RESERVES FOR PROTECTION OF BANK CREDIT Considerations Governing Size of Cash Reserve In Chapter VI it was stated that one of the three essential objectives in protecting bank notes is to provide for their instant convertibility upon demand by the holder and thus maintain their parity. The same applies to demand deposits, if checks and sight drafts are to be kept at par.
The problem is to keep on hand or within reach sufficient cash to meet not only ordinary but extraordinary demands. The sum kept for meeting the ordinary demand is spoken of as "till money," or "cash," and that for meeting the extraordinary is called "reserve money." "Reserve" is sometimes used to cover both sums. The till money may be in any form; the reserve should consist only of legal tender or standard money. The amounts that must be kept for these purposes are determined by experience and the conservatism of the banker. A bank with relatively few depositors, or with a few exceptionally large deposi tors, must be cautious and maintain larger reserves than banks with a large body of relatively equal depositors. A bank with a large body of foreign-born or ignorant and excitable depositors must fortify itself against precipitate, unreasoned runs; a bank in a large city needs higher reserves than banks in smaller centers or rural districts. A banker who is conservative, preferring safety to great earnings, and who feels a high sense of responsibility to the community, will keep higher reserves than one not so scrupu lous. A bank which has good business relations with a large cen tral bank, or which stands well with the other banks of the city, and which can, therefore, in emergency borrow or rediscount, may safely carry lower reserves. The reserves against demand liabilities need to be higher than against time liabilities, since advance notice may be required in the case of time liabilities, and the maturities being known, provision against their liquidation can be made. Finally a bank with a good secondary reserve which can be liquidated in emergency need carry only small reserves.
The proper reserve has to be determined, therefore, by each bank for itself in the light of these and other controlling condi tions. The penalty of expansion on too slender reserves is to incur adverse clearing house balances; the percentage of reserve, as among the banks of a system, cannot vary to a great extent with impunity. The state may determine upon some proportional reserve which, in the light of average experience to date, seems to provide a normal degree of safety, and prescribe this as a minimum, and close or penalize banks which continually tres pass on this minimum. This has been the practice in the United
States with respect to both notes and deposits. The banks are expected to keep—and usually do keep—larger reserves than this minimum.
Desirability of Minimum Reserve It is very questionable whether it is desirable to establish a minimum reserve by law, though it does exert a restraining in fluence on a few reckless bankers who might otherwise injure the whole financial fabric. On the other hand, the reservation of a minimum amount renders the reserves impotent at the very time they should, and otherwise would, perform the service for which they are kept, namely, that of providing for convertibility in emergencies. Such a minimum gives the banker a weapon of self-defense, but ties his hands. The psychological effect of the known large reserve is undoubtedly good, allaying the depositor's fears as to the bank's ability to pay on demand; but if the deposi tor also realized that this reserve could not be actually used when required, his faith would be less strong. A further disadvantage of the fixed minimum reserve is that it undoubtedly tends to become the maximum kept by the banks.
The banker steers his course between two opposing tendencies. A cash reserve which bears a high ratio to the demand liabilities promotes safety and high confidence in the bank; but the bank makes its profits on extensions of credit by way of notes, deposits, and so forth, and the lower the ratio of reserve to these liabilities the greater the earnings of the bank. The bank is a corporation whose raison d'etre is profits to its stockholders. The officers of the bank are, therefore, moved to build on the cash holdings of the bank as large a superstructure of credit as safety warrants; reckless extensions of loans bring dividends but invite disaster. In these respects a bank differs in no essential from any business institution; a working balance of cash is necessary to each; the important difference is one of degree. Demand liabilities, in contradistinction to time liabilities, constitute practically the whole credit of a bank, whereas they constitute only a small pro portion of the credit of other businesses. Consequently the greater importance of bank reserves is manifest.