The payment of interest on deposits, undertaken in addition to the other multiplex services of the reserve city banks and brought about by the force of competition among the reserve city banks for these accounts, resulted in making them unprofitable unless the funds were, as nearly as possible, employed constantly and at good rates and at call. Therefore the reserve banks were inclined to seek profitable investments based upon these balances, and because of the want of a discount market the banks built "lines" of demand loans to stock exchange speculators for trading purposes; if such loans were called, the speculators would liquidate the securities and pay their loans, and thus replenish the bank with funds to meet the demands of their correspondents - an operation which was perfectly safe when the market was buoyant but dangerous in times of panic.
The system tended to cause temporary superabundances and temporary shortages of loanable funds in the central reserve cities. During the dull seasons in the agricultural regions, for example, the banks would have excess funds and would remit these to their reserve agents, either to add to their balances on which they received the customary 2 per cent interest, or to have the agents invest for them in brokers' loans, securities, etc., so as to take advantage of the higher money rates on the market. The plenitude of funds in the reserve cities lowered money rates and eased the way for the speculators, and at the same time inflated the prices of securities. An inflation of stock exchange operations followed. With a revival of activity in the agricultural regions the local bank would recall part or all of its balances from the reserve cities and possibly become a borrower. The result was that it became impossible to maintain the stock market, money became tight, loans were contracted, investments were liquidated, and values fell.
In case of panic these conditions were accentuated and it became impossible to recover the "reserve" funds by liquidating the securities in which they were actually invested, or practically invested through call loans, without producing so severe a shrinkage of values as to cause wide-spread bankruptcy. The banks were therefore often obliged to suspend specie payments. For want of a broad discount market where such seasonally spare funds might have found investment in commercial paper, the rede-posited reserve plan forced the collateral call loan system, fostered an unsteady securities' market and money market, and confused commercial banking with financial banking. In the panic of 1907 this dependence upon the stock market was so convincingly proved to be dangerous and vicious that banks ceased to a large degree to make seasonal deposits and withdrawals from New York.