Rationale of Exchange of Credits The rationale of this exchange of credits is that the seller (or borrower) gives less widely known credit for the more widely known credit of the bank. The bank essentially guarantees the private credits, the bank credit being more widely accepted and therefore more useful to the customer in his business operations.
The exact nature of this substitution or guaranty of credits should be fully perceived, for it constitutes the fundamental principle of commercial banking. There is an exchange of less known credit for better known credit; of less useful credit for more useful credit; of credit in which the time element is considerable for credit in which the time element is inconsiderable, the check or draft on a bank being payable upon demand; of credit subject to interest and discount for credit freed from such depreciation.
To illustrate, suppose a retailer buys goods from a jobber on 3o days' time. The common methods of financing the transaction are three. The first method is for the jobber to carry the retailer on open account for 3o days. In this case the jobber will probably have to borrow at his bank funds to meet his own debts maturing meanwhile. He gives his own note, payable to the bank, and gets in exchange deposit rights which he transfers by check to his creditors. The bank in this way becomes the direct presumptive debtor to these creditors, and remains so until the checks are pre sented and paid. Such an operation is a substitution of credits. But the jobber was able to get this substitution only by showing to, or pledging with, the bank his account receivable, that is, the retailer's credit, the retailer's implied promise to pay in 3o days. The bank accepted the jobber's credit, supported by a contingent right to the retailer's credit, giving in return its own credit. The bank accepted credit items in which the time element was con siderable and gave demand credit items.
The second method is for the retailer to give to the jobber a promissory note for 3o days, or to accept (that is, sign) a draft drawn on him by the jobber by which the retailer agrees to pay in 3o days. The jobber can indorse (and thereby guarantee) this explicit promise of the retailer to pay, and can sell or pledge it with the bank for credit to his own account. The jobber can then
draw checks and remit to his creditors, and the bank becomes debtor to his creditors until the checks are presented for payment. The bank looks primarily to the retailer and secondarily to the jobber for payment; for the credit of these two men it substitutes its own.
The third method is for the retailer to borrow at his bank, giving his note for 3o days, and either receive credit to his account against which he can check and pay the jobber, thereby substitut ing the bank as debtor to the jobber till the checks are presented; or to have the bank authorize the jobber to draw against it and agree to accept the draft drawn payable in 3o days and to pay at maturity, thereby substituting time credit of the bank for the retailer's time credit.
Limitation on Creation of Deposits of System In an earlier paragraph it is stated that the creation of deposits by White was limited by the declining ratio of White's cash to his deposits. So far the hypothesis has been that White was the only bank in existence, or was an isolated bank, and that when custom ers drew checks against White and gave them to their creditors, cash to the amount of those checks was withdrawn by the latter and stayed out in circulation. If, however, these creditors are also customers of the bank, they will probably deposit the checks for credit to their own account, in which case the process of payment amounts to a transfer of deposits on the books of the bank, and, inasmuch as no cash is demanded in such cases, a smaller reserve need be held by White as the proportion of his customers to the whole population becomes larger. If all the people are White's customers and all the payments in the community are made by checks on the bank, it will need to keep no reserve whatever, and the creation of deposits through loans will be unlimited so long as the deposits remain acceptable circulating media. Profits, too, will be limited only by the demands of borrowers for loans.