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THE RELATION OF THE NEW CURRENCY ACT TO THE 
WORK OF COMMERCIAL PAPER HOUSES 

The function of the commercial paper house is, on the one hand, 
to supply credit to business houses by discounting their notes, and, 
on the other hand, to furnish to banks which have unemployed 
funds a liquid, quickly maturing form of investment. The neces- 
sity for so obtaining credit and the demand by banks for a liquid 
form of investment are vital alike to business and banking, and 
will exist under any system of currency. The effect of the new 
law on the work of commercial paper houses will be at most a 
change only of form, or in method of doing business, and not in the 
nature of the service performed. 

In the present practice of commercial paper houses advances of 
funds are made by the discounting of promissory notes. The money 
so obtained is used by the borrower in the purchase of goods and 
in preparing them for market. When the goods are marketed and 
paid for, the proceeds of their sale enable the borrower to pay his 
notes. 

The term "commercial paper" originally indicated notes or 
acceptances given in settlement for goods bought; but the com- 
mercial practice of settling bills by notes has long since been dis- 
continued in this country owing to the offering by wholesalers of 
substantial discounts for payment in cash. This practice is so 
general that a concern which does not discount its bills is regarded 
as being in a strained financial position. Discounting has become 
in this country the touchstone of credit standing. To such an 
extent is this true that a merchant who fails to discount his bills 
cannot possibly withstand competition. Indeed, in many lines the 
cash discount constitutes the entire margin of net profit. The 
result is that most concerns borrow from their banks or brokers on 
their promissory notes in order to take advantage of the cash dis- 
counts. It is apparent from this that such notes are issued against 
goods which the borrower has purchased, and their payment 
depends upon his properly marketing his goods. In the case of 

358 



NEW CURRENCY ACT AND COMMERCIAL PAPER HOUSES 359 

bills receivable, the merchant who discounts them with his bank or 
broker is obtaining funds on goods which he has sold; the proper 
marketing of the goods upon which the bills are created will depend 
upon the ability of another merchant than the one who obtains the 
bank credit on them. 

The extending of merchandise credits when the cash discount 
test is removed can be abused to a greater degree than direct bank 
loans. The merchant is always eager to sell, and a customer who 
need not pay cash may be tempted to buy beyond his means, but 
the bank which has fixed his line of credit has thereby set the limit 
of his purchases. The danger of overexpanded credit is thus 
checked at the source. 

There has been some apprehension that under the new law an 
attempt was to be made to restore the old practice and to favor the 
use of indorsed bills receivable as against simple promissory notes. 
For the reason stated, this seems to me to be an undesirable change 
and one which would inevitably tend toward undue expansion of 
credit. However, if the practice of obtaining credit by discounting 
indorsed bills receivable is to take precedence over the use of promis- 
sory notes, and the latter instrument is to be gradually abandoned, 
the work of the commercial paper house will consist of buying and 
selling indorsed bills receivable instead of promissory notes. This 
will in no way affect its general function. 

Aside from any change in the character of the loans dealt in by 
the commercial paper house, it is quite evident that its method of 
operation will be affected in many ways. I shall not attempt to 
trace the gradual changes as the law is put into effect step by step, 
but rather shall consider conditions after the law is in full swing 
and operation. 

In considering the relation of the new law to the commercial 
paper house, it is well to notice briefly the features which more par- 
ticularly affect the paper-buying ability of banks. The first of these 
is the smaller reserve required. After the three-year interim 
allowed for the gradual shifting of reserves, the reserve requirements 
for country banks will have been reduced from 15 per cent to 12 per 
cent; for reserve city banks, from 25 per cent to 15 per cent; and for 
central reserve banks from 25 per cent to 18 per cent on all demand 



360 JOURNAL OF POLITICAL ECONOMY 

deposits; and the reserve required against time deposits will be 5 
per cent in each case. It will be noticed that under the new act a 
sharp distinction in reserve requirements is made as between time 
and demand deposits, only 5 per cent being required on time 
deposits, whereas under the old act the same reserve was required 
against time as against demand deposits. 

The second important feature is the fact that reserves must be 
kept in a bank's own vaults or in the Federal Reserve Bank of its 
district. Deposits by country banks in reserve or central reserve 
cities, and deposits made with central reserve cities by banks 
located in reserve cities will no longer be counted as part of the 
depositing bank's reserve. 

