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Part Three: Money and Banking > Chapter 18. The Redemption of Fiduciary Media

5. The So-called "Banking" Type of Cover

The expressions solvency and liquidity are not always used correctly when they are applied to the circumstances of a bank. They are sometimes regarded as synonymous; but orthodox opinion understands them to refer to two different states. (It must be admitted that a clear definition and distinction of the two concepts is usually not attempted.)

A bank may be said to be solvent when its assets are so constituted that a liquidation would necessarily result at least in complete satisfaction of all of its creditors. Liquidity is that condition of the bank's assets which will enable it to meet all its liabilities, not merely in full, but also in time, that is, without being obliged to ask for anything in the nature of a moratorium from its creditors. Liquidity is a particular sort of solvency. Every enterprise—for the same is true of any body that participates in credit transactions—that is liquid is also solvent; but on the other hand not every undertaking that is solvent is also liquid. A person who cannot settle a debt on the day when it falls due has not a liquid status, even if there is no doubt that he will be able in three or six months' time to pay the debt together with interest and the other costs in which the delay is meanwhile involving the creditor.

Since ancient times commercial law has imposed on everybody the obligation to have regard to liquidity throughout the whole conduct of his business. This requirement is characteristically expressed in mercantile life. Anyone who has to approach his creditor for permission to defer the payment of a debt, anyone who allows matters to reach the point of having his bills protested, has imperiled his business reputation, even if he is afterward able to meet all his outstanding obligations in full. All undertakings are subject to the rule that we have already encountered as the business principle of the credit-negotiating banks, that steps must be taken to permit the full and punctual settlement of every claim as it falls due.8

For credit-issuing banks, regard to this fundamental rule of prudent conduct is an impossibility. It lies in their nature to build upon the fact that a proportion—the larger proportion—of the fiduciary media remains in circulation and that the claims arising from this part of the issue will not be enforced, or at least will not be enforced simultaneously. They are bound to collapse as soon as confidence in their conduct is destroyed and the creditors storm their counters. They, therefore, are unable to aim at liquidity of investment like all other banks and undertakings in general; they have to be content with solvency as the goal of their policy.

This is customarily overlooked when the covering of the issue of fiduciary media by means of short-term loans is referred to as a method that is peculiarly suited to their nature and function, and when the appellation "characteristically banking type of cover" is applied to it,9 because it is supposed that consistent application of the general rule about liquidity to the special circumstances of the credit-issuing banks shows it to be the system of investment that is proper to such banks. Whether the assets of a credit-issuing bank consist of short-term bills or of hypothecary loans remains a matter of indifference in the case of a general run. If the bank is in immediate need of large sums of money it can procure them only by disposing of its assets; when the panic-stricken public is clamoring at its counters for the redemption of notes or the repayment of deposits, a bill that has still thirty days to run is of no more use to it than a mortgage which is irredeemable for just as many years. At such moments the most that can matter is the greater or lesser negotiability of the assets. But in certain circumstances, long-term or even irredeemable claims may be easier to realize than short-term; in times of crisis, government annuities and mortgages may perhaps find buyers more readily than commercial bills.

It has already been mentioned that in most states two categories of banks exist, as far as the public confidence they enjoy is concerned. The central bank-of-issue, which is usually the only bank with the right to issue notes, occupies an exceptional position, owing to its partial or entire administration by the state and the strict control to which all its activities are subjected.10 It enjoys a greater reputation than the other credit-issuing banks, which have not such a simple type of business to carry on, which often risk more for the sake of profit than they can be responsible for, and which, at least in some states, carry on a series of additional enterprises, the business of company formation for example, besides their banking activities proper, the negotiation of credit and the granting of credit through the issue of fiduciary media. These banks of the second order may under certain circumstances lose the confidence of the public without the position of the central bank being shaken. In this case they are able to maintain themselves in a state of liquidity by securing credit from the central bank on their own behalf (as indeed they. also do in other cases when their resources are exhausted) and so being enabled to meet their obligations punctually and in full. It is therefore possible to say that these banks are in a state of liquidity so long as their liabilities as they fall due from day to day are balanced by such assets as the central bank considers a sufficient security for advances. It is well known that some banks are not liquid even in this sense. The central banks of individual countries could similarly attain a state of liquidity if they only carried such assets against their issues of fiduciary media as would be regarded as possible investments by their sister institutions abroad. But even then it would remain true that it is theoretically impossible to maintain the credit bank system in a state of liquidity. A simultaneous destruction of confidence in all banks would necessarily lead to a general collapse.

It is true that the investment of its assets in short-term loans does make it possible for a bank to satisfy its creditors within a certain comparatively short period. But this would prove adequate in the face of a loss of confidence only if the holders of notes and deposits did not apply simultaneously to the bank for immediate payment of the sums of money owing to them. Such a supposition is not very probable. Either there is no lack of confidence at all or it is general. There is only one way in which liquidity of status might be at least formally secured with regard to the special circumstances of credit-issuing banks. If such banks made loans only on the condition that they had the right to demand repayment at any time, then the problem of liquidity would of course be solved for them in a simple manner. But from the point of view of the community as a whole, this is of course no solution, but only a shelving, of the problem. The status of the bank could only apparently be kept liquid at the expense of the status of those who borrowed from it, for these would be faced with precisely the same insurmountable difficulty. The banks' debtors would not have kept the borrowed sums in their safes, but would have put them into productive investments from which they certainly could not withdraw them without delay. The problem is thus in no way altered; it remains insoluble.

  • 8. See pp. 263 ff. But the fact is often ignored that this "principle of the banking adequate cover" is valid not only for banks but similarly for all other undertakings. See, for example, Schulze-Gaevernitz, "Die deutsche Kreditbank," Grundriss der Sozialökonomik, Part V, section 2, pp. 240 ff.
  • 9. See Wagner, System der Zettelbankpolitik (Freiburg, 1873), pp. 240 ff.—The "golden rule" found its classical expression with regard to the business of credit banks in the famous "Note expédiée du Havre le 29 Mai 1810, à la Banque de France, par ordre de S. M. l'Empereur, et par l'entremise de M. le comte Mollien, ministre du Trésor" (I quote from the reprint in Wolowski, La Question des Banques [Paris, 1864], pp. 83-87): "Il faut qu'une banque se maintienne en état de se liquider à tout moment, d'abord, vis-à-vis des porteurs de ses billets, par la réalisation de son portefeuille, et, apres les porteurs de ses billets, viv-à-vis de ses actionnaires, par la distribution à faire entre eux de la portion du capital fourni par chacun d'eux. Pour ne jamais finir, une banque doit etre toujours prête à finir" (p. 87). All the same, Mollien had no doubt on the point that a bank that does not issue its notes otherwise "qu'en échange de bonnes et valable lettres de change, à deux et trois mois de terme au plus" can only call in its notes from circulation "dans un espace de trois mois" (ibid., p. 84).
  • 10. In the United States, before the reorganization of the banking system under the Federal Reserve Act, the lack of a central bank in times of crises was made up for by ad hoc organizations of the banks that were members of the clearinghouses.