The clearing system strengthens a bank's lending power

Every addition to the lending power of the bank means not only the possibility of serving the community more broadly but also the possibility of a larger profit for the bank itself. The general relation of bank's to the community will be more fully discussed in a subsequent chapter, but here a further word or two may be said about the increase of loanable resources from the bank's point of view.

Permits economy in the use of cash

This profitable to banks

1 These have been faithfully studied and their methods described by Mr. James G. Cannon, and in this place nothing will be said about them beyond what is necessary to explain their function.

A depositor of cash or of rights to demand cash, which in practice are as good as cash itself, does not, as was stated above, want cash itself, nor does he normally withdraw his whole deposit by means of checks. He maintains pretty constantly a "balance" which naturally varies from time to time, but which in most cases is not allowed to drop below a given minimum. The same thing is true of him who obtains his deposit as a result of a loan or discount. Indeed, in the case of most business men, who have paper discounted or who make loans, and who have occasion to make cash and similar deposits as well, no distinction arising from the source of the deposits is ever made or thought of. Cash and checks are deposited and noteg and bills are discounted as a matter of daily routine. The negotiation of a loan may suggest more than the ordinary need for funds but even here in some lines of business, as in stock brokerage, borrowing is the normal means of getting the customary funds. Hence, irrespective of the source of the deposits, it may safely be assumed that practically all depositors will keep, as a condition of maintaining the accountt, a minimum balance greater or less, according to the possible and usual requirements of the bank itself, and also according to the scope and magnitude of the transactions effected by the depositors through their accounts.

The maintenance of such balances is an assurance to the bank that the rights to demand cash represented by the deposits will not only not be directly exercised by the depositor, but also that they will not be transferred by means of checks to others. This double assurance is important to the bank because it means that on the one hand there will not be, within the limits of the balances, a direct withdrawal of cash, and that, on the other, within the same limits, there will be no debit balance at the clearing house. Since the bank uses its cash reserve simply to meet direct demands for cash and to settle clearing house debit balances the minimum balances maintained by depositors represent only dormant liabilities against which no active preparations have to be made.

Depositors usually maintain a balance

Minimum balances constitute a guarantee against withdrawal

The significance of these matters to a bank's profit account can be forcefully illustrated by assuming a hypothetical case. Suppose that a bank has cash deposits of $200,000, and suppose further that in the absence of any legal restriction, the bank learns by experience that because of the general use of checks as currency in its community and because of the maintenance of comfortable balances by the depositors, a cash reserve of 10% is adequate to meet direct demands for cash as well as possible debit balances at the clearing house. Twenty thousand dollars would then suffice to meet the cash demands of, and the clearing house requirements arising from the checks drawn by, the depositors of the cash. One hundred and eighty thousand dollars would then be released to the bank for other purposes. If now borrowers from the bank have about the same relative cash needs as the depositors of cash, and if they maintain an approximately equivalent average balance, the whole of this $180,000 may be used as a 10% reserve for the deposit liabilities that the bank may safely add to those assumed when the cash itself was deposited. In other words, instead of earning interest on only $180,000 the bank may earn interest on just ten times that amount, namely, $1,800,000. On the basis of a 4$ rate this would mean an annual income of $7,200 if the bank's lending power were limited to the actual cash held above the reserve required for cash depositors; but when this cash may itself be used as a 10% reserve against further deposits extended to the public the annual income at the same rate leaps to $72,000. This is to say, on a 10$ reserve basis every dollar in cash means an increase of $9 in the bank's lending power. That explains why the bank can afford to maintain an expensive establishment, to supply stationery and to undertake free of charge the collection of checks, coupons, etc., for its depositors. In the banking business nothing succeeds like deposits.

Example of influence on bank's profits

In the discussion preceding there has prevailed the tacit assumption that a bank dispenses its credit, namely, its obligations to pay cash on demand, only in the form of deposits, while only incidental reference has been made to bank notes. As a matter of fact, however, where unrestricted by legal enactment, the extension of credit by the bank may be in the form of its own notes. But in most countries the issue of notes is subject to rigid regulation, and so important from many points of view is the question of deposits versus notes that the whole of the next chapter is devoted to it. Here the effort will be made simply to point out the similarity between these two forms of bank credit.

A bank note is the duly executed promise of the bank to pay the holder on demand a specified sum of money. Bank notes are issued usually in convenient denominations so that they can circulate freely from hand to hand as a substitute for the monetary units in which, according to the promise on their face, they are redeemable. The individual who acquires possession of a bank note has therefore by virtue of his possession a right to demand money from the bank. But this, we saw, is exactly the right conferred on the depositor by virtue of his "deposit." What then is the difference between the two rights? The difference is only one of form, and of scope of usefulness. The deposit is an unembodied right to demand money which circulates as a substitute for money in the form of a check requiring indorsement as it passes from hand to hand. The bank note is an embodied right to demand made out to bearer and hence does not require indorsement as it passes from one holder to another. But from the bank's point of view both of these forms of credit are "demand liabilities," i.e., liabilities which have to be paid on demand, and the necessity for keeping itself always in condition to meet "demand liabilities" as they are presented is just as strong in the one case as in the other. Other things being equal then, and assuming the absence of any special restriction, the credit that the bank extends will take one or the other of the two forms, or both, in such proportions as, in its broad relations with its clients, the opportunities for profit to the bank seem to dictate.