37. THE CAUSE OF THE DEVELOPMENT OF COLLATERAL LOANS IN THE UNITED STATES'

BY EARLE P. CARMAN

National banks are fundamentally commercial banks. Their operations are restricted by law almost entirely to transactions involving short-term credits, which Congress assumed would consist mainly of commercial credits. The National Bank Act attempted to make such credits feasible by requiring the banks to keep a minimum cash reserve equal to a certain percentage of their deposit liabilities. It was assumed that this cash reserve would enable the banks to meet the unusual and extraordinary demands of depositors, and that their remaining funds could be employed in commercial credits by arranging their loans in such manner that they would mature in rotation, and thus maintain at an average level the funds required to meet the usual and ordinary demands of depositors.

In all countries commercial credits have always been preferred by banks of discount and deposit because of the fact that they automatically provide the means for their own liquidation under ordinary circumstances. In other words, the mere granting of the loan places the borrower in possession of property through the sale of which he will be able to pay the loan at maturity. And banking experience for more than a century has demonstrated that pure commercial loans are the safest of all temporary investments. Commercial loans, however, are usually made for periods of thirty, sixty, or ninety days, while the larger part of commercial bank deposits are payable on demand. Now it is obvious that a bank cannot safely loan for fixed periods of time any large percentage of funds which it may be called upon to pay out instantly unless it has some means of converting such loans into cash before maturity, if necessary.

For a century or more commercial loans in the leading countries of Europe have been instantly convertible into cash by reason of the fact that they could be rediscounted at the central banks of the countries where they originated. This instant convertibility of commercial credits, added to their inherent safety, caused them to be favored with a lower rate of interest than any other short-term credit. Thus in European countries commercial loans, or "discounts," as

Adapted from "The Change in Credit Methods Made Necessary by the Federal Reserve Act," Commercial and Financial Chronicle, 1915, pp. 1396–97

they are called, are made at a rate of interest usually 1 per cent lower than collateral loans, however choice the collateral pledged as security.

In America, however, prior to the passage of the Federal Reserve Act, no means existed for rediscounting commercial paper, and it could only be converted into cash when it matured. The necessity of loaning a large percentage of demand deposits in such manner that they could be instantly converted into cash was no less imperative here than in Europe, and it compelled American bankers to relegate commercial credits to a secondary position and devise a means of making loans which could be converted into cash whenever desired. Consequently, demand loans secured by collateral which could be sold in the open market became the favorite method of investing demand deposits, and clearly the most logical method under the circumstances. This preference for collateral loans encouraged the creation of collateral which could be pledged to secure such loans. This collateral, however, consisting of stocks and bonds, is the product of investment banking and represents fixed or permanent property. The loans made against it, therefore, are in no sense commercial. The stock exchanges furnished constant market quotations for such collateral and provided a means of selling it instantly should the banks desire to do so. Naturally, under such circumstances, collateral loans could be secured with the greatest ease, and this encouraged speculation on the stock exchanges. Whenever this speculation expanded sufficiently to absorb the demand money readily available, the interest rate for such money advanced, and whenever this interest rate rose above the legal rate for commercial paper it naturally drew into the demand, or "call," money market funds which otherwise would have been available for commercial credits.'

38. CALL LOANS

Call loans are loans that are terminable at the demand of either the borrower or the bank. If the borrower wishes to repay the loan he has the privilege of doing so without waiting for a maturity date. If the bank wishes to enlarge its cash reserve it may demand immediate payment of its call loans. In practice, "on demand" means subject to call the next day, and call loans always run at least one day. There is a rule, also, that loans cannot be called or paid after 1:00 P.M., unless notice has been given before that hour.

'Compare chap. xi, sec. 1.-EDITOR.

The rates on call loans are subject to very wide fluctuations. Ordinarily they are lower than any other rates, ranging from 1 to 2 or 2 per cent, but on a few occasions they have gone beyond 100 per cent. The call rate rose to 127 per cent on October 29, 1896; to 96 per cent on November 2, 1896; to 186 per cent on December 18, 1899; to 75 per cent on May 9, 1901; to 125 per cent on December 28, 1905; in 1906 to 60 per cent on January 2; to 30 per cent on April 5 and 6; to 40 per cent on September 5, and to 45 per cent on December 31.

These high rates occur at times when a dearth of loanable funds in New York coincides with both a heavy commercial demand and a great financial demand for credit. A flurry on the stock exchange will often give rise to the most insistent demand for funds for a short time.

High call-loan rates are often pointed to as evidence of a monopolistic control of credit; but as a matter of fact there is a greater profit accruing to the banks when the call rate is only 3 or 4 per cent than when it is 25 or 50 per cent. When money rates reach these high figures many corporations and large individual depositors are tempted to withdraw their funds from the banks in order to make loans to borrowers directly. This depletion of the banks' reserves at a time when money is generally tight more than counterbalances the high returns on the loans they may make on call. Because of this some banks in New York have made it a rule never to loan money on call at more than 6 per cent.

