Act. Back of the law forbidding the banks to loan on real-estate securities may be seen the long periods of industrial depression and financial reorganization following the panics of 1825, 1837, and 1847. Each period of prosperity immediately preceding these crises had been one of capitalization of new promotions. At that time, however, speculation was based on the possibilites of increasing profits to be derived from the development of agricultural resources. Westward immigration had appropriated for use large areas, a new empire of grain lands for which new transportation development had opened a market to the seaboard. New cotton, tobacco, and hemp lands enlarged this area to such an extent that the territory appropriated but still undeveloped was larger than the old Atlantic slope to which capital had before confined its investments. In these new areas all other demands gave way to the clamor for new capital, and the commercial banks attempted to supply this demand. The failure of some eight hundred commercial banking institutions during 1837 and 1838 was the result of this kind of bank-credit employment; the failure of nearly fifteen hundred banks during the next three decades of State banking based on investment securities brought to the mind of practical bankers the character and purpose of the commercial bank. In 1903 and 1904, while Europe was going through the throes of financial reorganization, our farmers were blessed with large crops and high prices; a kind and bountiful Providence filled the granaries and the storehouses of the great West and South, permitting us to levy tribute on a distressed world. Temporarily judgment of our financial folly was suspended, but the instruments of self-destruction were still in the hands of an unthinking speculative public. These instruments of destruction were placed in the hands of speculators by commercial banks in the great financial centers. They were not used alone in self-destruction, but they carried merchant and manufacturer with them. 224. RESULTS OF INVESTMENT LOANING BY COMMERCIAL BANKS BY WILLIAM A. SCOTT When commercial banks create their own demand obligations, either in the form of checking accounts or notes against investment securities, they are creating an obligation which they may not be I Adapted from "Investment vs. Commercial Banking," Proceedings of the Second Annual Convention of the Investment Bankers' Association of America, 1913, pp. 81-84. able to meet. When they exchange credit accounts for commercial securities, the ordinary processes of commerce bring into their possession day by day the means of meeting the obligations which they create; but when they create such obligations against investment securities the funds regularly coming into their possession for the meeting of such obligations are quite inadequate for the purpose. The enterprises which these investment securities represent, however productive they may be, bring into existence only after a series of years an amount of produce sufficient to offset the original investment. If such an enterprise produces a profit of 10 per cent a year, it takes ten years to reproduce itself. If only 5 per cent profit per annum is produced, twenty years are required. The demand obligations created by the banks, however, must be met long before these periods of time elapse. The result of such loans is overexpansion or inflation of credit, that is, the banks have created obligations against themselves which they are not able to meet in the normal course of business. So long as business is prosperous all goes well; but as soon as there is a break somewhere in the industrial system and borrowers for investment uses are unable to pay, serious trouble follows. The only means by which the banks can meet such obligations when they mature is by the sale on the market of the securities in their possession not yet due, and while an individual bank may be able to transfer such securities to another institution, and the banks of a country as a whole sometimes may be able to transfer them to the banks of other countries, the danger is always present that such transfers cannot be made, and even if they can be, only at a great sacrifice. Forced liquidation, in other words, is a necessary outcome of overexpansion of credit caused by the exchange of investment securities for checking accounts, and if such forced liquidation is general throughout a country and attempted on a large scale, it can only be accomplished through the agency of the bankruptcy courts, and when these function on a large scale, commercial crisis is inevitable. The fact that the paper of customers is drawn for thirty, sixty, ninety days, four or six months enables the banker to force this liquidation process upon customers, but this fact does not protect the country from the consequences of such liquidation. Sacrifice of property, fall in prices, commercial failures on a large scale, and a general readjustment of commercial and industrial relations cannot thus be avoided. B. The Federal Reserve System and Investment Operations 225. EFFECT OF THE NEW SYSTEM ON STOCK BY THOMAS CONWAY AND ERNEST M. PATTERSON The effect of the Federal Reserve Act upon stock exchange speculation in New York City will be watched with the greatest interest by everyone interested in banking. Some will look with concern lest the new law, by suddenly depriving stock and investment markets of funds, will create disorganization, palsying new construction which must be financed through sale of securities, and unsettling the value of collateral upon which thousands of business men have negotiated loans to carry on their enterprises. Others will be interested to see whether New York's power and prestige will be diverted to other centers with the localization of funds in these new districts. Everyone will be interested to know whether it will destroy the efficacy of the so-called "Money Trust," which is founded primarily upon the control of a comparatively small number of banking institutions