A third objection arises from the fact that this method of protecting note issues involves the maintenance of a permanent public debt. No substitute for national bonds has yet been found, notwithstanding a diligent search in the United States, the tendency of other similar securities* to fluctuate in value rendering them unsafe for such a purpose, unless the margin between the face value of the notes and that of the bonds is made so great as to make the issues unprofitable for the banks. Since a sound financial policy requires the gradual payment of public debts and their complete extinguishment whenever possible, under this system of note protection a government is liable to be confronted with the unpleasant alternative of either undermining its banking system, and thereby seriously interfering with commerce, or of adopting a financial policy which is expensive and wasteful and consequently opposed to the best public interests. The fact that many years may elapse before public debts will diminish to such an extent as to bring such alternatives within the field of vision of most governments does not diminish the force of the objection to one who is considering the relative merits of different methods of protecting noteholders.
* Such, for example, as the bonds of minor political divisions, like our states or municipalities, or the stocks and bonds of corporations.
B. The safety-fund system. - In accordance with this system banks are required to make contributions to a common fund to be deposited with a public official and preserved for the redemption of the notes of the banks which fail. It was employed at one time in the State of New York, but is at present best exemplified in Canada. Here the contributions aggregate five per cent of the amount of notes outstanding. This sum is kept at the provincial capital, and is employed exclusively in the predemption of the notes of any bank which may fail and whose resources are not adequate for such redemption. Whenever the fund is depleted new contributions are called for until it is completely replenished. This system secures safety quite as well as the one described in the preceding section. It has the further advantage of not limiting in any way the investment activities of the banks and of interfering in no way with the elasticity of their issues. Under it banks are permitted to invest their resources in any form which seems to them desirable. There is no limitation placed upon the amount of their issues, and no special machinery created for the redemption of notes which can interfere with their easy retirement when they become excessive, or their speedy issue in times of need. The chief difficulty of this system consists in the fact that it makes each bank suffer for the failure of any of the others. Wherever the system is applicable, however, this peculiarity should count as an advantage. It creates an esprit de corps among banking institutions which is healthful, and makes it the interest of every bank to look carefully into the operations of its neighbours and to prevent by every possible means the employment of bad practices. No better method of securing sound banking can be conceived than one which makes it the interest of each institution to prevent bad banking on the part of its neighbours. This mutual watchfulness is decidedly healthful and has produced excellent results in Canada. It must be admitted, however, that this peculiarity renders the system inoperative, or at least extremely difficult of operation, in a country like the United States, whose territory is very extended, and in which the number and variety of banks are so great that it is practically impossible for any institution to keep a watchful eye upon all the others. It is probable that few banks in the United States would be willing to enter a system which would make them subject to assessment whenever a bank failure in a remote part of the country took place. In a country, however, in which the banking business is concentrated in the hands of a few large and strong institutions which are intimately connected with each other, the safety-fund system is undoubtedly the best which has yet been devised.
C. Issues based on general assets. - It is difficult to describe in a phrase the methods employed in those states in which neither the government-bond nor the safety-fund systems are employed. In general it may be said, however, that bank-note issues in all of these cases are based upon the general assets of the institution rather than upon any special set of securities set apart and mortgaged to noteholders or any cash fund especially devoted to their interests. The German banking system furnishes a good illustration. By imperial legislation bank-note issues are distributed between the Imperial Bank and its branches and a few other institutions in such a way that each bank is permitted to issue a specified quantity of notes, on condition that it shall keep one-third of the amount on hand in cash and two-thirds in bills of exchange running not longer than three months and bearing not less than two solvent names, and that it shall comply with other regulations, which, however, do not especially concern this matter. Any bank which exceeds this specified limit must pay a tax of five per cent per annum to the government on the excess. In this way protection against excessive issues is secured at the same time with adequate elasticity. No special distinction is made between noteholders and depositors in the sense that one class has a lien prior to the other. The object of the legislation is to secure sound banking in all branches, and the assumption is that noteholders as well as depositors will be adequately secured under such circumstances.
The Bank of France furnishes another illustration. Like the Bank of Germany, this institution issues its notes on the basis of its general assets, and makes no distinction between depositors and noteholders. As a matter of fact, however, the intimate relation which exists between this bank and the French government amounts to giving its customers special governmental protection. It is well understood in France that the government will not permit the bank to fail, this feeling having a tolerably solid basis in the fact that at several critical periods in the history of the institution the government has come to its rescue and has thus created a precedent which has almost the force of law.
Under this system the only method of rendering special protection to noteholders is that of giving them a first lien upon all the assets of the bank in case of failure. This can be regarded as sufficient, however, only in case a high degree of success attends the efforts to safeguard the banking business as a whole. If the various means to this end described in this chapter could be made so efficient as to confine the banking business within legitimate limits and to render exceedingly difficult, if not impossible, the overstraining of bank credit this system would possess great advantages, since it affords protection to depositors as well as to noteholders. So far it has attained complete success only in the cases of the great State systems which have been mentioned. Previous to the establishment of the national banking system, many of the states of the American Union had so unfortunate an experience with it that prejudice against it is widespread throughout the United States. The means by which the system was rendered successful in New England, however, during the very period in which disaster was attending it elsewhere, are often overlooked. Through the efforts of some of the leading banks of that region the so-called Suffolk System was inaugurated, by which a sort of clearing house for bank-notes was established, which put to frequent test the ability of the banks of issue to redeem their notes, and made the banks watchful of each other's methods. The essential feature of the system consisted in making the Suffolk Bank of Boston an intermediary for the delivery to each bank, for redemption in coin or in the payment of balances due it, those of its notes which came into the possession of the other banks in the ordinary course of business. By this means each bank had its own notes returned to it several times a year, and thus the bank-notes of this region were invested with the quality which constitutes one of the peculiarities of checks, namely, that of returning frequently to the place of issue for a test of their validity.
It is probable that not all the possibilities of this system under the regime of free banking have been realized and its more extended use when the "bond system" disappears is almost certain. It is noteworthy in this connection that it will become more efficient as the field for the use of deposits expands, inasmuch as the quantity of notes will then bear a smaller proportion to the total assets of the banks, and a first lien will render greater protection. The use of deposits as currency normally increases as population becomes more dense and industry on a large scale develops and spreads into regions which were previously dominated by the farmer, the handworker, and the small tradesman. That this method of protecting noteholders will, therefore, become relatively more efficient as time advances seems highly probable.
D. Issues based upon public credit. - It is only necessary to mention this system in order unqualifiedly to condemn it. It consists in an attempt to float bank-notes on the general guarantee of the State that they are good and that the State will pay them in case the bank fails. In the early years of their history several American states tried it, and signally failed. Public credit is too indefinite and unmarketable a thing to serve as the basis of any kind of currency, and bank-notes issued in this way are certain to become practically government notes without the direct backing and control which such notes possess when issued and administered directly by the public treasury. In order to perform their legitimate functions in even an approximately satisfactory manner they must be based upon good mercantile securities or upon bonds of the first class for which the general promise of a State or its signature on the bonds of a private corporation can never be regarded as an adequate substitute.
Before closing our discussion of this topic it should be noted that a combination of the safety-fund and general-assets systems is possible. Indeed, this is the Canadian system, noteholders there having a first lien upon all the assets of the bank, as well as the protection of the fund deposited at Ottawa. In Canada, however, it is the safety-fund upon which special reliance is placed. It would be possible, however, to create a system in which this fund would play quite a subordinate role, and in which the emphasis would be placed upon the safeguarding of the bank's ordinary investments. Such a combination might be possible and efficient in cases in which either system alone would be impossible or inadequate.