In the legal regulation of the banking business most States have distinguished between depositors and noteholders and have granted special protection to the latter. The chief reasons for this practice consist in the peculiarities of bank-notes to which reference has already been made and for present purposes may be summarized as follows: -

(1) Notes circulate freely from hand to hand without endorsement, and, if issued in the proper denominations, may answer nearly all the purposes of currency, even taking the place of coin. They are, therefore, less liable to be presented for redemption than other forms of bank currency, and in consequence make fewer demands upon the cash reserve. If unrestricted in their operations, bankers are thus tempted to neglect their reserves and to unduly extend their loans. Long and bitter experience has shown that bankers as a class are unable to resist such temptation, and that unrestricted and unregulated note issues are a fruitful source of bad banking and commercial disaster.

(2) In order that bank-notes may perform their legitimate functions they must be rendered absolutely safe. They are the only form of credit currency which is elastic and at the same time adapted to the needs of rural communities, small towns, and certain classes of the population in larger industrial centres; but unless they are perfectly safe they are liable to injure rather than benefit such communities. Moreover, unless bank-notes are rendered absolutely safe by appropriate legislation, their circulation at par is sure to be restricted to the immediate locality in which they are issued, and consequently their general use as a medium of exchange obstructed.

The legal regulations employed by different nations for the special protection of noteholders vary widely, but the most important of them may be summarized under the following heads: -

A. The government bond system. - This is the system employed in the United States and England. It consists, in substance, of compelling banks of issue to invest a portion or all of their capital in government bonds to be held as security for the notes issued. In the United States national banks are permitted to issue notes only to the extent of the par value of the bonds which they have purchased and deposited with the comptroller of the currency as security. They are also required to keep on deposit with this public official, as a redemption fund, cash to the amount of five per cent of the total amount of their outstanding issues. In the case of the Bank of England a limit of 16,450,000 is set to the issue of notes against which the bank is permitted to hold government securities. For every note issued above this limit it is obliged to keep on hand pound for pound of gold. In the case of the United States the government guarantees the payment of the notes, it being adequately protected by the bonds which are deposited with it as security. The bonds held by the Bank of England as security for its notes, however, are not deposited with any public official, and the government does not guarantee the payment of the notes.

This system has the advantage of rendering banknotes safe, but is subject to many disadvantages. In the first place, besides compelling the investment of a considerable proportion of the bank's resources in the form of non-liquid securities which are not available for use in times of exigency, it establishes relations of mutual dependence between the banks and the government which are often productive of bad results and are always of doubtful propriety. On the one hand the government may be tempted to use the banks as a market for its securities and thus as a means of bolstering up its credit, and on the other the banks are apt to look to the government for protection in times of peril. Neither of these practices are criminal or necessarily injurious, but they are apt to be productive of very bad results on certain occasions not unlikely to arise. For example, the treasury may be in need of money, and by offering especially good terms may tempt the banks to invest too large a proportion of their funds in government bonds; or the banks may overestimate the government's interest in them or the advantage to them of their public character, and expand their credit in other directions to a greater extent than would otherwise have seemed to them safe. If not prevented by special legislation, the government may also make use of its relation to the banks to force them to accommodate it in other ways not consistent with good banking methods, as, for example, with advances upon treasury notes or other temporary securities. It is instructive in this connection to note the fact that in the cases of both the United States and England the practice of requiring banks to hold government bonds as security for their notes originated in the need for finding a market for government bonds, and not solely in considerations relative to an ideal banking system. While the specific evils to which reference has been made have not appeared in either of these cases, the reason is to be found in special circumstances and countervailing safeguards, and does not constitute good ground for the general recommendation of the system. Few, if any, exceptions can be taken to the general principle that a government should either establish banking institutions of its own or at least completely under its control, or leave the business entirely to private enterprise, surrounding it only with the most approved legal safeguards.

A second objection to this method of securing note issues is the fact that it renders them inelastic. In order to increase the quantity of notes in circulation under this system, the banks must be convinced of the need for an increase, the price of bonds must be such as to make it profitable, and time must be consumed in making the necesssary purchases, deposits, etc. However great the need, the failure of the concurrence of these three circumstances may prevent a new issue, and in case of their concurrence the need may pass away before the lapse of the necessary amount of time. The retirement of the notes is also far from automatic, requiring, as it does, a decision of bank officials, and the voluntary setting in motion of the machinery of redemption. Indeed, under this system, so far as the regulation of their quantity is concerned, bank-notes are rendered essentially like government notes and are made quite as inelastic as these. As an evidence of this, attention may be called to our own experience from 1882 to 1890. The volume of our bank-notes constantly diminished, though the need for currency was rapidly increasing, and since 1900 the increase has not been adequate to meet the legitimate and manifest demands of commerce.