If instead of supposing A equal to B, C, D, and E, combined, or equal to B, C, D, and E, severally, A is assumed to be smaller than B, C, D, and E, severally, adverse balances will likewise exist. For if it is assumed that each of the banks B, C, D, and E, has, say, twice the cash reserve that A has, then the checks on B presented by A, C, D, and E, will be divided somewhat in the proportions of r, 2, 2, and 2; and one-seventh of $800,000, or $114,285, will be less than the checks presented against A. There fore, whether bank A is considered as smaller, equal to, or greater than the other banks, it may expect adverse clearing house bal ances if its ratio of reserve to deposits is more slender than that which the other banks of the system maintain.
This limitation does not apply to deposit rights arising from the deposit of cash; it applies only to those additional deposits built upon cash holdings by the method of loan and discount. For if $roo,000 in cash is deposited, checks drawn later to that amount can be fully met. Any one bank can build up any amount of deposit liabilities by the cash method, and proceed to loan them all out except such a proportion as business expediency proves proper as a reserve. The adverse clearing house balances which follow the loans will be met by the cash that has been received over the window. Accordingly bankers solicit accounts and offer various inducements to get cash deposits and build up their demand liabilities in that way, whereas they guard very care fully against overextension of demand liabilities by the loans process.
Ratio of Loans to Deposits Because a very large proportion of deposit liabilities are created by the method of loans and discounts, and because re ceipts of cash deposits ease the bank's position and incline it to extend loans to an amount about equal to the cash received, de posit liabilities tend to increase and decrease pari passu with loans and discounts over a period of time. Temporary conditions may obtain in which deposits of any one bank or group of banks may expand faster than loans, or loans may even be decreasing. Instance the New York Clearing House banks the first week of April, 1917, when loans contracted nearly $40 million while deposits expanded over $86 million; the contraction largely reflected the withdrawal of funds from the time market in anticipation of the Victory Loan, and the expansion of deposits represented the flow of funds from interior banks to New York for investment in the call market. During 1915-1916-1917, before the United States entered the war, the heavy importations of gold from abroad created such an easy money market that bankers found real difficulty in loaning funds as fast as they came from depositors. On the other hand, loans may increase faster
than deposits, and then the money market will tighten.
The history of the ratio of loans to deposits in the New York Clearing House banks is shown by Figure 1. It will be noted that at times of crises the ratio of loans to deposits runs high (instance the autumns of 1904 and 1907, the midsummer of 1914, and the latter part of 1917) and then falls precipitately as contraction develops.
Bank Notes White's last two statements (see page 73 above) of assets and liabilities showed the alternative effects of his paying for dis counts with cash or deposits; the two previous statements showed the similar alternative effects of his making loans in cash or de posits; and the first statement showed deposits arising by the deposit of cash or cash items. Another alternative was open to White in each case. Instead of paying cash or crediting deposits to be drawn later by order, White might have paid by simple promissory demand notes payable to bearer. These notes would be in small denominations, round amounts, and convenient size, and, if White was well-reputed, would be readily accepted by others and would tend to circulate as money. If the proceeds of the $35,000 of discounts had been paid in bank notes, the financial statement in this case, starting with the figures given in the last statement on page 73, would have been as follows: Obviously many variations may be introduced here to indicate part payments of loans, discounts, collections, and so forth, in cash, deposits, and bank notes. For instance, items to the amount of $27,000 may be discounted and the proceeds, $25,000, be paid, one-fifth in cash, two-fifths in bank notes, and the rest credited as deposits, with the following results on the last state ment: Summary—The Three Functions of Commercial Banking The three fundamental functions of commercial banking are, then, discount, deposits, and note issue; discount (and loan) is, in practice, but one method of creating deposits and note issue; and the three functions readily reduce themselves to one, namely, the guaranty of the credit of individuals. The guaranty is effected by a highly developed, specialized, and well-known in stitution, holding a liquid cash reserve, as well as quickly con vertible assets, and standing ready to exchange its own credits for those of customers.