It is necessary, as we have seen, for every bank to keep some money on hand to meet counter payments and what are commonly the more considerable requirements of settlements with other banks in the same place. Balances with banks elsewhere must also be maintained in order to facilitate payments to distant banks. The amount of money and balances required for these purposes in normal times is not large since receipts from all sources tend to offset withdrawals although of course not exactly from day to day. Banks having large pay-rolls to make up for depositors must carry exceptionally large amounts of money on hand, but generally speaking reserves of cash and balances in the neighborhood of ten per cent. of demand liabilities are found to be ample for ordinary requirements.

In the experience of all banks, however, there will be occasions when withdrawals of funds will be exceptionally large. Not infrequently also these withdrawals will be accompanied by demands for additional loans from regular depositors, if possible endeavor to satisfy. A well managed bank with diversified loans and investments will ordinarily experience no difficulty in meeting a situation of this kind. It will reduce or entirely liquidate loans to borrowers who are not its own depositors; it may sell securities; and finally it may use its own loans as a basis for borrowing from other banks.

The effectiveness of these measures, it is to be observed, depends upon the ability of other banks to extend additional accommodation. The market for securities becomes at once restricted when would-be purchasers are unable by means of bank loans to secure a part of the purchase price. Call loans against securities listed on stock exchanges cannot be liquidated to any appreciable extent if the brokers to whom such loans are chiefly made are unable to borrow elsewhere. The payment of commercial loans as they mature is also largely dependent upon the continuance of the processes of production and marketing of goods and of the payment for them by purchasers in normal fashion. Ability of borrowers, however, to meet these obligations is at once weakened if those to whom they regularly sell commodities experience difficulty in securing the usual amount of accommodation from the banks. Payments for goods already sold are delayed and new purchases are curtailed. A diminution in the total amount of commercial loans will accompany a fall in prices, and a decline in the activity of trade, but for the banks to attempt to contract such loans quickly and in large amount subjects business to intolerable strain and if persisted in occasions failures so numerous and widespread as speedily to threaten even the solvency of the banks themselves. In short, business cannot suddenly be deprived of the volume of credit to which it has become adjusted without disastrous consequences both to lenders and borrowers.

For the satisfactory conduct of the business of banking something more then is needed than reserves of cash sufficient for ordinary requirements together with loans and other investments which can be readily liquidated when one or only a few banks find it necessary to strengthen themselves. Somewhere in every banking system a reserve of cash and of lending power is needed to meet occasions when the banks find themselves confronted with unusual demands both for money and for loans. Provision for such occasions may be made through the maintenance by all banks of larger reserves than they regularly require, by a few banks or by a single bank. Where, as in Canada, banking is conducted by a few banks of large size this requirement has been recognized and adequately met by the several banks. But in countries in which banking has been conducted by numerous banks large and small the responsibility has been so widely diffused that this need has not been fully realized and consequently provision for periods of financial strain has generally been entirely inadequate.

In an endeavor to remedy this defect which was repeatedly disclosed in the banking experience of the United States before the Civil War, the banks were subjected to legal reserve requirements considerably higher than the reserves needed in normal times. But in periods of financial strain the mere possession of reserves is not sufficient. They must be used. Where banks are numerous with no recognized leaders or strong combination among them, in any sharp crisis some of the bank managers may decide to take care of themselves by reducing their loans and filling up their reserves, and leave it to others to take care of the general welfare by enlarging discounts and satisfying demands of depositors for money. Knowledge that some may pursue a selfish course weakens the disposition and also the power of others to take a more liberal course, and this may lead all the banks to pursue a policy of contraction which is condemned by the judgment of the majority.

This difficulty of securing united action among many banks in emergencies was strikingly evident in successive crises in the United States after the establishment of the national banking system in 1863. Although the cash reserves of the banks were far in excess of what was needed for ordinary requirements, the banks in each crisis from 1873 to 1907 invariably endeavored to contract loans and in the more serious of these crises, those of 1873,1893, and 1907, partially suspended cash payments.1

The unhappy consequences to the community generally of the inability of the banks to cope successfully with emergencies finally led to the establishment of the Federal Reserve banks in 1914. This group of banks is patterned after the central banks which are found in most European countries as well as in Japan and thanks to which periods of financial strain had been handled far more satisfactorily than in the United States.

In the analysis of banking operations in preceding chapters it was assumed that each bank enjoyed similar powers, and consequently aside from differences of size was equally responsible for the maintenance of the mechanism of credit in a sound condition and in effective operation. The presence of a central bank relieves the other banks of some portion of this responsibility. It introduces important modifications both in the powers of these banks and in banking practice. In later chapters the history of the three most important central banks, those of Great Britain, France, and Germany, will be considered, but for the understanding of the significance of those chapters a preliminary analysis of the powers, functions, and policies of central banks will be helpful.