Intertrans-formability must also be assured

Difficulty in practice has been with notes

But in this connection emphasis must again be placed on the necessity, under any system, of permitting at least a proportion of the normal, routine assets of the bank to serve as cover for notes as well as for deposits. This is of obvious importance to the independent bank of issue, but it is equally important under a system of monopolistic issue if the balances obtained through rediscounting, etc., are to be freely drawn down in notes.

A good banking system must also guard against over-expansion of credit. As set forth in the chapter dealing with this subject credit inflation may develop actively or passively.

Active overexpansion may be guarded against in several ways. Absolute limits may be put on the amounts of credit that may be extended either in the form of deposits or in that of notes. The arbitrary limitation of deposit credits would present no serious difficulty under absolutely monopolistic banking conditions, but where there are numerous banks such a limitation would of necessity involve problems of apportionment, etc. Such maxima might moreover prove at times very embarrassing. As a matter of fact no country has ever attempted, for the banking system as a whole, to apply this expedient.

France is the only important country that has applied such a restriction even to note issue. In the field of note issue under a monopolistic system the imposition of an absolute maximum offers no difficulty, but the problem of apportionment would have to be solved under a competitive system of issue. Moreover, even here an absolute restriction would at times prove embarrassing. France avoided embarrassment only by hastily increasing the prescribed maximum whenever the actual circulation seriously approached it. Finally an absolute maximum does not touch the real question of the relation of credit to underlying reserves.

Some of a bank's normal assets must be equally acceptable cover for notes as well as for deposits

Over-expansion must be variously guarded against

Active over-expansion may be variously guarded against

Absolute limitations may be imposed

The extension of credit might also be checked through the imposition of what may be called relative limitations. It might be declared necessary, for example, to maintain a certain relation between credit extended and capital and surplus. Such a limitation could be applied either to a monopolistic or to a competitive system, to notes and to deposits, or to either form alone. As capital and surplus represent the final guarantee fund behind bank credit they might, taken together, be held a not unsuitable criterion for its regulation. But the guarantee that capital and surplus supply is one of ultimate solvency rather than of immediate redeemability. Security lying behind credit is, of course, of great importance, but the factor of first importance is that of available reserves. There are several examples in practice of the limitation of note issue on the basis of a specified relation to capital, but deposits have pretty generally escaped this limitation.

A more logical limitation, relative in character, is that which grows out of a prescription of reserves. This is familiar to all interested in the subject of banking in the United States, where reserves are prescribed for both deposits and notes. Abroad, this limitation is commonly applied to notes, but deposits escape it. While there is much to be said in favor of reserve prescriptions there is always the objection that a safe reserve is not a fixed thing, but rather something which has to be carefully determined in the light of circumstances. At one time a fixed reserve may be inadequate; at another it may constitute an unfortunate "dead-line" against needed further extension of credit.

Still another relative limitation on credit expansion is to be found in connection with prescription of investments. The law may limit the kinds of "cover" that a bank may hold against its outstanding obligations. The extension of credit would then be limited to the volume of the available investments. If, however, the prescription were narrow, flexibility of credit would be interfered with, while if the provisions were liberal their effectiveness in limiting credit would be slight. In the United States the law defines pretty narrowly the range of a bank's investments, behind both deposits and notes. In Europe it is the "cover" for the notes alone that is narrowly defined. But both here and abroad this particular class of restrictions aim to secure a careful selection of investments from the point of view of safety rather than from that of credit limitation.

Relative limitations are applicable

Capital and surplus as a criterion

Reserves maybe prescribed

Or investments

Considering all the fluctuating circumstances that bear on the problem of credit extension, the most wholesome control is that which is found in connection with the final determination of the rate. Given in a country an agency which can, in last analysis, dictate the terms on which credit can be extended, there then exists the possibility of intelligently holding credit expansion in check. Of course this assumes on the part of the regulating agency the requisite intelligence, understanding, and courage. But taking these for granted, a final effective control of discount and of loan rates renders superfluous the other limitations which are of necessity more or less arbitrary and rigid. In Germany a tax on notes issued in excess of a tax-free contingent is supposed to enhance the cost of issuing, and hence of obtaining notes as the outstanding issue increases. Under our new Federal Reserve System also taxation is relied upon under certain circumstances to enhance the cost of obtaining credit. Increasing rates have, of course, a chilling effect on inflationist ardor, but the determination of the rates ought to rest upon a careful consideration of all the germane circumstances, and should not be forced in one direction or another by rigid prescriptions in the law. This flexible control of discount and of loan rates, as already indicated, depends upon a high degree of centralization. A good banking system will therefore not overlook this aspect of centralized reserves.