One of the chief means thus employed has for its purpose the protection of noteholders and depositors in case of bank failures, and consists of the requirement that banks shall accumulate and maintain an adequate capital and surplus. By capital is meant the funds contributed or guaranteed by the stockholders or proprietors of the institution at the time of its foundation, and by surplus is meant an additional fund accumulated from the profits of the bank after it has engaged in business. In the case of joint-stock institutions the capital is usually accumulated by the sale of certificates of the denominations one hundred or one thousand dollars, the possessors of which acquire in return for their contributions a right to share pro rata in the profits and government of the institution. The capital of private banks is contributed directly by the proprietors, who, of course, enjoy all the profits subsequently accruing. The surplus is ordinarily accumulated by setting aside or reserving a, certain amount or proportion of the annually accruing profits until the total sum reaches a specified aggregate. For example, the law regulating the Imperial Bank of Germany provides that twenty per cent of the profits annually accruing, in excess of a four and one-half per cent dividend to be paid to stockholders, shall be reserved until the total amount reaches one-fourth of the total capital.
The statutory regulations regarding the amount of capital of banks are far from uniform. The National Banking Act of the United States limits the indebtedness of banks to the amount of their capital stock, but defines indebtedness in such a way as to exclude the notes in circulation, bills of exchange or drafts drawn against money actually on deposit to their credit or due to them, and liabilities to stockholders for dividends and surplus profits. The German bank act of 1875 limits the interest-bearing deposits of the Imperial Bank to the amount of its capital and surplus. In England and France the statutes do not fix any relation between the debts and the capital of banks, but special laws have been passed from time to time providing for an increase in the capital of their respective banks.
One of the purposes of legislation of this kind is to provide adequate funds for the payment of noteholders and depositors in case of the failure of a bank which has invested its cash deposits and its own credit in unre-munerative or inadequately remunerative forms. Provision is made, therefore, for the sale of the securities in which the capital and the surplus have been invested, and for the use of the proceeds to make up any deficiencies, and, in some cases, provision is also made for a levy upon the stockholders when these are inadequate. Noteholders are often given a preference in the form of a first lien on certain or all of the bank's resources, as in the cases of England, Canada, and the United States, but the design is to furnish adequate protection for depositors as well.
Regarding the value of this sort of legislation no question can be raised. As to the ratio that should exist between the demand liabilities of a bank and its capital and surplus, however, and the form in which the latter should be invested, there is room for differences of opinion. If the requirements regarding capital and surplus are too stringent, the development of the banking business is liable to be retarded. The profits of bankers arise chiefly from lending their credit and the capital of their depositors instead of their own, and if such loans are restrained within too narrow limits, dividends will be inadequate and capital deflected from this form of investment. On the other hand, the carefulness and conservatism of bank officials is apt to be in proportion to the amount that they and their brother stockholders have at stake, and it is best, therefore, to make that stake as large as is consistent with fair profits and an adequate development of the banking business. No general rule can be laid down regarding this matter. Wise legislators must be guided by experience, and this is certain to vary. Old countries with plenty of capital and relatively few opportunities for investment can afford to be more stringent than countries differently situated in these particulars. No nation, however, can afford to be lenient in a matter which so closely concerns the very basis of its prosperity.
Regarding the investment of the capital and the surplus, practice has followed two main lines. In the United States and England the favourite form is government bonds. Our National Banking Act requires that at least one-third of the capital of national banks shall be invested in registered bonds of the United States, and most of the capital of the Bank of England is invested in consols. In most other countries the banks are left free in this particular, no special regulations being prescribed by law.
Wherever government bonds or some other special form of investment of capital is ordered for the purpose of securing special protection for noteholders, as in the cases of England and the United States, the wisdom of such regulations depends upon the need and desirability of this particular form of protection, a topic which will be discussed in a subsequent section of this chapter. Assuming, however, that a proper basis for note issues can be secured in other ways, and considering the question from the standpoint of all the interests concerned, there seems to be no good reason for prescribing any form of investment for the capital and the surplus which could not equally well be recommended for cash deposits and bank credit. The fact that these funds are protective in their character and not designed as a means of meeting ordinary cash demands renders tolerably safe the investment of at least a portion of them in securities which mature only after the lapse of a long period of time, but it does not furnish an adequate reason for such investment. Whenever ordinary mercantile securities are available in sufficient quantities they constitute just as safe an investment and offer the special advantages of maturing in a short time and of being more readily transmutable into cash in cases of emergency. If invested in this form, therefore, the capital and the surplus may serve not only as a means of paying off noteholders and depositors in case of bank failure, but also as a means of preventing failure. If the volume of mercantile securities is not sufficient, the proper remedy is a diminution of the amount of capital invested in the banking business rather than a change in the form of its investment.