The noteholder is specially protected

There are good reasons for this

Notes fall into the hands of the ignorant and the helpless

Various means for protecting the noteholder have been devised. He may, for example, be made a preferred creditor. That is to say, the assets of the issuing bank will be pledged by law to be used first to liquidate the bank's notes and only after the noteholder's claim has been paid in full may the depositors and stockholders receive any consideration. Notes are a first lien on the assets of all our national banks under the provisions of the national banking laws. Similarly, in the new federal reserve system noteholders are made preferred creditors.

Supplementary to the special protection afforded by giving the noteholder a first lien there is found, especially in the United States, a provision under which a special liability attaches to the bank stockholder. One of the advantages of the corporate form of organization in industry and commerce is the limited liability of the stockholder. Almost everywhere, in the ordinary business corporation, the liability of the stockholder for the obligations of the firm is confined to his actual holding of stock. In banking corporations, however, the guarantee function of the capital is so important that it is usually considered advisable to increase the guarantee fund even beyond the nominal capital. This is done voluntarily by banks in the accumulation of a heavy surplus. But the law occasionally insists upon it by requiring the accumulation of a specified surplus, or, without requiring any immediate extra payment by the individual stockholder, by attaching to him a liability for the obligations of the bank beyond his stockholding. Thus every holder of stock in a national bank or in banks in some of the states is liable for twice the amount of his stock. A noteholder in a big bank like the National City of New York, for example, has a first lien on a fund made up of twice the bank's capital of $25,000,000 plus the surplus of $26,000,000. The special additional liability is, of course, also a protection to the depositor, but in view of the noteholder's first lien it is of even greater importance to the noteholder.

Various means of protection have been devised

The noteholder is sometimes a preferred creditor

Stockholders are sometimes subject to additional liability

Occasionally also the state will prescribe the investments or the assets by which the notes issued are to be "covered." It is believed that by limiting the discretion of the banker in the selection of such assets errors of judgment culminating in losses may be avoided. Thus Bank of England notes, notes of our Federal reserve banks, and United States national-bank notes are covered in fixed proportions by hard cash and by government bonds. The federal reserve notes, which are the obligations of the government although they are issued by the reserve banks,1 are covered by carefully defined, commercial paper. Similarly, the notes of the Reichsbank and of the Bank of France are based on commercial paper of a designated character. Not only that, but for the purpose of safeguarding the solvency and the redemption of the notes it is sometimes required that these special assets be deposited with an official of the government, who is empowered, if necessary, to sell them to obtain the funds required to pay off the noteholders. Such is the case with the bonds deposited with the United States government by the reserve and by the national banks to protect their several note issues.1 The special assets chosen are, of course, those which it is believed can be most easily and economically liquidated.

1 The federal reserve notes under our new system must be covered in full by two-name commercial paper of a maturity not to exceed ninety days. See infra, p. 251.

Investments are sometimes prescribed

Special cash reserve requirements are also not uncommon. In Germany the Reichsbank is required to keep against its outstanding circulation a cash reserve of 33-1/3% in gold, silver, and imperial notes. In England beyond the il8 million-odd "uncovered issue" - namely the issue based wholely on government bonds - the Bank of England is required to keep a sovereign for sovereign reserve. Hence beyond the £18 millions the notes are virtually gold certificates. In Prance there is no special cash reserve requirement, but in practice the Bank of France maintains an inordinately heavy reserve in gold and silver. In the United States the reserve banks are required to keep a gold reserve of 40% against the federal reserve notes which they have issued. A special specie redemption fund is provided for the notes of the reserve banks and of the national banks which are based on bonds. This fund is in "lawful money" to an amount equal to 5% of the outstanding notes. It is used by the government to redeem notes and, in case of failure of a bank to keep its quota up to the required amount, the government may sell the bonds deposited as security. This principle of a specie redemption fund was originally worked out in New York during the thirties and forties. It was known as the "Safety Fund" system. Each bank made an annual contribution to the fund until its total contribution equaled 3% of its authorized capital. In New York, however, the fund was used to repay depositors as well as noteholders and the double strain proved more than the fund could support. Had the fund been used only for note redemption it would have more than sufficed.1 The "safety fund" principle is a vital element in the existing Canadian banking system. Beyond a limitation of the total issue to an amount equal to the paid-in capital the only special protection afforded to noteholders in Canada is the preferred position given to them as creditors, coupled with a double liability of stockholders, and the maintenance of the mutual guarantee fund contributed by the banks up to 5% of their circulation. Canadian bank notes are acceptable, however, throughout the Dominion. Indeed, it may be said that where there are numerous banks of issue some form of mutual insurance of notes is almost essential to guarantee uniform acceptability.