Probably the most vital defect in our banking system in the past was the inelasticity and immobility of bank reserves. All national banks, and quite generally state banks also, are required to keep a certain reserve of lawful money against deposits. This regulation grew out of our earlier banking experience when numerous small banks, managed in many cases by inexperienced bankers, failed because they did not keep adequate reserves to meet emergencies or unusual demands upon their deposits. It became necessary, therefore, to impose some legal minimum below which a bank's proportion of money on hand to total indebtedness to depositors should not fall. The conservative bank manager, of course, needs no such restrictions; he will always be careful to keep ample reserves. But under our system of independent, free and decentralized banking it has seemed wise to require all banks to keep a minimum reserve. This is peculiar to our system. Foreign banks are not required by law to keep on hand any fixed reserve against deposits. They are left free to keep such reserves as experience shows to be necessary.

These may be large or small depending upon the character of the bank and upon local conditions. The Bank of England being a bank of banks finds it advisable to carry a reserve of 50 per cent or more, while the joint stock banks keep the greater part of their reserve with the Bank of England and hold very small amounts of cash in their own vaults. In most of the European systems banks are required to maintain a cash reserve against notes, but no definite reserve against deposits.

Under our national banking system banks in reserve cities, about fifty in number, were formerly required to maintain a reserve of 25 per cent of their deposit liabilities, and all other banks, known as "country banks" were required to keep a reserve of 15 per cent. In only three cities, New York, Chicago and St. Louis, known as "central reserve" cities, were the banks required to keep their entire legal reserve in their own vaults. The country banks were permitted to deposit three-fifths of their reserve in banks in reserve cities, thus leaving only 6 per cent in their own vaults; and reserve city banks might keep one-half of their legal reserves in banks in any of the central reserve cities. In general, state banks are permitted to redeposit a part of their cash reserves in the large centers in much the same way.

This rigid reserve requirement involved several fundamental defects. It subjected all banks to the necessity of curtailing loans when they approached the legal minimum reserve. The only flexibility, then, was in what is known as the "surplus reserve," that is, the amount of cash resources in excess of the minimum or "legal" reserve. Of course a bank could and sometimes did build up its reserve by selling some of its assets to other banks or by borrowing some of their funds, but when the need was most urgent, when financial stress came upon all banks, this method could not be used for all banks were then struggling to keep all the cash they could get.

The reserve system was weak, also, in that it scattered the cash reserves of the country among 25,000 different institutions, and provided no central reservoir from which banks could draw cash when it was urgently needed. This system of holding bank reserves has been compared to a system of fire protection in which each of several thousand families in a large city keeps its own cistern of water instead of having the whole city's water supply stored in a common reservoir, connected by conduits with every part of the city, and so instantly available in unlimited quantities for the extinguishment of a blaze at any point.

The weakness of the system of scattered bank reserves was intensified by the provisions allowing the redeposit of reserves. Country banks could keep three-fifths of their legal reserves in the form of credits at reserve city banks, and reserve city banks could keep one-half their reserves in central reserve city banks. Naturally no bank will keep any more idle money in its vaults than is absolutely necessary. The idle money therefore drifted to the central reserve cities, especially to New York, the financial center of the country, where it yielded two or three per cent interest and yet was subject to call at any time. The New York bank's had to keep these reserves deposited with them in such fluid form that they could quickly be turned into cash when needed by their country correspondents. In the absence of a rediscount market where prime commercial paper could be readily converted into cash, the New York banks had but one chief source of investment for these bankers' balances - the call loan. These call loans, as explained elsewhere, are made mostly to stock brokers upon the security of stocks and bonds, and usually at lower rates of interest than the prevailing rate for commercial loans. In European countries business men are able usually to borrow at lower rates than speculators. But with us the stock exchange was the only important liquid loan market, and under the old unscientific banking system the banks involuntarily fostered speculation at the expense of business.

