Capital In the discussion in the previous sections, White has been doing business entirely on his customers' money and his own credit. No mention has been made of any direct contribution of funds by himself; he started with a deposit transfer business, and later developed a loan and discount business and a bank note issue business. Undoubtedly any person who deposited money directly with White, or who borrowed from or sold discounts to White and left the proceeds on deposit with him, or took his notes in payment, that is, any person who became his creditor, would more readily become creditor if White himself were willing to put up a guaranty fund and thus increase the assets out of which the creditor could recover. Such contributions by A are generally made from the very start; they give confidence to would-be creditors that he will be willing and able to repay and make good his promises, and, of course, the greater such contributions the greater the security to the creditors, for they can collect, not only against the assets procured by White through their own cash de posits, but also against the assets procured by White through his own contributions.
Such original contributions are called "capital." White usu ally associates with himself other persons who likewise contribute capital. Ownership of the assets of the association is then in pro portion to the contributions; profits, losses, and responsibilities are proportioned upon the same basis. The association may be incorporated under the laws of the state and capitalized at, say, $ioo,000, the capital contributions and ownership being evi denced by $ioo shares of capital stock. Subscriptions (contri butions) to the capital stock may be in cash, real estate, securities, promissory notes, or other assets. If the subscription is paid in cash, some of it would be immediately invested in a bank building, furniture, and fixtures, and the rest of it, along with funds de posited by depositors, gradually absorbed in investments, loans, and discounts, real estate, cash reserve, and so forth.
As a result of all this White has now become a full-fledged banking company.
Surplus and Undivided Profits The company may, voluntarily or by force of law, over a pe riod of years add to the original capital contributions by with holding part of its earnings, not declaring them in dividends and converting them into a "surplus" fund. The state law, as a pro tection to the bank's creditors and as a means of adding to the stability of financial institutions, may require that the bank ac cumulate a surplus equal to, say, 4o per cent of its capital and that a certain fraction of the yearly earnings be diverted to that fund until it is filled. To make their bank's statement somewhat more comparable to those of other institutions, and also to reduce the extra liability that may attach to stock ownership, the founders of the bank may start with a capital of $ioo,000 and a surplus of $ioo,000 rather than with a capital of $200,000. The
surplus accumulated in an old bank may be many times its capital.
Public policy requires that capitalization bear a rough propor tion to the size of the business done; and, since size of business is roughly proportional to the population of the domiciling city, the state and federal laws have fixed the minimum capitalization of banks in various sized cities.
The existence of a fair-sized surplus also promotes stability in corporate control. If in bad years net operating deficits had to be met by assessing the stockholders rather than by using up the surplus, the wealthy stockholders would be at an ad vantage over the poorer, who would find it difficult to meet the assessments. In fact the corporation might fall into the con trol of unscrupulous men who would purposely operate it at a deficit in order to " freeze out " the weak stockholders. This operation, however, is less likely to succeed if a large surplus must be exhausted before assessments can be put on stockholders.
To maintain a working balance, the bank does not declare all its earnings as dividends nor convert them into surplus, but re tains a relatively small amount as "undivided profits." The capital, surplus, and undivided profits represent the original and accumulated contributions of the owners of the bank, and serve as a buffer to reinforce the claims of the bank's creditors. These contributions, along with the funds contributed by creditors, are invested in various assets, only a small part of which is held as cash reserve.
It is wholly wrong to think that surplus and undivided profits constitute a fund of cash in the bank, or any other particular form of assets. The surplus together with the undivided profits is a property right (in proportion to the shares owned) of the stockholders in the general assets, and as such is a valuation item in the financial statement. The accumulated aggregate assets have a book valuation more or less equal to the market valuation. This book valuation, less the creditor liabilities and the capitaliza tion, is the surplus. If the book valuation exceeds the market valuation, the surplus is not substantial; on the other hand, if the assets are undervalued, the bank creditors have more protection than is shown. Capital and surplus protect depositors and note holders, for in case of liquidation the greater the actual value of the assets belonging to stockholders the more are the funds that can be realized for the bank's creditors.