CHAPTER V. OF THE LEGITIMATE OPERATIONS OF BANKS OF CIRCULATION.

HAVING disposed of the question of the safest mode of employing the capitals of banks, I now come to the question, what is the legitimate function of a bank of circulation, considered in its distinctive character as a bank without any capital to lend?

The manifest answer to this question is, to lend its credit in such a way as to produce the greatest possible benefit to itself without injuring the public.

The mode in which a bank lends its credit is to exchange its own promissory notes payable on demand, for the promissory notes or acceptances of individuals payable at a future period, deducting the interest for the time which the latter have to run before they become due, and allowing no interest on its own notes for the time that may elapse before their payment is demanded. In making this exchange, the profits of the bank depend entirely upon the length of time that its notes remain abroad, and its ability to meet them depends of course upon the length of time which the notes have to run in exchange for which they were issued. If bank notes be issued only upon the principles laid down in a former chapter as mere substitutes for coin exported, and without augmenting in any degree the amount of the currency, they will remain in permanent circulation, unless in case of a panic, or discredit, which occasions a run upon the bank, and will constitute a source of permanent profit; for although some of them may be constantly returning in payment of debts, yet they are sent out again as fast as they come in, in the discount of other bills or acceptances. As to the length of time which the discounted paper should have to run, experience must decide, the bank having regard to the possibility of a panic, as well as to the action of other neighboring banks, seeing that an over-issue by anyone of them, by depreciating the currency, may occasion a temporary reaction upon other hanks as well as itself, and disturb even those that are the most prudently conducted. The practice of the banks in the United States prior to the war of 1812, was generally to limit their loans to paper not having more than sixty-three days to run. Since that time, loans have been made at longer periods, extending sometimes even to four and six months, and to this circumstance is no doubt to be ascribed, in a great degree, the frequent revulsions that have since taken place in our currency, and especially that which eventuated in a general stoppage of specie payments in May, 1837.* It must be manifest, that the power of a bank to meet any extraordinary emergency must depend upon the command it has over its loans, and if the experience of other countries can be considered as any guide, that of England and France may both be referred to, where discounts of paper having more than sixty or a hundred days to run, are wholly discountenanced. A similar practice in the United States could not fail to be productive of much benefit to the community, as a means of correcting with promptness any accidental expansion of the currency.

But in order to render legitimate the operations of a bank of circulation, its loans should not only be for short periods, but should be confined solely to the discounting of what is called business paper, that is, promissory notes and acceptances received by the holders for merchandise and property sold. If none others were discounted, the expansion of the paper system would only be in proportion to the expansion of business. When this was extended, so as to call for more currency, as at particular seasons of the year, more currency would be created; and when business was diminished, as at other seasons, so as to require less currency, the excess would be absorbed by the payments made back to the banks. In these operations, the level of the currency would not be disturbed, so as to produce a depreciation; for although there would at times be a greater quantity of bank notes in existence than at other times, yet this quantity would be in exact proportion to the increased demand, arising from an increase of transactions. Thus would the elasticity of the banking principle accommodate itself to the state of commercial wants. Money would always be procurable, when it was really wanted, and it would never be so plenty as to depreciate the currency. The holders of real paper could always get it discounted, and even those, whose sales of merchandise to the country should not put them in possession of notes or acceptances payable by resident debtors, could also, without any violation of the legitimate principles of banking, get discounts for short periods on the hypothecation of such foreign paper.

But it is absolutely necessary upon sound banking principles, that no paper except that received for property sold should be discounted. Fictitious or accommodation notes are not as safe investments for a bank as real notes. A real note given by A to B., for five thousand dollars, for a hundred hogsheads of sugar sold and delivered, endorsed by the latter, and discounted by a bank, is guaranteed by B., who has five thousand dollars in cash, the proceeds of the note, less the discount, and by A. who has five thousand dollars worth of sugar. Of this there is no doubt. An accommodation note drawn by C. to D. may have upon it two names apparently as solvent, but there is no certainty that the two together possess any thing more than the sum loaned by the bank. And this is not all. The discounting of a real note is merely anticipating a capital previously existing, whereas the discounting of an accommodation note is lending capital to one who did not possess it before. The borrower of money on an accommodation note must require it to pay an old debt, in which case his control over it is parted with, or, for some new operation, agricultural, commercial, manufacturing, or speculative, which in the nature of things may not be terminated in a short time, and in neither case is he the sort of borrower that a bank can rely upon to enable it to meet, under all circumstances, its notes payable on demand. Nor is this yet all. The discounting of notes given for property sold, does not encourage over-trading, like the discounting of accommodation notes. The latter, if the proceeds be not applied to pay old debts, places at the disposal of borrowers the means of speculating which they did not before possess. Speculation raises prices, and stimulates speculative sales and transfers, by which the regular business of the community is disturbed, only to be followed by a reaction.

From this view of the subject it may easily be seen, how absolutely essential it is for the interest of the public, that banks of circulation should retain unimpaired their control over their loans. So soon, therefore, as they exchange their promissory notes payable on demand in gold and silver, not for the promissory notes of individuals given for property sold, and payable at short periods, but for notes payable at distant periods, or for notes understood expressly or impliedly, to be renewable in whole or in part, they annihilate their power, and place themselves at the mercy of the public. They are liable to be called upon for the payment of their notes faster than their debtors are bound or are able to pay them; and instead of fulfilling their engagements promptly and in good faith, they are obliged to resort to discreditable expedients, to deter the holders of their notes from demanding payment.

In the preceding remarks, I have only spoken of bank notes as being the form in which banks of circulation lend their credit, but this was done to simplify the subject. All that has been said in relation to bank notes, applies equally to that other species of obligation which is expressed by the term bank credit or deposit when it arises from the discounting of a note, for it must be manifest that the same profit results to a bank, where such a credit or deposit remains undrawn for, as where an equal amount remains in circulation in the form of bank notes, and that the ability to pay such a liability depends, as in the case of notes, upon the length of time for which discounts are made.