The Panic and the Banks

THE recent panic is now far enough away to make it worth while to look back and endeavor to see as clearly as we can just what took place. Such an examination should not be unfruitful and ought to show us some things the avoidance of which in the future might lessen our next time of trouble. It may help us also to discriminate among the many proposed remedies for our financial ills, and to decide which are most worthy of serious consideration.

It is well known that from 1897 to October, 1907, this country enjoyed unexampled prosperity. Money became most abundant, thanks to the increased production of gold and to the increased national bank-note circulation, so that the amount in the country grew during the years under consideration from twenty-two dollars to thirty-four dollars per capita. Trade, both foreign and domestic, increased by leaps and bounds. The prices of staple articles rose. Labor was in increasing demand at higher and higher wages. Corporations, firms, communities, and individuals rivaled each other in increased expenditures. Liquid capital at last became so generally transformed into fixed capital that loanable funds became scarcer and scarcer, as evidenced by the higher rates of interest.

Perhaps the most interesting point about this period of expansion is that the longer it lasted the greater was its speed. The average prices of staple articles increased over 55 per cent dining this time, of which gain 35 per cent had been made in the last two years and nearly 25 per cent in the twelve months ending July, 1907. The increased volume of business, and its rate of increase, are well shown by the clearings of the national banks, which rose from $51,000,000,000 in 1896 to $112,000,000,000 in 1904, and to almost $160,000,000,000 in 1906.

The causes of this remarkable expansion, though of intense interest, need not be considered for the purposes of this article. Nor need we dwell on the various factors that brought it to an end. It may be sufficient to say that the last straw seems to have been the collapse of a speculative clique, which revealed the most reckless kind of financiering. Distrust spread, and a few days later, on the failure of a great New York trust company with $60,000,000 of deposits, became so general and led to such a desire to withdraw money, that the entire banking system of this country practically suspended cash payments for nine weeks. This was a most humiliating experience for a country of our wealth and resources. Could it not have been avoided, or at least lessened in its extent and severity? The most careful thought and study should be given these questions, and if any weak point should be revealed every effort should be made to strengthen it. The ability or inability of banks to make payments in cash depends in a great measure upon the size of their cash reserves. That is what reserves are for — to pay in cash, spot cash, all demand claims, whether of the routine day-to-day order, or totally unexpected demands. And it is on this point that the strength and reputation of a banking system ultimately rests. It was this test that our banks failed to meet. Why ?

Before an attempt is made to answer this question it will be advisable to study the history of the banks during the period of expansion. Here will be found a record of growth equal to that of general industry and trade. On October 1, 1896, the net deposits of the national banks were 1,798 millions; on August 22, 1907, they were 5,249 millions. On October 1, 1896, they had on hand in cash, that is in specie and legal tenders, $343,100,000 or 19 per cent of their net deposits; and their legal reserve, or the cash on hand plus cash in the redemption fund plus deposits with reserve agents, was $543,600,000, or 30.2 per cent. For the ten years previous the average cash reserve was 17.7 per cent and the legal reserve 29.3 per cent. During the following ten years the ratios of the two reserves are shown in the following table:—

Ratio of Legal Reserve. Ratio of Cash Reserve.
On or about October 1, 1896 30.2 19.0
1897 31.7 17.7
1898 30.1 16.9
1899 29.3 15.3
1900 29.7 15.8
1901 27.6 14.7
1902 20.9 13.2
1903 22.0 14.3
1904 22.4 15.0
1905 21.7 14.0
1906 20.7 12.7
On August 22, 1907 21.3 13.3

On August 22, 1907, the banks held in cash $701,000,000, the largest amount they had ever held, yet as shown above, the ratios of their reserves, figured either as cash or legal, were a third smaller than in 1896, and nearly 25 per cent less than the average for the ten years preceding 1896. Thus, other things being equal, the banks were just so much handicapped to meet the crisis awaiting them. But as we shall see, other things were not equal, and the handicap was really greater.

