XI THE INTERRELATIONS OF FINANCIAL OPERATIONS Introduction The purpose of this concluding chapter is, first, to indicate the interlacing and ramifications of the various forms of financial operations in the United States and to point out the consequences of the prevalent confusion that has existed with reference to the true functions of the different types of banking institutions; secondly, to show how the Federal Reserve System is designed to correct the weaknesses that have developed in our banking system in connection with the confusion of investment and commercial principles; and, thirdly, to outline the great problem of financial concentration and control, popularly called the "Money Trust." The material here presented is directly related at many points to the principles developed in preceding chapters. The very first selection, for instance, has already been foreshadowed in chapter iv, in the reading on "Collateral Loans and Stock Exchange Speculation"; but attention is here directed to the manifold relations that exist between commercial banks and the securities' markets and to the problems that arise in connection therewith. Similarly, the use of the funds of "commercial" banks for investment purposes was definitely pointed out in our analysis of the loans of "commercial" banks. Here, however, we are showing the extent of and the reasons for this practice, together with its effects, upon the financial system in general. Again, in our study of the Federal Reserve Act numerous provisions were noted which touched the field of investment; but here we are discussing the provisions that have most conspicuously been designed to differentiate commercial from investment operations. In a word, this chapter is built upon the general analysis of credit and banking that has been made in Part II of this volume and is designed to suggest the constructive reforms that are being discussed at the present time. The readings under "C. Financial Concentration and Control" reveal the tremendous rôle that the investment banker, or financier, plays in the modern business world and the problems that have arisen in connection with the use of this enormous power. The development of large-scale business and the uniting of independent concerns into gigantic combinations, which have characterized our transportation and manufacturing industries during the past twenty years, have been paralleled in the banking world. Indeed, the two movements have developed hand in hand, and each has been necessary to the other: large-scale industry required the development of financial institutions commensurate with their needs, and, conversely, the growth of large banking institutions made it possible to accumulate the capital required by modern industries. The public has been greatly agitated in recent years over what is termed the greatest of all monopolies, the "Money Trust." A government committee has made an investigation into the extent of financial concentration and control in this country, and a very able defense of current practices has been presented by the financiers of Wall Street. While results of the investigation clearly do not substantiate the charges that have been made, most students are agreed that the system that has developed gives to the financial interests an enormous power which, if wielded with sinister intent, or merely with unwisdom, would be fraught with tremendous consequences throughout the entire industrial system. The concluding selection of the volume points out the economic functions that are served by the modern financier and indicates the abuses that arise in connection with the exercise of these legitimate functions. The problem here would seem to be the same as with trusts or large-scale industries in general-to conserve the undoubtedly good features while eliminating the abuses that develop. A. Investment Operations of Commercial Banks 216. THE RELATION OF THE BANKS TO STOCK BY JACOB H. HOLLANDER In the United States the money market, in the form of bank loans, may be regarded as impinging upon the stock exchange at five distinct points: 1. Stock-exchange securities are used as collateral to secure mercantile discounts and personal loans in the insufficiency of commercial or personal credit. I Adapted from Bank Loans and Stock Exchange Speculation, pp. 4-26. (National Monetary Commission, 1911.) 2. In the interval between original sale and ultimate absorption by investors newly issued corporate securities are used by underwriting syndicates and syndicate participants to secure bank advances. 3. Banking institutions invest in stock-exchange securities such part of their resources as are not employed in loans and discounts in consideration of interest return and in anticipation, semispeculatively, of appreciation in market value. 4. Bond houses and stockbrokers engaged in the sale of investment securities obtain bank loans as working capital upon unsold holdings. 5. Speculative purchases of stock-exchange securities are financed partly by time loans, but in the main by demand loans obtained from banking institutions and secured by such securities as collateral. Let us consider these in turn. 1. The stock-exchange securities in this case represent in the main: (a) individual loans by those who are without commercial or personal credit or who are unwilling to use it even though they possess it; (b) supplementary business loans by those who have exhausted the maximum commercial credit which their customary banks have found it possible to accord, and (c) loans made by corporations who have been unwilling or unable to market their own obligations and are driven to use these in part to secure urgently needed borrowings. No question has ever been raised as to the utility of this feature of our banking system. It is obviously advantageous that those engaged in business activity, or individual effort, who happen to be owners of stocks or bonds, should be able upon proper occasion to secure temporary advances of credit thereon without the waste and friction of forced sale. The banks here simply serve as pawnshops for securities. Capital is made more mobile without sacrifice of productivity, and both the business community and the investing public are benefited. 