Currency Principle versus Banking Principle The matter of protection of bank credit has been the bone of contention between two schools of banking thought—those who believe in the "currency" principle and those who adhere to the "banking" principle. The former believe that bank notes by entering the currency displace so much gold, which is driven abroad, that such an issue of notes might completely expel the gold and force the country to an inconvertible depreciated basis, and that therefore the state, to protect itself and its citizens, must so regulate bank note issues as to prevent such results. The adherents of this theory would make the bank notes practically gold certificates with zoo per cent gold reserve, or if that were impossible, would minimize the uncovered issue.
It is evident that this theory emphasizes the safety of the currency but makes its volume constant and inelastic, neither of which is desirable. The volume of bank notes should expand and contract freely with the needs of business; if it does not the price level must vary inversely as business activity, or else the elasticity must be provided by deposit currency.
The adherents of the banking principle, on the other hand, hold that the right of note issue should be full and unlimited at the discretion of the banker who for business reasons, they assert, will find proper protection and reserves for noteholders and de positors, and who, so long as he keeps notes convertible, can bring neither the bank itself nor the business community into any danger. Should the notes become inconvertible, this theory holds that a redundant depreciated circulation would result, but if the notes are kept convertible the bank can only put a definite quantity into circulation, any excess being returned to it for redemption and for the liquidation of old loans.
This principle is sound except that there is no safeguard against imprudent and reckless banking. With conservatize bankers the maintenance of convertibility would be unquestioned, but if bankers should become reckless and give loans on easy terms the note issue would readily expand until the possibility of converting upon demand would cease, provided demand were at all general. To curb the reckless banker and protect creditors against his extravagances is the aim of modern bank regulation.
Safeguards Against Bank Insolvency The protection of bank credit resolves itself into two general lines: (r) the establishment of safeguards against the bank's insolvency, and (2) special protection of its creditors against the suspension of specie payments.
Insolvency is a condition existing when liabilities, other than to stockholders, exceed assets; under such a condition the bank would be unable, even after all assets had been liquidated, to pay noteholders and depositors par on their claims. Insolvency is
guarded against by the owners of the bank subscribing capital and by accumulating a large surplus to act as buffer. The capital subscribed should bear a reasonable ratio to the volume of credits extended; the maximum amount of this ratio may be decreed by law. When, however, banks are organized and capitalized, it is impossible to fix such capital requirements in advance, for no one knows what volume of business will be the fortune of the incipient bank. The state assumes, however, that the size of the bank and the size of the city in which it is domiciled bear some ratio, and accordingly the minimum capitalization of banks is roughly pro portioned to the city's population.
Laws further require the accumulation of some minimum surplus, usually a percentage, 20, 3o, or 4o per cent of the capital, during its earlier years. Any bank aspiring to greatness inevi tably accumulates such surplus and usually maintains it far in excess of the required minimum; such surplus not only is evidence of strength, age, and conservative policy, but provides working and earning funds. Our National Bank Law and some state bank laws impose upon the bank stockholders a double liability—that is, the stockholders in case of the bank's failure can be held for an additional amount equal to the par value of their shares, and this liability is a contingent asset of the bank. The accumulation of a large surplus, however, renders the use of this asset improbable, and the growth of the bank's credits outstanding renders the pro tection afforded by this double liability of the stockholders rela tively less important. In the light of their dividend percentages most banks are undercapitalized, but their creditors do not suffer therefrom since the accumulation of surpluses many times the size of their capital serves the same ends as a buffer against insolvency.
Other lines of protection against insolvency provided by law are: by the regulation of loans and business activities, by fixing the maximum loan to any one person, by forbidding loans to bank officers or loans of certain kinds, by regulating investments and forbidding certain dangerous forms, by restricting the incurrence of contingent liabilities by acceptances, indorsements, or guaran ties, and by restricting the field of operations to strictly credit transactions. For example, merchandising, real estate, insur ance operations, and the like, are usually prohibited to banks.