CHAPTER V

SOUND BANKING

If it is indisputable, therefore, that the confidence of the individual, and therefore the confidence of the nation, is based in the soundness of banking, we must see if that confidence be justified or not. I have, indeed, already said that it is justified. I must give reasons why I think so.

What is banking? What is soundness of banking? These terms must be defined.

I do not know if a definition of banking has been given that is universally acceptable. I know what the vague conception of banking is, but if a precise, explicit definition has ever been given, agreed upon unanimously by economic theorists, and accepted as the right and only formula, I am ignorant of that fact.

I consult Nuttall, and he describes a bank as an establishment which trades in money, by receiving, lending, exchanging, etc. He does not say it is an establishment which trades in credit, by receiving, lending, and exchanging credit, etc. This definition may be false and misleading, and Mr. Nuttall may have been deplorably ignorant of the functions of a bank, but as, in my opinion, it is as good a definition as I have met with in economic and financial works, I will accept it. At any rate, I consider it in no wise false or misleading.

A bank trades in money. This is indisputable. A bank receives money. This is indisputable. A bank lends money. This is indisputable. A bank exchanges money. This also is indisputable.

What money does it trade in? We know there are various kinds of money. Legal tender currency is but one kind of money. Cheques, bills of exchange, securities, and even commodities are other kinds of money. Even if the legislature declared that only legal tender shall be money, the legislature could not by this declaration alter the laws of nature and of economics. It can make one kind of money legal tender, but it cannot destroy the law that anything used for exchange purposes is money. If a beggar steals a watch and afterwards exchanges the watch for a decent shirt, the watch and the shirt become money. They perform the functions of money and the functions prove that they are money.

A bank trades in money subscribed by its own shareholders and money deposited with it by the public. A bank in the course of time finds itself in the possession of what it describes as its deposit and current accounts. These accounts, it is popularly supposed--included in the populace are political economists and City financiers--are the aggregate of the money placed with a bank by the public and the money with which it mainly trades.

These are called a bank’s liabilities, its immediate liabilities the redemption of which can legally be demanded at a moment’s notice. It is because they can be so demanded that banks are ever faced with a grave potential peril.

It is necessary to clear the way by destroying a delusion. This money on deposit is not entirely money placed in the keeping of a bank in the same fashion as one would keep money in a safe. This fact, in my view, is of great importance. Only a portion of these deposits is what we may call in an indefinite way pure deposits. By pure deposits I mean money placed with a bank that is not a direct loan. If I place £100 of my savings in a bank, instead of investing it, I call that a pure deposit, and this money I can withdraw without the subtraction of a farthing at a moment’s notice.

But we have already seen, from our analysis of a bank’s balance sheet in Chapter III, that these deposits are not all pure deposits. A considerable portion of them consists of loans to all kinds of people, loans made on the security of various kinds of wealth. That is to say, the bank owes money to these so-called depositors and the depositors owe that money to the bank. The depositors have the power, of course, to withdraw the entire sum of money lent to them temporarily by the bank; but the bank, in due course, has the power to claim the redemption of the loans. Not only has it this power to call in these loans, but it actually possesses the equivalent of the loans in a portion of the country’s wealth.

It is possible--but the wisdom or unwisdom of it need not be discussed here--for the legislature to enact that only pure deposits should be withdrawable at a moment’s notice, and that borrowers should be compelled in times of panic or vital urgency to give long notice. I merely say that this is within the power of the legislature to enact, but I do not say here that it is practicable, necessary, or wise.

I merely throw out the hint here in order to emphasize the importance of the distinction between pure deposits and loan deposits. The latter, I have already urged, may be regarded as the product of the machinery for converting wealth into currency, or liquid capital. From a sound banking standpoint the vital question to be considered and answered is as to the kind of wealth that is so converted.

Sound banking is to be tested by the nature of the wealth so converted, or, in the language of the financial community, the wealth on which loans are made.

Others argue that this is a matter of quite secondary and even third-rate importance. They contend that the matter of supreme and vital importance is the amount of gold a bank holds in proportion to its liabilities in deposits. Should there be some differentiation here? Should it be the amount of gold held in proportion to its pure deposits, and not in proportion to its aggregation of pure deposits and loan deposits? For the loans, as we have seen, are automatically redeemable.

If, say, a bank habitually holds gold to the proportion of 15 per cent. of its aggregate deposits, and if half these deposits are loans, then the gold Will be equal to 30 per cent. of its pure deposits, a proportion much higher than the figure advocated by those who agitate seriously and zealously for higher gold reserves.

We have seen many small banks go under in recent years. This was in some cases because they lent their money on what I will call bad wealth. In other words, because they gambled and speculated with the money of their depositors. Here we have some evidence that the general public are unable to discriminate between sound and unsound banking. This may be deplorable ignorance, but it is not culpable ignorance. It is to a great degree inevitable ignorance.

The matter is dismissed by the quidnuncs saying that fools deserve their misfortune, they should have placed their money in sound banks. We should not so readily denounce them as fools. The Government is not without its most serious responsibility in the matter. It should not allow such money-lending establishments to describe themselves as banks. The Government has a moral duty to protect the public, and it would not be at all difficult to take steps to this end. It should allow only those establishments to call themselves banks that are conducted upon sound banking principles.

Joint stock banks have a legal safeguard. Though they are under compulsion to repay deposits, they are under no legal compulsion to repay them in gold. They must repay them in legal tender, and they can fulfil their legal obligations by paying out in legal tender notes. These, of course, are Bank of England notes and now the new Treasury emergency notes.

This being so it is immaterial, or it should be immaterial, whether the reserve of a bank consists of gold or legal tender notes. If it can redeem its liabilities in notes and has sufficient notes for its purpose, it can consider itself safe and can securely stand in a crisis. The notes can, of course, be taken to the Bank of England and be exchanged there for gold; but this is immaterial to a bank which has successfully met the peril of a run.

Soundness of banking consists in the soundness of the wealth that constitutes a bank’s assets. We know there are infinite degrees and categories of wealth. But it is easily possible to discriminate and know exactly which is the highest class of wealth in the country.

Banks do and must speculate to some extent. It is unavoidable. If they did not speculate they would not incur bad and doubtful debts. But they must keep their speculations within the most prudent limits. This most of them undoubtedly do. Traders complain that they are, indeed, too cautious in this respect, that they do not lend freely enough. There have been, indeed, most bitter complaints on this head since the outbreak of the war.

But we cannot reasonably insist upon banks being ultra-cautious, and in the same breath complain of their cautiousness. We cannot reasonably insist upon them keeping large gold reserves, thereby diminishing their loan capacity, and with equal reason insist that they shall lend with increased liberality.

This is as impossible as trying to reach two goals simultaneously, when each lies in a direction opposite to the other. The man in the street would say you cannot eat your cake and have it.

When a bank lends to a man or firm on good security, it cannot be sure, of course, that that man or firm will be able to pay off the loan when it falls due.

We may, if we wish, call this a speculative chance, but the bank is considerably safeguarded by the security it possesses.

Public confidence is based, therefore, upon the soundness of banking methods. It is an article of belief with us that banks become gravely imperilled when confidence breaks down. It is when confidence is destroyed that runs on banks commence. Fear seizes the public, it develops into panic, depositors clamour for their deposit money, and banks either successfully meet these runs, or close their doors. But so long as confidence is strong and unimpaired, sound banks keep safe.

The safety of banks depends, therefore, upon this feeling of confidence in them, and this feeling of confidence, in its turn, is based upon the intelligence and common sense of the public. Up to now this intelligence and common sense have been triumphant. They have triumphed in a crisis unparalleled in the history of the British Empire, in that very crisis, in fact, which the prophets always feared would show their superficiality and vulnerability.

The predictions of the prophets have not been realized. This is because human genius and human wisdom have been mightier than human fear and apprehension, because the nation had supreme faith in the Government, in the economic strength of the Empire, and in the might of its navy and army.

And if the prophets have prophesied falsely in this supreme situation, they are just as likely to prophesy falsely in other potential emergencies.