This section is from the book "Money And Banking", by William A. Scott . Also available from Amazon: Money and Banking.
In times of crisis or panic the measures which have been described are frequently inadequate to prevent the failure of banks. On such extraordinary occasions large numbers of business men are unable to meet their obligations, either on account of the failure of their enterprises or because their debtors have failed to pay, and the reserves of banks are liable to run low because they are not replenished in the ordinary way by the payment of maturing obligations and because the demand for cash is unusually large. Extraordinary measures are, therefore, necessary at such times.
When a crisis is in an incipient stage bankers are usually confronted by a dilemma. The demand for loans is unusually large, and their cash reserves are unusually low. If they respond to the extraordinary demand for loans, they run the risk of completely exhausting their cash, and if they stop discounting for the purpose of protecting their reserves, they are liable to intensify the crisis. They may possibly precipitate a panic, and with it a run upon the banks, which means almost certain disaster. The problem is to steer a course midway between these extremes. It is in their interest as well as that of the community to accommodate, so far as possible, sound business men who are temporarily hard pressed, but at the same time they must protect them-selves against people who are hoarding money, and they must continue to meet their obligations to depositors and noteholders. To this end the device ordinarily employed is the raising of the rate of discount. This tempts the holders of money to turn their cash into the channels of circulation, and it discourages borrowing on the part of those who are not in real need. The Bank of England has employed this device at various times in her history with excellent results.
Another device for meeting the exigencies of a time of crisis is the provision for an emergency circulation of bank-notes. If such notes are issued in appropriate denominations, and if they are properly backed with sound securities, they may answer all the purposes of currency. The permission to issue them in extraordinary quantities, therefore, on occasions of great stringency enables banks to increase their accommodations to business men without too seriously endangering their reserves. The extra notes are not likely to be immediately presented for redemption, and, if provision is made for their redemption and retirement as soon as the stringency has passed, they present no obstacle to sound banking.
To this latter end the plan of taxing the extra issues seems best adapted, since it makes the extra notes unprofitable, except at times when the rate of discount is very high, and ensures their retirement as soon as the rate has fallen to the normal level.
In the absence of any provision for an emergency circulation in the United States, the bankers of New York City who are members of the clearing-house on several occasions have adopted the plan of combining their reserves. This is accomplished by permitting banks whose reserves are running low to deposit securities at the clearing-house, in return for which certificates are issued, which the banks agree to accept in the payment of balances. When the pressure of the crisis has passed the certificates are retired and the securities returned. By this means the reserves of all the banks are practically combined and made available, if necessary, for exclusive use in the accommodation of business men. This plan worked efficiently in 1860, 1873, 1884, 1890, and 1893, and does credit to the ingenuity and public spirit of the New York City bankers.
8. Is bank currency safe? - At this point the query naturally arises whether, with all the safeguards that have been mentioned, bank currency is really safe. In answer it may be said, first of all, that the history of banking in well-regulated and well-governed communities shows that the percentage of bank failures is very small, and that the losses to depositors and noteholders when compared with the grand total of notes and deposits is so small as to be almost insignificant. It should also be noted that human ingenuity has not yet done all that is possible in the direction of devising safeguards for the banking business, and that banking under direct government auspices is possible and might be expedient, if that were the sole condition of safe and sound banking. In the light of experience, however, it would seem safe to say that bank currency at the present day is safe enough to warrant its use to an extent even, greater than is now customary.
Macleod, v. II, chs. xviii and xix, contains a discussion of many of the topics included in this chapter. See also Dunbar, chs. vi-xi; Report of the Monetary Commission of the Indianapolis Convention, pp. 244-246; Wagner's Zettelbankgesetzge-bung, ch. ii, sec. 3, and ch. iii, secs. 2 and 4, and his Kredit und Bankwesen, ch. ii, sec. 2. Scharling, ch. ii, sec. 3, gives a good discussion of the nature and methods of investing the capital and surplus of banks. For a discussion of the safety of bank currency see Gilbart, v. I, ch. xxi.