The third feature is the discontinuance of the use by country 
banks of reserve and central reserve banks as their collecting agents, 
and, it is hoped, the eventual discontinuance, in large measure, of 
the whole practice of banks using other banks for this purpose. 
Under the new act, banks will deposit items drawn on banks in their 
own district directly with the Federal Reserve Bank, and such items 
will thus automatically become a part of their reserve, the Federal 
Reserve Bank in turn charging them up to the member bank on 
which they are drawn. While no provision has yet been made for 
Federal Reserve Banks to receive items on member banks of another 
district, it is believed that such an arrangement will eventually 
be completed. 

The fourth and most important of all these features is the 
rediscounting function of the Federal Reserve Bank. The new act 
provides that 

upon the indorsement of any of its member banks .... any federal reserve 
bank may discount notes, drafts, and bills of exchange arising out of actual 
commercial transactions; that is, notes, drafts, and bills of exchange issued or 
drawn for agricultural, industrial, or commercial purposes, or the proceeds of 
which have been used or are to be used for such purposes. 

Heretofore, in the older and more thickly populated districts of the 
United States, it has been the exception rather than the rule for 
good banks to rediscount paper, and the fact that they never have 
rediscounted has been a matter of pride with many banks. Espe- 
cially has this been true of banks in reserve and central reserve cities, 



NEW CURRENCY ACT AND COMMERCIAL PAPER HOUSES 361 

which have disliked exceedingly to show an item of rediscount on 
their published statement; but with an official government sanction 
on this procedure, rediscounting will become a perfectly normal 
incident of the banking business. 

Let us now consider the effect of the new law on the country 
bank. It is apparent that the decrease in legal reserve, in itself, 
necessarily means larger resources available for loans. The increase 
in loanable funds will be even greater than the amount represented 
by the percentage of reduction in the reserve actually required, 
because under the present system conservative banking practice 
has necessitated the maintaining of reserves in excess of the legal 
requirements. Under our present system, the limits of credit 
allowed to borrowing banks, other credit requirements being satis- 
fied, are in a large measure determined by the amount of their 
average balances in reserve and central reserve cities. As a result 
many country banks are compelled to keep large balances with their 
reserve city correspondents at certain seasons, as a compensation 
for the rediscounting accommodations which they are compelled to 
seek of these correspondent banks during other seasons of the year 
when their local demand is strong, as, for instance, during the crop- 
moving period. Under the operation of the new law, the necessity 
for these balances will have been obviated, because the Federal 
Reserve Bank will rediscount for its member banks in proportion to 
their legitimate needs rather than in proportion to the amount of 
their balance. 

Country banks have also carried large balances with reserve and 
central reserve banks in order to get favorable terms on collections, 
the larger balance compensating the city bank for the trouble and 
expense of collecting. The Federal Reserve Bank will now act as 
a clearing-house and will accept for immediate credit checks on other 
member banks and drafts on other Federal Reserve Banks at par. 

Many country banks have heretofore carried a large balance 
with reserve and central reserve banks as a general measure of 
prudence in order to be prepared for emergencies. They will not 
feel the same necessity under the new law because they will know 
that in an emergency they can immediately rediscount at the 
Federal Reserve Bank. 



362 JOURNAL OF POLITICAL ECONOMY 

It is apparent from all this that the country banks will have a 
much larger volume of loanable funds than at present, and will pur- 
chase commercial paper even more extensively than now. 

Furthermore, commercial paper is likely to supplant certain less 
liquid forms of investment now held by country banks. Many 
banks which carry a large amount of loans secured by stock 
exchange collateral, which will be ineligible for rediscount, will find 
it advisable to carry a larger proportion of convertible paper. 
Many of them in the past have carried bonds as an investment on 
the theory that they are always marketable. While it is true that 
there is always a market for high-grade bonds, it has usually been 
the case that at times when such banks have had to realize on their 
bonds the rates on money have been high and the price of bonds 
correspondingly low. This experience has proved costly to many 
banks. But if a bank should buy paper even during a period of 
very cheap money and should be obliged to rediscount it during a 
period of very high money, the loss would be inconsequential, since 
the paper would have only a short time to run. 

The effect of the new act on the city bank is more difficult to 
determine. It is evident, however, that just as in the case of the 
country bank its loaning power will increase to the extent that its 
legal reserve requirements are decreased. It will also have an 
increased loaning power, from the fact that it will be able to include 
in its reserve a large amount of funds which are now not available 
for that purpose. This has particular reference to so-called 
"transit items" — that is, checks drawn on out-of-town banks for 
which the depositor has received credit, but which the receiving 
bank is obliged to send out for collection. In the ordinary course 
of business several days elapse before returns are received on these 
items, and the bank holding them is not allowed in the meantime 
to treat them as part of its reserve. In the case of large Chicago 
banks, these so-called "transit items" amount to many millions of 
dollars. Under the new act the bank will deposit such items with 
the Regional Federal Reserve, where they will be counted as part 
of its reserve. 

The loaning power of banks in reserve cities will also be increased 
to the extent that the banks will no longer find it necessary to keep 



NEW CURRENCY ACT AND COMMERCIAL PAPER HOUSES 363 

balances with other banks to obtain collection service. City banks 
now have large funds tied up in deposits with each other. The 
Federal Reserve Banks will collect and remit for member banks, 
thus eliminating the necessity for such deposits. 

These increases of loaning power, however, will be more than 
offset by decreased loaning power as a result of probable withdrawal 
of country deposits. In our consideration of the effect of the new 
act upon country banks, we have fully set out the reasons why 
country balances will be greatly diminished. This decrease of 
country deposits will undoubtedly come about very gradually, 
however, and there will always be a considerable quantity of such 
deposits. It will take the country banker some time to accustom 
himself to the lower reserves permitted by the new act, and instead 
of keeping these surplus reserves with the Federal Reserve Bank he 
will naturally keep them in the city bank, because he will thus get 
interest on them. Moreover, many country banks will want some 
service from their city correspondent not obtainable from the 
Federal Reserve Banks, such as the taking of surplus lines of their 
customers without indorsement, the supplying of general credit 
information, the assistance of the city bank in the investment of 
their funds, and other incidental services. To obtain such service 
some deposits will be maintained. 

It is generally true of city banks doing a commercial business 
that their direct loans to customers exceed their loanable funds 
derived from their own capital and their individual deposits. This 
will probably be true, even with the decreased reserves required 
under the new act. The deposits by country banks have served to 
provide the necessary funds. It follows that a substantial reduc- 
tion in country balances must be followed by a large reduction in 
loans. This will be accomplished in one or more of the following 
ways, or more probably by all of the following ways: (1) the con- 
traction of loans to customers, (2) the cessation of purchases of 
commercial paper, (3) rediscounting with the Federal Reserve 
Bank. 

The net result of all this is that city banks which have heretofore 
been large purchasers of commercial paper will have little or no 
surplus funds to invest in the purchase of commercial paper; in 



364 JOURNAL OF POLITICAL ECONOMY 

fact, commercial paper houses will probably have to extend larger 
lines of credit to their customers to offset the decreased lines 
obtainable at the banks. It is evident, however, that the total 
loanable funds of the entire country will be substantially increased, 
so that the decreased city demand for paper must be more than 
offset by the increased country buying of paper. It is thus quite 
apparent that the commercial paper houses will have to take 
cognizance of the country banks as furnishing the real market for 
open market purchases, and they will have to organize their work 
accordingly. 

It is also likely that the act will open a new field for the com- 
mercial paper house — namely, that of dealing in bank rediscounts. 
The rate of discount in different Federal Reserve Banks will differ 
according to the demand for money in each particular district. 
For example, it is quite probable that at some seasons of the year 
the discount rate of the Federal Reserve Bank serving the banks in 
Texas might be 6 per cent, while that of the Federal Reserve Bank 
in Chicago would be only 4 per cent. It would be entirely within 
the province of the commercial paper house to rediscount paper 
bearing the indorsement of Texas banks at a rate slightly below the 
rate fixed by the Federal Reserve Bank of the Texas district, and 
place this paper with banks in Illinois. It would simply be another 
opportunity for the broker to exercise his function of acting as a 
medium between borrower and lender, and thus tending to lessen 
the disparity in rates. 

It is evident from the foregoing that there will be a largely 
increased supply of loanable funds. There is nothing in the act, 
however, to create any new or unusual demand for funds, so that 
it is a fair conclusion that the effect of the new act will be to lower 
rates of interest in general, and particularly rates on commercial 
paper. 

On the whole, the general work of the commercial paper house 
will require very little change to accommodate itself to the new law. 
Credit investigation will be the same, and methods of marketing 
paper will remain substantially as at present. The only important 
change that will follow will be in the location and distribution of 
the market for absorbing the paper. RoBERT C . Schaffner 

Chicago, III.