The protection of bank credit resolves itself into two general lines: (1) the establishment of safeguards against the bank's insolvency, and (2) special protection of its creditors against the suspension of specie payments.
Insolvency is a condition existing when liabilities, other than to stockholders, exceed assets; under such a condition the bank would be unable, even after all assets had been liquidated, to pay noteholders and depositors par on their claims. Insolvency is guarded against by the owners of the bank subscribing capital and by accumulating a large surplus to act as buffer. The capital subscribed should bear a reasonable ratio to the volume of credits extended; the maximum amount of this ratio may be decreed by law. When, however, banks are organized and capitalized, it is impossible to fix such capital requirements in advance, for no one knows what volume of business will be the fortune of the incipient bank. The state assumes, however, that the size of the bank and the size of the city in which it is domiciled bear some ratio, and accordingly the minimum capitalization of banks is roughly proportioned to the city's population.
Laws further require the accumulation of some minimum surplus, usually a percentage, 20, 30, or 40 per cent of the capital, during its earlier years. Any bank aspiring to greatness inevitably accumulates such surplus and usually maintains it far in excess of the required minimum; such surplus not only is evidence of strength, age, and conservative policy, but provides working and earning funds. Our National Bank Law and some state bank laws impose upon the bank stockholders a double liability - that is, the stockholders in case of the bank's failure can be held for an additional amount equal to the par value of their shares, and this liability is a contingent asset of the bank. The accumulation of a large surplus, however, renders the use of this asset improbable, and the growth of the bank's credits outstanding renders the protection afforded by this double liability of the stockholders relatively less important. In the light of their dividend percentages most banks are undercapitalized, but their creditors do not suffer therefrom since the accumulation of surpluses many times the size of their capital serves the same ends as a buffer against insolvency.
Other lines of protection against insolvency provided by law are: by the regulation of loans and business activities, by fixing the maximum loan to any one person, by forbidding loans to bank officers or loans of certain kinds, by regulating investments and forbidding certain dangerous forms, by restricting the incurrence of contingent liabilities by acceptances, indorsements, or guaranties, and by restricting the field of operations to strictly credit transactions. For example, merchandising, real estate, insurance operations, and the like, are usually prohibited to banks.