Only one-half of the banking business of the country is done by the national banks. The other half is done by some 9,600 state banks whose “individual deposits” of $4,750,000,000 exceed those of the national banks by $500,000,000. This, by the way, is a condition of affairs never dreamed of by the framers of the National Bank Act, who supposed that, through the monopoly of the right to issue bank notes, the national banks would in a short time be the only banks in the field. This is a point of importance to which attention will be called again a little later on. To return to the state banks: these institutions have increased very rapidly during the last ten years, through the creation of so many trust companies. They are subject to the laws of the different states, which, though varying widely, are generally quite lenient as to reserve requirements. For the most part, the state banks do not carry over five per cent in cash and five per cent on deposit. That part of their reserves that is on deposit is generally placed with national banks. The exact amount so deposited is not known. It can, however, be approximated closely enough for our present purpose. On about July 1, 1906, the state banks held $302,000,000 in cash ; and at about the same time the national banks reported that they owed on balance to the state and savings banks $584,000,000. Estimating the deposits of the savings banks at $100,000,000, there is left $484,000,000 which is approximately the amount of the deposits of the state banks ill the national banks on that date.

The burden of the state banks’ reserve is thus practically on the shoulders of the national banks through their receiving this vast sum of money on deposit. The national banks must therefore carry not only their burden but the burden of their rivals — of rivals who have already succeeded in securing half of the banking business of the country. And their own burden is not light — it consists of the deposits of other national banks in the banks of the reserve and central reserve cities, as allowed by law, and amounts to something like $350,000,000.

Now the significance of these facts is this: at the moment of panic the burden of maintaining a cash reserve for the ten billions of the combined deposits of the national and state banks fell for all practical purposes on the national banks alone, and for the most part on the banks of reserve and central reserve cities. When the state banks were called on for cash by frightened depositors they called in turn on the national banks where they kept their deposits. So did the smaller national banks. The total cash holdings of all the national banks were by the middle of October well under $700,000,000 and they were liable to be called on for $350,000,000 deposits of banks of their own class, and also $480,000,000 deposits of the state banks, not to mention the $100,000,000 deposits of the savings banks. Is it to be wondered at that, when distrust spread, the burden proved too great ? There were nine hundred millions of bank deposits and less than seven hundred millions in cash in the whole system of national banks. Even in the case of a great central bank, the Bank of England, which can accomplish with the same reserve far more than a large number of small banks, the cash on hand almost always equals or exceeds the deposits of the joint-stock banks.

It is to be noted that this burden of the national banks, carrying so large a proportion of the reserves of the state banks, is one that has assumed large proportions in recent years. It is also to be remembered that it is a burden never thought of by the framers of the National Bank Act, the best piece of bank legislation, all things considered, ever framed in this or any other country. As has been said earlier in this article, it was never believed that the national banks would ever have to share the field with any other class of banks. Consequently it was never thought that they would have to carry any other burden than that of the deposits of part of the reserves of the smaller banks in the larger institutions of the reserve and central reserve cities. The amount of such deposits of national banks with one another for purposes of reserve has never exceeded the total amount of cash held by all the banks, and usually has been much less. In October, 1906, it was little over half, or $350,000,000 against $626,000,000 in cash. As has been shown, the deposits of the state banks in the national banks on that date were approximately $480,000,000. Consequently the burden of bank deposits on the national banks is considerably over twice as much as was conceived of by the framers of the Bank Act.

It is not for a moment to be thought that there is any intention to ascribe the panic to the condition of the national banks. So long as men are human and swayed by hopes and fears, we shall have periods of expansion, and panics with their resulting periods of depression. Nothing can prevent them. But the point is here made that, when this particular panic occurred, it was intensified and prolonged by the inability of the banks to continue cash payments. And this inability on the part of the banks was caused in part at least by the increased burden on the national banks, assumed for the greater part during the last ten years, of carrying on deposit over half of the reserves of the state banks. Now it may be that the strain of future times of trouble can be lessened by reducing this burden of the national banks. If it should be deemed wise to do so, it could be accomplished simply and easily by so amending the National Bank Act as to prohibit banks, after, say, three years from the passage of the amendment, from paying interest directly or indirectly on deposits of banks other than national banks. The result would be to increase the cash reserves of the state banks, for those banks, unable to obtain interest on their deposits, would take home that part of their deposits not required to facilitate their daily business, and keep it in their own vaults, where it would be a true reserve. The period of three years suggested would allow the change to be made without disturbance to the loan market and to business interests.

To sum up: the panic was prolonged and intensified by the suspension of cash payments by the banks. The suspension of cash payments was caused by the breaking down of the present system of bank reserves. The national bank reserves, already low, were weakened by the banks carrying on deposit over onehalf of the reserves of the state banks. The state banks themselves were notorious for the small reserves they carried. No other country prominent commercially has two classes of banks similar to our national and state banks. That this country has both is an accident, due to its dual system of federal and state government. The change here suggested would at least make each class of banks stand squarely on its own feet, and would sever once and for all the Siamesetwin bond that now unites them.