12: The Principles Which Should Regulate the Amount of Banking Reserve to be Kept by the Bank of England
It is widely supposed that the central bank can set an arbitrary reserve ratio, perhaps a third of all deposits to be held in ready cash, and to be able to predict its cash flows by examination of historical patterns of the supply and demand of money. But there are several factors that prevent the business of a central bank from doing so, some arising from the general nature of the banking trade, others from the special position of a central bank.
The amount of liabilities of a bank is plainly the principle element in determining its required reserves - but it is not the only element, and neither is it homogeneous. Aside of demand accounts that can be withdrawn at any time, though they tend not to be, there are time deposits that cannot be demanded except on a certain date without penalty, and tend to be withdrawn only on that date. Naturally, the bank should consider the specific properties of these two very different forms of deposit when considering its reserve.
It is also necessary to consider the nature of deposits. The behavior of a single depositor is generally predictable, as his need of capital derives from habit that form a pattern of deposits (when he receives income) and withdrawals (when he pays expenses. A small bank with 3m in deposits that has one large client whose deposits are 1m would do well to give keen attention to the one client who, at any time, can demand a third of the bank's capital. While this situation is unusual, it is less unusual that a bank of this size might have a majority of its investors involved in the same trade: a bank in an agricultural district will deal with a large number of farmers, whose income and expenses move in similar patterns. It is not unreasonable to suggest that farmers might constitute 33% of the banks deposits, in which case the banker would do well to consider the specific pattern of these customers, in aggregate, to predict his need of reserves.
While this is a general truth about banking, it is particularly applicable to the central bank, as the Bank of England has one major customer that constitutes the majority of its deposits, that being the government of England, whose account balance is highly predictable, at least in times of peace. Moreover, a great deal of granular details is available about its revenues and expenses - the amount of taxes that will be collected on a given date, the amounts that will be disbursed on specific dates, is documented and its budget is subject to little fluctuation. In times of war or national crisis, the situation is entirely reversed, as the government will withdraw as much as needed, whenever it is needed, but this is periodic and irregular: even then, the ordinary business of government perpetuates with great predictability. While some exceptions exist - such as the Department of India whose expenses and revenues fluctuate in a manner that defies prediction - the government account is predictable, as the account of a large depositor at a country bank, and indications of future changes are even more so. Even its unusual activities are not unpredictable, as there is a great deal of discussion before any decision is made, and then implemented, that will impact its financial behavior.
If we look to private deposits to the central bank, we may observe a similar pattern. The BE holds the reserves of other banks, and as such the "bankers deposits" constitute another significant portion of the bank's assets, and they are also subject to little variance. Each banker seeks to keep as little stagnant money as he can, and is keenly aware of the flow of deposits and withdrawals, as well as the demand for credit - and as such he will deposit or withdraw from the central reserves very moderately. In this way, the smaller bankers mitigate fluctuations in demand of money by their own operations, and their own deposits and withdrawals are less frequent, moderate, and predictable for the central bank. Banks will behave unusually under unusual circumstances - during a fiscal crisis, they reduce credit and seek to fortify their reserves - but aside of these unusual periods, the bankers' deposits are largely stable and predictable.
The author provides the example of the German government, which at the time removed significant amounts of billion from English banks. As with other government accounts, the funds of the Germans were largely predictable, and some significant amount of funds was amassed over some years. The Germans kept their balance not with the Bank of England, but with a joint-stock bank where it was among the bank's largest account, which introduced one problem for the central bank: it could not monitor or predict the movement of these funds, as they were maintained in a private company and intermingled with the other funds of that bank. As such, the amount of money was unknown, and the potential impact to the English banking system should Germany withdraw its funds all at once remained unknown - but because the JSB that held the German accounts would need to demand its reserves of the BE to cover withdrawals, it had great and ominous potential: the government of Germany could by demanding the return of its deposits quickly bankrupt the central bank of England.
