§ 5. Discount and deposit. The process of discount and deposit is the purchase of the promissory note of a customer,4 the price being a credit in the form of a demand deposit on the books of the bank. This - the central and most characteristic banking operation - has something of mystery in it at first view. In simple deposit, described in the last section, the bank becomes the debtor and the depositor becomes the creditor of the bank. But in discount and deposit the depositor brings no money, and the credit paper that he gives is his own promise to pay, whereby he becomes the bank's debtor. For example, when a bank discounts a $1000 note for three months and credits its customer with the proceeds, its deposits are at that moment increased (let us say) $985. Notice that hereby the bank does not add a cent to the cash in its vaults while it has added to its liabilities payable on demand. As an offsetting asset it holds the note of its customer receivable at some future time. Most of the loans and discounts of commercial banks serve thus to create deposits, and the two items (loans and deposits) rise and fall in about the same ratio. In 1920 in all reporting banks (exclusive of the twelve Federal Reserve banks) individual deposits were $38,000,000,000 and loans were $31,000,000,000.

4 Usually with deduction of interest in advance; a process called discount. See Vol. I, pp. 275, 302.

§ 6. Nature of banking reserves. Banks would have nothing to gain by receiving deposits or by issuing notes if they were obliged to keep in the vaults actual money to the amount of their deposits and outstanding notes (unless they were paid by depositors for taking care of deposits). It was found necessary in practice for banks to keep on hand money amounting to only a fraction of all their outstanding obligations in order to be able to pay promptly all due demands under ordinary business conditions. The sum thus kept on hand is called the reserve or the reserves of the bank, and this is frequently expressed as a percentage of reserves against deposits or against note issues, respectively, or of both together. Frequently, as in the United States, a minimum percentage of reserves is fixed by law.5

A bank's reserves consist, first, of the lawful money that it actually holds in its vaults at any moment, and, secondly, of certain other credit items in other banks or with the government, of such a nature that a bank is permitted to count them as though immediately available.

The explanation of the adequacy of a mere fractional reserve is found in the nature of the individual monetary demand 6 and in the effective way in which a checking account serves as a substitute for actual money.7 Every customer, if he would avoid overdrawing his account, must at most times keep a goodly balance to his credit that he does not immediately need. Many individuals and corporations must at times keep very large balances. The times of maximum monetary need of the customers of a bank never exactly coincide, and many payments are made among the customers of a single bank, requiring only bookkeeping transfers. A fractional reserve is therefore ordinarily fully adequate, although with any less than 100 per cent reserve any bank would be insolvent if all of its demand obligations were presented at the same instant. Such an extreme condition is made impossible by business custom and public opinion, especially among the larger customers of banks; but the panic of small depositors and the urgent need of larger ones often bring about a dangerous situation, in which banks with abundant assets find their reserves nearly or quite exhausted. To prevent the breakdown of the separate banks and of the whole banking system at such times, by providing ways of replenishing the reserves, is a large part of the "banking problem."

5 The legal requirements as to minimum reserves vary greatly from no specific per cent to 40 or more in different countries, for different classes of banks, and for different purposes. Some examples of legal reserve requirements in the United States occur in the two following chapters.

6 See ch. 4, § 5.

7 See below, § 11,

§ 7. Time deposits. Time deposits are funds to the credit of customers which, by agreement, are to be left for some specified minimum time or on condition that the bank may require notice in advance of the depositor's intention to withdraw them. The notice that may be required is usually from thirty to ninety days; but only in times of general financial crises or of runs on particular banks is this requirement enforced. A sufficient deterrent to irregular withdrawal of funds is usually found in the loss of interest if deposits are withdrawn at other than stated times. The bank's right to require notice makes prudent the investment of a much larger proportion of its deposits and for a longer time; it reduces the proportion of deposits needed for reserves, and yet reduces the danger of a "run" upon the bank in time of financial distress. These are reasons why banks can and usually do pay interest on time deposits (at from 2 to 4 per cent), as until more recently they rarely did on demand deposits. From the standpoint of the depositor a time deposit is, by its very nature, an investment and not a demand credit available for current monetary uses. Only that portion of a person's capital that for some more or less considerable period is not likely to be needed for other purposes ought to be put into time deposits. A bank, however, is generally a much safer place in which to keep a fund of purchasing power for the future than is the strongest private treasure-box. Receiving time deposits is the one essential function of savings banks, but this function is increasingly performed by other banks.8 In some cases time deposits are cared for by a separate department and kept separate from the general business of a commercial bank.

§ 8. Bills of exchange, domestic. Foreign and domestic exchange is the sale of orders for the payment of specified sums of money at distant points. But for this, payments at distant points would ordinarily have to be made by sending the money in some way. It must often occur, for example, that hundreds of payments, aggregating millions of dollars, must be made by persons in and near Chicago to those in and near New York, while, at the same time, equally large sums are due from New York to Chicago. The wasteful process of shipping these sums back and forth is avoided by the cancellation of indebtedness between the two localities. It has been the practice for each small bank to keep a part of its funds in correspondent banks in one or more of the larger cities on which it draws bills of exchange for its customers and to which in turn it remits for collection drafts and checks which it has received. Before 1914 such deposits might, up to a certain percentage, be counted as part of the depositing bank's legal reserves. From time to time, as balances of accounts increase on the one side or the other, shipments of actual money become necessary; but these are only a small fraction of the total amount of the bills of exchange mutually cancelled. Similarly, the settlement of accounts between any two localities can be made by the shipment of comparatively small sums of money. Under the Federal Reserve Act the reserve banks have in various ways assumed the functions of the correspondent banks, aiming to bring about parity of checks issued in any part of the country.

8 The Federal Reserve Act of 1913 has given encouragement to this practice by reducing to 3 per cent the reserve required to he kept against time deposits. See ch. 9, § 7.

The wider use and acceptance of individual checks at long distances from the banks upon which they are drawn limit by so much the proportion of special bills of exchange drawn by the banks themselves. Domestic exchange involves just the same principles as foreign exchange of funds, except that in the latter, usually, two different units of standard money are used. In connection with the discussion of foreign trade below, foreign exchanges will be explained and further light will be thrown upon the adjustment of the money supplies and levels of prices of the various sections of a single country, as well as between different countries.