Nature of Loans The last paragraph introduces the subject of loans and dis counts. The person or bank, here termed " White," soon observes that, although payments of checks are being continually made, cash is as continually being redeposited by the payee or others; that, although payments and receipts are not synchronous or equal in amount, there is a continuous balance left in his hands, which varies but little in amount. As there is slight probability that all depositors will at one time demand the full amount of their deposits, White is therefore safe in loaning to any would-be borrowers, on their promissory notes, a sum, say, of $45,000. White's balance sheet would then stand as follows: (r) If cash is paid out to the borrowers: In this process deposits have been created; the borrower has come to possess rights to draw money from White, although the cash which he nominally borrowed and redeposited at no time left the possession and ownership of White. From the borrower, White has accepted an interest-bearing promissory note payable at a specified date, and in exchange for this note has given the borrower the right to draw on him to the amount of the note, with the implied agreement that he will pay such requisitions on de mand. The ratio of his cash to his demand liabilities has been changed from zoo: roo to 55: 'co, or zoo: 145. White does not normally allow interest to Black for such credits, however long it may be until Black demands payment of them; rather than allow interest on deposits created by loans, the rate of interest on the loan would be lowered. Receiving interest-bearing promissory notes in exchange for the right of the depositor to draw later is, in effect, lending with interest and borrowing without interest, by means of which White is able to make a profit, which is the motive of his business.
Nature of Discounts It may be supposed that the loans placed by White in this way do not exhaust the sum that may be loaned by him without endangering his ability to meet all demands made upon him, and that some of his customers have promissory notes, bills of ex change, or acceptances, which have come into their hands in the daily transactions of their businesses and which they are willing to sell. White may buy these to the face amount, say, of $35,000, but he will pay less than their face value by the amount of the interest on their face value till due. This interest is taken in ad vance, and the proceeds are either paid in cash or credited as de posits to the parties selling the paper. The interest taken in ad vance and calculated, not on the sum actually paid in cash or credited as deposits (that is, the sum actually loaned) but on the face of the paper, is called "discount," and the act of selling a note when discount is taken is called "discounting" the paper. At the time when White buys the paper the discount is not yet earned, but it is nevertheless credited at once. His balance sheet, based on the last above, will then stand: (r) If cash is paid: The process of discount results in the creation of deposits, in much the same manner as did loans. White has now in his port
folio commercial papers bearing the names of makers, drawers, and indorsers—claims against these parties, these claims being earning assets, with the earnings taken in advance. In exchange for these White has given either cash or deposits. If cash is paid, the payee may possibly redeposit it. The discount is profit, since no interest is allowed on the credits which White gives the seller of the paper.
Effect of Loans and Discounts on Deposits Under the circumstances just mentioned, White's ability to loan and discount further is decreasing; the ratio of his cash to his demand liabilities has decreased from 55: ioo (or 100:145) to 66: 145 (or 'co: 179). The larger the deposits, the larger abso lutely the demands that may be made for payment; hence the cash left on hand may barely suffice to meet them. On the other hand, the larger the loans and discounts, the larger the profits. White is tempted, therefore, to make loans and discounts, hus banding his cash and creating deposits, to such an amount as will bring the greatest profits and yet be within the bounds of safety.
Crediting the proceeds of loans and discounts is the usual method of creating deposits. "Loans" is the term applied to the extension of cash or credits to a customer on his own note. The lender, White, will require interest for the time the borrower has the funds; the interest will be payable, however, not in advance but at maturity of the principal. The note is usually drawn with interest at, say, 4 per cent for the period of the loan, but it may be drawn without interest, in which case the principal of the note is made large enough to cover the amount of the actual cash or credit advanced plus interest thereon. "Discounts" is the term applied to extensions of cash or credits to persons selling notes or other commercial credit instruments, of which the makers or drawers are usually third persons, at prices less than their face value by the amount of the interest on their face value till due. The buyer, White, calculates the "discount" at his "discount rate," deducts it from the face value, and pays the seller the "proceeds" in cash, or credits them to his account. The two operations are essentially the same and result in the creation of deposits. The financial statements of banks group these two assets together as Loans and Discounts.
Discount, then, is not a distinct function of commercial banks, but one of the methods of creating deposits. The promissory note or discounted item becomes the property of the bank to which the promissor is bound to make payment at maturity; the note is listed among the assets, and at maturity the bank will re ceive the face amount. The volume of deposits varies directly with the amount of loans and discounts. The borrower gives his promise to pay the bank (and the seller of discount paper gives the promises of himself or third parties to pay to his indorsee, the bank) and in exchange gets cash or the right to draw at will on the bank with the implicit promise of the bank to honor his requisitions.