This section is from the "Practical Banking" book, by Albert S. Bolles.
But ordinarily every banker is presented with more business than he can assume, and he is enabled to select the more profitable and reject the less profitable. In speaking of the profits of banking, we mean gains that proceed from some other source than the interest allowed by law for the use of the money. These gains are derived most largely from circulation and deposits; hence the loans are advantageous to a bank, in proportion as they increase the circulation or deposits of the bank. Money was sometimes borrowed to pay debts to a neighboring bank, or to a person who kept his money deposited in a neighboring bank. Such loans yield no profit to the lender except the interest on the loan; hence they are not so profitable as loans to borrowers who will take bank notes of the lending bank, and circulate them over the country in the purchase of agricultural products. While the notes remain in circulation, the bank is receiving interest on them from the borrower—interest not for the loan of money, but for the loan by the bank of its promises to pay money when demanded. So, on a loan made by a bank to one of its depositing customers, the bank receives interest only on its promise to pay the borrowed money when the borrower shall from time to time draw for the same. And when a deposit is thus drawn from a bank, the draft is not necessarily paid in money, but in bank notes which may obtain a circulation. This advantage is a usual attendant of the deposits of some customers, and makes their accounts doubly beneficial to a bank. Whether a depositor asks for more loans than his deposit account entitles him to receive, is a question whose solution depends on whether the bank can lend all its money to better depositing customers, or more profitably use it in loans for circulation. A banker should, however, estimate liberally the merits, which pertain to a steady customer; not deciding on any proposed loan by the amount of the proposer's deposit at the time of the proposal, but his antecedent deposits, which were doubtless made in reliance on the bank for a fair reciprocity of benefits. Competition for profitable customers exists among banks as eagerly as competition among borrowers for bank loans; hence liberality to customers by a banker is as much a dictate of interest as of justice.
Notes and time-drafts discounted by country banks, and payable in New York, Boston, Philadelphia, and other eastern places were payable in a currency whose value was enhanced by the rate of exchange, which existed in favor of the east and against the west. As country banks never allowed any premium in the reception of such paper, the benefit of the exchange was a strong inducement to a country banker for preferring loans thus payable to loans payable at his own counter. Borrowers would often take advantage of this predilection, and make notes payable artificially at New York, as a means of obtaining a loan of a country banker. Notes thus made were rarely paid at maturity; hence, so far as a banker relied on their payment, and founded his business calculations thereon, they were hurtful. To the extent that he colluded with the maker and supplied him with funds by which such note could be paid at New York, at a loss, to the maker, of the difference in the rate of exchange, the transaction was unlawful.
Banking is not exempt from the ordinary fatality which ever in a long course of business makes honesty the best policy. To gain unlawfully must also be a poor recommendation to a banker, with any thoughtful stockholder; for if a man will collude to make dishonest gains for his stockholders, what security can the stockholders possess that he will not collude against them, to make dishonest gains for himself? A country banker may properly discount a note payable in New York when the maker's business will make New York the most convenient place of payment, though the borrower's residence may be in the country: such is often the case with drovers, lumbermen, and some manufacturers. Transactions of this circuitous nature must, however, be spontaneous on the part of the borrower; for a note is usurious if, in addition to the receipt of legal interest, the banker superadds, as a condition of the loan, that it must be paid at a distant city, and consequently in a currency more valuable than that the lender received. But when such loans are legal, and possess the best commercial character for punctuality and security, they are not always so advantageous to the country bank as notes payable at the country bank, and connected with the circulation of bank notes or with deposits. The force of this remark can perhaps be better seen in what follows.
Banks can usually make as many loans as they desire to borrowers who will use the loan in purchasing from the bank a draft on New York or other eastern city, whereby the bank will obtain a premium on the sale of the draft, in addition to the interest on the loan. The operation becomes peculiarly advantageous to the bank when the loan is itself payable in New York, for while the borrower pays, in such a transaction, say an eighth of one per cent, to the bank for a bank draft on New York, he subsequently repays in New York the borrowed money without receiving any return premium from the bank. But howsoever profitable such a transaction seems, banks can rarely transact advantageously much of such business. Should the entire capital of a bank of three hundred thousand dollars be employed in discounting drafts on New York payable at three months from the tjme of discount, and should the bank pay therefor sight drafts on New York, charging for them a premium of a quarter of one per cent., the bank could not pay its stockholders above six per cent, the year in bank dividends.
As every loan is usually attended with some advantage to the bank, in the ways we have explained, beyond the interest paid by the borrower, the sooner the loan is to be repaid to the bank, the more frequently will the bank be able to reloan the money, and obtain a repetition of the incidental advantages.