either
through the medium of call loans or in any other direct or indirect
way to help those who buy an interest in a business only to sell
it at a profit does not produce anything. The use of bank credit
to help one to buy a safe and profitable investment may be con­
structive to some extent, but bank credit has not fulfilled its highest
destiny as a constructive force unless through its use the sum total
of wealth is increased. It may be safe and expedient to use it to
help to transfer title to1 a property right from one hand to another;
but unless something new and useful is produced as the result, bank
credit has not been used in a constructive way.
A judicial appraisal of the call loan situation as it exists today
moves one to hesitate to approve as a permanent, sound, economic
principle the universal acceptance of call loans as a secondary
reserve until we know more about the ultimate use of the funds that
are invested in such loans. If, as some assert, they find their way
into the realms of production and distribution for constructive pur­
poses and the situation can be controlled by the banks, there is no
other form of investment that offers more advantages than call loans
for the secondary reserve funds of banks.
In making a study of the effect of call loans one should not over­
look the following facts: 1. To use banking credit to give increased
motion to production by bringing into present use the consumptive
value of things produced to satisfy human needs is constructive
work. It helps to create wealth. 2. To use banking credit to create
and renew the tools of production is constructive work. It also
helps to produce wealth. 3. To use banking credit to accelerate
the process of bringing into present use the future hypothetical value
of a property interest in the tools of production is not constructive
work. It does not help to create anything new, nor add one cent to
the total of material wealth. This statement is not intended as a
criticism of that great free public market known as the stock
exchange which is just as necessary in the domain of business as
the bank.
The value of a secondary reserve can be demonstrated by analyz­
ing the hypothetical condition of two banks of the same located
in any one of the secondary reserve cities. Both are members of
the Federal Reserve System. Each has $100,000 Capital, $100,000
Surplus, $50,000 undivided profits, $1,000,000 of demand commercial
deposits, $500,000 of savings deposits and each one has $50,000
invested in the banking house. The legal reserve in each case is


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$115,000. $85,000 is retained for use over the counter. Thus, each
bank will have about $1,500,000 of working funds with which to
earn profits. One bank keeps $50,000 on deposit with a correspon­
dent, lends $250,000, or one-half of its savings deposits, on real
estate security, and uses the remainder, $1,200,000 in the following
way: Its directors believe that the bank should take a leading
part in' developing the community. If they have any policy it is to
encourage new business enterprises by supplying capital. Soon they
find that the bank has acquired an interest in a new opera house,
several gas stations, three or four automobile agencies, two or three
struggling factories, a real estate development, and several other
enterprises that are indebted to the bank for capital loans which the
bank must carry upon payment of interest and small curtails. In
addition to such loans the bank is carrying many personal loans made
to admiring friends who praise the liberality of their bank while
they condemn the ultra-conservatism of rival banks. This policy,
if it can be called a policy, is carried on until the entire amount of
loanable funds is out of control of the bank and the officers are doing
business in front of the counter and outside of the bank in an effort
to collect their scattered funds by attending meetings of directors
and managers of the various business enterprises in which the bank
has become a silent and unwilling partner. The only reserve the
bank can depend on is its legal reserve, its till cash, and the amount
due from its correspondent, in all $250,000 which constitutes its
primary reserve. Its debts are $1,500,000. Its primary reserve is
16%% and it has no secondary reserve. A sudden drop of 10% of
its deposits would exhaust 60% of its primary reserve with little or
no relief in sight as it has no liquid assets that can be sold immedi­
ately for cash. It is such banking that leads to failures or makes it
necessary for other banks or the clearing house to come to the rescue
in order to prevent public confidence in the local banking situation
from being shaken. A bank may get into such a condition without
violating the letter of the law. It may observe all legal provisions
for the conduct of its business and still get into trouble.
The other bank is willing to have the community developed and the
officers and directors may co-operate with other individuals to that
end, but they do not believe it is the function of a bank of deposit
which is indebted to part of its depositors and trustee for the
remainder to use their depositors’ money to make unsecured capital
or personal loans for that purpose.
This bank also keeps $50,000 on deposit with a correspondent, uses
one-half of its savings deposits to make high-class secured real
estate loans, but uses the other $250,000 of its savings deposits to
buy United States Government securities and various other high-


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class corporation bonds carefully selected that have a ready market
at all times on the theory that savings deposits represent an accumu­
lation of surplus capital and should be invested, not loaned.
In addition to that policy the directors establish another policy of
carrying always a fixed percentage of the bank’s demand deposits
in short-time, self-liquidating commercial paper( issued by makers of
undoubted worth. If that kind of paper is offered by the customers
of the bank it is bought, but if there is not a sufficient amount avail­
able to make up the required reserve the bank buys it elsewhere until
it has $250,000 of its funds invested in prime bankers acceptances
and commercial paper of undoubted worth eligible for rediscount by
a Federal Reserve Bank or that can be used as collateral to bor­
row from another bank. The remainder of its working funds are
used to make direct loans to customers both secured and unsecured,
but in making loans or buying paper it is the policy of the bank to
look into the quality of the credit purchased and find out the pur­
pose for which the proceeds are to be used, which is not only the right
but the duty of every bank that lends property belonging to others
The reserve position of this bank is:
$250,000 Primary Reserve or 16%% of $1,500,000 deposits.
$250,000 Bonds and Securities or 16%% of $1,500,000 deposits.
$250,000 Bankers Acceptances, etc., or 16%% of $1,500,000 deposits.

The $500,000 invested in bonds and securities, bankers acceptances
and prime commercial paper constitutes the secondary reserve, which
can be turned into cash in a short time. Its total primary and sec­
ondary reserve amounts to 50% of all of its deposits and it could
suffer a loss of 33%% of its deposits without touching its primary
reserve to pay its debts, whereas a 10% decline in the deposits of
the other bank would wipe out 60% of its primary and only reserve.
There is no question as to which one of the two banks is the stronger.
The great difficulty that confronts many banks with respect to the
establishment of a secondary reserve is the feeling that local bank
deposits should be used exclusively to supply local needs. If such
communities are attempting to support several banks among which
the available prime commercial paper which originates in the com­
munity is distributed, making it hard for each bank to get hold of
enough to make up a fair and reasonable secondary reserve, would
it not be better to concentrate banking resources and instead of hav­
ing four or five weak struggling banks, combine them in one strong
bank with adequate capital managed by trained bankers? The
demand for bank credit in some communities amounts to more than
the bank deposits, making it necessary, in order to supply the
demand for credit to use all of the bank deposits in making unse­


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cured, undiversified, capital loans. To meet such conditions would
not branches of large, strong, well-managed banks offer better facili­
ties than small, weak, local banks? These and other similar ques­
tions are engaging the attention of thoughtful bankers who realize
that while the principles of credit and banking may be comparatively
simple, it is no simple matter to apply them correctly and success­
fully amid the complex social and economic conditions that confront
us today. If this brief address has given you anything of a con­
structive nature to think about it has . served its purpose.


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