2. The ordinary procedure in modern corporate financiering is for the borrowing corporation to enter into an engagement with a banking institution, public or private, for the guaranteed flotation, commonly at a stipulated price, of the proposed issue. In the interval between the preliminary engagement and the consummated arrangement the purchasing institution will have secured from other institutions or individuals subscriptions to participate in the purchase covering all but such part as it may itself desire to retain. Such subscriptions will have been made to some extent by savings banks, insurance companies, and trustees for direct investment purposes, but in the main by junior banking and brokerage houses to meet customers' demands. If times be favorable and the securities popular the issue is likely to be absorbed by the public in response to the advertised offering made by the contracting house or the syndicate manager, if for no other reason than to accredit the issue, and reinforced by the elaborate selling organization that the ordinary bond house has developed. In such event, prompt absorption of the issue by actual investors, there will be no occasion for banking intervention. The funds requisite will be withdrawn from individual savings accounts and bank deposits and the purchased securities will find their way into strong boxes. If, however, general economic conditions are unfavorable, either the trade purchasers or the underwriting participants, or both, will find themselves with unsold blocks of securities on hand. These may be taken up at once by those ultimately responsible, or, more likely, the unsold quota will remain under the control of the manager until with the expiration of an agreed or reasonable time-often extended and re-extended-the distribution of the unsold remainder among the subscribers is consummated. Under such circumstances prompt recourse will be had to banking institutions for advances of credit upon the unsold or undistributed securities. The stage at which recourse is had to the banks and the extent to which credit advances are sought varies with the nature of the contract, the resources of the purchasing house, and the progress of the distribution. If the issuing corporation requires early payment, the obligations in temporary form, or even the purchase option, may be used by the purchaser as collateral for a bank loan. If the loan be undersubscribed, the part left over will be similarly hypothecated; or if the subscription be full but the absorption incomplete, the undigested parts, either in the custody of the syndicate manager or distributed among the separate participants, will be used as banking collateral. Ordinarily such advances are made by the banks at the rates prevailing for call money, or upon even more favorable terms in the case of underwriting syndicates having strong banking connection. If corporate enterprise is to secure with economy the additional capital necessary from time to time for growth and expansion, if accumulated savings are to find productive employment with promptness and certainty, some such relationship between corporate borrow ing and the existing banking organization of the United States meets this requirement of business enterprise with moderate success. Such evils as from time to time disclose themselves seem inevitably incident to the alternating fever and quiescence of modern economic organization. In flush times, when promoters abound and banks become less prudent, the availability of corporate securities as bank collateral undoubtedly serves as an artificial stimulus to evoke projects that are unnecessary or unwise. The way is opened for a perilous process of pyramiding that leads swiftly to reckless involvement. A further criticism is that such bank loans tend to encroach upon the accommodations that can be afforded ordinary business activity. The times in which the banks are most heavily involved in syndicate underwritings are periods of business activity rather than quiet. It is then that corporate projects take amplest shape and flotation follows quickly upon flotation. During the upswing the absorption is so rapid, the profits so alluring, and the public service so plausible that banking conservatism is put to the test merely in distinguishing accommodation from excess and enterprise from venture. A bank's mercantile customers ordinarily have the first claim upon its facilities. But in periods of business calm not all of its resources will be so employed and in lieu of the even less profitable avenue of employment in stock-exchange loans-advances upon syndicate collateral are very acceptable. Such loans are nominally payable on demand, but in reality they are much less liquid than the ordinary call loan. Such practice gives rise to serious problems and is unfortunate, but it appears to be a necessary result of the daring nature of modern business. Publicity and improved means of control are required to safeguard the situation. 3. The motives leading to investments by banks in stock-exchange securities are in some cases specific and obvious. The financial institutions of Baltimore, for instance, find it profitable to invest largely in Baltimore City bonds, because such securities are not only exempt from state and local taxation but, by a curious series of implied agreements, administrative rulings, and legal enactments, carry with them. a corresponding tax-deducting power, to the extent of largely relieving some of the institutions from capital taxation. More common is a bank's investment in a particular State's or municipality's bonds in the hope, or even as the condition, of becoming its public depository or of securing some public or semi-public account. This may even extend to a private corporation, whose profitable banking account |