The cash reserve of a bank fluctuates in size according to the business transacted, varying with the hour, day, season, year, and cycle of years. It is desirable that it should fluctuate, for rigidity would indicate that the bank was not accommodating its customers. This fluctuation is both absolute and proportional. Payments to the bank or deposits of actual cash by customers increase the reserves proportionally to the liabilities, whereas payments of cash by the bank have an inverse effect. Unless there are special state regulations which apply to notes or deposits, it is a mat'ter of little moment to the bank whether it extends credit by notes or by deposits, as demand liabilities of similar nature are created in either case. The bank, however, dislikes to pay out lawful money which will reduce its reserve, force a reduction of its loans, and lower its profits. The problem of the banker is to keep his reserve in proportion to his liabilities and he has many devices for increasing it in case of necessity.
One device is for a bank to borrow from other banks, in its own or a central city, on its note, secured or unsecured. Hence it is important for it to establish dependable relations with other banks. The relation may be founded upon voluntary association or upon a centralized banking system, or the local clearing house association may function as creditor to needy banks, or the reserve city correspondent may so serve. In a centralized system the central bank gives this succor as a matter of duty.
A second device for increasing a bank's reserve is to liquidate some of its assets. The assets of a business are classified as "slow" and "quick." Quick assets are those which can be converted into cash quickly and easily in emergencies, and consist of high-quality securities and self-liquidating, short-term, commercial paper, and the like. Marketability in emergency implies a well-organized market for the particular asset, such as the stock exchange market for the sale of stocks and bonds. The American practice has been for banks to carry in their portfolios quantities of high-class securities which perform the double function of secondary reserve and earning assets. European banks favor commercial paper for their secondary reserve, since their discount market is well organized; in fact their practice is to keep their spare funds continuously invested in this paper and rediscount freely with any shift in the market. This practice, though at present less possible in the United States, where the discount market is in its infancy, gives promise of rapid extension. The dependence of our banking system upon the securities markets has too closely interrelated the commercial and financial capital of the country and has tended to lay the basis for panics.
A third device is contraction of loans. This may be accomplished through positive methods; that is, the bank may call for payment of demand loans. If they are paid in cash, the reserve will be built up absolutely. If they are paid with credits on other banks, these may be collected directly or through the clearing house. If they are paid in the bank's own notes, one of two things will result - if the incoming notes are retired and canceled the liabilities will be reduced and the proportional reserve will be restored; if the notes are kept alive in the cash of the bank (as is the case with national banks in the United States), the liabilities will remain as they were and the till money will be increased.
Or the contraction may be accomplished through negative methods; that is, the banker may refuse to issue new loans or to renew old ones when they fall due. As demand liabilities, therefore, do not increase while loans are maturing and being paid, the reserve in consequence is increased absolutely and relatively. Such negative contraction may be accomplished without an actual refusal to loan, merely by raising the rate for bills offered for discount to discourage discounting. High discount rates indicate low reserves and difficulties in getting loans - the condition in which the market is described as "tight." Low rates indicate high reserves, ease in getting loans, and an " easy" money market. In refusing new loans or renewals and in asking higher discount rates the bank exercises discretion - desirable customers are favored, particularly those who have large accounts, carry good steady balances, and have wide business influence.
A further method of protecting reserves is the synchronizing of receipts and loans. By the careful selection of commercial paper with respect to maturities a steady inflow of funds can be realized, or if business is seasonal, large inflow can be had at the times when the demand for loans is exceptionally large. Rather than keep funds idle to provide against a time when it is known that the demand for loans will be great, the banker buys from note-brokers commercial paper which will mature at such time.