The unavailability of cash at the central bank would affect not only the bank itself, but the entire banking systems, whose cash reserves ultimately reside in the central bank: there would be the need to rebuild the reserves by curtaining credit, which itself would ripple through the economic system as all manufacturers and sellers of goods rely heavily on credit to produce goods and pay their employees (so that the employees may purchase goods that have been manufactured). And this, more so than the effect within the banking reason, is reason the central bank ought to deal "most cautiously and delicately" with banking deposits.
The author reiterates one of the main theses of the present book: the Bank of England holds the ultimate cash reserve of the entire country: whatever cash must returned to any depositor is ultimately drawn from the reserve of the central bank.
The author has not seen a written proposal, but has heard "from persons very influential and very qualified to judge" that the central bank ought to safeguard the deposits of other banks and refrain from lending them out - for the value of a bank's reserves if they are not convertible to ready cash is extremely questionable.
However, implementing such a rule would be dangerous to the money market and the economy of the nation: the fluidity of capital in the economy is entirely dependent on credit, and the deposits of the central bank are the origin of much of this credit. Were bankers deposits to be held in bullion, a great deal of cash in the form of credit money would be withdrawn from the economy to lie dormant in the vault of the central bank. The contraction of credit would cause stagnancy - as it is "niggardly lending" that causes panic and uncertainty about the stock of cash, and ready lending which creates confidence in its availability.
Another simple rule often considered for the management of banks must also be abandoned: the notion that the bank should look to the current market rate in setting its own rates has always been erroneous. In determining the rate to demand for credit and pay to depositors, a bank must consider the impact of the rate upon its own supply and demand of funds, rather than those of the money market in aggregate. Merely following the market in general does not ensure safety for any given bank, and the tendency of bankers to attempt to match market rates "has often produced grave disasters."
All of this considered, there is no certain or fixed proportion of deposits that should be kept in reserve by all banks at all times, or even for any specific bank at all times. The probable demands on any bank are so various that no simple and easy calculation is a sufficient guide, and an arbitrary portion such as one-third will be at some times insufficient and at other times more than is necessary.
There is also the question of whether a bank should make public an account of its reserves. There is some concern that advertising the fact that the bank keeps not enough cash on hand to repay its depositors would create a sense of insecurity and panic - but since it is generally accepted by depositors that the interest they earn is by virtue of the bank's ability to lend there funds, there is no expectation on the part of depositors that a bank should retain all their money, and they are satisfied merely by the ability to access their funds as needed. In practice, the effect of publication has had entirely the opposite effect: knowing that the bank has a considerable amount of money in reserve, even though it is not equal to deposits, has been found to be reassuring to depositors.
The author expects this remains true so long as the reserve itself is not exceedingly low. There is likely an "apprehension minimum" that is tolerable to depositors, and if the bank's reserve falls below that amount, fear may ensue - it may not be absolute panic, but some "vague fright" that causes the depositors to feel a sense of discomfort. Should the bank approach this point, a trickle of the most timid depositors will close their accounts, signaling the bank to suspend the issue of credit until the reserves can be built to restore depositors' confidence.
And again, there is no simple method for calculating this "apprehension minimum" for a bank - it can only be known by observation of the behavior of depositors at each instant in which the published reserve is decreased to see the effect, if any, on the confidence of depositors. This would also require the bank to take a conservative approach to credit, issuing loans in smaller increments rather than large amounts, so as not to make too great a change in its reserves that would panic a great many all at once.
It's also likely the "apprehension minimum" is not the same in all times. Where the economic activity in an area is high and depositors have ample income, they are likely less concerned about the security of their deposits and will tolerate a lower reserve; but when economic activity decreases and depositors feel they may need to rely upon their deposits to cover a personal shortfall, the sensitivity to the reserve will increase.
The author hazards a guess at the "apprehension minimum" of the British public, and suggests it to be about 10 million - and as such the bank should seek to maintain a minimum reserve of 11.5 million, given that about 1.5 million is a reasonable buffer. But this, too, is an arbitrary estimation that should not be taken at face value, whatever the strength of reasoning or evidence can be presented - the bank should instead monitor the temperament of its depositors, and it may find that apprehension arises at a higher amount.