3: The Problems of Commercial Banking
For the banker and the public, commercial banking poses a number of "problems" which the author means to discuss in this chapter.
The Supply of Cash
The chief problem that the banker faces is managing his supply of cash. He has promised to his depositors that he will return their money whenever they ask for it, even though he has loaned out most of their money to borrowers who will repay it according to the terms of their loan agreement. This puts the banker in a position where his depositors may wish to withdraw their money before the borrowers have repaid their loans.
To address this, bankers keep two reserves. Their primary reserves consist of the money they have on the premises, which can be paid out immediately. A secondary reserve consists of certain securities that they can quickly sell to generate cash within a day or two.
There is no single calculation that determines the amount that a bank must keep in reserve to be safe. It depends on when depositors can be expected to want their funds. As most people follow habitual patterns, the banker can predict when they will wish to have their cash - but habits differ among locations and groups. For example, most people in continental Europe use cash routinely, whereas those in England and the US are more likely to use checks fir their routine needs. OR if a bank has a large number of customers who are in the same profession, their patterns will be different than those of a bank whose customers are concentrated in a different one.
There are unusual circumstances that will cause people to need more or less cash than usual, some of which are predictable and others of which are totally random. And much of it depends on the skittishness of individuals: some people panic and react dramatically to rumors, others are more level-headed. The use of notes and bills in circulation also helps a bank manage its cash reserves. When a note is not payable until a specific date, the bank is assured that it will not need the money to redeem the note before that date.
There is a brief mention of the money supply, when there are simply not enough coins in the town, county, state, or country to supply all the demands to have them. This is regarded as a theoretical issue that seldom ever occurs and is usually temporary. The existence of government notes, which must be accepted a legal tender, is typically sufficient to tide banks through such periods where money is in short supply, but "whether or not a government ought to assume such a responsibility is a question which will be discussed in a subsequent chapter."
The Selection of Loans and Discounts
Where a bank extends a loan to a borrower, it is possible for the bank to investigate the creditworthiness, inspect the collateral, and oversee the business of the borrower to assure itself that the loan will be repaid. Where a bank accepts a promissory note or bill at a discount, these details are often opaque, placing the bank at the risk that the paper will not be honored when it is due.
Where paper that promises future payment is used as a means of reserve, it is a further risk to the bank because its immediate need for cash cannot be directly satisfied by a note that promises future payment. These notes may be sold by the bank at a discount to another bank, and that discount is generally small as a ration, but when aggregated the total amount of the discount can be significant. Hence the actual value that can be gained at any given moment is less than the amount represented by the maturity value of these vehicles.
Mitigation of this risk requires "a properly equipped credit department" - which larger banks have the capacity to maintain, but which smaller ones may not, and it is to their detriment because of the risk they take when accepting commercial paper on faith.
Rate Risk
Interest rates are the chief means of competition among banks, and there is pressure from the market to pay as much interest as possible on deposits while collecting as little interest as possible on loans. Were there a standard schedule of interest to which all banks agreed, and if this schedule never changed, a bank could easily determine its revenue and expenses of lending activities. But things are not thus.
Because most banks operate on thin margins, the daily variation of rates may pose a risk to the profitability and solvency of the bank. In general, a bank has made contractual agreements to its depositors (particularly those who have agreed to time deposits) to pay them a certain rate of interest - and this agreement is set before the bank knows what amount of interest it will be able to receive from lending those deposits. So a bank may contract to pay more interest to depositors than it can collect from its lending activities, where there is greater competition for deposits than there is for loans.
The bank also cannot control the aggregate amount of capital and credit in the market. It may so happen that there is a shortage of borrowers (the bank must pay depositors for money it cannot loan because no-one wants to borrow it). There is also an opportunity cost in lending, when rates increase and the bank has already committed its depositors' funds to loans at a lower interest rate, whose borrowers will be in no hurry to repay ahead of the agreed schedule.
Unsound Banking Practices
Commercial banks are part of the "essential machinery" of commerce: agriculture and industry alike depend on banks for their transactions and to supply their need of working capital. So the collapse of a bank harms not only its owners, but the entire community it serves. History has shown that the collapse of a bank is detrimental to the prosperity of its community, so there is ongoing debate about the degree to which government should regulate and monitor the banking industry to ensure its reliability.
