This section is from the "Practical Banking" book, by Albert S. Bolles.
Keeping in mind the definition already given, and which I now repeat, that the true function of banking is to bridge over the periods of credit which necessarily intervene between production and consumption, by immediately advancing on the faith of the property, to each producer and middleman, his capital invested in the product, and his profit earned in producing or handling it, it is easy to analyze and to test all loans and discounts of a different sort which banks are in the habit of making. The loans which come the nearest in principle to those embraced in the definition, are such as are made upon the specific pledge of property although not yet sold. These may be strictly legitimate, or highly speculative, according to circumstances. When property is on its way to a market, with the certainty or probability of early sale, according to a well established course of trade, it is strictly legitimate to loan upon it, if the loan is made with a proper margin. Of this character are all bills of exchange drawn against produce or merchandise, consigned for sale, either in the home or foreign market. If accompanied by a specific pledge of the property, they are called documentary bills, because the title is authenticated by bills of lading, and protected by policies of insurance, which accompany the paper. The merchandise is sold " for account of whom it may concern," that is to say, for account of the bill holder first, and of the owner of the property afterwards. A very large part of the grain, produce, cotton and tobacco business of this country is transacted by means of documentary bills. They have often little else than the value of the property to depend upon, the drawers and acceptors being only middlemen, or factors of small responsibility. If the property is of a staple character, always salable at a price, and the advances are sufficiently below its value, such bills make very desirable paper, for the reasons already given that they do .not depend on the solvency or even the good faith of the parties, the property itself, authenticated by its title deeds, being the real security. Foreign bankers make their profit very largely in buying documentary bills at one rate and selling their own plain bills at a higher rate; but it requires large capital and established credit to make a market for bankers' bills. In recent years the margin of profit has been very small, and the liability incurred in making it is immense, as both the bills purchased and those sold have to bear the banker's signature. Foreign bills are not usually dealt in by American bankers, except in the Southern cities, where cotton and tobacco are often consigned directly to a foreign market. The same is probably true to some extent in the grain-handling cities of the West and in California. It hardly pays to discount foreign bills and send them abroad for collection and remittances of proceeds. To deal profitably in them, a bank must draw exchange, as well as buy it, and the business of drawing is almost exclusively in the hands of private bankers, and of the representatives of European or Canadian banks. It has always been a surprise to many that some of the larger New York banks have never competed for this business. They possess in a high degree the most important qualifications necessary to a good drawer of exchange. They have an adequate known capital, make and publish periodical reports, arc examined by official experts, and are conservatively managed by officers and directors conspicuous for their wealth, experience and probity. Some of them have existed for a long time, and have acquired that wide-spread reputation which is a first requisite in a drawer of foreign bills. Such a participation in foreign business on the part of the incorporated banks would have this further advantage, that the banking of this country would be thus allied more closely with the banking and financial operations of the rest of the world. At present there is too great ignorance of, and too little regard paid to, what is going on in the monetary world abroad. It is not considered a necessary part of an American banker's education to study foreign banking and finance, and, as a consequence, all the profit which the banking business should properly derive from foreign commerce, is turned over to private individuals, largely foreigners, or to the representatives of more sagacious and cosmopolitan foreign institutions. One obstacle to engaging in foreign banking, by the incorporated banks, is the great subdivision of capital, and the smallness of the amount controlled by any one institution.
Besides loans on specific property consigned for sale, banks often lend on property withheld from market for a better price. Such withholding is, of course, speculative, and the loans are more or less tainted with that quality. They are not always to be condemned, but they should be made with great caution, and not relied upon to meet the bank's immediate liabilities. Enough available means should always be held in cash, and in* perfectly reliable short paper, certain to be paid at maturity, to cover circulation and deposits. Capital and surplus, when not absorbed in Government bonds (as is largely the case with that of the National banks), may be lent on longer and less convertible security. Convertibility, however, is the first requisite in the collaterals to a loan.
The moment such collaterals are inadequate to protect the loan by a forced sale, the debt becomes unsafe. The objection to loans on property not sold, or consigned for sale, is that they have no natural maturity, and however ample the collaterals, they are essentially accommodation loans, and have often to be inconveniently prolonged. The test of soundness in a bank is the speed with which it could liquidate, and return its capital to stockholders.
If loans and discounts could be kept within the limits which have been described, banking would be a very safe and easy business; but it is nearly impossible to avoid a class of transactions of a far more questionable character; and when banks fail, or lose heavily, it is almost always because questionable loans have become the rule, instead of the exception, in their business. The quality of convertibility has been gradually lost sight of (usually in the greedy pursuit of high rates of interest), and, little by little, the assets have become tied up in a harder and harder knot. Commonest among objectionable loans are those on personal security, and accommodation paper without collaterals; such as is not the outgrowth of any business transaction, out of the completion and fruition of which, the means of payment will be derived. Loans made for the purchase or improvement of real estate, whether productive or speculative; loans to provide quick capital for corporations, or for individual business, are not only very objectionable, but unfortunately also very common. However strongly fortified by names, they are always reluctantly paid, and often the cause of anxiety and trouble. It is entirely outside of the province of legitimate banking to furnish money for such purposes. Investments should be the result of savings, and it is very unwise, either for an individual to anticipate his savings by loans at short maturity, or for a bank to help him to do so. So of quick capital; I have shown that all business requires it, and it should be greater or less according to the business. It is the margin which protects from disaster, and guarantees success. It is no part of a bank's business to lend that margin. By so doing, it takes on itself the risk which belongs to the customer, and which is the strongest incentive to prudence. Its duty to him, and its proper relation to his business, begin and end with turning his products into cash, as soon as they are sold—converting his credit sales into cash sales, and thus reducing the necessary amount of his floating capital or margin, without assuming to provide that margin.