The national banking act provides that banks incorporating under it shall buy government bonds1 and deposit them with the Treasurer of the United States, and that they may receive in return circulating notes up to the par value (originally only 90 per cent) of the bonds so deposited, but not in excess of their capital. Any number of persons, not less than five, may, subject to the approval of the Comptroller of the Currency, organize a banking "association" to have succession for twenty years. The amount of capital required is based upon the population of the place where the bank is located. The smallest capital permitted is $25,000 and that only in places of three thousand inhabitants or less. In towns of six thousand or less the capital must be at least $50,000; between six thousand and fifty thousand, $100,000; and in cities of fifty thousand or more, national banks must have a capital of not less than $200,000. At least one-half of the capital must be paid in before a bank begins business, and the balance in installments of not less than 10 per cent monthly. As no provision was made for more than one place of business, national banks were not allowed to establish branches. The bank must have at least five directors, each of whom must own ten shares of its stock.1 Stockholders are individually liable for all obligations of the bank to an amount equal to their stock holdings.

1 The Federal Reserve Act of 1013 repealed this provision requiring national banks to deposit a stated amount of government bonds with the Treasury.

Prior to the passage of the Federal Reserve Act in 1913 each national bank before opening for business was required to deposit with the Treasurer of the United States a certain amount of government bonds. Against the bonds thus deposited a bank was entitled to issue circulating notes up to the par value of the bonds, but not exceeding the market value thereof and not exceeding its paid-in capital. National bank notes are not legal tender for private debts, but are receivable and payable by the Government except for import duties and interest payments on the public debt. Every national bank must receive the notes of every other at par, and redeem its own notes on demand at its own counter. It is also required to keep on deposit in the United States Treasury a sum of "lawful money' equal to 5 per cent of its circulation for the redemption of its notes. This is not a "safety fund," for each deposit belongs to the bank making it, and is held for the redemption of its own notes alone. The act of 1863 required each bank to redeem its notes over its own counters only, but the amended act of 1864 provided for the establishment of redemption agencies in certain leading cities. In 1874 a new system of redemption was provided, making the Government responsible for the redemption of mutilated notes from the redemption fund which each bank must keep good at all times. The expense involved in sending these notes to Washington and replacing them with new notes is borne by the banks.

1 Five shares in banks with only $25,000 capital.

The present system of redemption does not test effectively and continuously the ability of every bank to redeem its notes on demand. To apply such a test it would probably be necessary to forbid any bank to pay out any notes except its own as in the Suffolk Bank system. The chief effect of the system has been to provide a method for replacing worn and mutilated notes with new currency. The Government is ultimately responsible for the notes of every national bank. It is bound to pay on demand all national bank notes presented, and not merely to the extent of the redemption fund. To protect it in this responsibility it has ample security as follows: (1) the bank's bond deposit beyond the par value of which a bank cannot issue notes; (2) the 5 per cent redemption fund; (3) a first lien upon the bank's assets; (4) the personal liability of stockholders.

Until recently banks could reduce their circulation only by redeeming their notes over their counters and sending them to Washington to be cancelled, or by depositing money to an equal amount in the Treasury, receiving an equivalent amount of the bonds deposited. Prior to the enactment of the Federal Reserve law the total amount of bank notes that could be retired by all the banks in the system in one month was $9,000,000 1; but provision was made in the new law for the gradual withdrawal of all national bank notes and the substitution of reserve bank notes. National bank notes are subject to a federal tax at the rate of one-half of 1 per cent annually when secured by 2 per cent bonds, and 1 per cent when secured by bonds bearing a higher rate.

1 Prior to 1908 only $3,000,000 a month.

It is a common fallacy that national banks through the note-issue privilege make a double profit, by receiving interest on the bonds deposited with the Treasury and again on the lending of the notes issued to the bank on these bonds. The fact that thousands of banks have preferred to organize under state charters, and the further fact that in recent years the amount of bank notes outstanding has been less than 70 per cent of the total amount which the national banks could legally issue, offers sufficient refutation of the double or extraordinary profits theory. A bank makes money by lending its credit in the form of deposits or of bank notes. Profit is made upon deposits in precisely the same way as upon notes. A national bank has the advantage over other banks of being able to choose between the two methods of using its credit, but its investment is limited to its capital plus its credit which is also the measure for non-issuing banks.1 The profit which a national bank can make by lending its credit in the form of circulating notes depends largely upon the premium it must pay on the government bonds purchased. It also depends upon the current rate of interest and the opportunity the bank has of lending the money if it does not use it to purchase bonds. The bank receives no interest on the money used to buy bonds in excess of the amount of notes received for issue. According to the annual report of the Comptroller of the Currency for 1913, the profit on bank circulation based on Panama Canal bonds at 101 1/4 was about 1 1/3 per cent.2 This calculation assumed that money was worth 6 per cent and that the banks were able to lend all the notes issued to them against their bonds.

1 Dunbar: Economic Essays. p. 183.

2 Report of Comptroller of the Currency, 1913, pp. 23-24, 126.

The banking act requires each bank before declaring a dividend to carry one-tenth of its net profits for the preceding half-year into a surplus fund until it has accumulated a sum equal to 20 per cent of its capital. Many banks provide a surplus fund at the time of organization; thus, for example, if the subscribers raise $500,000 to start the bank, they may choose to divide that amount into $250,000 capital and $250,000 surplus.