Banks And The Law Of Probabilities

Let us then begin with banks. Like the Bank of Monte Carlo, they rest throughout primarily on money, or on such securities for money as cheques, which, although not legal tender, and, like railway tickets, good only for a single transaction, can nevertheless perform all the functions of money with a minimum of risk. Like the Bank of Monte Carlo, too, ordinary banking relies on the action of the Law of Probabilities for the stability and security of its profits; for it is only on the probability that the cash drawn out of the bank by cheques and discounts at one counter will be replaced by a continuous return of different cheques and deposits at another, that the outgoings and incomings of the bank can be counted upon to keep in a moving equilibrium with each other. Indeed, without this antecedent probability it would be impossible for a bank (with its legal compulsion to meet its notes and floating deposits in cash on demand) to estimate the amount of reserve in cash necessary to keep on hand, or, indeed, to do business on borrowed capital at all.

Risks Bank Stock Is Subject To

Again, the capital investments of banks are lent only on such securities as can be turned into cash at the shortest notice, and so the bank keeps as closely to the ideal security of Monte Carlo as is possible. Where it falls short is in the necessity, under which it lies, of having collateral as security at all, instead of cash. For on any hitch occurring, this collateral, however gilt-edged it may be, has to be sold, and so is subject to the state of the Money Market at the time, and to the fluctuations of Stock Exchange securities generally. And although this would not be any very great detriment, provided the collateral were sufficient to amply cover the debt, and there was time enough to realise it in, it is always a danger, where liabilities have to be met, as in banking, by cash on demand on pain of bankruptcy. Indeed, if we turn the banking business over on its reverse side to see what its natural risks are, we shall find that this is essentially its only risk, just as when an army has its lines extended so far from any given point of attack that it cannot bring up its full strength in time.

Directors' And Managers Methods Responsible For Panics

The Panic, which descends so suddenly out of the clouds, and leaves so much desolation behind it, and which is the form that this risk of not keeping time usually takes, is not in itself a natural risk in banking, in the sense, that is to say, that it is either inherent in the ordinary rules of the game, or due, as most other business risks are, to the impossibility of absolute foresight into the state of markets and prices in the future. These panics are due rather to the bad faith and unscrupulousness of directors or managers on the one hand, or to their excess of optimism or good nature in making advances to their customers on insufficient or improper collateral on the other - not to the want of capacity to master the few plain rules which are sufficient to enable any honest and sensible man to avoid either the immediate or the predisposing cause of these terrible visitations. Indeed, so strongly is the credit of banking naturally entrenched in its basis at once of Money, of the operation of the Law of Probabilities, and of the most easily realisable substitutes for Cash itself, that it only requires the most ordinary prudence and honesty to reduce everywhere the danger from panics to the minimum negligible point, which it has reached in England to-day. Now, taking all these considerations together, it will be evident that banks have as easy and automatic an action, as high a natural rank as stable and safe investments, as is possible perhaps outside the ideal of the Bank of Monte Carlo. Further peculiarities bearing on their natural rank and risks will appear when we contrast them with insurance companies, as I now propose to do.

Insurance Companies Compared With Banks

To begin with, we may say generally that Insurance companies, although, like banks, they rest primarily on Money and the operation of the Law of Probabilities, do not lie as closely to a cash basis at all points as banks, and so participate more largely in the risks inseparable from long-time as compared with short-time investments. They would seem, therefore, at first sight to have a less natural stability and freedom from risk than Bank stock; but whether this superior position may not be reversed in the future will depend upon considerations at which we shall now have to glance in passing. Both banks and insurance companies rest primarily, as we have said, on money, and upon their transactions in it - the banks on their capital deposits received from the public, the insurance companies on their capital and the premiums received from their policy holders. In both, again, their returns come back directly in money, and not in merchandise which still has to run the uncertain risks of sale before it is converted into money. But while with banks the mathematical Law of Probabilities is so smooth and even in its working - owing to the short circuit of each transaction - that the deposits and discounts, on which the profits of the bank so largely depend, come in in equable and regular file, in insurance companies, on the other hand, the Law of Probabilities has to work through statistics and tables of chances, which, although they are always being improved and provided against, are still far from reliable. And the consequence of this is, that, while in the ordinary way of business the proportion of cash which the bank must keep by it as its reserve can be easily estimated, and can be depended upon to remain steady throughout, if the rules of prudence proper to banking are observed, in insurance companies, especially in cases of fire, the risks come rolling in for payment intermittently, like epidemics, and so require not only a larger proportional reserve to meet them, but one which demands more careful watching, if it is to keep time and proportion with the risks. So far, then, the risks not being so calculable, they are not so safe as banks. But as a set-ofT, the insurance companies, so far as the future is concerned, have this advantage, that whereas the risks of the banks are neither diminished nor increased by the extent of their operations or the circle of their clientele, inasmuch as the extent of their business does not affect either way the periodicity and accuracy of their incomings and outgoings, the risks of insurance companies must diminish as the field covered by their policies increases in magnitude and range; so much so, indeed, that were a single insurance company to embrace the world, its risks could be taken haphazard for all comers without inspection, or, in the case of lives, medical examination, inasmuch as the Law of Probabilities working on the statistics of the death rates of all nations would enable the average of profits to be calculated to almost a working certainty.