It is the general use of the check that makes it possible for banks to create deposits through their lending operations. If borrowers made all payments with money, it would be necessary for them to withdraw the proceeds of their loans from the banks in the form of money. The business of commercial banks, like that of savings banks, would then be limited to the funds received from depositors and shareholders, and possibly some slight amount in addition thereto, since borrowers would presumably not immediately draw out the entire proceeds of their loans.
It may, however, be objected that even though the borrower does use checks, the bank will be obliged to make payment almost as speedily as if money were used. Checks do not circulate indefinitely; they are quickly pre sented for payment over the counter, or by other banks in which they have been deposited. Assuming that a bank were abruptly to double its deposit obligations by granting many new loans, it would unquestionably be confronted almost at once with heavy demands for pay ment of the largely increased number of checics that would certainly be drawn upon it. If, however, and this is the usual case, all the banlcs of a locality increase their loans at the same tirne with a consequent expansion of de posits, each bank will have a greater number of checks drawn upon it, but it will also receive from its depositors a greater number of checks drawn on the other banlcs. There would be a greater number of checks drawn, but not a correspondingly greater amount of cash needed in malting settlements between the banks. This increase in loans, if made by the banks of a single locality, would probably lead to in creased purchases from producers elsewhere, thus occasioning a balance of indebtedness against the local banks. Sooner or later cur rency would have to be shipped to the banks in other parts of the country, and this would soon prevent further expansion and might make contraction necessary; but again, if expansion of ban.. loans were country wide, this diffi culty would not be experienced unless gold ex ports were stimulated, and even this contin gency would not present itself if the expansion of credit were world-wide.
The general expansion of credit cannot con tinue indefinitely. An increasing volume of checics like an increase in the quantity of money has the same tendency to bring about an advance in prices. Rapidly rising prices invariably stimulate unhealthy business activ ities. Sooner or later the expansion of credit is checked by the deterioration in the average quality of the loans of the banks; failures become more numerous; confidence, not only in the future of business, but also in the banks, is weakened; a crisis breaks out followed by a period of depression; the volume of credit is then reduced through a slackening in the de mand for loans, and through the liquidation of loans previously made.
However universal the use of checks may become, the individual bank does not on that account cease to be subject to constant demands for cash. A bank can exert no control over the use its depositors make of their accotmts from day to day; checks deposited with it never exactly balance checks presented for payment; there will be wide variation, some times favorable, sometimes unfavorable. In
the latter contingency reliance may be placed upon a speedy dange in favor of the bank. More positive action is, however, certain to become necessary irom time to time in the experience of every bank. The requirements of depositors will occasionally result in a suc cession of unfavorable balances, and further, every bank must face the possibility that un founded rumors may subject it to a run. It is imperative, therefore, that a bank be able to pay large amounts of money on demand, and also be in position quicicly to replenish depleted reserves. Its assets, or at least a con siderable portion of them, must be of such a character that they can be quickly converted into money. To serve this purpose the same degree of liquidness in all assets is not a requisite. Immediate conversion into cash of a portion of the assets of a bank will ordinarily serve for the building up of reserve depleted on account of unusually large requirements on the part of depositors, and the gradual con version of the remaining assets is all that can be deemed necessary for exceptional contin gencies. Experience sbows that a bank, all of whose assets can be converted into cash within a few months without loss, is altogether un likely to be disturbed by lack of confidence, and should it be subjected to unfounded rumors, no difficulty is experienced in secur ing the necessary funds from other banks.
Central the develovinent of commercial banking in most countries, there has been a distinct tendency toward the estab lishment of a special class of institutions, the primary function of which is to enable other banks to convert their assets into cash in periods of stress. These special banks, com monly known as central banks, maintain them selves in ordinary times in a position of great strength. They endeavor to exercise a re straining influence during periods of rapid credit expansion, but when the emergency pre sents itself grant loans freely. The Bank of England is the oldest and most famous insti tution of this kind. The very great advantages secured through its operations and those of similar institutions in other European countries led to the establishment in the United States of the Federal Reserve Banks in 1914. See FEDERAL RESERVE SYSTEM ; FEDERAL FARM LOAN Am.; LAND CREDIT The bank notes which these institutions issue are as serviceable and acceptable for all domestic purposes as coined money. In many countries they are a legal tender. Consequently these central banks are able to supply the other banks with such amounts of cash as they may need to meet even the most severe contin gencies. The banks are thus relieved of the necessity of resorting to general loan contrac tion, a method of strengthening themselves which cannot be carried far without involving the business commuttity in serious financial difficulties.