undertake the functions of trusteeship. Most trust companies do not confine themselves strictly to trusteeship, but branch out into commercial and investment banking.

Miscellaneous forms of financial agencies include Morris plan banks for the provision of consumer's loans or small producer's loans, mortgage companies, discount and finance companies, commercial paper houses, note brokers, building and loan associations, and coöperative credit societies. Since commercial banking is of pivotal importance, we shall limit our discussion for the most part to that particular form of financial institution. The other forms are important, but it is impossible on account of space limitations to treat separately each type of institution.

The Function of Commercial Banking.-Commercial banking is a form of productive enterprise. To any one who looks beyond the mere making of loans or handling of deposits, it must be obvious that the final outcome of all technical banking detail must be a broad productive function. The test of the effectiveness of banking institutions is whether industries produce. If factories are idle, if plant is being used at a fraction of capacity, if goods and services are not being marketed continuously at full capacity, then banking to that extent has failed of its purpose. Other things may have failed also, but above all, banking has failed. Banks have over-financed here and under-financed there. They have failed to serve fully and adequately the economic purpose for which, in the interest of the community, they are intended.

The banks influence production in three main ways: by the judicious selection of the persons to whom money will be loaned; by controlling the total of all loans in such a way as will avert inflation or deflation of prices; by charging an interest rate which reflects the true scarcity of and demand for capital.

By the use of the first method, banks divert the control of capital to the hands of those most capable of making a profit from its use and employment. All sorts of people come to the banks for loans. Some are deserving, others are not. One borrower can take his loan out of the bank, engage in business successfully, earn a profit, and pay off his debt at maturity. Another borrower can take the same amount of credit, bungle the use of it, lose his investment, and default on the debt at maturity. The commercial banks attempt to place loans in the hands of those producers who are most competent to use them for a productive purpose. To the extent that the banks use sound discrimination, they tend to further production by placing purchasing power in the hands of the most effective producers.

With regard to the second method, banks as a class are seriously concerned with the grand total of their credit extensions. The grand total of all loans has a powerful influence upon the price level. As previous chapters have shown, a relatively steady price level is indispensable to sustained production. Inflation and deflation destroy the steady continuity of full time production. The total of bank credit

is of vital importance because through its effect upon price fluctuations it dominates the course of production.

The third method is of coördinate importance as the bank rate of interest vitally affects the course of production for good or for ill. The bank rate should reflect the true scarcity of savings of capital and the true demand for capital. A high rate of interest may be used to check the expansion of money and the inflation of prices, and at the same time to check the over-expansion of production. A low rate of interest may be used to resist deflation and to stimulate the expansion of production. The interest rate is a most important regulator of business activity.

These three tests of the effect of banking upon production serve to emphasize the fact that banks exist for a purpose outside themselves. They are auxiliaries and servants of the main productive currents of economic life. Banking must face broad economic tests, in order to find an economic justification for its existence.

Instruments of Bank Credit.-Credit instruments may be classified under two headings: orders to pay and promises to pay. Orders to pay are bills of exchange, drafts, checks, and acceptances. Such instruments are orders by one party on a second to pay to a third, or to the first party himself, a certain sum of money. A orders B to pay C, or under certain circumstances to pay A himself, the stated sum. The person to whom money is owed makes out the order and is the "drawer." The person who owes money and on whom the draft is drawn is the "drawee." A draft is synonymous with a bill of exchange. An acceptance is a draft or bill drawn on a person who owes money, and by him accepted by writing the word "Accepted" across its face and placing underneath his signature. The acceptance is in form an order to pay, but when accepted, becomes the acceptor's promise to pay. It is then as binding on him as a promissory note. A check is a special form of order to pay, in which the drawer orders his bank to pay out of his own deposit account with the bank a stated sum, either to another named party, or to bearer, or to himself, as the case may be. Drafts, bills, checks, acceptances are alike orders to pay.

The type form of promise to pay is the promissory note. Such promises form a very important part of the total credit used in modern business. An acceptance becomes in effect a promise to pay when the drawee writes "Accepted" across the face of the instrument. The promise to pay is a contract, enforceable at law, and the fact that such contracts are binding underlies much of the confidence which is indispensable to business transactions on a credit basis.

Bank Activities: Discount, Deposit, and Issue.-Banking serves the needs of commerce and business by three major types of operations, which may be classified as discount, deposit, and issue.

(1) Deposit. The popular conception often seems to be that a bank is merely a place to put money for safe keeping, perhaps also to draw a small rate of interest. This phase of banking is often the main phase in the eyes of the individual who maintains a small deposit and checking

account. It is true that banks solicit deposits of money and are very anxious to have such deposits as large as possible. But in the aggregate, all deposits of actual money are only a fraction of total bank deposits. Bank deposits are several times as great as all the actual money in the country. There must be some outside source of deposits much more important than the mere deposits of money itself.

This outside source is the creation of loans and discounts by the banks themselves. Banks make extensions of credit to borrowers, and these borrowers in turn redeposit the credits with the banks. "The naïve idea that a bank deposit normally originates by the bank's customer making a deposit of cash in the bank does not reveal the substance of the situation in countries like the United States, with a highly developed system of bank credit and its utilization through the form of the deposit account. The most usual form in which bank deposits originate is by borrowers going to a bank to seek accommodation and offering their notes for discount, the bank making the loan sought by the customer by opening a credit or 'deposit' on its books in the borrower's favor. Normally, therefore, what are called deposits, increase as loans and discounts do; in other words, as borrowings from banks increase.”’1 In the course of the day's business, the merchant receives in payment for his goods and services a mass of checks, drafts, and other credit instruments, as well as actual money. Scores and hundreds of checks and other credit instruments pour in, drawn on a widely scattered list of banks and individuals. The merchant takes them all to his own bank for deposit, and the bank considers them "cash items" of deposit. "Cash items" clearly are not actual money. They are simply rights to demand actual money from the various banks on which they are drawn. The bank which receives the cash items of the merchant proceeds to collect payment from all other banks.

