In the previous posting on this subject, we noted that a single commercial bank is always riskier than several commercial banks acting together as part of a system. There is also the problem that, however sound an individual bank may be and stable its issues with respect to their value over time, the banknotes of one bank will never have the same value as the banknotes of another bank which is independent of the first bank.
Thus, except by coincidence, the notes of the two banks will pass at a premium or a discount relative to one another, even though denominated in the same unit of currency, and each bank is both sound and issues a stable currency, just as the Canadian dollar, U.S. dollar, and Euro have rarely had the same value. This creates a problem if one of the goals is to have a uniform currency to facilitate transactions, so that people do not have to be constantly recalculating the value of one bank’s currency relative to that of another bank.
A final problem is that of unrestricted competition between banks. In the eighteenth century it wasn’t uncommon for some larger banks to play a “dirty trick” on smaller institutions. Due to the demand for convertibility of a certain amount of any bank’s issues into gold and silver (whether by customers who were holders in due course of the bank’s notes, or individuals or institutions that presented checks drawn on that bank for payment), even banks of issue kept a certain proportion of their total loans outstanding on hand in the form of precious metal — reserves. (Moulton, Principles of Money and Banking, op. cit., II.98-100.)
In the ordinary course of business, borrowers would redeem most banknotes by using the notes to repay the loans that were the occasion for the issuance of the banknotes in the first place. (Ibid.) Sudden demands for cash could be met by “call loans” (ibid.) that is, loans subject to immediate payment on demand. Other banknotes collected could be offset against the banknotes issued by other banks and traded back and forth. Some holders in due course of the banknotes, however, did not have any loans outstanding to repay, and preferred to convert the banknotes into the gold and silver reserves held by the bank that issued the promissory notes.
These reserves of specie were not the backing for the note issues. The backing consisted of the present value of the assets represented by the bills presented to the bank for discounting and rediscounting. Rather, the gold and silver kept on hand were to satisfy the occasional demand by the public to convert the banknotes issued by that bank into precious metal. This was the origin of “fractional reserve banking.” (Ibid., II.10-11.) When a bank operated alone, any reserve requirement acted as a brake on local economic growth, as it created a barrier to making a loan other than the inherent financial feasibility of a project brought to the bank for financing.
A commercial bank, however, needed to have reserves of precious metal in order to give the public confidence that its note issues were “as good as gold,” and thus convertible on demand into specie. What would happen sometimes, however, is that a large bank, intent upon driving a smaller rival out of business, would begin collecting the notes of the smaller bank. When the larger bank (sometimes even a consortium) had more notes collected than the smaller bank’s known reserves, the larger bank would present all the notes on the same day for conversion into gold and silver. This caused a “run” on the smaller bank and forced it into bankruptcy.
A smaller bank could, of course, apply to another bank for assistance and either sell some of its loans for specie, or obtain a temporary loan of gold or silver to tide itself over. If the other banks were joined in what amounted to a conspiracy against the smaller bank, however, the request for such a loan would be denied. The establishment of clearinghouses somewhat ameliorated this problem, but did not solve it. (Moulton, Principles of Money and Banking, op. cit. II.100-118.) What was needed was an institution to which a bank of issue could apply and be certain of obtaining an emergency loan of reserves to meet any sudden and unexpected demand on its existing reserves.
There were other problems with a commercial banking system that operated without a central authority. As we mentioned above, the note issues of individual banks would almost never pass at par with one another, even though the notes of a particular bank passed at par with all the other notes issued by that bank. There was also the fact that a reserve requirement acts as a brake on economic development for any region served by a single bank or banks acting independently. An independent bank acting under a reserve requirement would have to pass up otherwise profitable loans if it did not have sufficient reserves on hand to comply with the law or the demand for convertibility of its notes into specie.
The answer to these problems was the invention of a “commercial bank for commercial banks.” This is generally called a “central bank.” This will be covered in the next posting on this subject.
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