39. COLLATERAL LOANS AND STOCK EXCHANGE

SPECULATION'

BY SERENO S. PRATT

The stock-broker executes orders for his customers on usually 10 per cent margin, but he is obliged to pay for the securities in full upon delivery. It would be manifestly impossible for any broker to do this without borrowing money from the banks. He has extended credit to his customer; he must himself get credit from the banks. For instance, a broker buys 5,000 shares of New York Central at 110, amounting to $550,000. But he executes the order for his customer on a margin of $55,000, so that he must pay the difference of $495,000,

Adapted from The Work of Wall Street, pp. 267-74, 287, 275-78. (D. Appleton & Co., 1993.)

either out of his own capital or else borrow of the banks. Necessity compels him to go to the banks. He takes the 5,000 shares of the New York Central to the banks and offers them as collateral for a loan. If he is wise, he already has an agreement with his customers enabling him to do this. The banks lend him $440,000 on the collateral at the prevailing rate of interest. With the $55,000 from his customer and $440,000 from the banks the broker has $495,000, or $55,000 less than he must pay for the stock. This he would have to supply out of his own capital.

What is the net result? The customer is nominally the owner of 5,000 shares of stock, which he has, however, never seen, and which is actually in the possession of banks whose very names he may not know. The interest of the banks in the stock represents 80 per cent of its value; the broker's, 10 percent; and the customer's, 10 per cent. It does not follow that every transaction is exactly of these proportions of risk. The broker, in fact, may be able to obtain from the banks loans large enough to enable him, in connection with his customer's margin, to carry a transaction without the employment of much, if any, of his own capital. This example has been based upon the general rule that the margin demanded by the broker of his customer is usually 10 per cent, and the margin demanded by the banks of the broker is usually 20 per cent, the percentages in both cases varying in accordance with the character of the securities. The example serves to illustrate clearly the close intimacy existing between the money-market and the stock-market. The money-lenders are, in fact, the actual holders of the securities dealt in, and they have the largest interest at stake in the maintenance of values.

But this is not the only connection between the banks and the stock-brokers. Let us return to the example already given. The broker has bought stock for which, on delivery, he must pay $550,000. Now, before he can get any loans from the banks on this stock he must have the stock in his possession, so as to be able to use it as collateral for the loans. Before he can get it in his possession he must pay for it. His balance in the bank may not be more than $50,000. What is he to do?

Right here enters the new alliance between the banks and the brokers. It goes by the name of certification. The broker, in the case instanced, draws a check for $550,000 in payment for the stock. The check is sent to the bank where the broker keeps his account for certification. The cashier or paying teller indorses the check across

its face, thus certifying, not only that the signature is correct, but that the bank will pay the amount of the check on presentation and identification, or when it comes to it through the operations of the clearinghouse. But it has been said that the broker has a balance of only $50,000, and here the bank is certifying to his check for $550,000. That is what is called "overcertification," and it is another form of a great system of credits on which the transactions of Wall Street stand. Overcertification is in effect a temporary loan, and as employed in stock exchange transactions involves little risk. There are a number of Wall Street banks-not all—that do a regular business of certifying brokers' checks, but a large proportion of this business is done by the trust companies. A broker enters into a definite arrangement with one of the institutions on a basis something like this: The broker agrees to keep a daily cash balance at the bank of, say, $50,000; in return the bank agrees to certify his checks to an amount, say, of $1,000,000. While this seems startling, the practice is in reality not dangerous.

The banking institutions are very conservative in transactions of this kind. They must know all about the broker, his character, good judgment, and business methods and standing. In other words, personal character is a valuable asset in Wall Street. A man's credit in the Exchange and in the banks depends largely upon it. Then the bank stipulates, in entering upon an agreement of this kind with the broker, that, while it will certify, say, to an amount of $1,000,000 on a net daily balance of $50,000, the broker must not frequently reach that limit. Moreover, he must make his deposits at the bank as frequently as he receives checks for payment for securities delivered. He cannot wait until nearly 3:00 o'clock and then make one deposit for the day, but must deposit, it may be, six or seven times a day. The result is that while the broker is receiving the benefit of large certifications in excess of his balance, at the same time he is at frequent intervals depositing other certified checks. Deposits and certifications thus go on simultaneously.

In making these loans the banks scrutinize the collateral closely. The securities must be strictly good delivery according to the rules of the Exchange. Stocks and bonds for which there is not a constant market are generally not acceptable. The bank's protection consists in its actual holding of the collateral, and either in a note signed by the borrower in each transaction or in a continuing agreement, which its customer signs, enabling the bank to sell the securities, without