But in the process of collection, the bank finds that other banks are intending to collect similar items from its funds. The merchant, for instance, has drawn checks on his bank, payable to scattered dealers in other cities, and these dealers will deposit such checks with their respective banks. These various banks will in turn collect such cash items from the merchant's bank. In other words, cash items constitute two streams of payments. One stream is collections by bank No. 1 from all other banks. The other stream is collections by all other banks from bank No. 1. The greater part of cash claims in favor of the bank will be offset by cash claims against the bank. The claims for and against each bank are largely cancelled or cleared, without the give and take of actual cash. Cash items are, then, deposits of rights to other people's cash, but since these rights are cancelled by counter rights to cash by other people, only a small amount of cash is moved.

Deposits, therefore, arise in three main ways: actual money savings; loans and discounts left with the bank; and cash items. The bulk of the deposits arise in the second and third ways. Both of these sources are 1 Federal Reserve Bulletin, September 1, 1919, p. 815.

traceable ultimately to the amount of credit extended by the bank. Bank deposits are created by the banks themselves, through the process of loans and discounts.

The use of deposit accounts is a matter of business convenience. When the individual or corporation carries a deposit at the bank, the fund may be used to meet a wide variety of bills and expenses in the business. The bulk of payments may be met by checks and drafts drawn on the depositor's bank account. But at the same time, the business man has payments owing to him. He receives their checks and drafts, and deposits them at the bank to be collected and put to his account. The bank keeps a record of the outgoing and incoming payments. At certain intervals, the bank supplies statements of the amounts of each, and of the balance still on deposit. The process of accounting balances the two records of expenditures and receipts, and affords proper facilities for the settlement of an enormous number of transactions.

The banker bears a heavy burden of expense in rendering this service. The deposits as such yield him no gain. Their management and supervision are purely a cost, and if interest is paid to depositors, that payment increases the cost. Why, then, should the banker be so anxious to secure deposits? The only reason is, that deposits make possible further loans by the bank. Deposits are but a stepping stone to loans. The loans are the thing. On them the bank receives interest. From them the bank receives income. Through them, the bank has hope of defraying expenses and making profit.

(2) Loans and Discounts. In loans, interest is added to the principal at maturity. In discounts, interest is deducted from the principal in advance. "Loans and discounts" group together the total extensions of credit to commercial borrowers.

The borrower has new purchasing power at his disposal. Ordinarily the borrower will deposit this purchasing power in the bank, and check it out as he needs it. The purpose of the borrowing was to create a deposit account on which checks and drafts could be drawn.

If the Standard Oil Company of New York borrows $1,000,000 from the National City Bank, deposits the amount to its account, and proceeds to draw checks and drafts for the bulk of the sum, the deposit will be quickly cut down to a fraction of the original amount. The deposit exists to be used, and the only way to use it is to pay bills and expenses by drawing checks on it. But this using up of deposits is a danger to the bank, since it drains the bank of cash. Unless this drawing out of deposits by the Standard Oil Company is offset by new deposits in the National City Bank by other customers, or by the Standard Oil itself, the bank will be in a precarious position. Everything going out and nothing coming in would quickly exhaust cash and ruin the bank. The soundness of banking depends upon making sure that for all deposits drawn out, other deposits will be coming in.

Not one customer but hundreds or thousands are involved. Some are drawing out large sums while others are depositing large sums. The

average outgo of funds will just about equal the average intake of fresh deposits. As fast as one deposit account is worn down, some other deposit account is built up. The loss of funds on account of checks cashed will be made up by the gain of funds on account of new deposits. Debits to individual accounts must be offset by new deposits to individual accounts.

The come and go of deposits is a common routine of banking. The bank may be compared with a gigantic reservoir. Two great pipes of intake and outflow are connected. By arranging that on the average the intake of new deposits shall be about equal to the outflow from old deposits, the level of the contents of the reservoir can be maintained. Loans without deposits would drain the reservoir. Deposits without loans would be a stagnant burden of expense, earning nothing for the bank. Deposits and loans go together. Loans are unsafe without deposits. Deposits are impossible except to a limited extent without loans.

(3) Note Issue. A certain percentage of all payments involve the use of currency, either specie or paper money. The proportion of total payments made in this manner varies somewhat from country to country. For instance, in England and the United States, probably less than onetenth of all payments require currency itself, whereas in France probably more than one-half of all payments require currency. Since the World War, gold coin has practically disappeared from circulation. Subsidiary coin and paper notes constitute the active circulation.

Notes may be issued either by governments or by banks. Government issue usually has been due to the desire of the government to secure revenue for some emergency. The emergency of war commonly results in government issue, and tends to lead to fiat money and inflation. The Greenbacks are government notes issued in the United States during the Civil War. The drawback with government issue has always been that the criterion has been fiscal need rather than business need for money. The government issue does not expand in proportion to the requirement of business for a larger volume of medium of exchange, nor does it contract in proportion to the contraction of business. The government issue expands primarily with reference to the desire of the treasuries to get revenue without taxation. The government issue rarely, if ever, contracts. Consequently, under normal conditions, note issue is best left to banks. However, bank note issue is not left wholly to the private judgment of bankers, but is placed under some degree of government regulation. The notes issued by banks have general acceptability in the community, and perform all the work of gold money itself. They are commonly backed by some commodity or asset. The significance of the backing is that it places some limit upon the quantity of notes that can be issued.

By virtue of the combined activities of discount, deposit, and issue, banks provide a medium of exchange for business, and contribute to the ability of business to produce goods for the use of the community.