Furthermore, the development of any market is predicated not only upon the existence of commodities suitable for trading in such a market but also upon the willingness of traders to utilize the facilities of the market. An open discount market therefore assumes not only the existence of acceptable discountable paper but also the willingness of bankers to employ rediscounting as a normal expedient in strengthening reserves. Heretofore in the United States commercial paper has been a relatively "dead" asset because bankers developed the habit of holding on to it until maturity. A frank attempt to rediscount some of the paper in his portfolio would have subjected an American banker to suspicion. The attempt would have been interpreted as a confession of weakness. In certain rural districts of the West and of the South banks were less timid in this direction than were the banks of the country generally, but taking banking practice by and large in the United States it may be said that it was against the system of rediscounting. In Europe rediscounting is accepted as a routine matter, and the benefits of an open discount market have thus been long enjoyed.

Open market desirable

What is needed for open discount market

Willingness to use the market

The variation in relative demand - or the shifting of the demand for bank credit from one form to another - requires the transformation of this credit. If banks were not restricted by law the transformation would be rapidly made by them, according to the dictates of self-interest. While legal difficulties are not often thrown in the way of the transformation of n<5te liabilities into deposit liabilities, the reverse transformation, for reasons already discussed, is often strictly controlled by law. Yet when demand shifts from deposits to notes - that is from instruments of limited to those of general acceptability, impediments in the way of note issue, which prevent the notes from occupying the place of the deposits, tend to throw the demand on the money in the reserves. This, as is understood, involves widespread contraction of all credit.

The attainment of intertransformability of the two forms of bank credit must depend largely upon the system of note issue in a country. The privilege of issue may be in the hands of a single bank, or it may be extended to competing banks. Moreover the competing banks may be few with a safeguarded field, or they may comprise all the banks in a system.

Shifting of relative demand requires transformation of bank credit

Intertrans-formability depends upon system of note issue

The requirements of a monopolistic system of note issue may first be considered. Here local banks feeling the need of an increased issue of a hand to hand medium must perforce turn to the central bank of issue. The question under a monopolistic system is therefore, first, under what terms and conditions can local banks be sure of getting notes when notes are needed, and second, under what conditions may the central bank itself expand its note issue.

Centralization of reserves, more or less complete, in the central bank of issue, would seem to be essential. That is to say, local banks would have to carry balances with the central bank, which balances could at any time be drawn down in the shape of notes. Moreover, it must also be possible for the local bank to strengthen its reserve balance through rediscounting or by means of a direct loan. It is conceivable that a local bank might sell discounts to or borrow directly from a central bank of issue without carrying with such central bank any regular balance, but this method would itself imply a considerable concentration of reserve funds in the bank of issue if the demands likely to be put upon it are heavy and widespread. Irrespective, therefore, of the relations that may obtain between local banks and the central bank of issue, a free transformation of deposit liabilities into note liabilities, under a monopolistic system of note issue, requires a considerable degree of reserve centralization in the bank of issue, and an assurance vouchsafed to the local banks that through loans or rediscounts the needed notes can be obtained.

The extent to which the central bank of issue can meet the needs of the local banks depends, of course, upon the degree to which reserves are in its control and upon the legal prescriptions which a monopolistic system necessarily imply. The more complete the control of reserves that attaches to the central bank of issue the more readily can the fullest needs be met, and the more adequately can note issue as well as extension of credit in general be regulated. Similarly, the broader and more liberal the legal provisions under which the central bank operates, the more adaptable and the more elastic is its service likely to be.

Monopoly

Under a system of free or of limited competitive note issue several circumstances must be taken into account. Where each bank is a bank of issue, in the absence of legal restriction, transformation of deposits into notes will respond to demand. Here it is only a question of prudence in the original selection of investments and in the maintenance of adequate reserves. Where legal regulation is imposed the transformability of deposits into note liabilities must work within the limits set by law.

Where note issue is not, however, permitted to all banks, but is reserved for only a proportion of those in the field, either the issuing banks must be numerous and resourceful enough to meet the shifting demand, or the non-issuing banks must obtain the needed notes from the issuing banks. The latter condition implies some sort of a working understanding between banks of issue and non-note-issuing banks. Such an understanding might involve partial deposit of reserves, and direct or indirect rediscounting, or borrowing by the non-issuing banks from the banks of issue. In the absence of such understanding, or of market practice whereby non-issuing banks may rely on the banks of issue, there is available, when an increase in the demand for bank notes arises, only one expedient, namely, the paying out of money from the reserves.

There remains a final point of great importance to which, in this connection, reference must be made. Under any system of note issue a part if not all of a bank's normal investments must be equally acceptable cover for notes as well as for deposits. It is trite to say that for each liability a bank must have as "cover" satisfactory assets. Whether a bank is extending its credit in the shape of deposits or in that of notes it must have in its vaults forms of property the value of which offsets the liabilities represented by such credit. In the absence of legal restriction, any form of property normally acceptable as an investment to the bank would be considered as satisfactory cover for either deposits or notes. But the law may set up certain standards of investment for each kind of credit, and in this case the transformation of credit from deposits into notes could be effected only if the investments acceptable as cover for notes could be quickly obtained in adequate quantities. If the law demands as cover for the notes special forms of investments, especially if such investments are not those entering normally into the routine business of the bank, the bank may find that, when the demand for bank credit shifts from deposits to notes, the special forms of cover legally required for notes may not be obtainable in quantities or on terms that will permit adequate note issue. Our own national bank notes supply a case in point. These notes are based on government bonds. But government bonds enter but slightly into a bank's normal operations. Hence when a bank in the past wished to issue more notes it had to go out into the market and make special efforts to get more bonds. The bonds might, however, be unavailable on satisfactory terms, and the notes would not then be issued. By far the simplest and most certain expedient in the attainment of adequate intertransformability is to be found, therefore, in permitting a bank to use as cover for both deposits and notes a sufficiently large proportion of its normal banking assets. Full asset banking is not necessary, because it is hardly conceivable that there would be a complete shifting of demand from deposits to notes, but the proportion of normal assets that is made acceptable as cover for notes must be sufficiently large to take care of whatever demand for notes might arise.

Free and limited competitive systems

Cover for deposits must at least in part be also acceptable for notes

Summing up the contents of this chapter it may then be said that the question of mobility and elasticity of credit, in so far as changes in place and in time demand are concerned, is primarily a question of reserves. The more nearly reserves are centralized the more freely does bank credit tend to flow. In any case a bank feeling pressure on its reserves must, through the possibility of lending or rediscounting, be able to strengthen them. Owing to the nature of a bank's activities rediscounting is held to be the most approved method of strengthening reserves, and for this purpose, with or without centralized reserves, an open discount market is highly desirable. Lastly, in order to insure free interehangeability of deposits and notes a considerable proportion of the bank's normal assets must be legally acceptable cover for both these forms of its credit.

Summary

Selected References

C. F. Dunbar, Chapters on the Theory and History of Banking (1906), Chapter VII (International Clearing And Exchange).

L. M. Jacobs, Bank Acceptances (Volume 20, Publications of National Monetary Commission).

J. L. Laughlin, Editor, Banking Reform (1912), Chapters V-VII inclusive.

P. M. Warburg, Essays on Banking Reform in the United States (1914): "A Central Bank System and the United States of America," "A United Reserve Bank of the United States," "The Discount System in Europe," "Circulating Credits and Bank Acceptances."