Since the liabilities of a commercial bank are characteristically demand liabilities, the immediate convertibility of the earning assets is their prime essential. The creditors demand cash and are not satisfied with the delivery of securities, however excellent. To offer anything but cash is a confession of failure. Therefore it is the practice, even in the final liquidation of an insolvent bank, to convert the securities at market prices and pay cash to claim ants rather than to offer the securities direct. The same holds true of discount paper. Securities or purchased paper, however excellent, are no substitute for cash reserve, though the bank's reserve position may be greatly fortified by their judicious selec tion. Such readily convertible assets constitute the bank's secondary reserve.
Ready convertibility depends upon: 1. The organization of the market for the respective assets.
2. Their usance.
3. Their self-liquidating quality.
Convertible Forms of Earning Assets Though the market for stocks and bonds is the highly organ ized stock exchange, the term of such securities is usually very long and they do not rest upon commercial transactions which liquidate them. Call loans with stock exchange collateral have been regarded by American banks as particularly liquid assets.' From the point of view of an individual bank, call loans in ordi nary times answer well the requirements of a secondary reserve. Failure of the borrower to heed the call subjects the collateral to immediate sale. Collateral time loans are less liquid. The dis advantages of both call and time loans are: first, that the fear of alienating a customer often deters the call of the loan, or the refusal to renew the loan and sell the collateral; and, second, that in times of crisis the market for securities contracts severely and the collateral has to be sacrificed at such prices as promote the violence of panic. European banks rely less upon securities and more upon commercial paper for secondary reserve.
The market for commercial paper is the discount market, including the central bank, and such paper has short usance and is self-liquidating. The paper may be additionally liquid if there is no expressed or implied agreement to renew the loan at maturity, and if the borrower, in order to maintain the good-will of his name, stands ready to borrow elsewhere and take up his paper— even in advance of its maturity, if the holder so desires. This holds true only of commercial paper bought in the open market. Commercial loans to customers are much less contractile, for such customers may expect a continuance of their loans and even special accommodation in times of crisis. Therefore, assuming that the discount market is as broad and convenient as the securi ties market, and that the rate of interest (discount) is as high, it appears that commercial paper answers the requirements of a secondary reserve better than do stocks and bonds or loans based upon them.
Liquidity for Banking System as a Whole While in ordinary times an individual bank may fun' com mercial paper, call and time loans, and stocks and bonds readily convertible forms of earning assets, it is usually true that this seeming liquidity is rather the effect of their movement among banks than of an actual reduction of the earning assets of the bank system as a whole. If bank A converts securities by selling them to bank B, there is an interchange of cash assets for securi ties assets; if they are sold to an individual X, who borrows funds from bank B to make the purchase, there is then a secured promis sory note in B's assets instead of cash, and cash in A's assets instead of securities. Only to the degree (and it is usually small) that the cash is derived from other than banks, is there any genuine liquidity for the banking system as a whole. In propor tion as all banks rely upon one form of secondary reserve, whether securities or call loans or purchased paper, it becomes increasingly difficult for them to procure cash funds by selling assets.
It appears, therefore, that the ability of the banks of the entire system to pass through a panic without suspension of specie pay ments cannot be attained by the possession of securities, pur chased paper, or other earning assets which may in theory but cannot in fact be sold to other institutions, nor by the contraction of loans, whether call or time loans, secured or unsecured. When a violent panic breaks, every banking system, particularly the decentralized, has experienced the utter impossibility of defense against suspension by such means of liquidation, though local or moderate panics may be averted or assuaged.
In the time of boom immediately preceding a panic the busi ness world resists any extensive contraction of loans. Even bankers, moved by the desire for profits as well as the desire to promote the business enterprises in which their customers are interested, are often blind to the impending crisis or fearful lest a contraction might itself precipitate a panic. For these reasons they are hesitant and reluctant to call or refuse loans. Therefore the "expansion generally proceeds in the absence of fortuitous events to the acute stage, when financial disruption may be avoided only by a rapid expansion of accommodations, leaving the liquidation to be automatically achieved in the period of depression which follows." 2 In other words, contraction usually follows rather than precedes a panic, and the process after the panic is to liquidate first the financial (speculative) loans and then the commercial loans. The increased discount rate dis courages all but necessitous borrowers and attracts hoarded or foreign funds and may alleviate the situation, but too often such relief does not come until after the panic has broken.