In general, it is necessary to ensure banks maintain sufficient capital reserves to satisfy the needs of depositors. Bank runs have been the primary cause of the collapse of commercial banks, and these panics are only exacerbated by the public doubt about the ability of a bank to meet its obligations to depositors. While it is in the profit interest of a bank to keep as much of its capital "working" it is in the interest of the depositors to have the capital (their deposits) held in reserves. There is some consideration of the manner by which government may control the surplus of the bank, and an indication that the proper reserves of a bank ought to be between ten and twenty percent of its deposits.
There's an extended consideration of the liquidity of reserves, as banks often keep assets other than cash in their reserves (or invest their reserves in investment vehicles to improve their profitability), and the specific kinds of securities (bonds, stocks, etc.) a bank ought to be able to purchase with its reserves in order to have the ability to access cash quickly to satisfy its depositors' demands - not to mention to avoid risk. IT's noted that "foreign legislators have approximated more closely than ours what is needed in the regulation of bank investments."
Banks are often blamed for another public malady: price inflation, which occurs when the supply of money is too great in comparison to the supply of goods and services. Because banks are capable of creating money by extending loans and underwriting commercial paper, it is possible for banks to create so much money that its value in exchange decreases. The reserve requirement may address this, but because banks are able to obtain loans from other banks and use them to substantiate more loans (the money multiplier), banks have great latitude in the amount of (credit) money they can put into circulation.
The problem of inflation to the consumer is that the money they have and will receive becomes insufficient to purchase the goods and services it once did. The money in savings loses its purchasing power, and the laborer's weekly wages purchase less and less of the things his family needs.
Ultimately, the author feels that transparency is the best safeguard against bad bank practices. If the public were aware of what the bankers were doing with their money, they could react appropriately - and this watchfulness would serve to keep bankers honest, as they would be punished by an exodus of depositors for any malpractice. It is not uncommon for chartering agreements to require a bank periodically disclose its activities and make its ledgers open to inspection - the more frequently and more widely, the better.
Historically, banks were highly sensitive to their reputations as the trust of their depositors was necessary for them to remain in business. As competition and the number of banks increases, there are far more banks than can be kept track of and a number of upstarts and fly-by-night operations that seem to come and go. The cautious consumer chooses his bank wisely, but the avaricious one will choose indiscriminately - and perhaps it is fitting punishment when his greed draws him to a swindler.
Adequacy ad Economy of Service
Even in the author's time, it was observed that the evolution of banking in a society tends to follow a pattern: it begins with a large number of small banks that, over time, consolidate into a small number of large banks.
Where there are many small banks, they tend to be insular. Borrowers draw from funds contributed by depositors in the same community and there is little movement of capital into our out of the local market. This can perpetuate so long as deposits are sufficient to provide the funds needed for economic growth.
There are advantages to this system: the borrowers are well known and easily qualified and monitored by the bank, and if there is a catastrophic failure, it affects only one community. But on the other hand, this isolation slows economic growth (if the local depositors do not provide as much capital as could be used) and diminishes competition (it is easy for one or two banks to have monopoly power over interest rates in that community).
A system of few large banks with branch offices creates a system in which there is a great deal of capital that can easily be transported from one community to another and in which there can be more open competition among banks for depositors and borrowers that will offer each the most advantageous rates. Its chief weakness is that it is not fault-tolerant and the failure of a large bank can have a major impact on many communities.
It's also mentioned that the "bigness" of an organization tends to draw attention. For better and for worse, politicians are uninterested in small banks and far too interested in larger ones. Whether their intention is to protect the consumer or help themselves, they are much more prone to meddle in the affairs of a large organization.
Where banks are left to their own devices, both banks and offices tend to "spring up spontaneously" wherever they are needed. A banker will recognize the opportunity that exists in a given location, assess whether offering service can be done in a profitable manner, and act accordingly. This seems the best situation. While it can be said that the members of a community that is not large or prosperous enough to sustain a bank should be served, service can only be provided at a loss to the business that serves them - such a bank will not persist, or it will need to be propped up by government support (taxation of the members of the community to pay the operating costs of an unprofitable operation).
Some mention is made of the chartering system, in which no-one may operate a bank except by permission of the government, who uses operating licenses or charters to indicate where they think a bank ought to be established and how many banks ought to be needed for a community. This is helpful or harmful inasmuch as the government is correct in its assessment of the need for banking services. (EN: And is based on the presumption that politicians are more qualified than bankers to make this assessment.)