This decentralized reserve system, under which each bank held its own cash reserve, but permitted the re-depositing of part of it, caused such a concentration of banking reserves in New York as to produce a dangerous kind of centralized or single-reserve system. Formerly the banks of New York normally carried in their vaults cash reserves of about $500,000,000, which is about one-third of all the money in the banks of the whole country and about one-seventh of the entire fund of money in the United States. This centralization of bank reserves in New York worked fairly well in normal times, but when financial disturbances arose the centralized reserve system suddenly broke up into a many-reserve system. In the absence of any powerful central or regional association, upholding the whole structure of credit and giving confidence and support to all sound banks, the accumulated reserves in New York and other reserve cities were torn down and scattered among thousands of individual banks each scrambling for all the gold it could get. Under every great strain this many-reserve system has completely broken down. In the panics of 1873, 1894 and 1907 which cost the country untold millions of dollars the system of scattered reserves proved powerless to uphold the structure of credit. With no strong central reservoir to draw upon, the thousands of smaller banks, instead of lending freely to meet the urgent need of borrowers, hoarded the little stores of cash they could grab out of the central reserve banks in order to keep up their legal reserves. These reserves intended for an emergency could not be used to meet the emergency when it arose, without violating the law.

In times of extreme financial distress in the past banks have had to resort to temporary cooperative measures to protect their reserves through the local clearing house associations. They arrange to accept in payment of balances between themselves clearing house notes or credits issued by a committee representing the associated institutions. They agree to defer the settlement of their claims against one another until a future date, being protected in the meantime by bank assets in the form of commercial paper or securities turned over to the committee as security. Such expedients cannot of course avert a bank panic; they merely cheek its severity and to some degree its spread. These devices are at best temporary and local in their influence, and they are expensive. Clearing house loan certificates issued in times of panic usually bear interest at six per cent or more. Much greater cost is involved in the withdrawal of deposits and in the general weakening of the banks, and still greater loss is suffered by customers of the banks who cannot obtain the necessary accommodations to carry their business commitments. The panic of 1907 was due not so much to the clamor of depositors for their money as to the action of banks in various sections of the country in calling their deposits with agents in the reserve cities. This intensified public distrust and caused a general demand for cash from depositors. After the panic got well under way the banks pooled their resources through the clearing house associations and the panic soon spent itself.

After the panic of 1907, the Aldrich-Vreeland Act was passed permitting national banks to organize national currency associations for the purpose of issuing emergency currency against commercial paper and certain classes of securities other than government bonds. It was intended to provide a legal method of increasing bank currency in times of strain. It was understood to be only a temporary makeshift to remain in force until a scientific banking plan could be worked out. The law was to expire in 1914, but. pending the establishment of the new Federal reserve system, it was extended to June 30, 1915, and the tax rate on additional emergency circulation was reduced from a maximum of 10 per cent to 6 per cent. A score or more of these national currency associations were organized, and $500,-000,000 of emergency notes were printed and deposited in the sub-treasuries ready for immediate distribution in case of need. No occasion arose for the issue of this emergency currency until the summer of 1914 when large amounts were put out to meet the monetary and exchange disturbances caused by the European war.1

1 See p. 388.

Quite commonly it has been assumed that the issue of notes is the means by which the dangers of a financial panic can be averted. To be sure a system under which the reserve city banks can quickly increase their own notes and meet the demands for currency of country correspondents is helpful, provided these banks want currency for local circulation and not for their own reserves. Additional notes or "emergency" circulation would supply the country banks with a currency that could be paid out if urgently needed and so indirectly protect reserves, and they could be used as reserves by banks other than national banks. But while these emergency issues may afford some relief they do not meet the fundamental difficulties in times of panic. What the merchant needs at such times is a deposit account against which he can draw checks to meet his obligations; what the banker needs is the power to make loans without endangering his reserves. But a bank cannot replenish its reserves by issuing more of its own notes - these are only additional liabilities, not assets. The power to expand their note issues cannot add to the cash reserves of the banks and so enable them to assist needy borrowers and ward off panics. The power to expend their loans is the essential consideration. After the loan is made, checks provide the means of payment in the great majority of cases.