that hold these bankers' deposits from the other sections of the country. It is impossible to answer any of these questions authoritatively. It would appear that the day of exceedingly cheap money for stock exchange uses is past. Without a law which renders an enormous amount of money idle, thereby enabling the New York banks to attract it to New York with a 2 per cent interest rate, it will be impossible for the New York institutions to offer call money at an average rate of about 2 per cent, as has been the case within the last ten years. The stock speculator and the investment banker who are carrying securities until such time as they can dispose of them will have to pay rates of interest approximating those which have prevailed abroad and which are determined by commercial borrowers. Call loans will probably be offered at attractive rates in limited amount, but the great bulk of money will probably be secured at interest rates of 4 per cent or over. Certain New York bankers expressed the opinion before the Congressional committee that it would be impossible to deprive New York of funds for stock exchange uses so long as the borrowers were willing to pay a good rate of interest. A compara ' Adapted from The Operation of the New Bank Act, pp. 364–66. (J. B. Lippin cott Co., 1914.) tively small number of New York City banks now have funds of 15,000 other banks. These gentlemen predicted that these institutions could induce the out-of-town banks to rediscount commercial paper at, say, 3 or 4 per cent, which might then be the rate, forwarding the proceeds to New York to be loaned out upon stock exchange collateral at, say, 5 or 6 per cent. The profits to be derived from this transaction are, in their opinion, so obvious as to tempt many bankers. Such a practice, if it should develop to any large degree, would be unfortunate, for by indirection it would work an evasion of the plain intent of the act. Looked at from another standpoint, however, the matter does not seem to be as serious as might appear on the surface. There is abundant testimony to support the statement that it is very difficult to carry on profitable speculative operations on a large scale with high interest rates; but so long as the money is not being used to conduct feverish and undesirable speculation, from a national standpoint, there is no reason why New York should not be allowed to attract it. 226. THE FEDERAL RESERVE SYSTEM AND INDUSTRIAL EXPANSION1 By C. W. BARRON The expansion that is made possible by the economizing and lowering of bank reserves under the new bank law must go primarily to constructive industry. With the lowering of interest rates there will be rising prices for stocks and bonds until the returns are so low that money is invited into the constructive field. Afterward it will require all the power of the Federal Reserve Board to hold Wall Street and the expansive building industry of the country in check. Overinvestment in stocks and bonds is an absolute requisite in the construction and upbuilding of this country. When high interest rates are maintained, as in the past year, construction slows down, and the moment there is a restoration of confidence, or prospects for higher investment prices, as at the opening of 1914, there is a sudden outpouring of investment moneys. The undigested bonds are taken from the banks and the bank loans by the hundred million. We have money enough and credit enough to carry our commercial transactions and four or five years of overinvestment. We need at 1 Adapted from The Federal Reserve Act, pp. 68–73. (Boston News Publishing Co., 1914.) least three years of construction or overinvestment to be carried in bank loans before properties are in shape for digestion by investors. But do we need more than five years? And will there be danger under the new bank act in a few years of finding that we are six or seven years overinvested, our credit reserves exhausted, and our currency base endangered? That question can be answered only by the new Federal Reserve Board, and after all they may have very little to say about it at first. After rediscounting enough commercial bills to earn dividends on the new Reserve Bank shares and to insure against contraction, they must rest their activities in this direction. A steady bank rate and the assurance of relief when needed will alone be sufficient to give confidence for construction expansion outside the railroads. With confidence credit comes fully forth, and with full credit there is little need for currency or Treasury reserves. Until one or the other is called for, the Federal Board can have little control unless it undertakes to regulate the future in finance and raise the money rate and curtail credit when confidence is in full swing. The lending outside the reserve system based on demand promises will be greater than within the system, and especially so as regards construction and stocks and bonds. Here will be the first sign of trouble in future years. 227. COMMERCIAL PAPER UNDER THE NEW SYSTEM1 By EUGENE E. AGGER As a basis of the projected discount market, the act provides for three kinds of paper as follows: (a) commercial paper, namely, "notes, drafts, and bills of exchange arising out of actual commercial transactions," that is, paper "issued or drawn for agricultural, industrial, or commercial purposes, or the proceeds of which have been used or are to be used for such purposes"; (b) commodity paper, namely, paper secured by "staple agricultural products or other goods, wares, or merchandise"; and, lastly, (c) acceptances growing out of exports and imports. But while the act itself imposes certain requirements on the paper eligible for rediscount at, or for purchase by, the Federal Reserve Banks, it imposes on the Federal Reserve Board the responsibility of determining in detail the character of such paper. Adapted from "Commercial Paper and the Federal Reserve Board,” Annals. of the American Academy of Political and Social Science, LXIII (1916), 106–9. |