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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 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 1 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 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 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 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 3 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- https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 4 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 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 5 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 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 6 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 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 7 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 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 8 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 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 9 $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- https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 10 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 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis ll 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. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis