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The determinants of bank borrowing under the finance act, 1914-1934 Kerr, Erik Sven 1967

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THE DETERMINANTS OF BANK BORROWING UNDER THE FINANCE ACT, 1914 - 1934 by ERIK SVEN KERR .A., University of B r i t i s h Columbia, 1965 A THESIS SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF ARTS i n the Department of Economics We accept t h i s thesis as conforming to the required standard THE UNIVERSITY OF BRITISH COLUMBIA September, 1967 In p re sen t i ng t h i s t he s i s in p a r t i a l f u l f i l m e n t of the requirements f o r an advanced degree at the U n i v e r s i t y of B r i t i s h Columbia, I agree that the L i b r a r y s h a l l make i t f r e e l y a v a i l a b l e fo r re ference and Study. I f u r t h e r agree that permiss ion f o r ex ten s i ve copying of t h i s t he s i s f o r s c h o l a r l y purposes may be granted by the Head of my Department or by h.i.:s r e p r e s e n t a t i v e s . It i s understood that copying or p u b l i c a t i o n of t h i s t he s i s f o r f i n a n c i a l gain s h a l l not be a l lowed without my w r i t t e n pe rmi s s i on . Department of Economics The U n i v e r s i t y of B r i t i s h Columbia Vancouver 8, Canada Date September 3 0 , 1967 ABSTRACT The Finance Act (1914-34) provided the chartered banks with rediscounting f a c i l i t i e s . During World War I, these f a c i l i t i e s became part of the banks' regular means of cash adjustment. Subsequently, a controversy arose whether or not the chartered banks rediscounted f o r private gain. In defence of the banks, S i r Thomas White stated that the banks always borrowed sparingly because of the wish neither to incur the cost involved nor to be heavily indebted to the Treasury. The purpose with the thesis i s to test S i r Thomas* hypothesis. In order to do so, the hypothesis had to be re-vised; that i s , the difference between the rate charged for advances and the cost of alternative means of adjustment (the least-cost spread) was substituted i n the hypothesis f o r the simple cost determinant. By the use of indifference curve analysis, c e r t a i n c r i t e r i a for testing the hypothesis were developed and used i n t e s t i n g data f o r borrowing by the aggregate as well as the in d i v i d u a l banks. i i The evidence showed that the revised hypothesis was overgeneralized both i n i t s description of the banks* use of the Act and i n i t s explanation of the causal r e l a t i o n s h i p s . Thus, i n terms of both volume and duration of borrowing, the f a c i l i t i e s of the Act were used extensively by several banks. Both the least cost spread and the aversion to be indebted appeared to be c r u c i a l determinants of borrowing. The strength of the r e l a t i o n s h i p s , however, varied s i g n i f i c a n t l y among the banks. In p a r t i c u l a r , for the more conservative banks, the aversion to borrowing was strong at any l e v e l of indebtedness. For the other banks, the aversion was apparent only at l e v e l s of heavy indebtedness. • • * XXX TABLE OF CONTENTS Page ABSTRACT i i LIST OF TABLES . v LIST OF ILLUSTRATIONS v i ACKNOWLEDGEMENTS v i i i Chapter I. INTRODUCTION 1 II . THE CANADIAN FINANCIAL SYSTEM AND THE FINANCE ACT 9 I I I . THEORETICAL ANALYSIS OF SIR THOMAS' HYPOTHESIS 37 IV. EMPIRICAL TESTING OF THE HYPOTHESIS .. 57 V. AN EXAMINATION OF THE INDIVIDUAL BANK'S BORROWING BEHAVIOR 81 VI. CONCLUSION 99 APPENDIX A 104 B ... 117 BIBLIOGRAPHY 124 iv LIST OF TABLES Table Page I. Assets of Canada's Main F i n a n c i a l I n s t i t u t i o n s , Selected Years 1911-30 12 I I . Major Types of Non-Monetary F i n a n c i a l Assets held by the Chartered Banks and the Canadian L i f e Insurance Companies, Selected Years 1911-30 13 II I . Major Items of the Canadian Money Supply, Selected Years 1915-30 17 IV. Quarterly Average of Month-end Advances under the Finance Act to the Individual Banks, July 1927 - Sept. 1929 83 V. Heavy Volume and Frequency of Borrowings under the Finance Act by Individual Banks, July 1927 - Sept. 1929 87 VI. Rank-Ordering of the Banks according to the Conservatism of t h e i r P o l i c i e s 95 VII. Rank-Ordering of the Banks according to t h e i r Aggressiveness and Achievements 96 v LIST OF ILLUSTRATIONS Figure Page 1. Chartered Bank Data, 1914-34 27 2. Expansion path for Borrowing by One Bank •• 52 3. Possible Expansion Paths of Borrowing by Banking System .••«... 54 4. The Relationship between the Least—Cost Spread and Balances of Finance Act Ad-vances, Oct. 1917 - Dec. 1921 63 5. J The Relationship between the Least-Cost Spread and Balances of Finance Act Ad-vances, July 1927 - Sept. 1929 65 6. The Relationship between the Least—Cost Spread and Balances of Finance Act Ad-vances, Jan. 1922 - June 1927 ............. 67 7. The Relationship between the Least-Cost Spread and Balances of Finance Act Ad-vances, Jan. 1930 - Sept. 1932 68 8. The Relationship between the Amount of Advances paid to the Banks during F i s c a l Years and the Yearly Average of Month—end Balances of Finance Act Advances, 1918-32 • 76 9. The Relationship between Yearly Total Bank Clearing and Yearly Average of Month-end Balances of Finance Act Advances 78 10. The Relationship between Yearly Bank Clearings and Advances paid to the Chartered Banks each F i s c a l Year 79 11. The Relationship between the Least—Cost Spread and the Borrowings under the Finance Act by each Class of Banks 84 v i LIST OF ILLUSTRATIONS - Continued Figure Page 12. The Relationship between Finance Act Advances Calculated as Quarterly Averages of Daily Balances and Advances Calculated as Quarterly Averages of Month-end Balances, Jan. 1927 - Dec. 1932 107 13. The Relationship between the Least-Cost Spread and Quarterly Averages of D a i l y Balances of Finance Act Advances, Jan. 1927 - Dec. 1932 . 108 14. The Relationship between the Least—Cost Spread and the Quarterly Averages of Month-end Balances of Finance Act Advances, Jan. 1927 - Dec. 1932 109 15. The Relationship between the Low Quarterly Balances of Finance Act Advances and the Least-Cost Spread, 1927 - 32 113 16. The Relationship between the Least—Cost Spread and the "Median Low" Quarterly Balance of Finance Act Advances, Jan. 1927 - Dec. 1932 115 17. The Relationship between the Least-Cost Spread and each Bank's Borrowings under the Finance Act 119 v i i ACKNOWLEDGEMENTS I would l i k e to thank Dr. Ronald A. Shearer and Father Gerald F. McGuigan f o r acting as my thesis super-v i s o r s . In p a r t i c u l a r I would l i k e to express my gratitude to Professor Shearer for h i s constructive c r i t i c i s m , en-couragement and patience i n carrying out the supervision by correspondence. Only by Professor Shearer's help was I able to complete the thesis while l i v i n g i n Kingston, Ontario. v i i i CHAPTER I INTRODUCTION Or i g i n of the Finance Act The Finance Act was designed to meet a banking c r i s i s at the outbreak of World War I. At that time a world wide f i n a n c i a l panic led to the cl o s i n g of bourses and stock ex-changes i n the great f i n a n c i a l centres. Both i n England and i n the U.S.A., emergency measures were taken to provide the banks with additional l i q u i d i t y to meet an abnormal demand 1 for cash. In Canada there was fear that the gold standard could not be maintained i f access to the c a p i t a l market i n London was disrupted by a war. During the l a s t days i n July a heavy demand for gold arose among the p u b l i c . E s p e c i a l l y i n Toronto On August 1, 1914 Bank of England made an emergency issue of notes. This issue was authorized by parliament on August 6, 1914 when the banks also were given the opportunity to obtain the new currency on loan from the government to be able to meet any abnormal demand for Bank of England notes. In the United States, gold payments were temporarily informally suspended and emergency bank note issues were made under the Aldrich-Vreeland Act of 1908 on the c o l l a t e r a l of commercial paper. 1 2 and Montreal, notes and deposits were converted into gold 1 which was hoarded i n deposit boxes. There was no pro v i s i o n i n the Bank Act to deal with the s i t u a t i o n which was developing. Many runs throughout the 2 country showed that the public was becoming panicky, and the banks' cash reserves would be i n s u f f i c i e n t to meet nationwide withdrawals of deposits into Dominion notes and gold. The s i t u a t i o n was made worse by the fa c t that the banks' secondary reserves i n the form of c a l l loans i n New York and London were 3 not available at that p a r t i c u l a r time. On August 4th, 1914, the day on which B r i t a i n declared war on Germany, an announcement was made by the Canadian go— 4 vernment that the banks were authorized to make payment of *An account of the events leading up to the passing of the Finance Act i s provided by S i r Thomas White i n The Story  of Canada's War Finance, Montreal, 1921, pp. 6-10. 2 See Canada, Royal Commission on Banking and Currency, Report (hereafter c a l l e d the MacMillan Report), Ottawa, King's P r i n t e r , 1933, p. 22. 3 In U.S.A. gold payments were informally suspended during August, and i n B r i t a i n a moratorium had been declared by the government on August 2. The previous evening a proposal of measures had been embodied i n an order-in-council which had been signed by the Governor—General and printed i n a s p e c i a l issue of the Canada  Gazette (vol. XLVIII, p. 466). 3 1 t h e i r l i a b i l i t i e s i n t h e i r own n o t e s , and t h a t the government was prepared to make advances of Dominion notes t o the banks i n a d d i t i o n to other p o s s i b l e a s s i s t a n c e . Although the O r d e r - i n - C o u n c i l had no l e g a l v a l i d i t y , c o n f i d e n c e was r e s t o r e d . No f u r t h e r runs took p l a c e and when Parliament convened l a t e r i n August the Finance Act 1914 was 2 passed. The A c t l e g a l i z e d and e l a b o r a t e d the p r o v i s i o n s of the O r d e r - i n - C o u n c i l s t a t i n g t h a t i n c e r t a i n emergencies the Go-v e r n o r - i n - C o u n c i l c o u l d (1) a u t h o r i z e the Department of Finance to make advances o f Dominion notes t o the c h a r t e r e d banks on the s e c u r i t y of promissory notes secured by t h e i r f u l l v a l u e i n such s e c u r i t i e s as approved by the M i n i s t e r of Finance (2) a u t h o r i z e the c h a r t e r e d banks to pay the p u b l i c by t h e i r own bank notes and thus suspend the r i g h t of redemption i n Dominion notes and gold (3) a u t h o r i z e the e x t e n s i o n o f the p e r i o d o f excess c i r c u l a t i o n p r i v i l e g e from s i x months to a 1 I t was thought t h a t the p u b l i c , unable to convert t h e i r d e p o s i t s i n t o g o l d , might p o s s i b l y wish to h o l d bank notes as p r e f e r r e d to d e p o s i t s . Bank notes were more secure because bank note holders i n c o n t r a s t to d e p o s i t o r s were l e -g a l l y p r o t e c t e d as " i n v o l u n t a r y " h o l d e r s of bank l i a b i l i t i e s . 2 Canada, S t a t u t e s , 1914, 2nd S e s s i o n , Chapter 3. < 4 1 whole year and (4) suspend the c o n v e r t i b i l i t y of Dominion notes into gold. In addition, authorization was given to the government to declare a general moratorium; t h i s provision, however, was never used. In short, the o r i g i n a l purpose of the Finance Act was to provide some borrowing f a c i l i t i e s to the chartered banks i n the event of a l i q u i d i t y c r i s i s . The Act was successful i n c u r t a i l i n g the c r i s i s , which passed almost immediately, and borrowing for the o r i g i n a l purpose ceased to e x i s t . The F i n -ance Act, however, continued to be i n force throughout the War 2 and post war period u n t i l 1923, when part of the Finance Act mechanism was made a permanent feature of the f i n a n c i a l sys-tem. Under the Finance Act of 1923, the Minister of Finance By a Bank Act amendment of 1908, the banks were per-mitted to issue notes i n excess of the previous upper l i m i t set by t h e i r paid—up c a p i t a l . The period of excess c i r c u l a t i o n was at f i r s t l i m i t e d to four months but was extended to s i x months i n 1912. In the decennial r e v i s i o n of 1913, the banks were permitted to issue an amount of t h e i r own notes equal to the amount of gold and Dominion notes deposited by the banks i n a Central Gold Reserve. These measures were made to provide further e l a s t i c i t y to the banks' note issue as the l a t t e r was found i n s u f f i c i e n t to meet l i q u i d i t y demands during crop moving seasons. 2 The Finance Act of 1914 was o r i g i n a l l y passed as an emergency measure but i n 1919 a new act "provided for the con-tinuance i n force of the proclamation made on September 3, 1914, ' u n t i l two years a f t e r the conclusion of peace on t e r -mination of the present war'." See MacMillan Report, p. 22. 5 was authorized to issue Dominion notes to the banks against approved s e c u r i t i e s deposited with the Minister i n times when 1 no proclamation under the Act of 1914 was i n force. The dura-t i o n of the advances was l i m i t e d to one year. The purpose of the Act, thus, changed from being an emergency war measure to becoming a normal cash adjustment mechanism for the banks, somewhat l i k e the discount "window" of a c e n t r a l bank. The Act provided the banks with the f a c i -l i t i e s f o r obtaining funds at less inconvenience and often at a lower cost than by al t e r n a t i v e devices. The Act was probably also intended as a means to i n j e c t a d d i t i o n a l l i q u i d i t y into the f i n a n c i a l system for b r i e f periods such as crop-moving seasons and other temporary periods of heavy demands for l i -2 q u i d i t y . Unlike a c e n t r a l bank, however, the f a c i l i t i e s p r o v i -ded by the Act were not intended to be used as a means of 3 implementing monetary p o l i c y . No attempts at regulating the 1See Canada, Statutes, 1923, Chapter 48. The Acts of 1914 and 1923 are consolidated i n Chapter 70, R.S.C. 1927. 2 See Canada, parliament, House of Commons, The Select Standing Committee on Banking and Commerce, Proceedings, 1923, p. 350. Summary reprinted i n Bank Act Revision proceedings, compiled by the Canadian Bankers* Association, 1933, p. 460. . 3 See MacMillan Report, p. 59 and p. 66. 6 volume o f c r e d i t extended t o the banks by a l t e r i n g the r a t e 1 charged f o r advances appear t o have been made, and there i s no evidence t h a t the Act was designed as a means of a l t e r i n g the t o t a l money supply over an extended p e r i o d . The C o n t r o v e r s y over the C h a r t e r e d Banks' Borrowings Under  the Act The banks' e x t e n s i v e use o f the borrowing f a c i l i t i e s o f the Act d u r i n g the 1920*s and e a r l y 1930*s gave r i s e t o a p u b l i c d i s c u s s i o n o f the banks' motives f o r " d i s c o u n t i n g " under the A c t , and a c o n t r o v e r s y developed over whether the banks misused the f a c i l i t i e s o f the Finance A c t . I t was a r -gued by some t h a t the banks borrowed f o r a p r o f i t and through e x c e s s i v e c r e d i t expansion, caused i n f l a t i o n . On the other s i d e i t was argued that the banks o n l y borrowed when neces-sary and then used the f a c i l i t i e s o f the Act q u i t e s p a r i n g l y . Purpose and S t r u c t u r e o f T h e s i s The purpose o f t h i s t h e s i s i s t o e v a l u a t e the c o n t r o -v e r s y . S p e c i f i c a l l y , the aim i s to t e s t the f o l l o w i n g hypo-t h e s i s p r o v i d e d by S i r Thomas White as p a r t o f h i s d i s s e n t t o See The S e l e c t Standing Committee on Banking and Com-merce, Proceedings, 1924j p. 343. Summary r e p r i n t e d i n Bank  Act R e v i s i o n Proceedings, p. 489. See a l s o the MacMillan Re- p o r t , p . 59. 7 the MacMillan Report: They (the banks) have always been sparing i n t h e i r resort to i t s (the Finance Act's) p r i v i l e g e s and pay o f f their advances as quickly as possible. There i s a twofold reason f o r t h i s p o l i c y : f i r s t l y because they do not desire to continue to pay i n -terest any longer than necessary and se-condly because they do not care to incur or show i n t h e i r returns heavy indebted-ness i n respect of advances under the Act."'" The following chapter i s devoted to an examination of the structure of Canada's f i n a n c i a l system. The purpose of the chapter i s to examine the mechanism of the Finance Act and to demonstrate how i t f i t t e d into the o v e r a l l struc-ture of the monetary system. It also contains a b r i e f view of borrowing under the Finance^.Act. In Chapter I I I , an attempt i s made to c l a r i f y the conceptual and t h e o r e t i c a l issues i n the controversy i n question. In the f i r s t instance i t i s necessary to i d e n t i f y the precise meaning of the " p r o f i t motive" and the "need and reluctance" hypotheses regarding borrowing under the Finance Act. It i s demonstrated that these two interpretations can, i n f a c t , be merged into one which we c a l l "the least-cost hypothesis." The, concluding section of the chapter i s de-signed to specify the objective c r i t e r i a , which must be MacMillan Report, p. 87 8 satisfied i f this hypothesis i s to be accepted. In Chapter IV, the aggregate borrowings by the bank-ing system i s examined in relation to the least—cost hypo-thesis. To f a c i l i t a t e the analysis of determinants other than alternative costs and reluctance, the analysis has been made in four subsections. In Chapter V, the determinants influencing the bor-rowings of the individual banks are examined. It was found that the banks could be subdivided into groups according to their borrowing behavior. The banks in each group thus had certain characteristics in common with respect to frequency and relative size of borrowings. An attempt at explaining differences in borrowing behavior i s made in terms of d i f -ferences in conservatism of the various banks. In Chapter VI, the findings from chapters IV and V are related to the hypothesis by Sir Thomas White and a con-clusion i s drawn. CHAPTER I I THE C A N A D I A N F I N A N C I A L S Y S T E M AND T H E F I N A N C E A C T T h e p u r p o s e o f t h i s c h a p t e r i s t o g i v e a b r i e f d e s -c r i p t i o n o f t h e C a n a d i a n f i n a n c i a l s y s t e m a s i t e x i s t e d i n t h e e a r l y p a r t o f t h e t w e n t i e t h c e n t u r y a n d t o e x a m i n e t h e r o l e o f t h e F i n a n c e A c t w i t h i n t h i s s y s t e m . F u n c t i o n s a n d S t r u c t u r e o f t h e F i n a n c i a l S y s t e m A f i n a n c i a l s y s t e m p e r f o r m s t w o b a s i c f u n c t i o n s . T h e f i r s t i s t h e t r a n s f e r o f command o v e r e c o n o m i c r e s o u r c e s f r o m s u r p l u s s p e n d i n g u n i t s t o d e f i c i t s p e n d i n g u n i t s , t h a t i s , f r o m u l t i m a t e l e n d e r s t o u l t i m a t e b o r r o w e r s . T o t h i s e n d , i t mus t p r o v i d e a n a r r a y o f p o s s i b l e a s s e t s f o r s a v e r s t o h o l d , a n d i t m u s t p r o v i d e a s e t o f i n s t i t u t i o n s a n d m a r k e t s s o t h a t t h e s a v i n g s c a n b e t r a n s m i t t e d i n t h e f o r m o f c r e d i t t o t h e i n v e s t o r s , o r s p e n d e r s . T h i s , t h e n , i s t h e f u n c t i o n o f t h e c a p i t a l m a r k e t . S e c o n d l y , t h e f i n a n c i a l s y s t e m mus t p r o v i d e a p a y m e n t m e c h a n i s m . T h e l a t t e r m a k e s p o s s i b l e t h e c a r r y i n g o n o f s p e c i a l i z e d e c o n o m i c a c t i v i t y r e g u l a t e d b y e x c h a n g e a n d t h e m a r k e t m e c h a n i s m . I n t h i s c h a p t e r t h e c a p i t a l m a r k e t 9 10 and the monetary system are discussed separately. They are, however, highly i n t e r r e l a t e d and there i s no sharp d i s t i n c -t i o n between them. For instance, ultimate borrowers may either s e l l t h e i r f i n a n c i a l assets d i r e c t l y to ultimate len-ders or exchange them f o r claims against f i n a n c i a l i n s t i t u -t i o n s . Such claims may take the form of deposits and debt 1 c e r t i f i c a t e s . Deposits i n the chartered banks, however, are considered as means of payment and hence part of the monetary system. 2 The C a p i t a l Market The function of the c a p i t a l market i n financing Canada's economic l i f e was done p a r t l y by the f i n a n c i a l i n -s t i t u t i o n s which held types of assets d i f f e r e n t i n r i s k and l i q u i d i t y from t h e i r l i a b i l i t i e s , and p a r t l y by organizations which provided the f a c i l i t i e s f o r exchanging the non—monetary f i n a n c i a l assets such as stocks and bonds. In Gurley and Shaw's terms, the i n s t i t u t i o n s acquire primary s e c u r i t i e s (bonds, e q u i t i e s , mortgages, etc.) and issue i n d i r e c t s e c u r i t i e s i n the form of demand and time de-posits and s i m i l a r debts. See John G. Gurley and Edward S. Shaw, Money i n a Theory of Finance, Washington, D.C., Brook-ings I n s t i t u t i o n s , 1960, p. 4. For a more de t a i l e d description of the intermediaries, see the MacMillan Report, pp. 24-47. 11 Canada's F i n a n c i a l I n s t i t u t i o n s D u r i n g t h e e a r l y p a r t o f t h e t w e n t i e t h c e n t u r y , Canada's major f i n a n c i a l i n s t i t u t i o n s c o n s i s t e d o f t h e c h a r -t e r e d b anks, l i f e and g e n e r a l i n s u r a n c e companies, mortgage and t r u s t companies, and v a r i o u s s a v i n g s i n s t i t u t i o n s . The combined a s s e t s c o n t r o l l e d by t h e banks and t h e l i f e i n s u r a n c e companies c o n s t i t u t e d a p p r o x i m a t e l y 90 p e r cen t o f t h e a s s e t s h e l d by a l l t h e s e i n s t i t u t i o n s , as may be seen from T a b l e I . A l t h o u g h the banks and t h e i n s u r a n c e companies had d i f f e r e n t f u n c t i o n s , i t i s , n e v e r t h e l e s s , o b v i o u s t h a t t h e two t y p e s o f i n s t i t u t i o n s dominated the c a p i t a l market w i t h r e s p e c t t o l o a n s and debt i n s t r u m e n t s . The p r o p o r t i o n o f non—monetary f i n a n c i a l a s s e t s h e l d by the two i n s t i t u t i o n s i s shown f o r s e l e c t e d y e a r s i n T a b l e I I . The C a n a d i a n Bond Market The means o f t r a n s f e r o f s e c u r i t i e s were p r o v i d e d by the s t o c k exchanges, t h e s t o c k b r o k e r s and the i n v e s t m e n t d e a l e r s . The l a t t e r were i n s t r u m e n t a l i n c r e a t i n g a bond market i n Canada. B e f o r e W o r l d War I o n l y a s m a l l p e r c e n t a g e o f new bond i s s u e s were p l a c e d i n Canada. D u r i n g W o r l d War I , how-e v e r , when t h e B r i t i s h c a p i t a l market was c l o s e d t o C a n a d i a n 12 TABLE I ASSETS OF CANADA'S MAIN FINANCIAL INSTITUTIONS, SELECTED YEARS 1911-1930 (IN MILLIONS OF DOLLARS AT YEAR END) Ins t i t u t i o n s 1911 1921 1930 Chartered Banks 1.390 2.747 3.144 Gov't and Other Savings Banks 93 a 98 a 165 a Mortgage Loan Companies n.a n.a 250° L i f e Insurance Companies 275 658 1.973° Fi r e and Casualty Ins. Co. 53 113 177 a F i g u r e s are estimates. Year end figures not av a i l a b l e . ^Not including estates, trust and agency funds. cIncludes assets of Canadian Companies and assets i n Canada of other than Canadian Companies. Source: Canada Year Book. 13 TABLE II MAJOR TYPES OF NON-MONETARY FINANCIAL ASSETS HELD BY THE CHARTERED BANKS AND CANADIAN LIFE INSURANCE COMPANIES, SELECTED YEARS 1911-1930 FINANCIAL ASSETS SHOWN AS PERCENTAGES OF TOTAL ASSETS 1911 1921 1930 Chartered Banks Canadian Loans 1 60.9 50.1 50.4 S e c u r i t i e s 1 7.2 11.5 14.6 Insurance Companies Bonds 35.7 45.8 28.3 Stocks 4.9 3.3 23.8 Mortgage Loans and Agreements for Sale 33.6 25.4 23.3 Other Loans 13.4 13.0 15.3 Average computed from monthly returns each year. Sources: Canada Year Book and Canada, Royal Commission on Canada's Economic Prospects, Financing and Economic A c t i v i t y i n Canada, (by Wm. C. Hood), 1958, p. 334. 14 b o r r o w i n g , s e v e r a l g r e a t V i c t o r y l o a n campaigns were s u c c e s s — 1 f u l i n t h e f l o t a t i o n o f war l o a n s t o C a n a d i a n s . These V i c t o r y l o a n campaigns were o r g a n i z e d by Canada's inv e s t m e n t d e a l e r s who s u b s e q u e n t l y formed a m a r k e t i n g committee t o p r o -v i d e a market f o r o u t s t a n d i n g government V i c t o r y bonds. There was no bond exchange i n Canada but a group o f th e l a r g e r d e a l e r s made markets i n t h e m a j o r i t y o f s e c u r i t i e s t r a d e d , and p u b l i s h e d q u o t a t i o n s c o u l d be o b t a i n e d f r o m t h e i n d i v i d u a l bond d e a l e r s . The i n v e s t m e n t d e a l e r s g e n e r a l l y bought and s o l d bonds f o r t h e i r own a c c o u n t s . They f i n a n c e d t h e i r i n v e n t o r i e s by c a l l and s h o r t term l o a n s f r o m t h e banks and by b o r r o w i n g f r o m t r u s t companies and o t h e r c o r p o r a t i o n s . The Money Market The c h a r t e r e d banks* p o r t f o l i o o f c a l l and s h o r t l o a n s on s t o c k s and bonds i n Canada was o f t e n q u i t e s u b s t a n t i a l . D u r i n g t h e l a s t two y e a r s o f t h e 1920*s, the banks, f o r The changes i n amount o f new. C a n a d i a n bond i s s u e s and c o u n t r y o f s a l e a r e i n d i c a t e d below: 1911 1917 1921 1925 1931 T o t a l bond i s s u e d ( m i l l i o n s ) $ 267 756 400 459 1250 P e r c e n t a g e p l a c e d i n Canada 16.9 74.6 50.4 56.8 85.8 » •• »» U.S.A. 6.6 24.7 45.5 42.2 13.6 » " " B r i t a i n 76.6 0.7 4.1 1.0 0.6 So u r c e : M a c M i l l a n R e p o r t , p. 107. 15 i n s t a n c e , had an average o f a p p r o x i m a t e l y $260 m i l l i o n o u t -s t a n d i n g i n t h i s l o a n c a t e g o r y . I t might, t h e r e f o r e , be e x p e c t e d t h a t a money market e x i s t e d i n Canada. However, t h e c a l l l o a n s i n Canada were i n p r a c t i c e not c a l l a b l e ; moreover, the r a t e o f i n t e r e s t c h a r g e d on c a l l l o a n s was kept c o n s t a n t 1 f o r y e a r s . A Ca n a d i a n money market was not c r e a t e d u n t i l 1954. B e f o r e t h a t t i m e , the Can a d i a n f i n a n c i a l system depended on 2 the New Y o r k money market, which was c r u c i a l f o r t h e l i q u i d i t y o f t he b a n k i n g system. The New Y o r k money market was a l s o used i n c o n n e c t i o n w i t h the banks* f o r e i g n exchange t r a d i n g a c t i -v i t i e s , f o r which f o r e i g n c u r r e n c y b a l a n c e s were h e l d i n New Y o r k as w e l l as i n London. To sum up, t h e two c h a r a c t e r i s t i c f e a t u r e s o f the Canadian c a p i t a l market was t h e dominant r o l e p l a y e d by the c h a r t e r e d banks and t h e l a c k o f d e v e l o p e d open markets f o r bonds i n Canada. ^The i n t e r e s t r a t e c h a r g e d by t h e banks was 6% r e g a r d l e s s o f t h e s h o r t t e rm r a t e s i n New Y o r k . See Canada, R o y a l Commission on B a n k i n g and C u r r e n c y ( M a c M i l l a n Commis-s i o n ) , E v i d e n c e by CIDA, P r o c e e d i n g s , pp. 2540-3. 2 R. C r a i g M c l v o r , C a n a d i a n Monetary, B a n k i n g and F i s c a l Development, T o r o n t o , M a c M i l l a n , 1958, pp. 225-7. 16 Canada's P r e World War I Monetary System The monetary system may be d i s t i n g u i s h e d f rom t h e c a p i t a l market by the d i f f e r e n t f u n c t i o n p e r f o r m e d . W h i l e the c a p i t a l market, t h u s , p e r f o r m s t h e f u n c t i o n o f f a c i l i t a t i n g the t r a n s f e r o f command o f r e s o u r c e s from l e n d e r s t o b o r r o w e r s , t h e monetary system p r o v i d e s the payment mechanism. I n Canada, th e major i t e m s o f t h e payment mechanism c o n s i s t e d o f l e g a l t e n d e r , bank n o t e s and d e p o s i t s . A p a r t from c e r t a i n B r i t i s h and U.S. g o l d c o i n s , l e g a l t e n d e r money c o n s i s t e d o f Dominion n o t e s . L i m i t e d l e g a l t e n d e r was p r o — 1 v i d e d by s i l v e r and bronze c o i n s . The s u p p l y o f money, as shown f o r s e l e c t e d y e a r s i n T a b l e I I I , c o n s i s t e d o f c o i n a g e , Dominion n o t e s , bank n o t e s and d e p o s i t s . Dominion Note I s s u e The i s s u e o f Dominion n o t e s was managed by t h e M i n i s -t e r o f F i n a n c e p u r s u a n t t o t h e Dominion Notes A c t o f 1868. The notes were p a r t l y g o l d backed and p a r t l y f i d u c i a r y , and •••See the M a c M i l l a n R e p o r t , p. 37. O t h e r monetary i t e m s c o n s i s t e d o f i n t e r - b a n k d e p o s i t s and f o r e i g n exchange. I n c o n t r a s t t o the b a n k i n g system o f t h e U.S.A. t h e i n t e r -bank d e p o s i t s were i n s i g n i f i c a n t and w i l l h e n c e f o r t h be i g -n o r e d . Moreover, i n terms o f a g g r e g a t e money s u p p l y , the i n t e r -bank d e p o s i t s , o f c o u r s e , c a n c e l o u t . The banks' h o l d i n g s o f f o r e i g n exchange were n o m i n a l . 17 TABLE III MAJOR ITEMS OF THE CANADIAN MONEY SUPPLY, SELECTED YEARS 1915-1930 (IN THOUSANDS OF DOLLARS) C i r c u l a t i o n Dominion Notes Bank Deposits of Canadian Outstanding^ by the public Year S i l v e r Small Bank Notes payable i n Nickel and Notes i n Canada  Bronze C o i n s 1 $5 & Large Notice Demand Under Notes C i r c u l a t i o n Deposits Deposits 1915 19,801 25,184 126,937 105,137 690,904 358,444 1921 30,301 34,404 234,365 194,621 1,289,347 551,915 1930 32,354 37,029 137,189 159,341 1,427,570 622,895 Net issues of coinage since 1858. 2 Yearly averages. Source: Canada year Book. 18 1 t h e f i d u c i a r y i s s u e was i n c r e a s e d from time t o t i m e . W h i l e Canada was on t h e g o l d s t a n d a r d , Dominion n o t e s were redeemable 2 i n g o l d . Dominion n o t e s were used f o r two p u r p o s e s . S m a l l de-n o m i n a t i o n s from one t o f i v e d o l l a r s were used as hand-to-hand c u r r e n c y and l a r g e d e n o m i n a t i o n s were used as cash r e s e r v e s f o r t h e co m m e r c i a l b anks. The l a t t e r n o t e s , a l s o c a l l e d " l a r g e l e g a l s , " c i r c u l a t e d o n l y among banks who used them t o meet c l e a r i n g house d r a i n s . Bank Notes and D e p o s i t s Under the Bank A c t o f 1880, t h e C h a r t e r e d banks c o u l d i s s u e bank n o t e s i n d e n o m i n a t i o n s o f $5 and m u l t i p l e s t h e r e o f , up t o an amount e q u a l t o t h e i r p a i d - u p c a p i t a l . As bank n o t e s were not l e g a l t e n d e r , the banks were r e q u i r e d t o m a i n t a i n ^ B e f o r e W o r l d War I , the f i r s t $30 m i l l i o n Dominion n o t e s were c o v e r e d by a 25 p e r cent g o l d r e s e r v e and a l l i s -sues above t h i s were c o v e r e d by a 100 p e r cen t r e s e r v e i n s p e c i e . I n August 1914, the p a r t i a l l y c o v e r e d i s s u e was r a i s e d t o $50 m i l l i o n , i n 1915 a $26 m i l l i o n note i s s u e was made w i t h o u t g o l d coverage but p a r t l y c o v e r e d by r a i l w a y s e c u r i t i e s , and i n 1917 an emergency i s s u e o f $50 m i l l i o n was made w i t h o u t g o l d b a c k i n g but s e c u r e d by I m p e r i a l t r e a s u r y b i l l s . 2 The g o l d s t a n d a r d was adopted by the U n i t e d p r o v i n c e s o f Canada i n 1853 and i t c o n t i n u e d as the monetary s t a n d a r d o f the Dominion o f Canada u n t i l t h e o u t b r e a k o f W o r l d War I i n 1914. I n J u l y 1926 Canada r e t u r n e d t o t h e g o l d s t a n d a r d which o f f i c i a l l y c o n t i n u e d t o be the base o f t h e monetary s t r u c t u r e u n t i l 1931. 19 c o n v e r t i b i l i t y of t h e i r notes. No l e g a l reserve was required to be held by the banks against t h e i r note issue. By the 1890 r e v i s i o n of the Bank Act, however, the banks were r e -quired to deposit f i v e per cent of t h e i r average yearly note issue i n a fund c a l l e d the Bank C i r c u l a t i o n Redemption Fund. The fund provided a mutual guarantee by the banks of a l l bank notes i n c i r c u l a t i o n . At the same time, bank notes were made a f i r s t l i e n on the assets of f a i l e d banks. P r i o r to World War I, a currency shortage during crop-moving seasons had resulted i n some revisions of the e a r l i e r 1 system. In 1908 the l i m i t on the note issue was r a i s e d and i n 1913, the banks were permitted to issue an amount of t h e i r own notes equal to an amount of gold or Dominion notes deposit-ed i n a Central Gold Reserve. The major items of the money supply consisted of bank deposits by the public payable i n Canada. Deposits were created by a bank either upon receipt of cheques and monetary instruments, or when a bank made a loan by exchanging a de-posit l i a b i l i t y on i t s e l f for the debt instrument of the The l i m i t on the note issue was raised to 115 per cent of the banks' combined paid-up c a p i t a l and rest fund. To encourage quick withdrawal, the excess c i r c u l a t i o n was taxed at f i v e per cent per annum. The period of excess c i r -c u l ation was at f i r s t l i m i t e d to four months but extended to s i x i n 1912. 20 b o r r o w e r . Bank L i q u i d A s s e t s A l i m i t t o t h e d e p o s i t c r e a t i o n by e x p a n s i o n o f bank l o a n s were p r o v i d e d by the r e s e r v e management p r a c t i c e s o f the system. A l t h o u g h no l e g a l minimum r e s e r v e r e q u i r e m e n t e x i s t e d , the banks kept a c e r t a i n p r o p o r t i o n o f t h e i r d e p o s i t l i a b i l i t i e s i n the f orm o f l i q u i d f u n d s i n o r d e r t o ensure the l e g a l l y r e q u i r e d c o n v e r t i b i l i t y . I n o t h e r words, t h e banks h e l d v a r i o u s forms o f r e s e r v e s , which may be c l a s s i f i e d as c a s h r e s e r v e s , s e c o n d a r y r e s e r v e s and l i q u i d a s s e t s . Cash r e s e r v e s s h a l l be d e f i n e d as c o n s i s t i n g o f g o l d and s u b s i d i a r y 1 c o i n , Dominion n o t e s , f o r e i g n c u r r e n c i e s , n o t e s o f o t h e r b a nks, cheques on o t h e r b a n k s , b a l a n c e s due by o t h e r banks i n Canada and d e p o s i t s i n t h e C e n t r a l G o l d Reserve not h e l d 2 a g a i n s t e x c e s s c i r c u l a t i o n . Secondary r e s e r v e s s h a l l here be d e f i n e d as c o n s i s t i n g o f b a l a n c e s due by banks and b a n k i n g c o r r e s p o n d e n t s e l s e w h e r e t h a n i n Canada and c a l l and s h o r t A c c o r d i n g t o t h e Bank A c t , 40 p e r cent o f c a s h r e -s e r v e s were t o be h e l d i n the f o r m o f Dominion n o t e s . 2 The l a t t e r was i n a sense a " f r e e " d e p o s i t , i . e . an amount o f g o l d and/or Dominion n o t e s h e l d i n s a f e k e e p i n g by t h e R e s e rve f o r t h e b a n k s . 21 (30 days or less) loans elsewhere than i n Canada. In con-tras t to cash and secondary reserves, f o r which no uniform c l a s s i f i c a t i o n existed, l i q u i d assets by general consensus included the two forms of reserves mentioned above plus that part of the deposits i n the Central Gold Reserve which was held against excess note c i r c u l a t i o n , Dominion and P r o v i n c i a l Government s e c u r i t i e s , other Canadian and foreign p u b l i c se-c u r i t i e s , bonds, debentures and stocks and f i n a l l y , c a l l and short term loans i n Canada. Cash reserves and secondary reserves were substitutes because of the high degree of l i q u i d i t y of both. Part of the secondary reserves consisted of bank balances i n New York which were used to s e t t l e clearing drain to other Canadian banks. C a l l loans i n New York were, i n contrast to Canadian c a l l loans, payable on demand and, therefore, almost as l i q u i d 1 as the New York bank balances. The l a t t e r could, i f neces-sary, be converted into gold or currency which could be shipped by t r a i n to Montreal and thus replenish cash reserves See J.F. Johnson, The Canadian Banking System, Wash-ington, 1910, p. 73, and Ronald A. Shearer, The Foreign Cur-rency. Business of Canadian Banks, Canadian Journal of Econo- mics and P o l i t i c a l Science, v o l . 31, No. 3, August 1965, p. 331. 22 1 w i t h s h o r t n o t i c e s . The h i g h degree o f l i q u i d i t y was not s h a r e d by o t h e r i t e m s i n the l i q u i d a s s e t s . F or i n s t a n c e , d e p o s i t s i n the C e n t r a l G o l d Reserve up t o the amount o f e x c e s s c i r c u l a t i o n was " f r o z e n " u n t i l the note c i r c u l a t i o n was r e d u c e d . O n l y the d e p o s i t above t h i s was f r e e and c o u l d be t a k e n out a t any 2 t i m e . The i n v e s t m e n t p o r t f o l i o o f the banks c o n s i s t e d main-l y o f h i g h g r a d e , s h o r t t e r m s e c u r i t i e s , but no o r g a n i z e d bond 3 or money market e x i s t e d i n Canada a t t h a t t i m e . The i n d i v i -d u a l bank c o u l d i n normal c i r c u m s t a n c e s r e p l e n i s h i t s c a s h r e s e r v e s by s e l l i n g i t s s e c u r i t i e s i n New Y o r k o r by r e f r a i n i n g ^-Before t h e enactment o f t h e F i n a n c e A c t , t h e banks r e l i e d on r e s e r v e s h e l d i n New York f o r t h e maintenance o f a s t a b l e c a s h r e s e r v e r a t i o . V i n e r f o u n d t h a t g o l d movements i n and out o f Canada depended on the banks' r e s e r v e r e q u i r e m e n t s r a t h e r t h a n on the s t a t e o f the i n t e r n a t i o n a l b a l a n c e o f pay-ment . See J a c o b V i n e r , Canada's B a l a n c e o f I n t e r n a t i o n a l I n - d e b t e d n e s s , 1900-1913, Cambridge, H a r v a r d U n i v e r s i t y P r e s s , 1924, pp. 177-190. 2 I t i s c o n c e i v a b l e t h a t t h e banks d u r i n g the p e r i o d a l l o w e d c o u l d reduce t h e f r o z e n p a r t o f t h e d e p o s i t by t a k i n g advantage o f t h e 1908 Bank A c t amendment t o i s s u e e x c e s s n o t e s up t o 15 p e r cent o f t h e i r combined r e s t f u n d and p a i d - u p c a p i t a l . I n t h a t case t h e banks would, o f c o u r s e , have t o pay 5 p e r cent t a x on t h i s e x c e s s i s s u e . 3 . See Douglas H. F u l l e r t o n , The Bond Market xn Canada, T o r o n t o , C a r s w e l l Co. L t d . , 1962, p. 3; Investment. D e a l e r s A s s o c i a t i o n o f Canada, S u b m i s s i o n t o t h e R o y a l Commission on B a n k i n g and F i n a n c e , 1962 (see S u b m i s s i o n s , v o l . 22A, pp. A19, A 4 9 ) ; M a c M i l l a n R e p o r t , p. 33. 23 f r om r e p l a c i n g m a t u r i n g s e c u r i t i e s . The i l l i q u i d i t y o f t h e banks' i n v e s t m e n t s was due t o t h e f a c t t h a t t h e y might be 1 s o l d o n l y a t a g r e a t l o s s i f t h e New York market was d e p r e s s e d . The l a s t i t e m i n t h e l i q u i d a s s e t s , t h e c a l l and s h o r t term 2 l o a n s i n Canada, were i n p r a c t i c e not c a l l a b l e . There were s e v e r a l t y p e s o f l i a b i l i t i e s f o r which r e -s e r v e s might be h e l d , but t h e r e was no consensus about the d e s i r e d r e s e r v e s f o r each type o f l i a b i l i t y . Thus, r e s e r v e s were not s t a t e d t o a p p l y t o Can a d i a n o r t o f o r e i g n d e p o s i t 3 l i a b i l i t i e s , and no s t a t e m e n t s have been f o u n d about d e s i r e d i n d i v i d u a l r e s e r v e r a t i o s f o r each o f t h e t h r e e l i a b i l i t i e s — 4 note i s s u e , demand and ti m e d e p o s i t . Bonds were c o n s i d e r e d u n s a t i s f a c t o r y as r e s e r v e s , be-cause i n case o f need, t h e U n i t e d S t a t e s might s i m u l t a n e o u s l y be i n a f i n a n c i a l p a n i c which r e n d e r e d t h e s a l e o f Am e r i c a n bonds " v i r t u a l l y i m p o s s i b l e . T h i s c o n d i t i o n was remedied t h r o u g h t h e s t a b i l i z i n g i n f l u e n c e o f t h e Reserve System which has g i v e n g r e a t e r s e c u r i t y t o t h e bond market and made bonds more r e a d i l y s a l a b l e or s h i f t a b l e , " B.H. B e c k h a r t , The Bank- i n g System o f Canada, New Y o r k , Henry H o l t and Co., 1929, p. 433. 2 See evid e n c e , g i v e n f o r t h e M a c M i l l a n Commission about c a l l l o a n market i n Canada, i n R o y a l Commission on B a n k i n g and C u r r e n c y , P r o c e e d i n g s , 1933, pp. 2540-3. 3 M a c M i l l a n R e p o r t , p. 32. 4Some C a n a d i a n b a n k e r s e x p r e s s e d p r e f e r e n c e f o r 10-12 pe r c e n t c a s h r e s e r v e s and 40-50 p e r cent l i q u i d a s s e t s o f d e p o s i t l i a b i l i t i e s . See S e l e c t S t a n d i n g Committee on B a n k i n g and Commerce, P r o c e e d i n g s , 1923, pp. 348, 574. 24 For deposits, i t i s probable that a larger reserve r a t i o was held against demand deposit than against time de-p o s i t . The clearing house drain was much greater for demand deposits, which were estimated to have a rate of turnover 1 approximately f i f t y times t h a t v o f time deposits. In summary, before the discount f a c i l i t i e s of the Finance Act became available to the banks, there was no way of replenishing aggregate cash reserves from sources within Canada. L i q u i d i t y of banking assets was obtained by resort to foreign f i n a n c i a l centers, that i s , p r i m a r i l y New York, and to a lesser degree, London. The Finance Act: Provisions and Mechanism of Operation The introduction of the Finance Act of 1914 made a basic change to the Canadian f i n a n c i a l system. Under i t s most important provision the Department of Finance was authorized to advance Dominion notes to the banks upon the pledge of acceptable c o l l a t e r a l . While the other provisions of the Act ceased to exist at various dates, the provision regarding the re-discount feature was made a per-manent part of the f i n a n c i a l system with the 1923 r e v i s i o n of MacMillan Report, p. 31. 25 1 t h e F i n a n c e A c t . One o f t h e main a t t r a c t i o n s f o r b o r r o w i n g under t h e F i n a n c e A c t was t h e ease and speed w i t h which t h e t r a n s a c t i o n c o u l d be made. Once or t w i c e a year e a c h bank would a p p l y t o the T r e a s u r y f o r a l i n e o f c r e d i t a g a i n s t which the bank p l e d -2 ged s e c u r i t i e s approved by t h e M i n i s t e r . The s e c u r i t i e s were l o d g e d w i t h t h e R e c e i v e r G e n e r a l o f Canada and whenever a d d i -t i o n a l c a s h was needed, i t c o u l d by t e l e g r a p h i c i n s t r u c t i o n s f r o m the R e c e i v e r G e n e r a l i n Ottawa be made a v a i l a b l e i n any p r o v i n c e a t t h e o f f i c e o f t h e A s s i s t a n t R e c e i v e r G e n e r a l . The F i n a n c e A c t s o f 1914 and 1923 a r e c o n s o l i d a t e d i n t h e R e v i s e d S t a t u t e s o f Canada, Ch. 70, 1927. Advances »ere extended agatnst var ious types of se -c u r i t i e s , w hich were r e q u i r e d t o ex c e e d t h e advances by t h e margins shown- below: S e c u r i t y M a r g i n (%) Dominion T r e a s u r y b i l l s and bonds 0 , Bonds g u a r a n t e e d by (government o f Canada 10 B r i t i s h Government t r e a s u r y b i l l s and bonds 10 P r o v i n c i a l s h o r t t e r m s e c u r i t i e s 10 Oth e r s e c u r i t i e s i s s u e d by or g u a r a n t e e d by a P r o v i n c i a l Government 15 Can a d i a n m u n i c i p a l bonds 20 Ass i g n m e n t s s e c u r e d by documents c o v e r i n g g r a i n , f l o u r , c e r e a l s and f e e d 25 Exc e p t f o r Dominion T r e a s u r y b i l l s and bonds, which were v a -l u e d a t p a r , a l l t h e s e c u r i t i e s were v a l u e d a t market v a l u e s (Sec. 2 o f F i n a n c e A c t , June 30, 1923). See e v i d e n c e by Mr. J.C. Saunders, S e l e c t S t a n d i n g Committee on B a n k i n g and Com-merce, P r o c e e d i n g s 1 9 2 4 , p. 344. R e p r i n t e d i n Bank A c t Re- v i s i o n P r o c e e d i n g s , p. 470. 26 N o r m a l l y t h e Dominion n o t e s were r e q u i r e d i n M o n t r e a l , where t h e C h a r t e r e d banks' c e n t r a l c l e a r i n g f u n d was s i t u a t e d . A l l advances became due on May 1 each year but a r r a n g e -ments f o r r e n e w a l s o f o u t s t a n d i n g amounts were u s u a l l y made by each bank w i t h t h e T r e a s u r y B o a r d p r i o r t o t h i s d a t e . The B o a r d had the a u t h o r i t y t o l i m i t the amount o f advances a l -lowed each bank. T h i s a u t h o r i t y , however, appears not t o have been used; as l o n g as s a t i s f a c t o r y s e c u r i t i e s were p r o — 1 v i d e d , no l i m i t was p l a c e d on t h e b o r r o w i n g o f a bank. Time S e r i e s o f Bank A s s e t s and Advances Under the F i n a n c e A c t I n F i g u r e 1 t h e y e a r l y a v e r a g e s o f month-end borrow-i n g s under the F i n a n c e A c t have been p l o t t e d w i t h some o t h e r t i m e s e r i e s . The purpose w i t h t h e c h a r t i s t o examine the time s e r i e s o f some o f t h e a s s e t s w h i c h were i n t e r r e l a t e d w i t h b o r r o w i n g s under th e F i n a n c e A c t . The t o t a l l o a n s made by the c h a r t e r e d banks (the t o p l i n e i n F i g u r e 1) r e f l e c t economic a c t i v i t y . A n o t h e r c o n t r i -b u t i n g f a c t o r t o t h e e x p a n s i o n o f l o a n s d u r i n g W o r l d War I "^Mr. J.C. Saunders, Deputy M i n i s t e r o f F i n a n c e , de-c l a r e d , "When we get t h e s e c u r i t i e s , i f t h e y a r e good we do not have t o say t o t h e bank, "Are you good?" I f t h e y g i v e us t h e s e c u r i t i e s i t p r o t e c t s any advance we make under th e A c t . " See S e l e c t S t a n d i n g Committee on B a n k i n g and Commerce, P r o c e e d - i n g s , 1924, p . 360; r e p r i n t e d i n Bank A c t R e v i s i o n P r o c e e d i n g s , p. 454. 28 was t h e p r o c e d u r e by which t h e p u b l i c undertook t h e p u r c h a s e o f war bonds. These were o f t e n p a i d out o f d e p o s i t s or bought on an i n s t a l m e n t b a s i s , but i t was a l s o common t o get 1 l o a n s f r o m t h e banks t o buy t h e bonds. T o t a l s e c u r i t i e s (second l i n e from t h e t o p ) a l s o be-gan t o i n c r e a s e f a i r l y e a r l y i n the war. The r i s e , r e f l e c t -2 i n g war f i n a n c i n g , c o n t i n u e d w i t h i n t e r r u p t i o n s t o 1919. Whereas th e banks' p u r c h a s e s o f l o n g term p u b l i c war l o a n s were i n s i g n i f i c a n t , t h e i r p u r c h a s e s o f s h o r t term t r e a s u r y 3 b i l l s were r e l a t i v e l y l a r g e . A n o t h e r s u b s t a n t i a l p a r t o f t h e banks' s e c u r i t i e s c o n s i s t e d o f B r i t i s h t r e a s u r y b i l l s . From 1914 t o 1916 t h e banks had made l o a n s t o t h e B r i t i s h g overn— •'•J.J. Deiiits'ch ,"War F i n a n c e and the Canadian Economy 1914—20," Ca n a d i a n J o u r n a l o f Economics and P o l i t i c a l S c i e n c e , V o l . 6, 1940, p. 516. 2 An account o f war f i n a n c i n g i s g i v e n by R.C M c l v o r , who a l s o p r o v i d e s a l i s t o f some o f t h e more i m p o r t a n t works on t h i s p e r i o d . See R. C r a i g M c l v o r , C a n a d i a n Monetary, Bank- i n g and F i s c a l Development, T o r o n t o , M a c M i l l a n Co., 1958, C h a p t e r V I and pp. 254—5, 3 D u r i n g t h e y e a r s 1917, 18 and 19 ; t h e banks* y e a r l y p u r c h a s e s o f Dominion t r e a s u r y b i l l s were, r e s p e c t i v e l y , $200 m i l l i o n , $174 m i l l i o n and $245 m i l l i o n . The banks* o n l y a l l o t m e n t o f C a n a d i a n i n t e r n a l war l o a n bonds was $21 m i l l i o n o f t h e f i r s t war l o a n . T h i s a l l o t m e n t a c c o u n t e d f o r about one per c ent o f t h e t o t a l s i x war l o a n s made, 1915-1919. C A . C u r t i s , "The C a n a d i a n Banks and War F i n a n c e , " C o n t r i b u t i o n s  t o C a n a d i a n Economics, T o r o n t o , U n i v e r s i t y o f T o r o n t o p r e s s , V o l . 3, 1931, pp. 12, 20. 29 ment of $175 m i l l i o n f o r which B r i t i s h treasury notes had been given as security. Only part of t h i s had been repaid and i n 1917 the chartered banks were reluctant to acquire more B r i t i s h treasury notes which at maturity could be expec-ted to be renewed rather than paid o f f . At t h i s point the rates on Finance Act advances were reduced f o r borrowing on 1 the security of B r i t i s h treasury b i l l s , which were not f i n a l -l y repaid u n t i l 1922. From the end of World War I, there i s a noteworthy inverse r e l a t i o n s h i p between loans and s e c u r i t i e s r e f l e c t i n g the r e s i d u a l nature of bank investments. The t h i r d l i n e from the top i n Figure 1 depicts the banks* deposits to the Central Gold Reserve. Variations i n these deposits represented v a r i a t i o n s i n the banks* note issue. "It i s quite probable that the loans of the banks to B r i t a i n were not made without pressure from the Canadian govern-ment, which apparently was anxious to have the banks give a l l possible a i d to the B r i t i s h Government, and even went to the extent of reducing the rediscount rate on B r i t i s h treasury b i l l s to three and one-half per cent." Ibid., pp. 25-6. 2 The s i m i l a r i t y of the volume of the deposits with the advances during the war and immediate post—war years might indicate some d i r e c t causal r e l a t i o n s h i p between the two s e r i e s . This r e l a t i o n s h i p , however, appears less close for the following decade. Only f o r the l a t t e r decade was i t possible to examine the r e l a t i o n s h i p on an i n d i v i d u a l bank basis; for that period, no r e l a t i o n s h i p was apparent. 30 The advances under the Finance Act, as shown by the bottom l i n e on Figure 1, had two peaks occurring at the time of high lev e l s of economic a c t i v i t y . The notable increase i n advances during 1932 was due p a r t l y to the government's p o l i c y measure of increasing the money supply. Thus, the go-vernment made i t compulsory f o r the banks to buy $35 m i l l i o n Canadian treasury b i l l s which were to be discounted under the Act. The banks subsequently reduced t h e i r voluntary borrowings under the Act u n t i l the balance outstanding con-s i s t e d of the compulsory advance. The Finance Act and the Private Sector of the F i n a n c i a l System The introduction of the Finance Act influenced the banks' need f o r l i q u i d reserves and reduced th e i r dependency 1 on the New York money market f o r reserve adjustment purposes. Although the banking system's reliance on the New York money market was less under the Finance Act than previous-l y , the banks' New York c a l l loans increased during the f i r s t 15 years of the Act. Thus, the yearly average of month-end balances of c a l l and short term loans elsewhere than i n Canada was $119 m i l l i o n i n 1915 and $301 m i l l i o n i n 1929. The equi-valent figure for 1931 had decreased to $109 m i l l i o n . Major factors accounting for variations i n the banks' p o r t f o l i o of New York c a l l loans consisted of the expected changes i n ex-change rates ( i . e . differences between the spot and the f o r -ward rates) and differences between the New York c a l l loan rates and interest earnings opportunities available i n Canada to the banks. See-the forthcoming doctoral d i s s e r t a t i o n by K. Hay, Money and Cycles i n Post-Confederation Canada, unpublished Ph.D. Thesis, Brown University, 1967. 31 Moreover, the i n d i v i d u a l items of the banks* p o r t f o l i o were affected by the advances borrowed. With the re-discount f a c i l i t i e s provided under the Act, the l i q u i d i t y of the banks' cash p o s i t i o n , thus, became less e s s e n t i a l . This may be part of the reason why the banks during the period of the Finance Act gradually reduced their cash reserve-deposit r a t i o s from about 17 per cent to about 1 10 per cent. The e f f e c t on the other items of the banking system depended on the use made of the Dominion notes borrowed under the Act. More s p e c i f i c a l l y , the Notes could have been used to replenish the banks* cash reserves, thereby allowing a 2 multiple expansion of loans and deposits. AOther factors probably contributed to the decline i n the reserve r a t i o . One of these may have been economies of scale i n r e l a t i o n to size of reserves. Through a number of amalgamations, a considerable concentration took place i n the industry so that the number of banks were reduced from 30 to ten during the f i r s t t h i r d of the twentieth century. 2 The size of the m u l t i p l i e r would depend on whether the banks worked to a cash reserve r a t i o or a l i q u i d asset r a t i o . There i s no evidence that the l i q u i d asset r a t i o dur-ing the period under discussion was ever a l i m i t i n g factor to an expansion of the banks' deposits. This means that the m u l t i p l i e r could have been greater than unity. On the other hand, i t also means that the banks could replenish t h e i r cash reserves by s e l l i n g s e c u r i t i e s on the New York market and either repatriate the proceeds i n form of gold, or leave the funds as secondary reserves i n New York. Deposits could, there-fore, be expanded as long as the l i q u i d asset r a t i o provided the r e s t r a i n t . It was only a technical problem to convert cash substitutes into cash on the New York market. 32 The Dominion notes could also have been used to de-posit i n the Central Gold Reserve, thereby enabling the banks to issue an equivalent amount of t h e i r own notes. In that case the banks' outstanding note l i a b i l i t i e s could have been expanded without reducing cash reserves by the amount de-posited i n the Central Gold Reserve. F i n a l l y , the banks could have converted Dominion notes into gold to be exported. Gold was shipped abroad i n payment of d e f i c i t s either on the current account or on the long term c a p i t a l account balance of i n t e r n a t i o n a l payments. The l a t t e r occurred, f o r instance, i n 1928 when Canadians invested heavily i n the New York stock market. The gold flow was also affected by the banks* movements of short term capi-t a l . During the 1920's, f o r example, there was a f a i r l y steady increase of the Canadian banks' c a l l loan p o r t f o l i o i n New York, where the c a l l loan rates compared favourably with in t e r e s t earned on Canadian loans. Dominion Note Issue and Monetary P o l i c y In the pre-World War I monetary system, the Dominion note issue was limited by the government's gold reserves. With the enactment of the Finance Act, the Canadian system passed from the quasi—automatic rules of the gold stand-ard to the system where deliberate rules were necessary 33 to maintain a f i x e d exchange rate. At the same time, the Finance Act i t s e l f constituted a p o t e n t i a l instrument of monetary p o l i c y as the a u t h o r i t i e s could regulate both the discount rate and the volume of credit available to the banks. A f t e r Canada returned to the gold standard i n July 1926, however, a lack of conscious monetary p o l i c y i n a few years led to the end of the free redemption i n gold of Domin-ion notes. The termination of the gold b u l l i o n standard was caused by a heavy gold drain suffered by the government during 1 1928. Under the gold b u l l i o n standard, i t was the responsi-b i l i t y of the Department of Finance to convert Dominion notes into gold at the p r i c e f i x e d i n the statutes. The banks could thus obtain gold f o r export by presenting Dominion notes and at the same time replenish t h e i r cash reserves by borrowing 2 under the Finance Act. The rate charged f o r advances was not 1Between June 30, 1927 and June 30, 1929 the gold re-serves declined from $106 m i l l i o n to $59 m i l l i o n , while the r a t i o of gold to Dominion notes outstanding declined from 60 to 28 per cent. See C.Y.B. From December 31, 1927 to January 31, 1929 the reserves declined from $128 m i l l i o n to $49 m i l -l i o n . F.A. Knox, An Introduction to Money, Banking and In- ternational Finance, mimeographed text for Fellows Course i n Banking, Queen's University, n.d., p. 299. 2 . The Dominion notes issued t h i s way were not requxred to be covered by gold as was the case with notes issued under the Dominion Notes Act. 34 kept at the same l e v e l or above the short term interest rates p r e v a i l i n g i n New York. On September 1, 1928, for example, the rate charged for advances was reduced from 5 to 4-1/2 per cent, while the average monthly New York c a l l loan rates for J uly, August and September, 1928 were 6.05, 6.87 and 7.26 1 respectively. There was, i n other words, no attempts made to use 2 the discount rate as a device to reduce the gold drain. Neither was any attempt made before November 1932 to use monetary p o l i c y for s t a b i l i z a t i o n purposes. When the Deputy Minister of Finance i n 1924 was asked i f the intere s t rate could be used as an instrument of monetary p o l i c y he de-clared that i t had never been considered and that he d i d not 3 think i t would have any r e l a t i o n to that matter at a l l . S i m i l a r l y , there i s no evidence that the l i n e s of credit made ^Hence, the banks could p r o f i t by borrowing funds un-der the Act to lend out i n New York. It should be pointed out that the Finance Act was not the only factor causing the gold drain; that i s , $40 m i l -l i o n of the gold reserves were used to pay o f f c e r t a i n Cana-dian government obligations which became due i n New York during 1928. See M.W. Stokes, The Bank of Canada, Toronto, Hunter-Rose Co., 1939, p. 24. 3 Select Standing Committee on Banking and Commerce, Proceedings, 1924, p. 348; reprinted i n Bank Act Revision Pro- ceedings , p. 455. 35 available to the banks were ever r e s t r i c t e d for p o l i c y pur-poses. In short, although the Finance Act could have pro-vided the authorities with an e f f e c t i v e p o l i c y instrument, there i s no evidence before 1932 that the Act, with any e f -f e c t , was used as such. For the purpose of t h i s t h e s i s , the Finance Act w i l l , therefore, not be considered as a p o l i c y instrument. Summary The Canadian f i n a n c i a l system was discussed i n t h i s chapter and i t was pointed out that the introduction of the Finance Act made a basic change both to the c a p i t a l market and to the monetary system. B r i e f l y , the advances under the Finance Act were aimed at giving ultimate borrowers, such as farmers, businessmen and i n d u s t r i a l i s t s , command over a d d i t i o n a l resources for temporary periods. The objective of the Act was achieved by increasing the f i d u c i a r y issue of Dominion notes and lending these to the banks. The domestic as well as the i n t e r n a t i o n a l c a p i t a l mar-kets were, therefore, affected by the Finance Act. This was due to the circumstance that the banks could use their f i n a n -c i a l assets as c o l l a t e r a l for loans rather than s e l l i n g them 36 on the markets. The monetary system was fundamentally changed by the Finance Act. The semi-automatic rules of the gold standard ceased to apply when the banks, at their own d i s c r e t i o n , could obtain Dominion notes not covered by gold. To maintain the gold value of the Canadian d o l l a r , i t would have been ne-cessary to conduct a deliberate monetary p o l i c y . This was not done although the Finance Act i t s e l f would have provided an e f f e c t i v e p o l i c y instrument. CHAPTER III THEORETICAL ANALYSIS OF SIR THOMAS' HYPOTHESIS Purpose and Structure of Chapter The purpose of t h i s chapter i s to examine and c l a r i -fy the hypothesis set out i n Chapter I, and to check the hypothesis for l o g i c a l consistency. In the case of S i r Thomas' hypothesis, i t i s possible by t h e o r e t i c a l means alone to prove that his hypothesis i n i t s o r i g i n a l form i s l o g i c a l l y inconsistent. It w i l l , there-fore, be re—formulated and the l o g i c a l consequences of the revised hypothesis w i l l be deduced. In the following chapters, the implications of the revised hypothesis w i l l be compared with empirical data and a conclusion w i l l be drawn. The analysis of the hypothesis w i l l begin i n t h i s chapter by interpreting the terms of the hypothesis on the background of economic t h e o r e t i c a l developments during the 1920's and 30's. Interpretation of the Terms of the Hypothesis S i r Thomas postulated that the banks borrowed only 37 38 when i t was "necessary," that i s when a "need" for borrowing existed. He also made the assumptions that the banks would repay their borrowings to avoid incurring the interest cost of borrowing and to avoid being heavily indebted to the 1 Treasury. To explain the banks' borrowing behavior, S i r Thomas thus selected three explanatory variables - need, cost and reluctance. In abstracting these three elements as the cru-c i a l f a c t o r s , S i r Thomas appears to have been influenced by some contemporary but rather imperfectly formed economic theories about re—discounting developed by American economists. To interpret the meaning of S i r Thomas* hypothesis, i t may, therefore, be h e l p f u l b r i e f l y to consider the h i s t o -r i c a l development of American hypotheses about re-discounting. The reason being, of course, that the f a c i l i t i e s of the F i n -ance Act operated f o r Canadian banks i n a similar manner as the re-discount f a c i l i t i e s of the Federal Reserve System d i d fo r American banks. •'•Sir Thomas did not say that the banks would repay t h e i r loans when they became unnecessary f o r the operation of the banks. The repayment was assumed to be a function of cost and reluctance. This l i n e of reasoning w i l l be devel-oped i n a later part of the chapter. 39 E v o l u t i o n o f T h e o r i e s about D i s c o u n t i n g The s e a r c h f o r d e t e r m i n a n t s o f r e - d i s c o u n t i n g had become an i m p o r t a n t t h e o r e t i c a l i s s u e i n the U n i t e d S t a t e s d u r i n g t h e 1920*s, where a c o n t r o v e r s y had d e v e l o p e d whether the banks r e - d i s c o u n t e d f r o m n e c e s s i t y o r t o i n c r e a s e t h e i r p r o f i t . One o f the e a r l i e s t t h e o r i e s was t h e p r o f i t t h e o r y , a c c o r d i n g t o which the banks were assumed t o borrow from t h e F e d e r a l Reserve banks when t h e y c o u l d f i n d o u t l e t s f o r a d -d i t i o n a l funds a t h i g h e r net e a r n i n g s t h a n t h e i n t e r e s t r a t e c h a r g e d on b o r r o w i n g s . S i n c e the e a r n i n g s , net o f expenses, on l o a n s and i n v e s t m e n t s were o f t e n i n e x c e s s o f the d i s c o u n t r a t e , the banks c o u l d , under t h e r e q u i r e m e n t s o f p r o f i t maxi-m i z a t i o n , be e x p e c t e d t o i n c r e a s e t h e i r b o r r o w i n g s u n t i l the m a r g i n a l net revenue on e a r n i n g a s s e t s were e q u a l t o t h e f i x e d r a t e o f b o r r o w i n g . I n a s t u d y d e a l i n g w i t h t h e f i r s t decade o f the o p e r a -t i o n o f the F e d e r a l R e s erve System, G o l d e n w e i s e r e x p l o r e d the 1 r e l a t i o n o f d i s c o u n t r a t e s t o member banks e a r n i n g s . He arg u e d t h a t f u n d s were borrowed, not t o e a r n p r o f i t on the open markets o r on customer l o a n s , but i n o r d e r t o en a b l e the •'•E.A. G o l d e n w e i s e r , F e d e r a l R e s erve System i n Opera-t i o n , New Y o r k , M c G r a w - H i l l , 1925. 40 1 banks to meet demand f o r loans by business and industry. Goldenweiser gave two main reasons for t h i s . F i r s t , accord-ing to American banking t r a d i t i o n , heavy borrowing by a bank, except i n emergencies, r e f l e c t e d unfavourably on i t s stand-ing; second, the spread between the discount rates and cus-tomer rates were usually found too narrow to more than cover the expenses of a loan. S i m i l a r l y , the margin between discount rates and open market rates was said to be i n s u f f i c i e n t to make i t p r o f i t a b l e to invest borrowed funds i n the open market. Goldenweiser rejected the p r o f i t motive because the banks d i d not increase the volume of re—discounting whenever the spread between the re—discount rate and bank lending rates 2 widened. In an i n f l u e n t i a l and widely quoted book, the f i r s t e d i t i o n of which appeared two years aft e r Goldenweiser*s, This argument may be interpreted to mean that the banks were more concerned with t h e i r long run business r e l a -tionships than with short run d i r e c t gains from re-lending borrowed funds. In other words, the bank would not borrow i n order to take advantage of p r o f i t a b l e opportunities on the open market but would borrow from the Federal Reserve System i n order to meet a demand for loans. The l a t t e r they presumably regarded as th e i r primary function. 2 "The volume of borrowing at the reserve banks i s thus not immediately and d i r e c t l y responsive to changes i n the d i s -count rate as i t would be i f member banks were i n the habit of borrowing as much as they could lend at a rate higher than the discount rate." Ibid., pp. 48-9. Burgess l i s t e d f i v e r e s t r a i n t s tending to prevent e x c e s s i v e use of borrosed f u n d s . These r e s t r a i n t s were: (1) T r a d i t i o n a g a i n s t borrowing, (2) Discount r a t e , (3) Open market opera-t i o n s , (4) D i r e c t d e a l i n g w i t h i n d i v i d u a l banks and (5) Pub-1 l i c i t y . The t r a d i t i o n a g a i n s t borrowing went back t o the pre« Reserve System under which a bank came under s u s p i c i o n i f i t borrowed other than t e m p o r a r i l y from i t s correspondents. The t r a d i t i o n of borrowing only i n case of emergency and d u r i n g seasonal s t r a i n on resources was encouraged by the Reserve banks . The d i s c o u n t r a t e s charged by the Reserve banks had u s u a l l y been c o n f i n e d to a f a i r l y narrow band bordered by the open market commercial paper r a t e and the ninety-day bankers* acceptance r a t e . To Burgess, a change i n the d i s c o u n t r a t e was p r i m a r i l y s i g n i f i c a n t as an i n d i c a t o r of planned F e d e r a l Reserve p o l i c y . As an i n c r e a s e or decrease i n p r i c e of accom-modation at a Reserve bank, an a l t e r a t i o n i n the d i s c o u n t r a t e was found to be of l i t t l e economic s i g n i f i c a n c e . As long as the d i s c o u n t r a t e moved w i t h i n i t s customary ribbon and as 1 W. Randolph Burgess, The Reserve Banks and the Money  Market, (Rev. e d . ) , New York, Harper, 1946. 42 long as the t r a d i t i o n against continuous borrowing existed, member banks, according to Burgess, would borrow only to meet seasonal and unusual needs of ag r i c u l t u r e , production and trade. With respect to open market operations, Burgess rather vaguely suggested that t h e i r usefulness as a p o l i c y instrument lay i n t h e i r e f f e c t on the indebtedness of member banks. He assumed that open market operations were large l y offset by changes i n member bank borrowings without d i r e c t l y a f f e c t i n g the money supply. However, as open market operations were not used as a p o l i c y instrument i n Canada, Burgess' discussion of t h i s factor i s not d i r e c t l y relevant to the theme of the paper and w i l l , therefore, not be further pursued. The r e s t r a i n t of moral suasion could be used by the Reserve banks i n t h e i r d i r e c t dealing with i n d i v i d u a l banks. A cert a i n measure of d i s c r e t i o n i n the granting of credit was also provided by the Federal Reserve Act to guard against abuse by the banks of th e i r borrowing p r i v i l e g e s . The p u b l i c a t i o n of economic information by the Reserve System was regarded by Burgess as an influence toward fi n a n -c i a l s t a b i l i t y . For example, the publ i c a t i o n of the views of the Federal Reserve Board toward security speculation i n 1929 affected the demand for bank accommodation f o r speculative 43 purposes. In s h o r t , Burgess' o p i n i o n was that the banks b o r -rowed mainly to r e p l e n i s h cash r e s e r v e s when found d e f i c i e n t 1 a f t e r completion of a day's o p e r a t i o n s . The a v e r s i o n o f the banks to being i n debt r a t h e r than the c o s t was c o n s i d e r e d the main f a c t o r l i m i t i n g the s i z e and d u r a t i o n o f borrowing. R i e f l e r , whose book was p u b l i s h e d i n 1930, developed h i s concepts with g r e a t e r c l a r i t y and p r e c i s i o n than had been done by h i s p r e d e c e s s o r s . In h i s study he examined the r e -l a t i o n s h i p between open market r a t e s and d iscount r a t e s . I f the banks borrowed f o r p r o f i t , he reasoned, the two i n t e r e s t r a t e s c o u l d be expected to f o l l o w each other c l o s e l y with o n l y minor d e v i a t i o n s as member banks otherwise would act to c l o s e the gap. For example, i f sho r t term market r a t e s were above the d i s c o u n t r a t e , banks with e l i g i b l e papers would d i s -count them i n order to l e n d the proceed on the open market. I f the d i s c o u n t r a t e was the higher of the two, banks with funds i n the short term market would withdraw them to repay 2 t h e i r indebtedness at the F e d e r a l Reserve Banks. E i t h e r I b i d . , p. 180. 2W.W. R i e f l e r , Money Rates and Money Markets i n the  U n i t e d S t a t e s , New York, Harper and Bros., 1930, pp. 20-21. 44 a c t i o n s h o u l d h o l d t h e m a r k e t r a t e s c l o s e t o t h e d i s c o u n t r a t e . O b s e r v i n g t h e a c t u a l d i v e r g e n c y b e t w e e n t h e t w o r a t e s , R i e f l e r c o n c l u d e d t h a t b a n k s d i d n o t b o r r o w f o r p r o f i t a n d d i d n o t p a y o f f t h e i r i n d e b t e d n e s s a s s o o n a s t h e d i s c o u n t r o s e a b o v e t h e s h o r t t e r m o p e n m a r k e t r a t e . I n s t e a d , he f o u n d t h a t b a n k s g e n e r a l l y w e r e r e l u c t a n t t o b o r r o w b u t t h a t t h e y d i d i t " i n o r d e r t o meet a p r e s s i n g n e e d f o r q u i c k l y a v a i l a b l e f u n d s s u c h a s a r i s e s o u t o f u n e x p e c t e d d e f i c i t s i n 1 t h e i r r e s e r v e s . " A c c o r d i n g t o R i e f l e r , b a n k s w o u l d r e p a y t h e i r b o r r o w i n g s a s s o o n a s t h e y c o u l d a d j u s t t h e i r l o a n s a n d i n v e s t m e n t s t o t h e i r own r e s o u r c e s . He r e c o g n i z e d , h o w -e v e r , t h a t t h e l e v e l o f t h e d i s c o u n t r a t e w o u l d h a v e a m i n o r e f f e c t o n t h e v o l u m e o f b o r r o w i n g a s t h e s p e e d o f t h e a d j u s t -m e n t s b y t h e b a n k s w o u l d be a f f e c t e d b y t h e c o s t o f b o r r o w i n g v e r s u s t h e s h o r t t e r m o p e n m a r k e t r a t e . H e n c e , i f c a l l r a t e s w e r e b e l o w t h e d i s c o u n t r a t e , b a n k s w o u l d a d j u s t t h e i r r e -s e r v e s b y c a l l i n g i n l o a n s i m m e d i a t e l y . I n t h e o p p o s i t e c a s e t h e y m i g h t d e l a y t h e a d j u s t m e n t f o r a f e w d a y s . R i e f l e r d i v i d e d t h e n e e d f o r b o r r o w i n g i n t o two c a t e -g o r i e s : t h e n e c e s s i t y f o r r e p l e n i s h i n g t e m p o r a r y d e f i c i t s i n r e s e r v e s , a s d i s c u s s e d a b o v e , a n d t h e n e c e s s i t y t o b o r r o w t o I b i d . , p . 3 2 . 45 meet a heavy s e a s o n a l demand f o r b a n k i n g accommodation. A c -c o r d i n g t o R i e f l e r , t h e i n c e n t i v e f o r b o r r o w i n g i n the l a t t e r case a r o s e f rom th e c r e d i t need o f bank c u s t o m e r s , who would be d e p r i v e d o f accommodation i n the absence o f the d i s c o u n t i n g 1 f a c i l i t i e s . I t i s n o t e w o r t h y t h a t t h e t h r e e s t u d i e s a l l a r r i v e d a t t h e c o n c l u s i o n t h a t the r e l u c t a n c e t o be i n debt was the main f a c t o r r e s p o n s i b l e f o r e a r l y repayment, and t h a t the c o s t o f b o r r o w i n g , t h e r a t e o f d i s c o u n t , o n l y p l a y e d a minor r o l e i n a f f e c t i n g t h e amount o f b o r r o w i n g s . Not i m p l i c i t l y s t a t e d was t h e i m p l i c a t i o n t h a t t h e banks r e g a r d e d t h e i r unused l i n e o f c r e d i t w i t h the F e d e r a l Reserve System as a l i q u i d a s s e t . T h i s l i q u i d a s s e t , which was a v a i l a b l e f o r m e e t i n g unexpected demands, was i n f a c t a s u b s t i t u t e f o r cash and s econdary r e -s e r v e s h e l d by t h e b anks. U n l i k e t h e a s s e t s h e l d as r e s e r v e s , ^The i m p l i c a t i o n o f R i e f l e r ' s t h e o r y was t h a t open mar-k e t o p e r a t i o n s i which a f f e c t e d t h e banks' i n d e b t e d n e s s t o the R e s e r v e System, were a more s i g n i f i c a n t f a c t o r i n c o n t r o l l i n g the banks' b e h a v i o r t h a n was the d i s c o u n t r a t e . Member banks would borrow when open market o p e r a t i o n s r e d u c e d t h e i r r e s e r v e s and r e p a y b o r r o w i n g s when the F e d e r a l R e s e rve System, i n c r e a s e d r e s e r v e s . "Member banks do not borrow i n o r d e r t o i n c r e a s e t h e i r l o a n s , but r a t h e r endeavour t o c o n t r a c t t h e i r l o a n s i n o r d e r t o r e p a y t h e i r i n d e b t e d n e s s . " ( I b i d . , p. 2 6 ) . T h e r e -f o r e , an i n c r e a s e i n the banks* i n d e b t e d n e s s would be r e f l e c t e d i n a r i s e o f the i n t e r e s t on the c r e d i t markets r e s u l t i n g f r o m t h e c o n t r a c t i o n o f banks' l e n d i n g a c t i v i t y . 46 however, the unused l i n e of credit with the Federal Reserve System did not cost the banks anything. On the other hand, the d i s u t i l i t y of drawing on the l i n e of credi t involved not only the cost of the discount rate but the aversion of being indebted to the Federal Reserve System. The three studies also a r r i v e d at the conclusion that the banks borrowed because of need but i n none of the studies was an attempt made to evaluate the need factor i n monetary terms. In one of the subsequent important studies, Robert C. Turner i n 1938 reduced the need factor to a minor role by suggesting that banks made th e i r cash reserve adjustment either by discounting or by open market transactions depending on the 1 r e l a t i v e c o stliness of the two a l t e r n a t i v e s . Turner tested t h i s theory by c o r r e l a t i n g aggregate borrowings with the spread between the discount rate and va-rious market rates. His conclusion i s summed up by Meigs i n the form of the equation 2 RB = f <* KU» RB> rm ~ rd) •^Robert C. Turner, Member-Bank Borrowing, Columbus Ohio State University, 1938. A. James Meigs, Free Reserves and the Money Supply, Chicago, University of Chicago Press, 1962, p. 21. 47 which means t h a t a change i n borrowed r e s e r v e s ( R g) i s a f u n c t i o n o f the change i n unborrowed r e s e r v e s ( R y ) , the l e v e l o f b o r r o w i n g s ( R B ) , and the s p r e a d between the market r a t e and the d i s c o u n t r a t e . The l e v e l o f b o r r o w i n g s f u n c t i o n s as a r e s t r a i n t as b o r r o w i n g s i n c r e a s e . T u r n e r b e l i e v e d t h a t banks were u n w i l l i n g t o i n c r e a s e t h e i r b o r r o w i n g s above a c e r t a i n l i m i t which depended on v a r i o u s f a c t o r s such as the s i z e o f t h e bank, t r a d i t i o n a g a i n s t b o r r o w i n g , custom, p e r — 1 s o n a l a t t i t u d e s and the need f o r b o r r o w i n g . T u r n e r ' s c o n c l u s i o n thus d i f f e r e d f r om t h o s e o f h i s p r e d e c e s s o r s by s t r e s s i n g t h e l e a s t - c o s t s p r e a d r a t h e r t h a n t h e need as an e s s e n t i a l e x p l a n a t o r y v a r i a b l e . By s u b s t i t u t -i n g the l e a s t c o s t s p r e a d f o r t h e need he, i n a sen s e , p r i c e d the v a l u e o f need as the s p r e a d between the two r a t e s . T h i s p r o c e d u r e may be used i n e s t i m a t i n g t h e economic wort h o f the need f a c t o r . E v a l u a t i o n o f Need i n Monetary Terms S i r Thomas would presumably have a g r e e d w i t h R i e f l e r t h a t need f o r b o r r o w i n g c o u l d be c a t e g o r i z e d i n (1) the ne-c e s s i t y o f temporary b o r r o w i n g f o r d a i l y cash a d j u s t m e n t s , Need was d e f i n e d as a r i s i n g f r o m customer demand f o r bank accommodation or from t h e need t o m a i n t a i n secondary r e s e r v e s ; T u r n e r , p. 156. 48 and (2) b o r r o w i n g i n o r d e r t o meet a heavy, o f t e n s e a s o n a l , demand f o r b a n k i n g accommodation. As l o n g as a d e p o s i t e x p a n s i o n was not r e s t r a i n e d by the l i q u i d a s s e t r a t i o , d i s c o u n t i n g i n b o t h o f t h e two cases was r e a l l y o n l y the a l t e r n a t i v e t o t h e p u r e l y t e c h n i c a l m atter o f c o n v e r t i n g non—monetary a s s e t s i n t o c a s h . The v a l u e o f b o r r o w i n g f o r b o t h t y p e s o f need was con-s e q u e n t l y e q u a l t o t h e c o n v e r s i o n c o s t and the r a t e o f e a r n i n g s on t h e a s s e t s which would a l t e r n a t i v e l y have t o be c o n v e r t e d . The p r o p o r t i o n o f t h e two t y p e s o f c o s t , however, v a r i e d a c -c o r d i n g t o the d u r a t i o n o f the need. Thus, t h e c o s t o f r e -p l e n i s h i n g a temporary, p e r h a p s s e l f - r e v e r s i n g , cash d e f i c i e n c y c o n s i s t e d m a i n l y o f c o n v e r s i o n e x p e n s e s , w h i l e the c o s t o f l o n g t e r m b o r r o w i n g approached t h e o p p o r t u n i t y e a r n i n g s on the r e -l e v a n t a s s e t s . On t h e b a s i s o f t h i s r e a s o n i n g i t would seem u s e f u l t o s i m p l i f y the problem by p o s t u l a t i n g t h a t t h e v a l u e o f the need f o r d a i l y c a s h adjustment was e q u a l t o the c o s t i n terms o f i n c o n v e n i e n c e and a c t u a l expenses o f c o n v e r t i n g New York c a l l l o a n s i n t o c a s h r e s e r v e s p l u s t h e c o s t o f the subsequent r e v e r s a l o f c a s h i n t o e a r n i n g a s s e t s . I n a s i m p l i f i c a t i o n o f r e a l i t y , t he v a l u e o f need f o r medium and l o n g term b o r r o w i n g may be assumed t o be e q u a l t o t h e New York c a l l l o a n r a t e . 49 Assuming the conversion cost always to be greater than the cost involved i n discounting, temporary borrowing may be assumed to be a function of cash drains (or bank clearings) and the size of cash reserves. Borrowings other than for tem-porary cash adjustments may be assumed to depend p a r t l y on the difference between the discount rate and the New York c a l l loan rate, and p a r t l y on the reluctance f a c t o r . Accepting the proposition that need has an economic value d i r e c t l y comparable to the cost of discounting, i t now becomes necessary to re-examine S i r Thomas* hypothesis. Two reasons were suggested by S i r Thomas as being r e s t r a i n i n g i n -fluences on borrowing — to avoid paying interest longer than necessary and to avoid being heavily indebted to the Treasury. However, the interest cost on advances under the Finance Act was simply the cost of that means of adjustment. Other means of adjustment also had t h e i r costs. In t h i s sense, some costs were unavoidable and rather than reacting only towards the cost of borrowing under the Finance Act, r a t i o n a l beha-vior would lead the banks to compare alt e r n a t i v e costs and select the cheapest way of adjustment. It appears, therefore, that the hypothesis may be either rejected as meaningless or reformulated to be consistent with r a t i o n a l behavior. Of these two a l t e r n a t i v e s , the l a t t e r w i l l be chosen. 50 I n a new f o r m u l a t i o n o f S i r Thomas' h y p o t h e s i s ( h e r e -a f t e r c a l l e d t h e r e v i s e d h y p o t h e s i s ) the banks' r e a s o n f o r u s i n g the f a c i l i t i e s s p a r i n g l y must be changed from " t h e y do not d e s i r e t o c o n t i n u e t o pay i n t e r e s t any l o n g e r t h a n ne-c e s s a r y " t o : t h e y w i l l p r e f e r t h e l e a s t - c o s t means o f r e -p l e n i s h i n g c a s h r e s e r v e s . The p o s t u l a t e about the banks* r e l u c t a n c e t o borrow s t i l l a p p l i e s , t h a t i s , "they do not c a r e t o i n c u r o r t o show i n t h e i r r e t u r n s heavy i n d e b t e d n e s s i n r e s p e c t o f advances 1 under the A c t . " The c e n t r a l p o s t u l a t e s o f t h e r e f o r m u l a t e d h y p o t h e s i s may be summed up as f o l l o w s . Any b o r r o w i n g depended on two c r u c i a l f a c t o r s . One o f t h e s e was the c o s t o f a l t e r n a t i v e means o f o b t a i n i n g f u n d s . The o t h e r f a c t o r was t h e banks* a v e r s i o n t o b e i n g h e a v i l y i n d e b t e d t o t h e T r e a s u r y . These, t h e n , a r e t h e p o s t u l a t e s which a r e t o be t e s t e d by the e m p i r i -c a l e v i d e n c e . F o r m u l a t i o n o f an E m p i r i c a l T e s t The p r o b l e m i n t e s t i n g the r e v i s e d h y p o t h e s i s a r i s e s f r om d e t e r m i n i n g t h e r e l a t i v e i m p o r t a n c e o f the r e l u c t a n c e I f t h e c o s t o f b o r r o w i n g on t h e open market was e q u a l t o t h e c o s t o f advances, the bank would, hence, p r e f e r t o use t h e open market adjustment mechanism. 51 a g a i n s t b o r r o w i n g and the l e a s t - c o s t c o n s i d e r a t i o n . One d i f -f i c u l t y i s t h a t a t "heavy i n d e b t e d n e s s , " t o use S i r Thomas' p h r a s e , the r e s t r a i n t a g a i n s t b o r r o w i n g i n c r e a s e s . The r e -l a t i v e s t r e n g t h o f the two d e t e r m i n a n t s o f b o r r o w i n g , t h e r e -f o r e , changes w i t h the l e v e l o f b o r r o w i n g . I n o r d e r t o i n t e -g r a t e t h e l e a s t — c o s t and t h e r e l u c t a n c e p o s t u l a t e s i n t o one t h e o r y and d e r i v e some o b j e c t i v e c r i t e r i a f o r e m p i r i c a l t e s t -i n g , t h e p r o b l e m w i l l be a n a l y s e d by the use o f i n d i f f e r e n c e 1 c u r v e s and u t i l i t y f u n c t i o n s . I n t h e f o l l o w i n g a n a l y s i s a b a n k e r ' s a v e r s i o n t o be i n d e b t e d i s e x p r e s s e d i n d i s u t i l i t y w h i l e t h e s a v i n g from b o r r o w i n g s i s assumed t o g i v e r i s e t o u t i l i t y . The r a t e o f s a v i n g by b o r r o w i n g , a l s o c a l l e d the l e a s t - c o s t s p r e a d , i s assumed t o be e q u a l t o t h e d i f f e r e n c e between the r a t e charged on advances ( r ^ ) and the New York c a l l l o a n r a t e ( r ^ ) . F o r the p e r i o d under s t u d y , the l a t t e r r a t e may be assumed t o be a s u i t a b l e i n d i c a t o r o f a l t e r n a t i v e c o s t o f b o r r o w i n g . A c c o r d i n g t o the r e v i s e d h y p o t h e s i s , the m a r g i n a l d i s u t i l i t y o f i n c u r r i n g a d d i t i o n a l debt w i l l a f t e r a p o i n t i n c r e a s e more r a p i d l y t h a n the m a r g i n a l u t i l i t y o f the s a v i n g s f r om s u c h b o r r o w i n g . T h i s i s t h e p o i n t where t h e a n a l y s i s The a n a l y s i s i s p a r t l y based on Murray E. P o l a k o f f , " R e l u c t a n c e E l a s t i c i t y , L e a s t Cost and Member-Bank B o r r o w i n g : A Suggested I n t e g r a t i o n , 1 * J o u r n a l o f F i n a n c e , V o l . XV, No. 1, March 1960, pp. 1-18. 52 s t a r t s . The analysis may therefore not include some of the banks' short term borrowing at r e l a t i v e l y low borrowing levels as l i t t l e or no d i s u t i l i t y may be involved i n that range. In Figure 2 the horizontal axis represents the volume of an i n d i v i d u a l bank's borrowing (R B) , and the v e r t i c a l , the t o t a l saving derived from borrowing ( r ^ — r^) . R B . The slopes of l i n e s s^, S 2 , s^ and s^ represent suc-cessively greater interest rate d i f f e r e n t i a l s ; the steeper the slope, the greater i s the least—cost spread. Aj^ A t Borrowed Reserves Figure 2. Expansion Path f o r Borrowing by One Bank The slopes of the indifference curves, i j , i-2* ^3 —MD and i ^ are equal to B/MUg where MDB i s the marginal d i s -53 u t i l i t y o f b o r r o w i n g and MUg i s the m a r g i n a l u t i l i t y o f s a v i n g s . The i n d i f f e r e n c e c u r v e s may have many d i f f e r e n t shapes but have the u s u a l c h a r a c t e r i s t i c s o f b e i n g non-i n t e r s e c t i n g and c o n t i n u o u s , and a l l a r e p o s i t i v e l y s l o p e d and c u r v i n g upward. The p o s i t i v e s l o p e i n d i c a t e s t h a t the d i s u t i l i t y o f b o r r o w i n g i s i n c r e a s i n g more r a p i d l y t h a n the u t i l -i t y o f s a v i n g f r o m t h e a d d i t i o n a l b o r r o w i n g , and t h e upward cur v e i n d i c a t e s t h a t the m a r g i n a l d i s u t i l i t y i n c r e a s e s as the i n d e b t e d n e s s becomes h e a v i e r . If. s ^ i s assumed t o r e p r e s e n t the l e a s t — c o s t s p r e a d , t h e bank w i l l borrow and save S^. M a x i m i z a t i o n o f u t i l i t y w i l l be a t p o i n t X^ where the r a t i o between the mar-g i n a l u t i l i t y o f s a v i n g and t h e m a r g i n a l d i s u t i l i t y o f b o r -r o w i n g ( - M DB/MUs) i s e q u a l t o t h e net r a t e o f s a v i n g on borrowed funds ( S j or S l / A 1 ) . I f t h e s p r e a d i n c r e a s e s t o s 2» s 3 or S4 t h e b o r r o w i n g s w i l l i n c r e a s e a l o n g the e x p a n s i o n p a t h . I t i s , however, c l e a r from t h e f i g u r e t h a t even i f the s p r e a d s h o u l d i n c r e a s e beyond s 4 , no a d d i t i o n a l b o r r o w i n g s w i l l be made. Above X4 the e x p a n s i o n p a t h i s v e r t i c a l as any amount o f advances above A4 r e p r e s e n t s t h e t o o "heavy i n -d e b t e d n e s s " which the banks, a c c o r d i n g t o S i r Thomas, were not 5 4 w i l l i n g t o i n c u r . I f the i n d i f f e r e n c e c u r v e s o f the i n d i v i d u a l C a n a d i a n banks had the s u g g e s t e d shape, t h e r e s u l t i n g a ggregate ex-p a n s i o n p a t h may be supposed t o l o o k as the l i n e A i n F i g u r e 3. Rate o f S a v i n g ( r b ~ rd> F i g u r e 3. Aggregate R e s e r v e s Borrowed P o s s i b l e E x p a n s i o n P a t h s o f B o r r o w i n g by B a n k i n g System I n F i g u r e 3 t h e r e s e r v e s borrowed a r e shown as a f u n c t i o n o f the l e a s t - c o s t s p r e a d . Of the t h r e e p o s s i b l e p a t h s shown, l i n e A has the same shape as the i n d i v i d u a l X I n h i s a n a l y s i s o f U.S. a g g r e g a t e bank b e h a v i o r , Po-l a k o f f s u g g e s t s t h a t t h e e x p a n s i o n p a t h might bend backwards i n s t e a d o f r i s i n g v e r t i c a l l y . H i s h y p o t h e s i s r e f l e c t s the U.S. banks' a v e r s i o n f o r s t a y i n g i n debt f o r more t h a n a tem-p o r a r y p e r i o d . 55 bank's e x p a n s i o n p a t h . I f , t h e r e f o r e , an aggregate f u n c t i o n a l r e l a t i o n s h i p as shown by l i n e A was f o u n d by e m p i r i c a l i n v e s -t i g a t i o n i t would c o n f i r m the c o n c l u s i o n assumed f r o m the m i c r o a n a l y s i s o f F i g u r e 2. I f , on t h e o t h e r hand, a r e l a -t i o n s h i p as shown by l i n e B o r C was f o u n d , the a s s u m p t i o n o f F i g u r e 2 might have t o be r e j e c t e d . An a g g r e g a t e e x p a n s i o n p a t h l i k e l i n e B or C might i n d i c a t e e i t h e r t h a t a v e r s i o n a g a i n s t b o r r o w i n g was i n s i g n i f i c a n t or t h a t i t became weaker r e l a t i v e t o s a v i n g s as t h e l e a s t - c o s t s p r e a d and volume o f 1 b o r r o w i n g s i n c r e a s e d . I f the r e l a t i o n s h i p s h o u l d be f o u n d t o be l i k e B or C, the c o n c l u s i o n f r o m F i g u r e 2 may have t o be r e j e c t e d . On th e o t h e r hand, t h a t would not n e c e s s a r i l y be the case as d i f -f e r e n c e s i n t h e s l o p e s o f i n d i v i d u a l bank's i n d i f f e r e n c e c u r v e s would l e a d t o d i f f e r e n t b o r r o w i n g b e h a v i o r , and by a g g r e g a t i n g d i f f e r e n t shaped e x p a n s i o n p a t h s , any shape o f t h e a g g r e g a t e p a t h c o u l d be p l a u s i b l e . The l a t t e r v i e w , c o n t r a r y t o t h a t o f S i r Thomas, has r e c e n t l y been e x p r e s s e d by Mr. C.E. Walker from D a l l a s R e s e rve Bank. " E x p e r i e n c e has demonstrated t h a t t h e r e l u c t a n c e i n g e n e r a l tends t o grow weaker as the p r o f i t s p r e a d between mar-k e t r a t e s . . . and the d i s c o u n t r a t e widens." See C h a r l e s E. W a l k e r , " D i s c o u n t P o l i c y i n t h e L i g h t o f Recent E x p e r i e n c e , " J o u r n a l o f F i n a n c e , v o l . I I , No. 2, May 1957, p. 230. 5 6 It therefore appears that both the aggregate expansion path and the i n d i v i d u a l bank's paths may have to be analysed. Conclusion Except for the reformulation of the necessity postu-l a t e , S i r Thomas' own words have been preserved i n the follow-ing r e v i s i o n , which brings together a l l the elements of the hypothesis. They (the chartered banks) have always been sparing i n t h e i r resort to i t s (the Finance Act's) p r i v i l e g e s and pay o f f t h e i r advances quickly. There i s a twofold reason for t h i s p o l i c y : f i r s t l y , because they prefer the least—cost means of replenishing cash r e -serves and, secondly, because they do not care to incur or to show i n th e i r returns heavy indebtedness i n respect of advances under the Act. The t h e o r e t i c a l analysis of the hypothesis, which was the subject of t h i s chapter, proceeded by revealing the im-p l i c i t assumptions and the inconsistency of the o r i g i n a l hypothesis. Corrected f o r the l a t t e r deficiency, the i m p l i -cations of the re-formulated hypothesis were deduced and objective c r i t e r i a were developed to v e r i f y the v a l i d i t y of the hypothesis. The next stage - the empirical te s t i n g -w i l l be undertaken i n the next chapters. CHAPTER IV EMPIRICAL TESTING OF THE HYPOTHESIS The purpose of t h i s chapter i s to provide some quan-t i t a t i v e evidence r e l a t i n g to the revised hypothesis formu-lated i n Chapter I I I . The empirical analysis w i l l be confined to what may be c a l l e d the period of "extensive voluntary borrowing" under the Finance Act. Extensive use may be said to have begun i n October 1917. During that month, balances outstanding under the Act increased from $1.45 m i l l i o n to $43.62 m i l l i o n . The period of voluntary borrowing ended i n November 1932 when the government forced the banks to borrow $35 m i l l i o n by making the borrowings compulsory for a l l the banks. The Data In Chapter III i t was noted that borrowing under the Act could be divided i n temporary borrowing for cash adjust-ment and longer term borrowing for other purposes. It was, however, found that no s a t i s f a c t o r y source of data was a v a i l -able f o r the short term borrowings. 57 58 Lacking a better measure of temporary borrowing, the t o t a l amount of advances paid out by the Treasury during a c e r t a i n i n t e r v a l (that i s the flow) has been used as an approximation f o r the volume of short term borrowing. Borrow-ings for other than day—to-day cash adjustment i s assumed to approximate the month—end balances of outstanding advances* Thus, i t was found that the two types of advances might be analysed i n terms of flow of advances f o r short term borrowing and stock of advances outstanding at p a r t i c u l a r times for longer term advances. At t h i s point, a b r i e f discussion about the sources, nature and l i m i t a t i o n of the available data may be appropriate. The major part of the analysis i s concerned with two sets of time series - advances under the Finance Act and inte r e s t rates. The sources of the data are few; most of the data has been obtained from the MacMillan Report and the "Monthly Re-turns of the Chartered Banks." The l a t t e r returns are found as supplements to the Canada Gazette. With respect to the Finance Act, the flow series i s available on a yearly basis only. The t o t a l amount of ad-vances received and repaid by the chartered banks i s , thus, published i n the Sessional Papers of Canada under "Public Accounts." As to records of the stock or balances outstanding, 59 the only monthly series available for the f u l l period under 1 study i s the month—end balances owed by the banks. From January 1927 to the end of the period under study, the month-l y average of d a i l y advances and the monthly high and low balances are, moreover, available i n the MacMillan Report. With respect to the alternative interest costs, the concept of least-cost spread was formulated i n Chapter I I I . B r i e f l y , the least—cost spread was defined as being the d i f -ference between the New York c a l l loan rate and the discount rate charged on advances. As pointed out i n Chapter I I , there was no short term money market i n Canada at the time and the banks, therefore, were using the New York market for cash ad-2 justment purposes. The discount rate i s supplied i n the MacMillan Report and the New York c a l l loan rate i s r e a d i l y For the period up to December 1929, the aggregate month-end balances owed by a l l the Canadian banks may be found i n C l i f f o r d A. C u r t i s , S t a t i s t i c a l Contributions to Canadian  Economic History, Toronto, MacMillan, v o l . I, p. 27. From October 1923, the chartered banks also reported the borrowings under the Finance Act i n t h e i r monthly returns. 2 In c a l c u l a t i n g the opportunity cost, i t would have been preferable to combine the New York c a l l loan rate with a forward exchange rate but no record of a forward rate has been found for that period. 60 1 a v a i l a b l e . The data and i t s l i m i t a t i o n s are discussed more f u l l y i n Appendix A. In short, the only stock time series of ad-vances available f o r the whole period under study i s the re-cord of month-end balances. This s e r i e s , of course, i s a record of balances for only one, not necessarily representa-t i v e , day out of each month. The conclusion from the examina-t i o n of the data i n the appendix i s that the month—end balances i n general overstated the volume borrowed during the months and were subject to considerable random v a r i a t i o n s . On the other hand, i f quarterly averages are used and i f allowances are made for month-end peak borrowings, the month-end s e r i e s , on the whole, give a r e l i a b l e i n d i c a t i o n of the "stock" or balances borrowed under the Act. Moreover, a l l the major trends found i n the record of d a i l y averages and high and low monthly balances are evident i n the series of month-end balances. Method of Analysis In Chapter III the examination of S i r Thomas' o r i g i n a l hypothesis revealed c e r t a i n inconsistencies with the basic See, for instance, U.S. Bureau of the Census, H i s t o r i - c a l S t a t i s t i c s of the United States, C o l o n i a l Times to 1957, Washington, D.C., 1960 61 economic p r i n c i p l e of r a t i o n a l behavior. The hypothesis was, therefore, reformulated and an attempt was made to devise a means of tes t i n g the hypothesis using indifference curve analysis* B r i e f l y , the postulates of the hypothesis were that the advances under the Finance Act f o r purposes other than day-to-day cash adjustment depended, f i r s t l y , on the a l -ternative cost of obtaining funds f o r the banks, that i s the least—cost spread; and, secondly, on the strength of the banks* aversion towards being indebted to the Treasury. Ac-cording to these postulated r e l a t i o n s h i p s , the banks' ex-pansion paths of borrowing could be expected to be p o s i t i v e l y correlated with the least—cost spread up to a certa i n range of borrowing. Thereafter, as the aversion against heavy i n -debtedness became stronger, the rate of borrowing would become less responsive to an increase i n the least—cost spread. Borrowings f o r d a i l y cash adjustment were also d i s -cussed i n Chapter I I I . It was found that t h i s type of borrowing d i f f e r e d from other types, not only i n regard to purpose and length of time of borrowing, but also i n regard to the determinants of borrowing. Instead of being deter-mined by the least-cost spread and aversion to being indebted, short term borrowing was found to be a function of clearing drains. 62 For the testing of these postulates, charts rather than multiple c o r r e l a t i o n analysis have been used. A multiple c o r r e l a t i o n analysis was t r i e d but rejected. The high corre-l a t i o n between the advances and the least-cost spread combined with a high degree of m u l t i c o l i n e a r i t y of other f a c t o r s , made the r e s u l t s of the multiple c o r r e l a t i o n analysis inconclusive. The less sophisticated method of simple c o r r e l a t i o n , there-fore, appeared better suited f o r the a n a l y s i s . Advances as a "Stock" Concept For the purpose of t e s t i n g the hypothesis, the period during which the Finance Act was used extensively has been analysed i n four subsections. From 1917 to 1932 there were thus two periods of heavy borrowings during high l e v e l of economic a c t i v i t y and a period of r e l a t i v e l i g h t borrowings following each of the booms. The f i r s t peak period occurred during and immediately a f t e r World War I. It was therefore by no means a normal period. The banks had been urged to buy B r i t i s h treasury b i l l s , f o r which an incentive i n the form of a preferred discount rate had been provided. The government had thus i n a sense encour-aged the use of the borrowing f a c i l i t i e s , and there had been l i t t l e or no t a l k about the d e s i r a b i l i t y on the part of the banks of using r e s t r a i n t with respect to heavy continuous bor-o Co 64 rowing. S t i l l , the banks' reluctance to be heavily indebted to the Treasury i s apparent from Figure 4. Although the least-cost spread reached i t s highest yearly average during 1920, the seasonally adjusted advances l e v e l l e d o f f during the end of 1919. The next boom occurred i n the late 1920*s. The l e a s t -cost spread and the volume of borrowing began a steady i n -crease during the second half of 1927. While the interest spread reached i t s peak i n the t h i r d quarter of 1929, the ad— 1 vances began to l e v e l o f f i n the second quarter of 1929. From Figure 5 i t may also be seen that the month—end balances declined i n absolute terms from the second to the t h i r d quarter of 1929, although the least-cost spread widened. The two booms were thus s i m i l a r with respect to the rela t i o n s h i p between the advances and the least—cost spread. In both cases there was at f i r s t a strong p o s i t i v e c o r r e l a t i o n between the two f a c t o r s . In both cases, moreover, any increases i n borrowing above a ce r t a i n l e v e l of indebtedness appear to have been restrained by the reluctance f a c t o r . It i s also noteworthy that r e l a t i v e to the least-cost spread, the l e v e l Figure 13 i n Appendix A indicates that the l e v e l l i n g o f f process began already during the fourth quarter of 1928. 6 5 •nipt :!:!!;!;!' iiii TIT: irelif Hi! Ill ••I !i ;•• 1 .ati iiiiiiiii ori'sh: i i i |! p^llli ^ cite, 192 iaf Iiii '..in we. lib? i|iippi.;i en Iiit. he' iiiiiliiijiiiil:!!.! : ileast-c t t t t T T t ~ iii;!;:;; !.:.: :.l; L i i ost •ii! : | | : Iiii iiii !l ! l : lit : ; . i : • •'" • i ifli fill- iiii. iiii 111 HI ; i i! ici MA iiii iiiif iriuint pre« 927 "eiral id id\ i i i i Lis ;:ia'ndjimphit:hp;< ;ance'sj;!!:qua; a l l W a nee aver S::OX;iF ages--,:: inance juiyil! ti-!-i Hi! :!!! : i;: .: i r-l-' ;' j t : : : 1:::; :]:::: iii J i it! 1 .r\ x's b: T:ind tembjer ij Licaitieliiy iiii} thai n-l i i i i nu me I I I : ria -lii-iiii 1 I . . iiii-Fi ' i — T l rial he el Ac rui* 1 1 AdviE in it iiiiiiiii :e.S|;.j TTTttiir "ilpcii fif! iij iiii; iii! aixf iiii t-er l l m f M i l ! jiii lit! 4.! Hi! ill iiii rii-L M i l ; ; 1 h i ii!| i ' i * lili 11 III iiii ii!! ill! i'i' iiii ii ii iiii- P V / - V 1 1 a T - C ill; : i ' 1 iiii 'ii! Iii ii[j Ii! tj! ; ; 1 ; ii-ii ; f 1|.|: i i i i iii! |j iii! i! (ji !|-li rrrr i;:! j iii! iiii. Iiii i i i i Hi! Iiii iiii jj-ii :: 1:1 Iiii i i i . - i i l ; ! iii llill !;::i 'III !:il i : ! 1 iiii Iiii ! i 1 t • ( • i f !:•: iiii IH! |lll|l!ll : 9 q: i'iij !;:: ii:i \] i! i i j •-! Ml ill i i i i ill iiii !!|: ; i i r Jit! '! i'i |. :iii n t j - ililll lijIH H I i'i: iiii jjii-I j i! :iil i:i! iii:. i4ri im 1'}'' i J: i ii! ill! -iH Iiii-il:! illI iiii l i i i l lW iliijiii; iiii j::; i i i i j ; j; j • T T T T i i i < 1 1 ! Iiii liii iiii 1 i : [ ! i! * 0: i-i-i-lili iiii t - 1 1 iiHT .;!-:!• iiii. iiii iii Hi ii 1 a i . iii] i'iii 1 1 : iiii i I t i i i iiijj ilil 1 i i i i i i i j ll 9-; ; ; ; 1 ijii-! Ii i iiH ill! iiii ii ii I H I l!!i iTIT"tr ti iitl Hi i'li 44 H-i;i- H I8 iiii iiii t - 1 i 1 n.i 1 1 . . . 1:1 ( | t : ii Hif ii-ii ii!! ii'i ijii t t r r ~ "p • i • * 9:; l i t ' i - i . i . . jiiiiiii! ill! lu- iiii iiii ; t!; Hi! !.!;! i-ii iii iii: i i i ! • H i iiii ..: .1 H:! Oil iiii ! ! !? »: ii! nil 111! i 1:: ! ! i i iiii jili 1:11 ll II )'.!' • • ii ii iiii $ ii ; iiii V\ ipi iij! ii] I'i; !i!} 1! : : i ':.! ! IHl 11! Iiii ;;-;; I i i : iiii f i i i Uii • ri '- :! i: -iiii tii-i-ill! lili iiiiii iiii i~i~ :::« iiii i * 1 ; !4t :: i : 111! iii] [ii! i:i.:l:i !:! •: i ; i i i ; Iii i'iii ijiiii T-irij 8!' TV itii ! j!) iiii i i i! Iii! ill! Iiii i'i I-i ::::{:::; t;:ii i i i III- :ili iiii iiii iij! ' i j l t : ; ; ; i i ; | . iii! H i ' : . i . . i t : 11 • ; iiii iiii i j • i l ; ; i i .!..< Jm V . . I I . . • 1* : iii! t ! | : : ii'i! ill! I ' l l ! ijii Hi i iiii! .:::.: lilljiii iiii • ; j - t .;.! i ; iiii ml i i . ! 1 i l l : jiii 1:'.; iiii iiij Ii!! ij i is!! V, : i : : mi iii! • l i t !:';! Iii! i'i-ill iii 1 iiii lili iiiiiiiii iiii iii! iii! iii! l!|l iii! i ii ii" iiji iii; Iiii iiii I! '•] M M Hi: i * '• < iii! iH! iii; III! ;! j -ill iiii M • * iii! iiii :::: ' i; ] iiii i-ii iiii ii i i i i ! •'!; 1 . M :!!.:.! i i i i i i ! iiii iiii l| ill! -Iii! Vi i . i !:!i! r  : t Hi; ! . u . i il: i ill! ii'i! Iiii 1 . " . : i!l iiiiii \::t 61 !;l! tiOj iiii ji!! iiiiii ii'!! i H I-jii-i iiii 28 i l l 1 iiii iiii i i i l| i'- 11!! i i j.i •lll- i i | • ; i li iiii iiii i!:; B l •1:1 III: iiii :;\". Iiii !-! • 1 j i . ' j ! 1 ii-iiii - I i i '$ iiii- Ill iia iiii iiii! i i i ! • 'Ii •iiii i.i i-i iii! I-i! 1 ••: p. i i l ! ill! ill! I':.':' i l l III! i I i : ii! 1- iiii iii'! ii!! i i i i " : t '.!:»; .j.; ;.).; i iiiiii if-iiii 1 *!!: ' r t j t ;-; i i iiii iiii 1! 11 . . 1 . 1 ; 1 ! ; ! ! i|ii iii! iiiiiiiii iiill IIII ri Iiii : . i : Iiii il;! iiiiiiil Hi! iii; . . . 1 f \ \} iiii ::.: irif'riit- IIII -~:D :::; iii; • •; j ill! iiii iiii iiii Iiii iiii Hi! !! ij ill:! 1 ; . 1 iiii . f. i Iiii In; !!!: ill! ::;:!::;: Iiiiiiiii Iiiiiiiii iiii iiii iiii 1-iH iiii iiii Iiii \.i :* 28 Iiii j ' i 'M liiii!: i'i iiii ill! ill! ill] -iiji iii! HHtiH. | | •Hi; i-iii i l l iiii iiii ItH iiii j i i ; : " i I I; j : U : ! •;'1 l|i; !• ill! i!: : iii! ; ; ; j llllillli :iiiiiiii :|::! '. 1'. i iii iiii iiii iiii iiii Iii: : i . : "TIT; ; I  ii!! iii! Iiii ill! ' ! : : : ;: j i ii i 1 ii:: Iiiiiiiii :.::!::::. Iiiiiiiii llllillli r.A 6: ill! ill! Iiii !:!J iiii iii !.:: i iii1 i i!: Iiii iiii: ! !||! iiii i'i':: :i:.! :1:1 :-iif : i i: |i|! iiii •tili -iiii . . . . • : • ; iiii ;;:: Iiii iiii iii! Iii! • i -iii; ttr -ttfr • : f t 111! i ii!'!;! Hi! Hi! ill! ; ! ! ! ;ii: '.ill ..:; i:::: l l r l rl:l r r l l l i l i 111-1 • • i ; n j ! fill .; i iiii ii;! 1 1': i :: i: : j : . ; : !!:: I |ii E l l i !: :| ;::: iii! t ; : i ::.!.; I i i i r;i: Iiii':::! H i : iiii .. .r iiii \i:: :.;:: iiiiii!! iiii " 1 ' 11 i il ill 1 \'M jiii: i i| lili .il! i-i •} ii! 1 ; I : i P : : i j.t'. Iii! Iiii Hi! •iii; iiiijiiii iii; iiii tiii -iiii $0; .... .-iii iiii. iiiiiiiii ::;^  ;•-!• iiii ! ' i : i 1$ • 11 ! • J ; !•!]! i t - . : •:• i i i i i i iiii ijii "311 iiii ii-il . ! ! i I 1 ! ~ iiii iiii |ii-i-Iiii •2' V^i Iiii iiii'fi! •-•' I - : iii \ .1 it Iiii iiii i; iiii !' ii'fi'ir ijii 111 i iiii j'iii ill! • i t } ! m Ill I Hi! ! ill f r i t ii-ii iiii -iiii IliliHIl i-i; !i7l ii: iiii !jii! i-li-i i- 1 i; i-i :iii; I I |i ii iiii : i i ! ;i :iis ill! iiii jiii iii1 ii!| ! ij 1 }][! 1 j-*-] iiii iiii Iiii iiii Hi! •iiii tit|. iii iiii j|[ iiiiii: iii •' - r iiii iii! i i i i i: iiiiii !;!'! i 't! i iiii l-i'!i Trj;: iiii mi iii! ill! iiii ill! Iiii ill i-ili Hi -1-if-;!;: ! i' I "iii i! ; i !ii! iiii * !.!.:! ill! -!!i'i ;• ii iiii i i i'i !;'": iiii ; i 1 i :' i-i :;ii! jit: :: i : 1 . . . . iiii 1! ii iiii iiii iiii • 1 •• .ill j i!:! iiii i'ji' !: ii. iiii i-i'ji t i i-l 1::: !:! i'i 1"' i iii.! |!!i i:lii 1::.; ;•!!"• iiii I i i - ' iiii iiii iiii '-" '• • '• iiii i i 1 1 • i 1 • •Iii iii! i ' li ; t > •Hi' ill! i J: ! i i 1 •rH! iiii Iiii ;'-i'i 1 • f t 1 ill! li|l iiii iiii ill! j : : ; : ill! iiii :o ilil iiii iiii iiii i-iii iiii Iiii ijii 1' i': :'i: !•! Iiii! ...i... 'in i iii i'-.i i iii.' ijii rii.i l-i'i ;:; ii ;:; ii Iiii •r :4 • i'4 iiiiiiiii .•'ri!! •til till iiii : : : i -ii; iiii :;:: iii! iiii ill; iiii "ill Hi! iii! .uii ij iiij i!;! Ell! iiii I-i 1.  i i:: iii! ili-1 iiii ill! iiii i|l! -iiii IIII •; iiii ]H[ !i!i iiii iii! i i i iiii iii! ii-Hi "Ii!;(; -I f H iii- iiii lili 11! j ! Iii i'li i l l ! i'iii ill! i i i i ii-i jii-i -i-i-r i~f -i~ rf; i Itii if i l iiii 'fiii fjfj !.': i j;;- mi •m iiii -ii-ii- -I-if iiii iiii! iii! i | i ' iiii iii! ii|t i-iH • t-t-« i 1". . i I Iiii iii •iiii Iiii ii ii! iii! iiiiiiiii ::; ill! :iii .ii. t : 1 •iiii! 1 •• !•! ;:: iii; iiii flit "y? M iiii 5i t i t ! lit i-iil I tfrt l i l i iii! ii! hw • It 'jjlj 1 i iii! )TITi :in; I i i i 3.C >! ||| ill! im in! iii-4. f; iiii iii; iiii 5ll it!' P H[ iii: ijii iii jlji III -ttr •i i-i ill +•1* i 1V. ii-j: w : r:: iii! iii! iiii iiii iiii Itfi mi' i l l - i b Uj; -it 'iiii in; jiii !:••! •1 •; • iii! iiii fa lii'l t i l ; > ii j i i i ii i'i in If!' 1 i-ii ill: Til: ill |i|! f Ki" i l H i ' !!i iii il! l|E -irjl iiii iiii !' \ i !''; ii'i !K! i |.|-| iiii !ii •i|>-iii * IT! i i i ; ;.;•!! HlilHlllil.il ::!i|:-::|fiijj!i |ll iii iii; ii-l ijif 66 of borrowings was considerably lower i n the l a t t e r period. This was the case both i n terms of absolute amounts and of borrowings i n per cent of the banks* deposits. The banks evidently behaved i n a similar manner with respect to borrowing during the two separate peak periods. The same does not apply to the aggregate behavior of the banks during the two troughs. In the period 1922-1927 there was apparently l i t t l e r e l a t i o n s h i p between borrowings and the least-cost spread (see Figure 6). During the trough from 1930 to 1932, the r e l a t i o n s h i p , on the contrary, appeared quite strong, even at maximum borrowings during the p a r t i c u l a r per-i o d . The aggregate expansion path of the l a t t e r period, as shown i n Figure 7, does not seem to l e v e l o f f l i k e the expansion paths during the peak periods. The reason f o r the absence of r e s t r a i n t was the r e l a t i v e l y low l e v e l of borrowings made during the trough period. At such leve l s the reluctance to borrow could be expected to be weak according to the hypothesis. Of the four sets of observations, only the one for the trough period between the two booms does not confirm the l e a s t -cost spread as being an important determinant of borrowings. To f i n d the causes for the "abnormal" r e l a t i o n s h i p , i t i s ne-cessary to examine the d i s t i n c t i v e features of that period. 67 68 69 D e t e r m i n a n t s o f B o r r o w i n g s D a r i n g Trough 1922-26 The p a r t i c u l a r p e r i o d must f i r s t o f a l l be c o n s i d e r e d i n c o n t e x t t o t h e post-war boom. The banks' l o a n s had c o n t i n u e d t o expand u n t i l l a t e 1920 a f t e r which a r e c e s s i o n began. Dur-i n g the f o l l o w i n g c o u p l e o f y e a r s , a r a p i d and s e v e r e p r i c e d e c l i n e t o o k p l a c e , and the banks s u f f e r e d heavy l o s s e s from 1 l o a n s g r a n t e d d u r i n g t h e p r e v i o u s e x p a n s i o n . From F i g u r e 6 i t may be seen t h a t t h e F i n a n c e A c t ad-vances c o n t i n u e d a g r a d u a l d e c l i n e from t h e i r p r e v i o u s peak u n t i l t h e y r e a c h e d a low p o i n t i n the second q u a r t e r o f 1923. The 1922*s h i g h l e v e l o f b o r r o w i n g s r e l a t i v e t o the l e a s t -c o s t s p r e a d may t h e r e f o r e be e x p l a i n e d by a l a g i n a d j u s t m e n t . The o b s e r v a t i o n s , a p p a r e n t l y randomly d i s t r i b u t e d w i t h i n a narrow range o f $15 m i l l i o n and z e r o i n t e r e s t s p r e a d , do not c o n t r a d i c t t h e l e a s t — c o s t h y p o t h e s i s . T h i s group o f o b s e r -v a t i o n s show t h a t i n the s m a l l i n t e r v a l between p l u s and minus 3/4 o f one p e r cent s p r e a d , the b o r r o w i n g s were f a i r l y t i g h t -l y bunched w i t h v a r i a t i o n s caused by random f a c t o r s such as •^According t o C A . C u r t i s , t h e enormous l o s s e s w h i c h th e banks u n q u e s t i o n a b l y i n c u r r e d from 1921 t o 1924 "were owing i n p a r t t o the b r e a k i n p r i c e s a l l over the w o r l d , many were a l s o a r e s u l t o f l o a n s which were made t o p o o r e r r i s k s d u r i n g t h e p e r i o d o f e x p a n s i o n . " C l i f f o r d A. C u r t i s , "The C a n a d i a n Banks and War F i n a n c e , " C o n t r i b u t i o n s t o C a n a d i a n Economics, T o r o n t o , U n i v e r s i t y o f T o r o n t o P r e s s , I I I , 1931, p. 31. 70 clearing drains. The observations which are more d i f f i c u l t to explain are the ones occurring i n the last quarter of 1923 and during 1924. In spite of the large negative least—cost spread, the borrowings during those f i v e quarters were general-l y higher than the rest of borrowings between 1923 and 1927. As previously mentioned, the banks began to show their month-end balances owing under the Finance Act i n the la s t quarter of 1923. By examining these records i t was found that approximately 65 per cent of the borrowings from October 1923 to September 1924 was done by banks which were subse-quently absorbed by more solvent banks. Several of these banks were approaching insolvent conditions mainly from losses suffered during the previous years of contraction. An i n d i c a -t i o n of losses suffered by the weaker banks i s the fact that between 1921 and 1923 the reserves of these banks (including the Merchant Bank and the Home Bank) were reduced by approxi— 1 mately $20 m i l l i o n . In the months (or years i n the case of the Standard Bank) before the banks ceased to exist as inde-pendent banks, they apparently used the Finance Act as a A more de t a i l e d account of the reasons for insolvency or decline i n earnings may be found i n A.B. Jamieson, Charter- ed Banking i n Canada, Toronto, Ryerson Press, 1953, pp. 63-8; a few of the pertinent f a c t s about size and time of merger are given below. 71 source of substitute for working c a p i t a l paying no regard to •1 the least-cost spread. Apart from the borrowings by the insolvent banks, the Finance Act was used to finance the purchase of Dominion se-c u r i t i e s . During 1924 the banks' p o r t f o l i o of Dominion and P r o v i n c i a l s e c u r i t i e s as a percentage of t o t a l assets reached Name of Bank Date of Merger* Indication of Size Approxi- Relative C a p i t a l Reduction mate F i n a l Size i n and Rest i n Re-No. of Branches' 1920:% of To-t a l As-sets of a l l Banks^ Fund, Dec.31, 1923 4 serve Funds, 1922-3 5 J9 $3 $1 $9 B. of Hamilton 31/12/23 152 Banque Nationale 30/ 4/24 106 S t e r l i n g Bank 21/12/24 76 Molsons Bank 20/ 1/25 124 Union Bank 31/ 8/25 327 2.80 2.25 .82 2.95 5.33 850,000 -399,000 $2,000,000 735j000 ,000,000 - * ,750*000 $4,250,000 Standard Bank 3/11/28 226 3.00 $6,750,000 $2,250,000 •Rest-Fund reduced $2,000,000 at take over i n January 1925. Sources: 1. MacMillan Report, p. 19. The dates given are those of the Orders-in-Council authorizing the absorbtions. The arrange-ments among the banks were previous to these dates. 2. Canada Year Book and Jamieson, pp. 63—68. 3. Beckhart, pp. 332-3. 4.1 Canada Year Book,, 1924, p. 800. 5. Jamieson, pp. 63-68; Monetary Times, v o l ; 72, January 1924, p. 28. "^Except f o r the Union Bank, none of the absorbed banks had any c a l l loan p o r t f o l i o i n New York. The least-cost spread may only be an important determinant when, i n t h i s case the New York c a l l loan rate represents an actual opportunity cost of funds which are r e a d i l y a v a i l a b l e . 7 2 a peak higher than at any time before the 1930's, including 1 World War I. Part of the Dominion s e c u r i t i e s may have con-s i s t e d of Treasury notes or Treasury b i l l s carrying interest at up to 5-1/2 per cent during 1924. The reason for the pur-chase of longer term bonds may be found by comparing t h e i r y i e l d s with short term interest rates during 1923 and 1924. The yearly average of New York c a l l loan rates had f a l l e n from 4.86 i n 1923 to 3.08 i n 1924 while the long term rates on Dominion s e c u r i t i e s had decreased from 5,09 to 5.00 per cent only. During 1924, bankers may have f e l t the large d i f -ference between long and short rates to be i n d i c a t i n g a r i s e i n bond p r i c e s . The banks could be expected to switch some of t h e i r funds out of c a l l loans into s e c u r i t i e s i n such a s i t u a -t i o n . That t h i s was a c t u a l l y done i s indicated by the fact that the banks' p o r t f o l i o of New York c a l l loans during 1924 was reduced to the lowest balance during the decade. When the rates charged f o r Finance Act advances i n November 1924 was reduced by 3/4 of one per cent, they sud-denly became lower than the long term bond y i e l d and the banks may have used the Finance Act to finance purchase of s e c u r i — See C u r t i s , S t a t i s t i c a l Contributions to Canadian  Economic History, p. 65. 73 1 t i e s . "Window-Dressing" as a Determinant o f Borrowing The Finance Act was, moreover, used f o r the purpose of window-dressing. T h i s term r e f e r s to the past custom among the banks to manipulate t h e i r a s s e t s and l i a b i l i t i e s i n order to g i v e t h e i r b a lance sheets an appearance of g r e a t e r than u s u a l l y p r e v a i l i n g l i q u i d i t y . On the l a s t day of a monthly or y e a r l y accounting p e r i o d , the banks would, thus, i n c r e a s e t h e i r cash r e s e r v e s by v a r i o u s means. The banks might, f o r i n s t a n c e , o b t a i n Dominion notes by i n c r e a s i n g t h e i r l i a b i l i t i e s under the Finance A c t . It c o u l d be expected that i f window-dressing was ever f e l t t o be necessary, i t would be i n a year such as 1924 which had seen s p o r a d i c runs on the banks caused by the bank-2 ing episodes d u r i n g 1923 and 1924. Under the Finance A c t , 1 During the l a s t q u a r t e r of 1924 the borrowings by Canadian Bank of Commerce i n c r e a s e d from no borrowings d u r i n g the previous q u a r t e r to an average of $8 m i l l i o n . In the same q u a r t e r , the h o l d i n g s of s e c u r i t i e s i n c r e a s e d by $8 m i l l i o n . The Royal Bank borrowed $12 m i l l i o n i n December 1924, d u r i n g which month the holdings of Dominion s e c u r i t i e s i n c r e a s e d by $12.9 m i l l i o n . 2 The adjustments o f r e s e r v e funds, the bank absorb-t i o n s d u r i n g the p r e v i o u s years and p a r t i c u l a r l y the f a i l u r e of the Home Bank, r e s u l t e d i n " s p o r a d i c •runs' by the d e p o s i -t o r s , which on l y a few of the very s t r o n g e s t banks escaped." Jamieson, p. 65. 74 a bank's cash reserves could be replenished for one or a few days at the end of a month. This form of window—dressing was p a r t i c u l a r l y important at the end of a bank's f i n a n c i a l year, which for a l l the banks f e l l i n the l a s t quarter of the calendar year. An i n d i c a t i o n of "window—dressing" may be gained by comparing the two d i f f e r e n t records of the Dominion notes held by the banks. In the monthly returns, the banks reported not only the balances held at the month—end but also the average:amount held during the months. By comparing the quarterly averages f o r these two series i t becomes apparent that f o r the l a s t quarter of 1924 the excess of month—end balances over the average amount held during the months averag-ed about $20 m i l l i o n a month, which represents about 13 per 1 cent of the average amount held. To sum up, the least—cost spread hypothesis was not xThe equivalent "excess" amounts for the l a s t quarters of 1925 to 1929 were, i n m i l l i o n s , $15.5, 10.1, 15.5, 14.3, and 36.1. In the l a s t quarter of 1929, the difference between the month—end balances and the "average held" amounted to 34 per cent. The l a s t quarter of 1924 must be compared with the la s t quarters of other years only, as "window-dressing," ac-cording to t h i s i n d i c a t o r , was always considerably smaller during the f i r s t three quarters than during the l a s t . During the f i r s t nine months of 1924, a monthly average of the d i f -ference between the month—end balances and the average amount of Dominion notes held during the months was less than $5 m i l l i o n . The equivalent figure for the f i r s t nine months of 1925 and 1927 was only about $2 m i l l i o n . 75 r e f u t e d by the r e l a t i o n s h i p between b o r r o w i n g s and l e a s t c o s t s d u r i n g t h e p e r i o d 1922 t o 1927. D u r i n g t h i s p e r i o d , s p e c i a l e v e n t s t e n d e d t o d i s t u r b t h e u s u a l s t r o n g aggregate r e l a t i o n s h i p between the two f a c t o r s . The major p a r t o f t h e i n t e r e s t i n e l a s t i c b e h a v i o r was caused by banks a p p r o a c h i n g i n s o l v e n c y . F o r them the r a t e on advances p r o b a b l y r e p r e s e n -t e d t h e l e a s t c o s t o f b o r r o w i n g . F o r the o t h e r banks the New Y o r k c a l l l o a n r a t e may f o r a p e r i o d not have been an a p p r o p r i a t e o p p o r t u n i t y c o s t i n case t h e banks were u n w i l l i n g t o r e d u ce t h e New Yo r k c a l l l o a n p o r t f o l i o any f u r t h e r . Advances as a "Flow" Concept I n d i s c u s s i n g t h e d a t a about t h e b a l a n c e s o f advances o u t s t a n d i n g , the h i g h c o r r e l a t i o n between month—end and average d a i l y b a l a n c e s was n o t e d (see F i g u r e 12, Appendix A ) . The c o r r e l a t i o n between t h e same month—end b a l a n c e s and the t o t a l y e a r l y amount o f advances p a i d out ( F i g u r e 8) i s much l o w e r , i n so f a r as any comparison i s v a l i d . T h i s poor r e l a t i o n s h i p might be e x p e c t e d as t h e tem-p o r a r y b o r r o w i n g s , a p p r o x i m a t e d by the f l o w o f advances, were assumed t o have been made f o r a d i f f e r e n t p u rpose t h a n the b a l a n c e s o u t s t a n d i n g and were assumed t o depend on c l e a r i n g d r a i n s r a t h e r t h a n l e a s t - c o s t s p r e a d and a v e r s i o n t o w a r d i n -d e b t e d n e s s . Comparing t h e graphs o f bank c l e a r i n g s p l o t t e d 76 77 a g a i n s t month-end b a l a n c e s ( F i g u r e 9) and advances p a i d out ( F i g u r e 1 0 ) , t h e c o n s i d e r a b l y c l o s e r r e l a t i o n s h i p e v i d e n c e d i n t h e l a t t e r g raph appears t o c o n f i r m t h a t c l e a r i n g d r a i n s a r e more c l o s e l y a s s o c i a t e d w i t h s h o r t t h a n w i t h t h e l o n g e r term b o r r o w i n g s . C o n c l u s i o n I n t h i s c h a p t e r t h e e m p i r i c a l e v i d e n c e o f t h e banks* b o r r o w i n g under the F i n a n c e A c t was compared w i t h t h e hypo-t h e s i s f o r m u l a t e d i n Ch a p t e r I I I . The b a l a n c e s o f month-end b o r r o w i n g s were a n a l y s e d i n f o u r p e r i o d s . D u r i n g t h e two booms, the h y p o t h e s i z e d r e -l a t i o n s h i p between the advances borrowed, the l e a s t — c o s t s p r e a d and the r e l u c t a n c e f a c t o r was c o n f i r m e d . D u r i n g t h e e a r l y 1930's the amounts o f b o r r o w i n g s appeared t o be below t h e " t h r e s h o l d o f r e l u c t a n c e , " but t h e l e a s t - c o s t f a c t o r was e v i d e n t . D u r i n g t h e t r o u g h o f t h e e a r l y and middl e 1920's, o t h e r f a c t o r s a l s o o b s c u r e d the l e a s t - c o s t r e l a t i o n s h i p . L i t t l e d a t a was a v a i l a b l e f o r a n a l y s i n g the temporary b o r r o w i n g f o r c a s h adjustment p u r p o s e s , but i t was b r i e f l y shown t h a t , i n c o n t r a s t t o t h e month—end b a l a n c e s , the amounts p a i d out d u r i n g each f i s c a l year appeared t o be r e l a t e d t o t h e banks* c l e a r i n g d r a i n s . The l a c k o f d a t a r e l a t i n g t o 78 79 111! ill: ii ill: liii !;!; Mil F i d i iii! nniiiH jii! Tii Li i ii.:!|!i.!l he rel« ' ' " I ' ' ' ' i i i i i i i i a L t l o n s h l i !ji 111: ?; III; Ii biet ween P i l i l v e a r l v . . . 1 . ; . , •in; -iii % :rr: :!:: :'ii ii'i iiii II if iii: ;::: liii :'ii rrrr iii: ::;; Tt illi illi i'l' i 1 i 1 iiii I'll :.. i iiii [HI |ilT iiu illi ifc j!![!tii l l l l i c i l i i i ly:< ink icleari: iej [Finance lartlefedl ' i i Lngs |andlja •1 ''Alctiiip'aid dvances unc il iiMiiij^iil-nin;;; •i t o the ; : i. ..rt er III'!' ill; lil- i i i nn W\\ iii! i i ill: 111: "tii Iii' janksj Id ii ur[i ng.i f i s c a l l i i Iji lil! ii! illi iii; iiii iin 3ars'*|il 191< iiii j; ijliill i i i i i i i ip lp l III! ;in lill rlH IlH Hi! ;::: T: nu Hi! in; nil ill! iii Illi i!(r iiii' liii' ^Est LIII iiii ate!: ;rlf I -iiii | ! Iii! fill i iii nsji! fr] ii c l e i' iiii ax 9f liii i i j-14-"if i ' ! t iiii 1111 :! 1 i •;:i ;!.; i illi :IF In air C€ ' ; .ct ill/ td\ lii[ iai ill! i!, i ic< ;s Hi •; 1; TTTT .UL; i | i i lill lill liii iiii 'tit •; iiii 1 j i i ; i: | ;*jit" j i 1 ! i jJlj. 1; iti! Hi! nn :;:: ::ij nn r -. ; 1 f i i !!!!i!!!! iiii i:!i iiij i; i.i :i !;;! ill! Hu- H-::i :!. . . p a i d id lilt; jit; iii! Hit nil nu iiU. 1 i ItnPi' iii 1' i-til" m | i -IIII i[ 1 till IH-H i liii I; ill !.|:i| I t ' ' HH iii! 1!;: -ii- !. jiij ill! nn j! ii III: Iii'! iiii ! ! ! ! ! ! : i lil.| 11} i H i l l i'i! ]\ ; mi liii i!ji ! i i! iiii ill! HH ll'! ill! lilt |!H : Hi 1c ' * n I I I I :!•! Lil • tr Hi i i tii t I liii Hi! illi i-l -iiiii •jiij nn nn iii! i i i i iii! nn ill! ii! I Mil] —-1 >|nl : i:: fill ml l i i n l fp j j ' |l H ; ;i ;r 1 ilH ! I::' Hii liii II i iin jiji iii iin ill! ill ii:! ji;! Hi: i 1: i sin :::: Hit D o l l a r IHi ; i-i 1 iiii nu Li LL ill! WW Hi i II ji.!i Illi iin • • 1 lilt ii !_ liii i-i I i ; 1 -,! ijli iii! I iUi '' 1111- ;j;i iiii III! iiii ;:!i '. il :::: 1 ; , - i::! ; t; t • nil' OpTl iiii l i l t 11 nu iiii iiii i:! i 1 IIIII III! ii •in i - lit HI* iii! ;:ii • t i i i i! 1 ill! iii! lil! ;: H nn fill ;;;;p • i-i i i'' : Hi ! 1 ' • iiii iin 11" i; iin Lit. liii liii iiii i i [ill I : !'i! i iU-i 1 - 1 i'i; in! rii-i i>ii i l \l ! i! 1 1 iiii !.!', : IHi If liii nn nil iiii III! t Hi; mi-i in nn ill liii ::; j tr t]1 i i i i i i i i iiii iiii t' i l l i 1 II III 11 !•! Mil 1*1! i Hi i i i i 1|il i i I"' i i i ! lill iii-ijiH-i- Illi ; j ; ; illi • i j i !:![ in; i;;; . j;: • Hi ill iii! nu Hil ::;: jt ":> i nil :: j! 1 j: i nil 1 II lill III III) ii;; III! HI! j i i'i i i ; i I-i ll 11 ilil .tni". H;i 1 • ; ) ;: i: t' - : : ; 1 ' : :. i'i Hi TffFtm i.| i 1 •:M h ml il ! .ii.;: i i:;:. nn il'i' nn H H HH il I: lill iii! i i i i : f.J: liii liii iii! ;::;: nn iiii ::.. oc )•-: ;' i' iiu Hi! i •' i i iii it' 1 ii:; Iin Hi; ii 1; •: ;: lill tii'1 • •it : II Hil Iii' liii .ill;'. ill: '•t t ! I j ji-TfJ7 IlH iiii :: :* 29: n:'. 1111 •fiT!' '-rTi-lli! Illi lill nil iii!: iilr I.J i 1 i l l i i ! i ! t i : i ttj : I i n|t-!•!•:.! liii. l • -i-ii; 1 l-l-r ii. iiii i ii ill:! i || ij'tf tit- tlil Illi iiiii -'in 1::::; : :'.;-:! i:i.: 5f. Hii ";LlH:t 1Iiiiiiii iii] ill: liii iiii Hill liii. i i l i i i - • 1 ->! 1 ! ill . i i i . l i t i n ill' L I 'pi- ;•-!! iiii •Lil t I I nil i ' i i liii .Liii VJ;| (i-i . liii : i'i.i i'i •;: I.Ti'. 1 iiii; riii ::::}:::•: .... oc :::i ;!!i i'lii. I'll lii-j 11 ;•{ Ii H iiii i|l • •ii I'• .1:.! -.t.i: It! ilj. 111 liii j •'i-f " :| ii! lill Hi. 1111 •it -tii it nil !!-! •H! ii. -iiji I j; t .! I -j I'i!! ;; It iii! :; '. \ •;:•: ::;::•< )— :::: j!i! :: {.: ii-i ipi iiii ,,..) .j...., HLi nu iin lill II :j -J|J u j: ii; • ; iii! iiii nn '' t-i -ill! nn I:; i Hi! ill;. :::: iiiiiiii! i;;; nil ii-li Iiiiiiii Iin iiii iii! i j Hi: ii 1.. nil i:i!" 3ii; i Hii nil lill •tii nn i; ii nn ill! ' i i ij Hi; ii ii :; ii III; IT Ilil|llll nil ii»i ji:i HI: I'M iiii H!j lill lil| -jii Hi :::; II ' * -;4-i • -1- ! nil il It I ii iiii Illi till III! l i l l !:!! ii.: : \ Iljl Lill ILLI '.'. *z Inni .11; 1 Ii i; 1 • M i-'ii Iii II lii| rjti It l'\ '• '.',. I'l i TI22 i 11 Iiiii III 1 11 nil 1 i ji£ :8'i ill! nn \ v. \ : |Hi iiii iiii :i!.l jit! Irjil iiii; i:i1|32 m • liii Ii ••; 1 [•' • j ; • !:!:i jit! lill ' i i-;. iiii t-H j l!|i iiii illi ill! : Hi it! i :.!:; r H! liiijiiii 3;:.: ii: i liii H i l l l ^ i i!;: 24 H i!2 01 HH II Hil !|11 I l-ii- , i J : iii: iiii IHi iH: Jiiliiiii liii lOC M liii !Hi IHi Lj::L2 5* IHt'll iittt iii.i i i i i i :trt i : i;;; i-i-! 1 iin nn. lill : 1 1 1 III! ill! Hii Hil-111111111 I'll! 11:1 liii Liii nil nil Iti! til. i:i H 2 / ill i i-i 1 : i Hi •till- Il i j l i jt HL! ii i-i liii •Ii:; nil '! • • ; i i 1 nil illi Lill it:: i'i i Ml;;; i ii! :: ii ii'H : t i li-ll • 1: i:*!.! • Ili'jHi "JiTi iiii;? 26 |-Iii| iiiii Ii • nn '•Hi iii! Illi f II lill 1111 iii:! IlH .:.; : ! i v.; :HJ i i'li ill! illi in in in Si f t 111': liii •Hi; i l:l:l ill! |.|;.| ; i ! ' .l .4r ?rr* HI: Hi. :::j: p ;• .lit!. 111! 1 ill HI: i •linn |ii 11 11 It iii! ii j ' ' 11 Hi! !?!! ill! Hii iiii: 'l;j|j|||; HI-iii: or ITjT 1 Hi; •i-f i I l'i I-I ri ' I f \ \ * ]• 't 1 r-t Hl;i ti il Hil :; iii-Iilr 11.11 " il;] 'tii Hi 1 if.. ill! iH 1 IHi Lill liii Hil lllii li|i iii " -iiii H iti I i i ! I iiii ":'i i nn; li-Hii 1111 lill i.i.:.! liii lil! ' rt i ill! I l l "." i'. III; *"; 1:11! "ifriS :-j|iai, .!+,.. .L..i ijlliljli ilH 'ii il llfl liii fill-: rl| lill i *'*'• iin liii ii H ji!:! :j1i! Iiiii t-i-i-i 1 ['A Liii iiii Hit liii • - • • iiii i':R g i i l J Hi Illi 1 ;•:..:. ;•; III !-|li Iiij i.jt :|:!ii .. II: !i!i ' H : ! liii 1 TlX* Hii 111 1 i i'i: Hn :i:.:i :n:.: liii ilj-i !.:.:] iii ; ; • 1 lill II :! ! j! i ::: i '•'•>'• Illi 1 1  iiii! I I I I ii;; 1111 It;! iiii ii:: nil III! iiii nn 1 '.'.'. nil !::: ;•!.;: ;•;; HI ; liii illi Ii iin iii Hii 1 Ii rji! 1' i| ; i III! ! hi nil tii i i i i ; -iiii nn II. j||| iKt Hil iiii iii iii.i iiiji-fi 1! iiii :: •.' i.i... ill! ! ii'H i i.i i !:;:: U- -j ij.il i ri-H til! illi : ||: iiii I I ; -— ! : ;ii III t|H IIII lil i i i 5ii 1 IIII I8i: - i : ! : i. j.. : f 1 tj:i2f ^ -iiii-l nil 2; 2111! •H- H iiii 2t Itjij Lit! H !:l i l l ! •kri tfl 'iiij III! : i:; 'iii iiii Hi ;i:! i::: i a rik| ;!;; • : • ' '• Il i'l'l! ii Li illi j-itf liii ...i-i j HI! liii lit! nn ;!ii ::.. | iiii i l l i i l i l H!l II • •': 1 liii Illi nu l-iil il . l l illi \". \'. '.'-'"i Gile ar i r jgsi M JI: Hi: .61 >6 lill w Hi: liii :;:: l|li n • i mi ui •ill;; IHi nil 44  - v ii III; •lill-rl J ' l l i | •;; i" l i l tin r)-i . IHi i'i! lit! trl-i Hj! ill: ! I Li ill! IHI 'tii: i li::t l:lil ':: h Hi: ! I 1 1 iiii iiii lil lill illi Illi iii! i ii |:i|j 1: i ! i | ill ill! !•;: l l i i t l i i l 11 iiiiiiii; Illi iii! iin ! ; : i H 1 ; ? i iiii lil iiii iiii Iin lili II i l l ' iiii 1 j H i :i 1 11 -i |:j|i T: p l-H! Iii! illi 'Hi! •t-rri III! WW ' ! ! ' • ill! TrtL lil! 1 di: liiltiili IHi 1-ilj iii; i I: }•!! Iii ii.:: 111 HI! Hi Hil ;it; :;:! i 11 • sit • II Iii : j 11 i t * t t •};.] i H i 1 lit. ui; II 1 III i.iii lit! •iii ii;-; i • 1 H III! III: TtTi iiii III!!; i! iiii!!! •'ii I'll ::: :: i i i : ;i ••ill t'! r LUJ. !-.. |i! {it i i i i liii iii.|- : illi t t i j. i t ! ii- II i P Ijt i l l •if! lit! I r t 1 • -ii i-i 1;! iii' iiii it!!' •Ui. • iii' ri:!!i-: Hi iiiijij-i! -I i !'i ti.i m .(•. | il! Til I- • k •ii- l : i | : -ii liii i f iLi-lll i f 1 t i i i i i II -|{i t i I-ii i l l Ii ; 1! 11 -t; .. Ii i' Iii i-lji - it-1 fiT '::.: lit 80 s h o r t term b o r r o w i n g s , r e g r e t t a b l y , c u r t a i l e d the a n a l y s i s o f t h i s i m p o r t a n t f u n c t i o n o f the F i n a n c e A c t . W h i l e t h e e m p i r i c a l a g g r e g a t e d a t a on the whole ap-p e a r e d t o c o n f i r m the r e v i s e d h y p o t h e s i s , i t was e v i d e n t t h a t t h e i n d i v i d u a l bank's b o r r o w i n g b e h a v i o r s a t t i m e s were e s s e n -t i a l l y d i f f e r e n t . D u r i n g the m i d d l e t w e n t i e s , t h e r e was, f o r i n s t a n c e , a marked c o n t r a s t between t h e b e h a v i o r o f t h e s o l -v ent and i n s o l v e n t banks. Any i n f e r e n c e about the i n d i v i d u a l bank's b e h a v i o r f r o m the a g g r e g a t e d a t a would, t h e r e f o r e , be i n v a l i d . I f t h e i n d i v i d u a l banks were f o u n d t o r e a c t i n d i f -f e r e n t ways, t h i s paper would be i n c o m p l e t e w i t h o u t a d i s -c u s s i o n o f t h e f a c t o r s i n f l u e n c i n g the b o r r o w i n g s o f each bank. T h i s , t h e n , w i l l be t h e purpose o f Chapter V. CHAPTER V AN EXAMINATION OF THE INDIVIDUAL BANK'S BORROWING BEHAVIOR In Chapter IV an examination was made of the r e l a -tionship between the aggregate advances under the Finance Act, the least—cost spread and the banks* aversion to being heavi-l y indebted. The empirical evidence appeared to confirm the hypothesis formulated i n Chapter III at the aggregate l e v e l . The purpose of t h i s chapter i s f i r s t , to examine the borrowings of the i n d i v i d u a l banks to see i f they were de-pendent on the two hypothesized factors — the least—cost spread and the aversion against heavy indebtedness — and second, to explain any important variances i n the relationships among the various banks. The following analysis w i l l be l i m i t e d to the boom period of the late 1920*s. For that period the records of the month-end borrowings by each bank are a v a i l a b l e . At the same time, both the least-cost spread and the volume of borrowings varied over a wide range, thus making the period quite s u i t -able for studying the influence of both f a c t o r s . 81 82 C l a s s i f i c a t i o n of Borrowings According to the Least-cost  Spread To f a c i l i t a t e the analysis, the banks may be grouped according to th e i r manner of borrowing. In t h i s section the banks w i l l be c l a s s i f i e d according to the strength of the 1 least-cost factor on t h e i r borrowing. The data supplied i n Table IV and charted in Figure 11 show that the banks f e l l into three f a i r l y d i s t i n c t classes. F i r s t , there was a group of banks whose borrowings apparently were strongly influenced by the least—cost spread. These banks either borrowed frequently or were continuously i n debt 2 to the Minister of Finance. Second, there was a group of banks which only borrowed when the least—cost spread was 1.70 and above. Compared with the banks i n the f i r s t group, the banks i n the second group borrowed l e s s frequently. The banks of these two groups, here c a l l e d the " l e a s t -*A b r i e f discussion r e l a t i n g more to the i n d i v i d u a l banks i s provided i n Appendix B. 2 In t h i s paper, frequency of borrowing refers to f r e -quency of reported indebtedness. The only record available f o r the i n d i v i d u a l bank's borrowings i s the month-end balances of advances owed. Some of these balances were outstanding f o r several months at a time while others were repaid within a few days. No d i s t i n c t i o n has been made between these two types of borrowings. TABLE IV QUARTERLY AVERAGE OF MONTH—END ADVANCES UNDER THE FINANCE ACT TO THE INDIVIDUAL BANKS, JULY 1927 TO SEPTEMBER 1929 (IN THOUSANDS OF DOLLARS) Name of Period 1927" " 1928 1929 Q2 Q3 Ql Q2 Q3 Q4 Ql Q2 Q3 Bank Spread -.40 -.04 + .61 +1.70 +2.44 +3.29 +3.61 +4.37 +4.52 Least—Cost Borrowers Frequent Borrowers Royal Bank 4,000 9*667 14*000 14*000 22,333 21*667 21,667 25,000 25,000 Can. Bank of Com. 3,000 7,333 4,667 6*667 9,000 17,000 18,667 21,667 19,667 Banque Can. Nationale 8*500 667 2*500 4,667 4,000 7,500 11,833 8,300 Dominion Bank 2,000 2,833 3,833 2,833 5,167 5,000 5,667 4,000 5*167 Sub Total 17,500 20,500 22,500 26,000 41,167 47,667 53,501 62,500 58,134 Infrequent Borrowers Bank of Montreal Bank of Nova Scotia Imperial Bank Sub Total Non Least—Cost Borrowers Remaining Banks Bank of Toronto Banque Prov. du Can. Sub Total l l , 6 6 7 a 15,000 15,000 15,000 5,667 6,667 10,000 13,333 7,000 4,000 667 833 11,667 15,000 20,667 21,667 17,667 18,166 333 1*250  1,583 1,167 750  1,917 3,000 1,167  4,167 3*000 1,833  4,833 667  667 1,000 2,000 2,167 333 1,000 2,000 2,167 333 Absorbed Banks Standard Bank Weyburn Security B. Sub Total Total 2,833 4,333 2,333 2,833  21,916 4,333  26,750 2,333  29,000 417  417 700 700  77,168 82,751 77,333 aBank of Montreal began to borrow i n May, 1928. Average for May and June: $17,500. ^Standard Bank ceased to exist Qn Nov. 3, 1928. October borrowing: $3,000. Source: "Monthly Returns by the Chartered Banks," Canada Gazette. co bo 84 85 cost banks," consisted of those banks which maintained a port-f o l i o of c a l l loans i n New York. They included a l l the large well established banks and some of the smaller ones. A t h i r d group consisted of the banks whose borrowings apparently were not dependent on the least—cost spread. These "non-least-cost banks" consisted of some of the smaller banks which usually had no c a l l loans i n New York. For such banks, the New York c a l l loan rate d i d not appear to be a relevant a l t e r n a t i v e cost to the rate charged on advances. The follow-ing analysis w i l l mainly be concerned with the solvent banks of t h i s group. The borrowing pattern of the insolvent banks, which were subsequently absorbed by other banks, has already been discussed i n Chapter IV. B r i e f l y , the absorbed banks appeared to use the Finance Act as a substitute f o r their de-f i c i e n t working c a p i t a l ; they often borrowed continuously with 1 l i t t l e month-to—month v a r i a t i o n . C l a s s i f i c a t i o n of Borrowings According to Volume According to the revised hypothesis, the reluctance to "4>uring the l a s t two years before November 1928, when the Standard Bank was absorbed by the Canadian Bank of Commerce, the former interrupted i t s month-end borrowings only on the l a s t day of each f i n a n c i a l year so as to show no balance owing on the balance sheet. The Weyburn Security Bank borrowed uninterrupt-edly during 19 months before i t i n the beginning of 1931 was absorbed by the Imperial Bank of Canada. 86 be heavily indebted under the Finance Act tends to exert an increasingly r e s t r a i n i n g influence as the amount of indebted-ness grows. In Table V the banks have been grouped according to r e l a t i v e l e v e l of heavy borrowing. The average of the s i x highest month—end balances were used as a measure for heavy 1 borrowing. To standardize t.o; size t h i s measure has been calculated as a percentage both of the banks* net worth and t o t a l assets. The number of months during which the banks reported balances of advances owing, as shown i n the last column of Table V, appears to separate the banks along the same l i n e s as does the r e l a t i v e measure of indebtedness. Explanation of Differences i n Borrowing Habits The borrowing habits r e l a t i n g to volume and frequency have been described, but no reason has been provided for variances i n behavior among the banks. It was evident i n res-pect to both frequency and volume that the "Heavy Borrowers" "^Various measures for heavy borrowing were t r i e d be-fore i t was decided to use the average of s i x high balances as an indicator of normal heavy borrowing. Thus i t was found that the single highest balance could be considered an except-ion which might not r e f l e c t a bank's normal p o l i c y . On the other hand, the average borrowing during a period would r e f l e c t the l e v e l of continuous borrowing rather than high borrowing. S t i l l , i f the highest quarterly averages had been used the r e -sul t would have been e s s e n t i a l l y the same. 87 TABLE V HEAVY VOLUME AND FREQUENCY OF BORROWINGS UNDER THE FINANCE ACT BY INDIVIDUAL BANKS, JULY 1927-SEPT. 1929 Class of Borrowing and Name of Bank High Advances Ave. of six highest month-High Advances as percentage of Frequency of Reported i n -debtedness by end balances Net Total continuing (Thousand Worth** A s s e t s 3 banks D o l l a r s ) 1 Heavy Borrowers Royal Bank 25.000 25.7 2.60 25 Can. Bank of Com. 22.167 37.1 3.00 27 Banque Can. Nat. 10.950 78.2 7.09 21 Dominion Bank 6.333 39.6 4.11 25 Banque Prov. du Can. 2.083 37.9 3.90 21 Light Borrowers Bank of Montreal 15.833 21.4 1.77 16 Bank of Nova Scotia 7.000 23.3 2 * 55 c 17 Imperial Bank 2.500 16.7 1.73 2 Bank of Toronto 3.333 22.2 2.53 9 Absorbed Banks Standard Bank 4.416 57.2 4.21 Weyburn Security 677 87.4 11.00 The s i x observations were taken from the period July 1927 to September 1929. Only two month—end borrowings were found for the Imperial Bank; on the basis of borrowing done subsequently, the higher of these were chosen as representing a normal l e v e l of high borrowing. 'Paid-up C a p i t a l and Reserve fund were taken as of December 31, 1929 for a l l banks except the Standard Banks for which the Net Worth as of December 31, 1927 was used. T o t a l Assets as of December 31, 1929 were used except i n the case of the Standard Bank for which the calculations were based on December 31, 1927. Source: "Monthly Returns of the Chartered Banks," Canada Ga-zette. used the f a c i l i t i e s of the F i n a n c e Act more than the banks i n the other group. To account f o r t h i s , i t would seem l i k e l y t h a t the a v e r s i o n to being indebted under the Act would be s t r o n g e r among c o n s e r v a t i v e banks than among l e s s c o n s e r v a t i v e 1 banks. To t e s t t h i s assumption, the whole s t r u c t u r e of the banks' p o l i c i e s must be examined. A c o n f i r m a t i o n of the as-sumption would r e q u i r e that the banks with the more r e s t r a i n e d borrowing p o l i c i e s g e n e r a l l y would be more c o n s e r v a t i v e than the other banks. Thus, i f c l a s s i f i e d by o t h e r p o l i c i e s , the banks c o u l d be separated i n the same two groups, then the bor-rowing p o l i c i e s c o u l d be e x p l a i n e d as being p a r t of a coherent p o l i c y s t r u c t u r e . To make such a c l a s s i f i c a t i o n , i t w i l l be attempted f i r s t , to f i n d some o b j e c t i v e c r i t e r i a of conserva-t i s m , and second, to o r d e r each bank i n rank of degree o f conservatism. Unless the r e s u l t of such a t e s t shows the more c o n s e r v a t i v e banks a l s o to be the l i g h t u s e rs of the f a c i l i -t i e s under the Finance A c t , the assumption must be r e j e c t e d . I t may be d i f f i c u l t , i f not i m p o s s i b l e , to f i n d seve-r a l c r i t e r i a of conservatism which are i n d i s p u t a b l e , independent 1 Both Burgess and Turner hypothesized that t r a d i t i o n a g a i n s t borrowing was a f a c t o r i n f l u e n c i n g r e d i s c o u n t i n g p o l i c i e s . See d i s c u s s i o n i n Chapter I I I . 89" and f o r which data are a v a i l a b l e . The conservatism of a bank may, for instance, be defined according to the bank's lending and investment p o l i c i e s . Thus, an auditor might be able to determine the aggressiveness of a bank's lending p o l i c i e s by examining i t s current loans according to the d i s t r i b u t i o n of 1 r i s k s , the r a t i o of overdue accounts and the percentage of bad debts. Compared with the less conservative, the conservative banks could be expected to have r e l a t i v e l y smaller losses from bad debts. The degree of conservatism might also be apparent to the auditor by an examination of the bank's s e c u r i t i e s , t h e i r maturities and their evaluation f o r balance sheet pur-poses. A l l t h i s information, however, i s not a v a i l a b l e . An apparently obvious c r i t e r i a of conservativeness i s the reserve r a t i o which a bank held against i t s l i a b i l i t i e s . The data for c a l c u l a t i n g reserve r a t i o s are a v a i l a b l e , but there are major problems i n in t e r p r e t i n g any calculated r a t i o s . For example, the reserve r a t i o s of small banks and large banks *It i s desirable f o r a bank to d i s t r i b u t e i t s loans over various industries and regions and to r e f r a i n from making excessively large loans to a single i n t e r e s t . The danger i n making large loans to one f i r m was demonstrated by the heavy loss sustained by La Banque Nationale i n 1923. The p r i n c i p a l reason for the absorption o f that bank was the default on the payment of a loan of approximately $5 m i l l i o n by a farm imple-ment plant which went bankrupt. See Jamieson, p. 63. 90 may not be d i r e c t l y comparable. Reserves were held p a r t l y against random variations of clearing drains, but the propor-tions of random variations were conceivably smaller f o r a large than f o r a small bank. Also, the large banks had large deposit l i a b i l i t i e s i n other countries and i t i s not known what proportion of t h e i r reserves were held against foreign l i a b i l i t i e s . However, i t would be reasonable to expect that con-servative banks would generally be w i l l i n g to forego some earn-ing power by holding a larger proportion of money or near—money 1 than would less conservative banks. Consequently, one c r i -t e rion might, therefore, be based on the opportunity cost of holding reserves. Such a cost i s obvious for cash reserves which earn no interest at a l l . But cash reserve r a t i o s cannot be considered separately from t h e i r substitute, secondary cash reserves, that i s , c a l l loans i n New York. Moreover, a bank which had a large l i q u i d security p o r t f o l i o would obviously need less cash and secondary reserves than a bank with a small 1The high l i q u i d i t y of reserves i s usually obtained by a s a c r i f i c e of earning power. Thus, s e c u r i t i e s of very short maturities and c a l l loans i n New York generally pay less inter e s t than current loans and s e c u r i t i e s of longer maturi-t i e s . 91 1 l i q u i d security p o r t f o l i o . To guage a bank's conservatism with respect to reserves, i t would, therefore, be necessary to consider i t s l i q u i d assets (not including Canadian c a l l loans) i n r e l a t i o n to i t s l i a b i l i t i e s . Another problem arises i n choosing an appropriate date for which to calculate the reserves. If a r a t i o were calcu-l a t e d as of the beginning of the period under study, i t would 2 be r e l a t i v e l y large compared to a r a t i o calculated l a t e r . A large holding of s e c u r i t i e s i n 1927, however, d i d not r e f l e c t deliberate reserve p o l i c i e s . Rather, the large security port— 3 f o l i o s were the r e s u l t of lacking demands for current loans during which s e c u r i t i e s substituted as a l t e r n a t i v e earning assets. In short, i t would not be relevant to speak of an opportunity cost of a large security p o r t f o l i o for that period. ^As previously mentioned, there are no data available about the maturities of s e c u r i t i e s held by the banks. The l i q u i d i t y of security p o r t f o l i o s may have varied s u b s t a n t i a l l y among the banks, but f o r the purpose of t h i s analysis i t w i l l be assumed that the banks generally held short term s e c u r i t i e s and that the proportion of very l i q u i d to longer term maturi-t i e s was the same fo r a l l the banks. 2 T o t a l s e c u r i t i e s were 18.3 per cent of t o t a l assets i n July 1927, compared to 12.7% i n December 1929. See C u r t i s , S t a t i s t i c a l Contributions to Canadian Economic History, p. 64. 3 Apart from the recent recession, there had been a decline i n demand for bank loans by large firms which increas-i n g l y had turned to the c a p i t a l market f o r working c a p i t a l . See Mclvor, p. 117. 92 On the other hand, during 1929 the security holdings were r e -duced but the c a l l loans i n New York had increased. Again the increase was made for the purpose of taking advantage of the high c a l l loan rates rather than f o r the accumulation of re-quired reserves. Thus, these rates increased from about 4 per cent i n 1927 to more than 9 per cent i n the middle of 1929. Mo s a c r i f i c e of earning power was, therefore, made by being l i q u i d during the f i r s t three quarters of 1929. In the last quarter, the New York c a l l loan rate began to f a l l and the banks' New York c a l l loans declined. At the end of the year the c a l l loans had, consequently, lost some of the i r a t t r a c -tiveness as earning assets. The end of 1929 was, therefore, used for the c a l c u l a t i o n of a measure i n d i c a t i n g the banks' reserve p o l i c i e s . The measure i t s e l f consisted of the r a t i o of t o t a l current loans and Canadian c a l l loans to t o t a l assets. The smaller the r a t i o , the larger were the reserves and, there-fore, also the l i q u i d i t y of the bank. A second index of rank was based on the r a t i o of the banks' rest fund to the i r paid up c a p i t a l . A large r a t i o was 1 a sign of s t a b i l i t y and security to the bank's c r e d i t o r s . Reserve or rest funds were considered to be a resu l t of a) long years of c a r e f u l , persistent and economic management on the part of the banks b) long years during which the shareholders were content 93 A t h i r d index was constructed from the r a t i o of net worth to t o t a l l i a b i l i t i e s . The larger the r a t i o , the safer were the claims of the c r e d i t o r s , c e t e r i s paribus. These f i r s t three indexes are ordinary and quite universal i n d i c a -tors of the conservatism of a bank. The fourth index i s p e c u l i a r to the circumstances of the late 1928 and f i r s t three quarters of 1929 as i t i s based on the proportional change i n each bank's Canadian c a l l loans. In the banks' annual reports f o r 1929, the banks warned against speculative a c t i v i t y and branch managers had been counselled against making loans f o r speculative purposes, including Ca— 1 nadian c a l l loans. In these circumstances, i t could be expec-ted that the banks' Canadian c a l l loans would show a decline except perhaps i n the case of some of the less conservative banks. The fourth index, i n short, compares the average of September and October holdings of Canadian c a l l loans f o r 1928 and 1929 and the banks are ranked according to the r e l a t i v e change. The most conservative bank i s the one with the greatest to accept low dividends and allow earnings to accumulate c) premiums obtained by the sale and allotment of new stock. See Canada, Parliament, House of Commons, Debates, 1913, p. 2352, reprinted i n Bank Act Revision proceedings, p. 68. ^See Jamieson, p. 71 94 r e d u c t i o n d u r i n g t h a t y e a r . I n T a b l e VI the banks are r a n k e d a c c o r d i n g t o f o u r i n d e x e s . Moreover, the r a n k — o r d e r numbers f o r each bank have been added. For c o n v e n i e n c e o f comparison w i t h T a b l e V, the 1 banks have been d i v i d e d i n t o two groups. A comparison w i t h T a b l e V shows the c o n s e r v a t i v e banks t o be t h o s e f o r m e r l y r a t e d as l i g h t b o r r o w e r s , w h i l e the l e s s c o n s e r v a t i v e banks were the heavy u s e r s o f t h e f a c i l i t i e s under the A c t . To examine i f t h e l e s s c o n s e r v a t i v e banks c o u l d be i d e n t i f i e d by t h e i r a g g r e s s i v e p o l i c i e s , the banks were o r -d e r e d i n r a n k s a c c o r d i n g t o t h e i r achievements as shown i n 2 T a b l e V I I . From T a b l e V I I i t appears t h a t the banks* b o r r o w i n g p o l i c i e s c o u l d not be p r e d i c t e d from t h e i r a c h i e v e m e n t s . I t may be o b s e r v e d t h a t i f o n l y one o r two i n d i c a -t o r s were used, t h e banks might not f a l l i n t o the same c l a s s i f i c a t i o n s . T h i s r e f l e c t s t h e f a c t t h a t the whole p o l i c y s t r u c t u r e o f a bank i s made up by many i n d i v i d u a l p o l i c i e s and the more p o l i c i e s t a k e n i n t o a c c o u n t , the s t r o n g e r the t r e n d s h o u l d show up. I t i s sometimes d i f f i c u l t t o d e t e r m i n e whether an i n -d i c a t o r such as the change i n c a l l l o a n s s h o u l d be i n c l u d e d as an i n d i c a t o r o f c o n s e r v a t i s m or i t s h o u l d be i n c l u d e d as an i n d i c a t o r o f a g g r e s s i v e n e s s , g i v i n g the bank w i t h t h e g r e a t -e s t i n c r e a s e t h e h i g h e s t r ank as an a g g r e s s i v e bank. I n t h i s p a r t i c u l a r case i t was assumed t h a t an i n c r e a s e i n c a l l l o a n s r e f l e c t e d a p a s s i v e accommodation o f c u s t o m e r s , whereas a r e d u c t i o n r e q u i r e d an a c t i v e and sometimes unpopular p o l i c y . TABLE V I RANK-ORDERING OF THE BANKS ACCORDING TO THE CONSERVATISM OF THEIR POLICIES (HIGHEST NUMBER GIVEN TO THE MOST CONSERVATIVE BANK) R a t i o o f R a t i o o f Re- R a t i o o f R e l a t i v e Change T o t a l C u r r e n t Loans s e r v e Fund Net Worth i n C a n a d i a n C a l l o f Name o f and Canadian t o P a i d — u p t o T o t a l Loans D u r i n g Rank Bank C a l l Loans t o C a p i t a l L i a b i l i - y e a r e n d i n g Numbers T o t a l A s s e t s t i e s O c t . 3 1 , 1929 a L e s s C o n s e r v a t i v e Rank Rank Rank Rank Banks R o y a l Bank 4 3 1 3 11 Can. B. o f Com. 8 3 2 2 15 Banque Can. N a t . 7 3 4 7 21 Dominion Bank 3 - 7 5-1/2 1 16-1/2 Banque P r o v . du Can. 2 1 5-1/2 4 12-1/2 C o n s e r v a t i v e Banks Bank o f M o n t r e a l 9 5 3 6 23 Bank o f Nova S c o t i a 6 9 8 9 32 I m p e r i a l Bank 5 6 7 5 23 Bank o f T o r o n t o 1 8 9 8 26 a T o reduce random v a r i a t i o n , the c a l c u l a t i o n s were based on a two months average (Sep-tember and Octo b e r ) f o r 1928 and 1929. Source: C a l c u l a t i o n s based on "Monthly R e t u r n s by t h e C h a r t e r e d Banks," Canada G a z e t t e . TABLE VII RANK-ORDERING OF THE BANKS ACCORDING TO THEIR AGGRESSIVENESS AND ACHIEVEMENTS (HIGHEST NUMBER GIVEN TO THE MOST SUCCESSFUL BANK IN TERMS OF PERCENTAGE CHANGE) Number of Change i n Change i n Increase i n Total of Branches Canadian Total Share Values Rank Name of Bank opened Current Assets from 1926 low Numbers 1923-29a Loans 1927-29 to 1928 high 1927-29 Less Conservative Banks Rank Rank Rank Rank Royal Bank 10 8 9 9 36 Can. B. of Com. 8 9 10 6 33 Banque Can. Nat. 1 2 3 1 ,: 7 Dominion Bank 5 3 8 2 18 Ban. prov. du Can. 4 4 4 5b 17 Conservative Banks Bank of Montreal 6 7 6 8 27 Bank of Nova Sco. 2 5 5 4 16 Imperial Bank 3 6 2 3 14 Bank of Toronto 9 10 7 7 33 aThe period 1923 to 1929 was chosen i n preference to 1927 to 1929. The establishment of new branches were part of long term p o l i c i e s and the period 1927—29 was too short to give a true in d i c a t i o n of the banks' long term achievements. b The shares of Banque Provinciale du Canada were not l i s t e d on the stock exchanges. The rank i s therefore only an estimate. The estimate i s based on the r e l a t i v e change i n net p r o f i t s , which i n the case of the other banks were strongly r e l a t e d to the change i n share values. Source: Calculations based on "Monthly Returns by the Chartered Banks," Canada Gazette, and The Financial Post, Survey of Corporate S e c u r i t i e s , Toronto, MacLean Pub-l i s h i n g Co., 1930, pp. 122-129 and Canada Year Book. 97 Although the Royal Bank and the Bank of Commerce are shown to be among the most aggressive, the Banque Canadienne Nationale, the Bank of Toronto and the Bank of Montreal f a l l i n the wrong category i f conservative were equated with unprogressive and less conservative, with aggressive. Conclusion The purpose with t h i s chapter was to test that an analysis of the i n d i v i d u a l bank's borrowing behavior would y i e l d r e s u l t s consistent with those of l a s t chapter's aggre-gate a n a l y s i s . The findings of the micro analysis appear to confirm that both the least—cost spread and the reluctance to borrow were important determinants of the banks' borrowings. Moreover, the micro analysis revealed c e r t a i n behavioral relationships which are obscured by aggregation. The conclusions of t h i s chapter may be b r i e f l y stated as follows. The least-cost spread appears to have exerted an influence on the borrowing of most of the banks. It appears, however, that the New York c a l l loan rate was an alternative cost only for those banks which had regular p o r t f o l i o s of c a l l loans i n New York. For the others, mainly the smaller banks, the use of the c a l l loan rate appears not to have been relevant as a measure of alt e r n a t i v e cost comparable to the 98 rate charged on advances. The micro analysis shows the reluctance factor to be important but d i f f e r e n t i n effect from what had previously been assumed. Not only d i d the factor operate as a voluntary c e i l i n g to the banks 1 indebtedness, to some conservative banks the t r a d i t i o n against borrowing from the Government also con-s t i t u t e d an aversion to borrow at a l l . Only the advantage of a comparatively high least—cost spread would outweigh the re-luctance to borrow of the more conservative banks. Each of these banks, moreover, abstained from increasing t h e i r i n -debtedness beyond a c e i l i n g which was considerably lower than those of the less conservative banks. Because the conservative banks began to borrow only at a s i g n i f i c a n t least-cost spread when some of the other banks had reached t h e i r c e i l i n g , the aggregate expansion path of borrowings does not indicate the f u l l e f f e c t of the aver-sion to borrow. Based on the analysis of the i n d i v i d u a l banks, i t can be stated that the aggregate expansion path i n Figure 5 gives a misleading impression; that i s , the l e a s t -cost r e l a t i o n s h i p appears stronger and the reluctance f a c t o r , weaker, than revealed by the analysis of the i n d i v i d u a l bank's borrowing. CHAPTER VI CONCLUSION The purpose of t h i s thesis i s to evaluate the con-troversy over the use made by the chartered banks of the f a c i l i t i e s provided under the Finance Act. During the inquiry of the MacMillan Commission, the Act was c r i t i c i z e d f or having operated to the private benefit of the chartered banks rather than to the benefit of the country's economy i n general. S i r Thomas White defended the banking system's use of the Act by stating that the banks had always borrowed sparingly and repaid t h e i r loans quickly. The reason for t h i s behavior, he hypothesized to be due to the banks' d i s i n c l i n a -t i o n to pay the int e r e s t rate on advances combined with an aversion on the part of the banks of being heavily indebted to the Treasury. In Chapter III S i r Thomas' hypothesis was examined for l o g i c a l consistency. The hypothesis, however, was found meaningless as o r i g i n a l l y expressed. The interest cost of 99 100 advances, t h u s , c o u l d o n l y be a v o i d e d by u s i n g o t h e r means o f a d j u s t m e n t , which a l s o had t h e i r c o s t . On t h e as s u m p t i o n t h a t the banks would p r e f e r the l e a s t c o s t l y means o f a d j u s t -ment, S i r Thomas' h y p o t h e s i s was r e v i s e d t o t h e f o l l o w i n g f o r m : They ( t h e c h a r t e r e d banks) have a l w a y s been s p a r i n g i n t h e i r r e s o r t t o i t s (the F i n a n c e A c t ' s ) p r i v i l e g e s and pay o f f t h e i r advances q u i c k l y . There i s a t w o f o l d r e a s o n f o r t h i s p o l i c y : f i r s t l y , because t h e y p r e f e r the l e a s t — c o s t means o f r e p l e n i s h i n g c ash r e s e r v e s and, s e c o n d l y , because t h e y do not c a r e t o i n c u r o r t o show i n t h e i r r e t u r n s heavy i n d e b t e d n e s s i n r e s p e c t o f advances under t h e A c t . A method f o r t e s t i n g the h y p o t h e s i s was d e v i s e d by i n d i f f e r e n c e c u r v e a n a l y s i s . I t was argued t h a t i f b o t h t h e l e a s t — c o s t c o n s i d e r a t i o n and t h e a v e r s i o n toward heavy i n -debtedness were i m p o r t a n t d e t e r m i n a n t s , t h e e f f e c t s would be apparent f r o m t h e shape o f t h e e x p a n s i o n p a t h o f b o r r o w i n g r e l a t i v e t o the l e a s t - c o s t s p r e a d . I n t h a t case the e x p a n s i o n p a t h c o u l d be e x p e c t e d t o l e v e l o f f when a l e v e l o f heavy i n -debtedness was r e a c h e d . I n C hapter I V , t h e h y p o t h e s i s was c o n f i r m e d by an e m p i r i c a l t e s t o f aggregate d a t a o f t h e b a n k i n g system's b o r -r o w i n g s under t h e A c t . However, when t h e i n d i v i d u a l bank's b o r r o w i n g s were examined i n Ch a p t e r V, i t was f o u n d t h a t i n d i -v i d u a l v a r i a t i o n i n the b e h a v i o r a l r e l a t i o n s h i p s had o b s c u r e d 101 some o f the e f f e c t s o f the a v e r s i o n f a c t o r i n t h e aggregate a n a l y s i s . Hence, i t was o b s e r v e d t h a t some banks had i n i t i a t e d b o r r o w i n g s a t a l e a s t - c o s t s p r e a d at which o t h e r banks had be-gun t o l e v e l o f f i n t h e i r b o r r o w i n g s . An e x a m i n a t i o n o f the p o l i c y s t r u c t u r e s o f the i n d i -v i d u a l banks showed the a v e r s i o n f a c t o r t o be p a r t o f a c o h e r e n t s e t o f p o l i c i e s . I n t h i s c o n n e c t i o n , the more con-s e r v a t i v e banks were f o u n d t o be r e l u c t a n t t o borrow a t a l l l e v e l s o f i n d e b t e d n e s s , w h i l e t h e l e s s c o n s e r v a t i v e banks were r e l u c t a n t t o borrow o n l y a t l e v e l s o f heavy i n d e b t e d n e s s . On t h e b a s i s o f t h e e m p i r i c a l a n a l y s i s , the q u e s t i o n whether t o a c c e p t or r e j e c t the r e v i s e d h y p o t h e s i s must be answered. The answer may be d i v i d e d i n two p a r t as the hypo-t h e s i s i t s e l f , c l e a r l y , c o n s i s t s o f two s e c t i o n s . The former s e c t i o n i s a statement o f f a c t s w h i l e the l a t t e r i s a s t a t e -ment o f c a u s a l r e l a t i o n s h i p s . The statement o f f a c t s must be j u d g e d t o be a m i s l e a d -i n g and i n c o r r e c t o v e r g e n e r a l i z a t i o n . There were, t h u s , g r e a t d i f f e r e n c e s among t h e banks. W h i l e t h e c o n s e r v a t i v e banks borrowed r e l a t i v e l y s m a l l amounts, some o f the o t h e r banks borrowed up t o 80 and 90 p e r c e n t o f t h e i r net w o r t h . More-o v e r , w h i l e a few banks borrowed f o r r e l a t i v e l y b r i e f p e r i o d s , o t h e r banks were i n d e b t e d t o t h e government f o r y e a r s a t a 102 time. With respect to the relationships of the second part of S i r Thomas' statement, i t must be concurred that both the least-cost spread and the aversion to indebtedness were cru-c i a l f a c t o r s . The least-cost spread, which was not part of the o r i g i n a l hypothesis, appeared to influence the majority of the solvent banks although i t was most obvious i n r e l a t i o n 1 to less conservative banks. The aversion hypothesis, however, appeared to be de-f i c i e n t by not recognizing an aversion to borrow at a l l lev e l s of indebtedness by the more conservative banks. For these reasons the revised hypothesis must be rejected. Summing up the discussion, i t i s evident that apart from substantial i n d i v i d u a l differences the banks could be c l a s s i f i e d by t h e i r borrowing behavior into three groups: con-servative banks, less conservative banks and insolvent banks. The conservative banks borrowed only at substantial least—cost spreads and borrowed only moderate amounts. The No relevant a l t e r n a t i v e cost was found f o r those banks which d i d not have regular c a l l loans i n New York. If a relevant a l t e r n a t i v e cost had been used for a l l banks i n the c a l c u l a t i o n of the least-cost spreads, a further c o n f i r -mation of the least-cost hypothesis would not have been un-l i k e l y . 103 less conservative, but solvent, banks borrowed frequently and remained indebted to the Treasury up to several years. They borrowed comparatively larger amounts than the conserva-t i v e banks. The insolvent banks borrowed r e l a t i v e l y large amounts and were regularly i n debt to the Treasury u n t i l they were absorbed. The determinants of borrowings consisted of the l e a s t -cost spread and the aversion to indebtedness. The least-cost spread may be assumed to have effected a l l banks to varying degrees. The aversion to being indebted under the Act was apparent at a l l lev e l s of borrowing for the conservative banks but only at high levels for the others. With respect to the controversy which led S i r Thomas to formulate h i s hypothesis, i t appears that the majority of the banks took advantage of the Finance Act to t h e i r own benefit. APPENDIX A A COMPARISON OF THE DATA FROM THE VARIOUS AVAILABLE RECORDS OF ADVANCES UNDER THE FINANCE ACT As previously noted, the only monthly record of ad-vances covering the whole period of the Finance Act i s the 1 record of month-end balances owed by the banks. This i s a record of balances owed by the banks for one day only out of each month. The borrowings reported i n the monthly returns re-f l e c t four d i f f e r e n t types of borrowings. F i r s t , there i s the discounting for cash adjustment purposes. This type of borrowing may be assumed to have been made generally for periods of one day to perhaps a few weeks. This type of borrowing probably occurred during the month according to the cash drain at the Clearing Houses. Thus, a month-end balance may some-times r e f l e c t a borrowing f o r cash adjustment. Secondly, The data from August 1914 to December 1929 may be found i n C u r t i s , S t a t i s t i c a l Contributions to Canadian Eco'  nomic History, p. 27. From October 1923 a record of borrowings i s also provided i n the "Returns of the Chartered Banks," Canada Gazette. 104 105 borrowings may r e f l e c t attempts at "window-dressing." As noted, t h i s term referred to the custom among the banks to change the i r assets and l i a b i l i t i e s i n t h e i r monthly and year-l y statements to give an appearance of greater soundness of 1 the bank's p o s i t i o n . Borrowings under the Finance Act were an easy way to replenish cash reserves on the l a s t day of the month. There i s strong evidence that the banks used the Finance Act for t h i s purpose which, of course, tended to make the recorded balances greater than the average borrowings. Thirdly, borrowings were made during seasons and other periods of exceptional heavy demand for bank loans, and fourthly, bor-rowings were made by banks suf f e r i n g from a more than seasonal or temporary shortage of working c a p i t a l . Such borrowings were often made during several quarters before the i l l i q u i d banks were f i n a l l y absorbed by larger and usually f i n a n c i a l l y stronger banks. For the period from January 1927 to July1933, the 2 MacMillan Report contains some series of borrowings which For a b r i e f discussion of "window-dressing" see Cur-t i s , S t a t i s t i c a l Contributions, p. 5. o MacMillan Report, pp. 41-3. 106 p r o v i d e a means o f c h e c k i n g t h e r e l i a b i l i t y and b i a s e s o f t h e month-end b a l a n c e s e r i e s as an i n d i c a t o r o f t h e " t r u e " average b o r r o w i n g s under the A c t . I n the f o l l o w i n g p a r t o f t h i s a p p e n d i x , an a n a l y s i s o f t h e s e r i e s w i l l be made. I n o r d e r t o reduce t h e element o f random v a r i a t i o n s , which i s e s p e c i a l l y pronounced i n the month-end b a l a n c e s e r i e s , q u a r t e r l y a v e r a g e s o f monthly d a t a w i l l be used i n t h e comparison o f month—end b a l a n c e s and monthly a v e r a g e s o f d a i l y advances. I n F i g u r e 12, a c o r r e l a t i o n i s done o f t h e s e two s e r i e s f o r t h e y e a r s 1927 t o 1932. The month-end b a l a n c e s appear always t o be h i g h e r t h a n t h e d a i l y a v e r a g e s . The l a t t e r a r e a p p r o x i m a t e l y z e r o when month-end b a l a n c e s a r e $10 m i l l i o n and the d a i l y a v e r a g e s v a r y g e n e r a l l y 75% o f t h e v a r i a t i o n i n the month—end b a l a n c e s . From an e x a m i n a t i o n o f month-end b a l a n c e s and monthly " h i g h , " t h e r e i s l i t t l e doubt t h a t the advances are c o n s i s t e n t -l y a t t h e i r h i g h e s t p o i n t a t t h e end o f each month. T h i s f a c t p r o v i d e s a s t r o n g i n d i c a t i o n o f " w i n d o w — d r e s s i n g . " I n F i g u r e s 13 t o 16 d i f f e r e n t s e r i e s have been c o r -r e l a t e d w i t h t h e l e a s t - c o s t s p r e a d f o r the p e r i o d 1927-32. Q u a r t e r l y averages o f monthly d a t a have been used i n t h e f i r s t two c a s e s . 107 o 03 -l-i-h It Finance-Act H-rr iXX} - rH- I xxxt xjxrlxlxi: xRx; ances::: xm .i+lj-Figure i:14 + ? T T ' t T p ' m T^T-i' itfc!: H-H +IR- TlTi TM7 ij.ijj H-H- .1±i. _Th e r e l 6t ions h iplx.be;t wee •nllthe. quarterly under;*he ;ayerage:s': bf; -Finance Act month—e anuar ;x:xr: least.-rcost ..Ispr'e adiaridxLthe . , : . • I.':-' • : - : : ' I.;x.: .-z - ; - • i ;•":|-; •; i: nd i bajlance.s -of (advance s yA\92 7:-:;pecember 1932 m 'Mill ion ..T-jq: . !XU TJxi' ;-:T!' +!Tf I- - r r t i l l xxn: •'nix tl-i+ifxtt p a . , „ 1Doliars -14;: xx;± l -H-±l±i .;?o_ ± t - + T - y i + r T T T T + i l l x::x:: :H±r J x i i ±i±i 4±tt T80 xtxt x b i T4TI +-H4 T - n - r 2911 ± 2 9 1 rxxixSjI • 2 9 1 I I R T F rtt TrR ' • M r - i r : : 2 8 I V -60 r!±t. 5 F i i i i I S FFf- • 2 8 I I T O vo -tt~ •-H4+ - - r - t - H -:40 3011 E E H-R- FRT ttfci 301 RTF ±l|: ••t+f-S 2 RTF 321 28-I-I-+TF tttt : Jitx o n _ x d x i SEE rxx r r H - +t TRT 3 0 I V x!±t •3211 33+1 -30III :EEB: H~rr -rp-r "TTTf-271:112 I K I t t l " •281 2:7-I:V TFR H-H-: H T p T I20RT -+H+ HRT rlO 31I-I-it HS5J fi- TFTr T I T E E 3 1 I I I Etj±31i5B -Trf?-' TRT :F5 RT T|4l;IrR # 2 n l ; 11.1.; r-t-i-I xi: Pip IFF tlti j 4 . L i . :BI| X p X p j X j l H 2711 XX - l - r f i -r+i- +i-B-x g :H+i-±a - r r H - t o x x ; Ski Spa m--IM-H iTT/ii "in"!' +3 ;-+4TI; m -*5 -H-H- xri': ±J±i H-H-fFrl Sfi : L t ± j : TR-'i H . . nr-r-. H-i-'r : |l?ea !s :t^bo ;st' : RTF 110 The c o r r e l a t i o n o f month-end b a l a n c e s e v i d e n t l y has two i m p o r t a n t s i m i l a r i t i e s w i t h t h e c o r r e l a t i o n based on d a i l y a v e r a g e s . B o t h f i g u r e s show a l e v e l l i n g o f f o f borrow-i n g s as a l e v e l o f "heavy i n d e b t e d n e s s " i s r e a c h e d . The l e v e l l i n g o f f p r o c e s s b e g i n s e a r l i e r and i s more pronounced i n . F i g u r e 13 t h a n i n F i g u r e 14. S e c o n d l y , b o t h c o r r e l a t i o n s show a d i s t i n c t s h i f t i n t h e b o r r o w i n g r e l a t i o n s h i p o c c u r r i n g it a t t h e end o f 1929. For some r e a s o n the banks' demand c u r v e f o r advances appears t o have s h i f t e d upwards between the l a t e 1920's and t h e e a r l y 1930*s. Many e x p l a n a t i o n s c o u l d be made o f t h e s h i f t . I t c o u l d c o n c e i v a b l y be r e l a t e d t o t h e "need" o f b o r r o w i n g . Thus, a l a r g e p a r t o f t h e p r e v i o u s y e a r ' s c r o p had not been e x p o r t e d and when i n t h e f a l l o f 1929 the new cr o p had t o be moved, l o a n s were r e q u i r e d not o n l y t o move the cr o p but t o f i n a n c e t h e i n v e n t o r y o f t h e p r e v i o u s y e a r ' s c r o p . As the F i n a n c e A c t was e s p e c i a l l y p r o v i d e d t o f i n a n c e s e a s o n a l r e -q u i r e m e n t s , t h e banks c o u l d be e x p e c t e d t o use the f a c i l i t i e s f o r t h a t purpose w i t h even l e s s r e s t r a i n t t h a n u s u a l . T h i s e x p l a n a t i o n has much i n common w i t h the o l d "need and r e l u c -t a n c e " t h e o r y and i s not t o o s a t i s f a c t o r y . There a r e , however, some o t h e r r e a s o n s f o r t h e s h i f t . The l e a s t - c o s t s p r e a d , as p r e v i o u s l y e x p l a i n e d , was d e f i n e d I l l as the d i f f e r e n c e between the New York c a l l l o a n r a t e and the r a t e charged on advances. W i t h s t a b l e exchange r a t e s the r i s k o f exchange l o s s e s f o r r e s e r v e s h e l d i n New York would be s m a l l . A f t e r the c r a s h , the i n s e c u r i t y r e l a t i n g t o e x -1 change r a t e s was g r e a t l y i n c r e a s e d as r e f l e c t e d i n a w o r l d -wide t a l k o f d e v a l u a t i o n . F o r whatever r e a s o n , t h e banks began a r a p i d r e d u c t i o n o f t h e i r New Y o r k r e s e r v e s . The banks* c a l l and s h o r t l o a n s e l s e w h e r e t h a n i n Canada, t h u s , d e c l i n e d f r om $282 m i l l i o n i n November 1929 t o $184 m i l l i o n i n March 2 1930, and t o $90 m i l l i o n i n September 1931. I n the l a t e r p a r t o f t h e p e r i o d under d i s c u s s i o n , s e v e r a l banks who had p r e v i o u s l y used t h e i r New York r e s e r v e s f o r c a s h a d justment p u r p o s e s , may s i m p l y not have had s u f f i c i e n t f u n d s i n New York t o c o n t i n u e t o do s o . ^ I f the banks c o v e r e d t h e m s e l v e s a g a i n s t exchange l o s s i n the f o r w a r d m arket, the c o s t o f d o i n g so a f t e r t h e c r a s h would have i n c r e a s e d as the s p r e a d between spot and f o r w a r d r a t e s p r o b a b l y widened. (No r e c o r d o f f o r w a r d r a t e s f o r t h e 1920*s and e a r l y 30's seems t o be a v a i l a b l e . ) An e v e n t u a l i n c r e a s e i n the c o s t o f p r o t e c t i o n would, i f a p p l i -c a b l e , i n c r e a s e t h e c o s t o f u s i n g New York f u n d s t o meet temporary r e q u i r e m e n t s i n Canada. 2 A n o t h e r r e a s o n f o r t h e d e c l i n e o f the banks' New Y o r k c a l l l o a n s and the i n c r e a s e i n s e c u r i t y h o l d i n g s was the f a c t t h a t w h i l e t h e c a l l l o a n r a t e c o n t i n u e d t o d e c r e a s e f r o m a y e a r l y average o f 7.61 p e r c e n t i n 1929 t o 1.74 p e r cent i n 1931, t h e bond r a t e s remained h i g h d u r i n g t h o s e y e a r s . 112 A t h i r d r e a s o n f o r the apparent s h i f t was the i n c r e a s -i n g use o f b o r r o w i n g f o r s h o r t t e rm p u r p o s e s . Comparing the amounts o f advances p a i d t o the banks d u r i n g the m i d d l e 1920*s w i t h t h o s e o f t h e e a r l y 1930's, i t i s o b v i o u s t h a t t h e f l o w o f advances had s h i f t e d upwards i n the i n t e r v e n i n g y e a r s . W h i l e the advances p a i d out i n t h e f i s c a l y e a r e n d i n g i n 1927, f o r i n s t a n c e , amounted t o $234 m i l l i o n , the e q u i v a l e n t f i g u r e 1 f o r 1931 was $364 m i l l i o n . Some o f t h e s e s h o r t t e r m borrow-i n g s would be r e f l e c t e d i n t h e month—end b a l a n c e s and would t h e r e f o r e e x p l a i n the s h i f t . P a r t o f t h e s h i f t i n month—end b a l a n c e s may c o n c e i v a b l y have been caused by an i n c r e a s e i n the use o f t h e F i n a n c e A c t f o r p u r p o s e s o f " w i n d o w - d r e s s i n g " d u r i n g the e a r l y p a r t o f t h e d e p r e s s i o n . D u r i n g t h a t p e r i o d o f economic i n s e c u r i t y , i t i s l i k e l y t h a t t h e banks were e s p e c i a l l y c o n c e r n e d t o p r e s e n t a sound appearance t o t h e p u b l i c . The s h i f t i n the use o f the F i n a n c e A c t f o r s h o r t term b o r r o w i n g s would not n e c e s s a r i l y be r e f l e c t e d i n t h e r e c o r d o f low monthly b a l a n c e s . I n F i g u r e 15 the l o w e s t q u a r t e r l y b a l a n c e s a r e c o r r e l a t e d w i t h the l e a s t - c o s t s p r e a d and the The d e p o s i t s i n Canada were a p p r o x i m a t e l y 7 p e r c e n t g r e a t e r i n the l a t t e r y e a r compared w i t h 1927. 113 114 s h i f t , i f any, i s much l e s s pronounced. F i g u r e 15 shows a s t r o n g r e l a t i o n s h i p t o e x i s t between b o r r o w i n g s and the l e a s t - c o s t s p r e a d . However, no i n d i c a t i o n o f a r e l u c t a n c e i s a p p a r e n t . T h i s l a c k o f c o n f o r m i t y w i t h t h e o t h e r s e r i e s may be e x p l a i n e d by random v a r i a t i o n i n the "low" b a l a n c e s e r i e s . The q u a r t e r l y " l o w " o c c u r r e d d u r i n g one day out o f t h r e e months and the low f o r two c o n s e c u t i v e months v a r i e d up t o $15 m i l l i o n . To reduce the s i z e o f t h e random v a r i a t i o n s , t h e second l o w e s t q u a r t e r l y o b s e r v a t i o n was used i n F i g u r e 16. A q u a r t e r l y average o f monthly " l o w s " c o u l d a l s o have been used t o reduce the random v a r i a t i o n s . Such an average would have shown a p p r o x i m a t e l y t h e same t r e n d as F i g u r e 16. I t i s o b v i o u s t h a t F i g u r e 16 conforms b e t t e r t h a n F i g u r e 15 t o t h e o t h e r s e r i e s . The l e v e l l i n g o f f p r o c e s s o b v i o u s l y began i n t h e second q u a r t e r o f 1929 a c c o r d i n g t o the l a t t e r g r a ph. When comparing the f o u r l a s t graphs o f t h e a p p e n d i x , i t i s n o t e w o r t h y t h a t the o b s e r v a t i o n f o r t h e f o u r t h q u a r t e r o f 1929 i s not p a r t o f the same " u n i v e r s e " as t h e o t h e r ob-s e r v a t i o n s f r o m 1929. P a r t o f the r e a s o n f o r t h e e x c e p t i o n a l -l y h i g h b o r r o w i n g i n r e l a t i o n t o t h e r e l a t i v e l y narrow l e a s t -c o s t s p r e a d may be f o u n d i n t h e p r e v i o u s d i s c u s s i o n about the s h i f t i n b o r r o w i n g b e h a v i o r . There may t h u s have been a s t r o n g s e a s o n a l demand f o r l o a n s which i n a more normal time 115 116 would have been met by c a l l i n g some o f t h e New York l o a n s . I n t h a t p a r t i c u l a r q u a r t e r , however, the banks l a r g e l y r e f r a i n e d f r om c a l l i n g t h e i r s t o c k market c a l l l o a n s . I f the C a n a d i a n banks as a group had begun t o c a l l l a r g e volumes o f t h e i r New Y o r k c a l l l o a n s , i t would not o n l y have been d i s a s t r o u s f o r t h e b r o k e r s and o t h e r b o r r o w e r s d i r e c t l y i n -v o l v e d , but i t would have d e p r e s s e d s t o c k p r i c e s s t i l l f u r t h e r . The c o n c l u s i o n o f t h e e x a m i n a t i o n o f the v a r i o u s s e r i e s r e l a t i n g t o . t h e F i n a n c e A c t must be t h a t f o r t h e s i x y e a r s examined, the month—end b a l a n c e s i n g e n e r a l o v e r s t a t e d the volume borrowed d u r i n g the p a r t i c u l a r month and were s u b j e c t t o c o n s i d e r a b l e random v a r i a t i o n s . On t h e o t h e r hand, i f q u a r t e r l y a v e r a g e s are used as done i n t h i s appendix and i f a l l o w a n c e s a r e made f o r month—end peak b o r r o w i n g s , the month—end s e r i e s g i v e s a r e l i a b l e i n d i c a t i o n o f t h e " s t o c k " o r b a l a n c e s borrowed under the A c t . Moreover, a l l the major t r e n d s f o u n d i n t h e o t h e r s e r i e s a r e a l s o apparent i n t h e s e r i e s o f month-end b a l a n c e s . APPENDIX B The F r e q u e n t B o r r o w e r s As i n d i c a t e d i n F i g u r e 11, the g r e a t e r p a r t o f the t o t a l advances o u t s t a n d i n g were u s u a l l y owed by the f r e q u e n t b o r r o w e r s . A l t h o u g h t h i s group o n l y made up about 55 per cent o f t h e b a n k i n g system's net worth and t o t a l a s s e t s , i t g e n e r a l l y borrowed 70 — 80 p e r cent o f the t o t a l b a l a n c e s owing by a l l banks. The f r e q u e n t b o r r o w e r s c o n s i s t e d o f f o u r banks, namely, t h e R o y a l Bank o f Canada, the Canadian Bank o f Com-merce, the Banque Canadienne N a t i o n a l e , and t h e Dominion Bank. The R o y a l Bank was Canada's l a r g e s t bank i n terms o f t o t a l a s s e t s and number o f b r a n c h e s . Except f o r two months i n 1927, the R o y a l Bank had b a l a n c e s o f advances owing each l a s t day o f a l l t h e o t h e r months. Not o n l y was t h e R o y a l Bank one o f the most f r e q u e n t b o r r o w e r s , but i t borrowed w i t h a few e x c e p t i o n s t h e l a r g e s t amount each month. W i t h r e s p e c t t o i t s s i z e , however, t h e R o y a l Bank's b o r r o w i n g s were t h e lo w e s t i n the p a r t i c u l a r c l a s s . R e l a t i v e t o net w o r t h , the R o y a l Bank's h i g h b a l a n c e s were s l i g h t l y below th o s e o f the Can a d i a n Bank o f Commerce and t h e Dominion Bank. R e l a t i v e 117 118 to t o t a l assets, the Royal Bank's borrowings were considerably lower than those of the other banks i n the c l a s s . As shown i n Figure 17;, the expansion path of the Royal Bank's borrowings has a d i s t i n c t shape. The volume of bor-rowings i s i n i t i a l l y quite responsive to increases i n the least—cost spread and the amounts borrowed r i s e r a p i d l y as the spread widens. However, when the borrowings reach $25,000, i . e . 35 - 40 per cent of net worth, they become com-p l e t e l y i n e l a s t i c to further improvement i n the spread. The Canadian Bank of Commerce and the Dominion Bank were f a i r l y similar i n th e i r borrowing behavior considered i n r e l a t i v e terms of t h e i r sizes. In general the Dominion Bank borrowed r e l a t i v e l y heavier and reached i t s levelling—out point at a lesser spread than d i d the Bank of Commerce. The borrowing habits of the Banque Canadienne Nationale were quite d i s t i n c t from the rather uniform habits of the other three banks i n the group. Not only were the borrowings by the Banque Canadienne Nationale approximately twice as heavy as those of the other three banks but the expansion path rose i n an almost straight l i n e u n t i l the second last quarter-l y observation aft e r which a rapid decline took place. A l -though the Banque Canadienne Nationale borrowed less regularly and with greater variations i n the amounts borrowed than the 1 1 9 : i : h : S i : j ; i | ; : '.in'-V.'-i U l l j x u l 120 o t h e r banks i n i t s c l a s s , i t was s t i l l the h e a v i e s t borrower o f the group. The I n f r e q u e n t B o r r o w e r s The i n f r e q u e n t b o r r o w e r s c o n s i s t e d o f the Bank o f M o n t r e a l , the Bank o f Nova S c o t i a and the I m p e r i a l Bank o f Canada. Together t h e s e t h r e e banks had c l o s e t o 40 p e r cen t o f t h e b a n k i n g systems' t o t a l a s s e t s . The average b o r r o w i n g s over t h e l a s t y e a r s t u d i e d c o n s t i t u t e d , however, o n l y about 25 p e r cent o f t h e b a l a n c e s owing under the F i n a n c e A c t . The Bank o f M o n t r e a l was by f a r the l a r g e s t bank i n i t s group. I t was about the same s i z e as the R o y a l Bank, but i t s h i g h b o r r o w i n g s were o n l y about 60 per cent o f the l a t t e r ' s . The e x p a n s i o n p a t h o f t h e Bank o f M o n t r e a l i s c o m p l e t e l y d i f -f e r e n t f rom t h o s e o f t h e f r e q u e n t b o r r o w e r s . From h a v i n g had no r e c o r d e d b o r r o w i n g s d u r i n g t h e f i r s t 3—1/2 y e a r s s i n c e 1 Oc t o b e r 1923, the Bank o f M o n t r e a l borrowed §20 m i l l i o n i n 2 May 1927. The f o l l o w i n g month the b a l a n c e was r e d u c e d t o §15 m i l l i o n , w h i c h , e x c e p t f o r one i n t e r r u p t i o n , remained the •^October 1923 was the f i r s t month f o r which t h e month-l y r e t u r n s o f the c h a r t e r e d banks s p e c i f i e d the month—end b a l a n c e owing under t h e F i n a n c e A c t . 2 ! ' The Bank o f M o n t r e a l began t o borrow i n t h e middl e o f t h e second q u a r t e r o f 1928 when the s p r e a d had r e a c h e d ap-p r o x i m a t e l y 2.00. 121 month-end b a l a n c e u n t i l September 1929 when the b a l a n c e was reduced t o $10 m i l l i o n . C o n s i d e r i n g t h e b o r r o w i n g r e l a t i v e t o i t s s i z e , t he Bank o f M o n t r e a l ' s b o r r o w i n g s were con-s i d e r a b l y below those o f t h e banks i n the f r e q u e n t borrower c a t e g o r y . The Bank o f Nova S c o t i a was t h e second l a r g e s t bank -among t h e i n f r e q u e n t b o r r o w e r s . I t s e x p a n s i o n p a t h was d i f -f e r e n t from any o t h e r bank's. Thus a f t e r f o u r y e a r s o f no r e c o r d e d b o r r o w i n g , the Bank o f Nova S c o t i a i n October 1928 borrowed $6 m i l l i o n . As t h e l e a s t — c o s t s p r e a d c o n t i n u e d t o widen, the b o r r o w i n g s were i n c r e a s e d t o $8 m i l l i o n i n A p r i l and May o f 1929, w h e r e a f t e r the b o r r o w i n g s d e c l i n e d i n s p i t e o f an improvement i n t h e s p r e a d . I n r e l a t i o n t o i t s s i z e , the b o r r o w i n g s by the Bank o f Nova S c o t i a were s l i g h t l y above t h o s e o f the Bank o f M o n t r e a l but below t h o s e o f t h e f r e q u e n t b o r r o w e r s . The I m p e r i a l Bank had o n l y two r e c o r d e d monthly b a l a n -c e s . The f i r s t o f t h e s e o c c u r r e d i n June 1929 and t h e second one took p l a c e t h r e e months l a t e r . R e l a t i v e t o i t s s i z e , the b o r r o w i n g s by the I m p e r i a l Bank were t h e l o w e s t o f a l l t h e Ca n a d i a n Banks. S m a l l S t a b l e Banks w i t h no New Yo r k C a l l Loans The s t a b l e o r r e m a i n i n g banks were t h e ones which were 122 not merged d u r i n g o r i m m e d i a t e l y f o l l o w i n g the p e r i o d under s t u d y . O n l y two banks, the Bank o f T o r o n t o and the Banque p r o v i n c i a l e du Canada, were i n t h i s group. I n c o n t r a s t t o t h e f a i r l y u n i f o r m group c h a r a c t e r i s -t i c s o f t h e f r e q u e n t and i n f r e q u e n t b o r r o w e r s , t h e Bank o f To r o n t o and Banque P r o v i n c i a l e had few b o r r o w i n g h a b i t s i n common. I n i t i a l l y i n the p e r i o d , t h e y b o t h borrowed r e g u l a r l y but as t h e l e a s t - c o s t s p r e a d widened t o about 2 ( t h a t i s where the i n f r e q u e n t b o r r o w e r s began t o b o r r o w ) , the Bank o f T o r o n t o , a c c o r d i n g t o t h e month—end r e t u r n s , s t o p p e d borrow-i n g f o r the r e s t o f the p e r i o d . The Banque P r o v i n c i a l e con-t i n u e d i t s p a t t e r n o f b o r r o w i n g up t o the end o f the p e r i o d . W i t h r e s p e c t t o the volume o f b o r r o w i n g s r e l a t i v e t o t h e s i z e o f t he banks, the Bank o f T o r o n t o resembles t h e i n f r e q u e n t b o r r o w e r s w h i l e the Banque P r o v i n c i a l e r e s e m b l e s t h e f r e q u e n t b o r r o w e r s . Absorbed Banks The a g g r e g a t e b o r r o w i n g s by t h e s u b s e q u e n t l y absorbed banks f l u c t u a t e d w i t h minor d e v i a t i o n about $3 m i l l i o n u n t i l November 1928 when t h e S t a n d a r d Bank was a b s o r b e d by t h e Cana d i a n Bank o f Commerce. From May 1929, the Weyburn Se-c u r i t y Bank became a c o n t i n u o u s b o r r o w e r . Thus i n June 1929, 123 i t s b a l a n c e owing was $700,000, w h i c h , w i t h two e x c e p t i o n s , remained as a debt d u r i n g t h e f o l l o w i n g 18 months, d u r i n g which the l e a s t — c o s t s p r e a d changed from +4.52 t o -2.05. An i n t e r b a n k comparison o f b o r r o w i n g s r e l a t i v e t o s i z e i s made d i f f i c u l t by t h e f a c t t h a t the S t a n d a r d Bank ceased t o e x i s t i n 1928 w h i l e most o f the r e m a i n i n g banks had t h e i r h i g h b o r r o w i n g s s u b s e q u e n t l y . Thus, the o t h e r banks' b o r r o w i n g s r o s e g e n e r a l l y about 40 p e r cent s i n c e the r e — 1 c o r d e d h i g h b o r r o w i n g s by the S t a n d a r d Bank. The b o r r o w i n g s by Weyburn S e c u r i t y Bank were, r e l a -t i v e t o i t s s m a l l s i z e , f a r above a l l the banks i n t h e system. The d i s c u s s i o n o f t h e v a r i o u s t y p e s o f b o r r o w i n g i s summarized i n F i g u r e 12, which f o r each bank p r o v i d e s an e x -p a n s i o n p a t h - p r o p o r t i o n a l t o t h e bank's net w o r t h . I f t he h i g h b o r r o w i n g s by the S t a n d a r d Bank were 40 pe r c e n t h i g h e r , t h e y would be a p p r o x i m a t e l y 80 p e r cent o f i t s net w o r t h . BIBLIOGRAPHY Books Beckhart, B.H. The Banking System of Canada. New York: Henry H o l t and Co., 1929. Burgess, W.R. The Reserve Banks and the Money Market. (Rev. ed.) New York: Harper, 1946. Canadian Bankers' A s s o c i a t i o n ( e d . ) . Bank Act R e v i s i o n Pro- ceedings (by the e d i t o r s ) , 1933. C u r t i s , C.A. S t a t i s t i c a l C o n t r i b u t i o n s to Canadian Economic  H i s t o r y . T oronto: MacMillan, 1931, v o l . I . F i n a n c i a l P o s t . Survey of Corporate S e c u r i t i e s . T o ronto: MacLean P u b l i s h i n g Co., 1932. F u l l e r t o n , Douglas H. The Bond Market In Canada. Toronto: C a r s w e l l Co. L t d . , 1962. Goldenweiser, E.A. The F e d e r a l Reserve System i n O p e r a t i o n . New York: McGraw-Hill, 1925. G u r l e y , John G. and Shaw, Edward S. Money i n a Theory of F i n a n c e . Washington, D.C.: Brookings I n s t i t u t i o n s , 1960. Jamieson, A.B. C h a r t e r e d Banking i n Canada. Toronto: Ryerson P r e s s , 1959. Johnson, J.F. The Canadian Banking System. Washington, D . C : 1910. Mclvor, R. C r a i g . Canadian Monetary, Banking and F i s c a l Development. Toronto: MacMillan Co., 1958. Meigs, A. James. F r e e Reserves and the Money Supply. C h i c a g o : U n i v e r s i t y of Chicago P r e s s , 1962. 124 125 R i e f l e r , W.W. Money Rates and Money Markets i n the United States. New York: Harper and Bros., 1930. Stokes, M.W. The Bank of Canada. Toronto: Hunter—Rose Co., 1939. Viner, Jacob. Canada's Balance of International Indebtedness,  1900-1913. Cambridge: Harvard University Press, 1924. White, S i r Thomas. The Story of Canada's War Finance. Mon-t r e a l , 1921. Public Documents Canada, Bureau of S t a t i s t i c s . Canada Year Book, 1914-1934. Canada Gazette, Supplement, "Monthly Returns of the Chartered Banks," 1914-1934. Canada, Parliament, House of Commons, Debates, 1913. Canada, parliament, House of Commons, Select Standing Com-mittee on Banking and Commerce. Proceedings. 1924. Canada, Parliament, Sessional Papers, "Public Accounts," 1917-1934. Canada, Royal Commission on Banking and Currency. Proceedings, (mimeographed) 1933. Canada, Royal Commission on Banking and Currency. Report. Ottawa: King's p r i n t e r , 1933. Canada, Royal Commission on Banking and Finance. Submissions. 1962, v o l . 22A. Canada, Royal Commission on Canada's Economic Prospects. Financing of Economic A c t i v i t y i n Canada (by Wm. C. Hood), 1958. Canada, Statutes, 1914 c.3i 1923, c.48. R.S.C. 1927, c.70. 126 U.S. Bureau of the Census. H i s t o r i c a l S t a t i s t i c s of the United States, C o l o n i a l Times to 1927. Washington, D.C: U.S. Government Pr i n t i n g O f f i c e , 1960. A r t i c l e s and Periodicals C u r t i s , C A . "The Canadian Banks and War Finance." Con- tr i b u t i o n s to Canadian Economics. Toronto: Uni-v e r s i t y of Toronto Press, 1931, I I I . Deutsch,Jij. "War Finance and the Canadian Economy 1914— 20." Canadian Journal of Economics and P o l i t i c a l  Sciences VI, 1940. Polakoff, Murray E. "Reluctance E l a s t i c i t y , Least Cost and . Member—Bank Borrowing: A Suggested Integration." Journal of Finance, V o l . XV, No. 1, March 1960. Shearer, Ronald A. "The Foreign Currency Business of Cana-dian Banks." Canadian Journal of Economics and  P o l i t i c a l Science, V o l . 31, No. 3, August 1965. Walker, Charles E. "Discount Policy i n the Light of Recent Experience." Journal of Finance, V o l . I I , No. 2, May 1957. Reports and Unpublished Material Hay, K. Money and Cycles i n Post-Confederation Canada. Unpublished Ph.D. Thesis, Brown University, 1967. Knox, F.A. An Introduction to Money, Banking and Interna- t i o n a l Finance, mimeographed text for Fellows Course i n Banking, Queen's University, n.d. Turner, Robert C. Member-Bank Borrowing. Columbus Ohio State University, 1938. 

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