PROFIT ON BANK NOTE ISSUES.

103. It is frequently asserted that the national banks secure an exorbitant profit upon their note-circulation. Many argue that the prohibitory tax of 10 per cent. on state bank issues which confines the privilege of issuing circulating notes to the national banks, grants a monopoly to a limited number of institutions whereby a "double profit" is obtained, (1) by receiving the interest upon the bonds deposited as security for the notes, and (2) the interest at current rates on the notes when issued for loans.

At the very outset, however, it is impossible to speak of a profit arising from the issue of notes as distinct from the general operations of banking. The source of profit resides in the discount operation; in the process of buying a right to receive money in the future in return for giving an immediate right to draw means of payment. The extent to which this can go on is limited only by the amount of resources left with the bank by others over and above necessary reserves. The lending, or investing of these amounts, brings a profit. It is sheer ignorance of banking operations, therefore, to assert that the banks. make a profit out of the notes issued. It is true that one form of liability by which loans are consummated is notes; but the profit could be made equally well by a deposit account, without the issue of a single note.

The only possible ground for saying that banks make a "double profit" is the fact that a bank loans not only its own capital, but also any funds left with it by the community (uncovered by necessary reserves). A bank lending only its own capital would be scarcely more than a loan company; and would earn scarcely more than enough to pay expenses, to say nothing of dividends. To earn ordinary dividends a bank must, by some means, be able to loan funds beyond its capital. If it can issue notes which remain outstanding at a regular

amount, to that extent it thereby gets funds from the community which it can lend. Or, if it by loan operations creates deposits, which are not drawn out, but are used as a currency by means of checks, then it finds itself in possession of funds which it can loan on good, short time paper.

104. Where banking is perfectly free, therefore, and goes on subject to no restriction, the profit arising from a loan is the same whether the funds retained by the bank are balanced by liabilities of notes, or of deposits. When, however, banks are obliged to invest their funds in a specified sort of security in order to obtain notes, the result is a loss of profit equivalent to the difference between the rate of interest paid by these securities and that currently paid by ordinary commercial paper. For the security in which the bank is required to invest as a guarantee for its notes will of necessity bear a low rate of interest on the investment, if this is of such unquestioned value as to afford greater safety to the note holder than would ordinary commercial paper. This is precisely the case with the national bonds. which banks are now compelled to deposit before taking out notes. Inasmuch as the average rate of return on an investment in national bonds is now less than 3 per cent., while in practically all parts of the country the rate on ordinary commercial loans is appreciably higher than that, it results that, because of the requirement to buy bonds, the bank earns less upon its resources than it would if they were invested in ordinary commercial paper. The profit to the bank depends wholly upon how its resources over and above its cash reserve can be invested, and the obligation to invest a part of its resources in low interest-bearing bonds as a security for its notes is a means of preventing it from putting the same resources into better-paying investments, and consequently reduces, rather than "doubles," the profit of a bank. Even if this explanation were not conclusive, the fact that national bank circulation has been largely reduced, and that where the commercial rate of interest is high, the banks take out no more notes than the minimum amount necessary in order to hold their charters, should entirely destroy the ground for this erroneous belief.

105. While it is true that the profit arising from the issue of notes cannot be dissociated from that gained through the exercise of the functions of discount and deposit, and since it is impossible to speak of a separate profit as arising from the notes, it may be practicable to estimate what, under current conditions, might be the maximum profit derivable from taking out notes on the basis prescribed by the present system, as compared with a banking business where an equal amount of deposits was used or with loaning the funds directly. Supposing a bank to use only notes, and no deposits at all, it may be possible to see the truth of what has been above explained. If the 4 per cent. bonds of 1907, which are mainly used as a security for notes, were to sell on a 3 per cent. valuation, it would require in July, 1898, $107,861 to buy $100,000 of bonds, on which only $90,000 of notes can be issued. The account would stand as follows, under the present law:

From the available capital and notes amounting to $190.000, there must be subtracted the reserve, the redemption fund, and the cost of the bonds in order to ascertain how much could be loaned ($68,639).

Then contrast the above account with one in which no notes are used, but only deposit accounts:

Thus the advantage in favor of the deposit system would be $10,590 minus $6,395.52, or $4,194.48, while the loaning of the original capital of $100,000 at 6 per cent. simple interest (without the necessity of forming a bank) would have brought a return of $6,000-only $395.52 less than that earned by the bank of issue.

106. It has been previously explained that deposits perform essentially the same function as notes, though in a different way and with a different class of people, and that the profit arising to the bank is the same whether its loans are made possible by the use of notes or of deposits, where the use of both is free. It follows that those banks whose customers demand their loans in the form of notes will be placed at a disadvantage (relatively to those using deposit-accounts), and in order to make the same rate of profit as the banks which are not obliged to issue notes they would be forced to charge borrowers a higher rate of discount upon loans. That is, the tendency of the present national banking law is to make the issue of notes more expensive, and this in the end falls upon borrowers. And as it is in less thickly settled regions that notes rather than checks are chiefly used, it follows that at the present time country banks are at a relative disadvantage as compared with city banks, and their customers are at a relative disadvantage as compared with those of the city banks.

Recurring to the illustration given above, it will be seen that a bank of $100,000 capital with $90,000 of deposits, if its expenses were $5,000 could make loans to the community at 6 per cent. interest and yet make a dividend of 5.59 per cent. on

its capital; while a bank with no deposits, but issuing $90,000 of notes under the present system, with the same expenses and $900 additional taxation, in order to make the same dividend upon its capital stock (5.59 per cent.) would have to obtain an average of 12.02 per cent. on the loans which it makes to the community.

This state of affairs works injustice in another way by subjecting banks in different portions of the country to different conditions. It is a direct inference from the computation concerning the profit derivable from a note-issue, given at an earlier point, that the higher the rate of interest current in a specified locality, the less is the inducement under the present system to issue circulation in excess of the minimum required by law, and vice versa. This follows directly from the fact that since the fixed charges, such as tax, redemption fund, etc., remain the same in every case, the higher the rate of interest the greater the inducement to elect the direct investment of the capital in carrying on the ordinary business of the bank in preference to using it for the purchase of bonds and issue of notes. This may readily be shown by a computation similar to that already given, the rate of interest used being 10 per cent. instead of 6, as before. With this rate of interest the situation would be as follows: