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Home -> Neil H. Jacoby -> Business Finance And Banking -> Chapter 2

Business Finance And Banking - Chapter 2

1. Preface

2. Summary

3. Part 1 Chapter 1

4. Chapter 2

5. Part 2 Chapter 1

6. Chapter 1 - continue

7. Chapter 2

8. Chapter 3

9. Chapter 3 continue

10. Chapter 4

11. Part 3 Chapter 1

12. Part 4 Chapter 1







CHANGES FROM 1900

TO 1940 IN THE INSTITUTIONS SUPPLYING
BUSINESS CREDIT



AFTER THE EARLY TWENTIES the institutional organization of the
business credit market underwent significant changes, and these
changes were greatly accelerated during the thirties. First, new
private lending agencies developed, and their activities and opera-
tions influenced established agencies of business financing. Second,
relationships between established agencies were realigned and re-
adjusted with functional differences tending to become increasingly
blurred. Third, a number of public business financing agencies
emerged to supplement the facilities offered by private financial
enterprise.

RISE OF NEW PRIVATE LENDING AGENCIES

Consumer Credit Agencies

One of the major developments on the supply side of the business
credit market was the growth of consumer credit agencies per-
sonal finance and industrial banking companies, credit unions, and
sales finance companies. This growth was especially rapid during
the 1920*8, paralleling the growth of the consumer durable goods
industries.

The personal finance company, which is the oldest at least in
terms of its antecedents of the consumer credit agencies, grew
rapidly from not more than 500 offices with outstandings of less
than $25 million in 1920 to 4,000 offices with outstandings of $577
million in 1 940. The industrial banking company made its appear-
ance in this country in 1910, and by 1940 had expanded to between
400 and 500 companies with outstandings estimated at $288
million. The first credit union was organized in 1 909 and by 1 940
there were nearly 9,000 in operation with outstanding loan balances

no



INSTITUTIONS SUPPLYING CREDIT 111

of $ 1 90 million. Most of the sales finance companies were organized
after World War I, although some of the largest were started just
before the war and even before 1900. By 1940 their number totaled
over 1,000, and they held among their assets retail instalment
paper of nearly $1.5 billion. 1

Numerous factors lay behind the growth of consumer cash lend-
ing agencies, but two were fundamental. First, the urbanization and
industrialization of the country made most individuals entirely
dependent on a flow of cash income. Interruptions in this flow, or a
sharp increase in consumer outlay, could quickly produce a need
for borrowing whereas in a rural, agricultural society interruptions
in income came mainly from crop failures, and even in those cases
individuals would not be cut off entirely from a means of subsist-
ence. Second, cash lending was encouraged by the wider use of
goods and services of high unit value, many of which are considered
as "essentials" to the American standard of living, and nearly all of
which require the expenditure of amounts that are substantial in
relation to current income.

Commercial banks in general were content until the early 1930*8
to serve as wholesalers of credit in this field rather than as retailers,
for many reasons: newness of the credit area; inexperience in han-
dling credits of the type involved; the necessity of conducting
consumer instalment lending within a range of permissible charges
designed primarily for business lending; doubt as to their ability
to acquire locally a volume of business sufficient to carry overhead
costs; unreadiness to conduct the promotional work essential to the
acquisition of needed volume; the relative attractiveness of alterna-
tive uses of bank funds. The new agencies, in contrast, were favored
by many conditions, not the least being the right to organize na-
tionally and laws that exempted them from usury statutes and per-
mitted higher rates on loans of small amount.

The primary reason for the growth of consumer instalment sales
credit was that mass production, a necessary condition of low pro-

1 More detailed historical discussions of these consumer credit agencies may be found
in studies of the Financial Research Program of the National Bureau of Economic Re-
search: Personal Finance Companies and Their Credit Practices, by Ralph A. Young
and Associates (1940) j Sales Finance Companies and Their Credit Practices, by Wil-
bur C. Plummer and Ralph A. Young (1940) j Industrial Banking Companies and
Their Credit Practices, by Raymond J. Saulnier (1940) 5 and The Business of Con-
sumer Instalment Financing, by Ralph A. Young (unpublished).



112 BUSINESS FINANCE AND BANKING

duction cost and low price, was contingent on mass consumption
which, in turn, was impossible, or at least would not have occurred
so soon, without liberal deferred payment terms. For various rea-
sons, dealers and manufacturers failed to satisfy this credit demand
directly: dealers were generally unable to assume the burden of
carrying customer receivables, and manufacturers were unwilling to
accept this burden because it was a function alien to their manage-
ment capacities and because they had other financing burdens of
considerable weight. In those cases where manufacturers under-
took to carry the receivables of their dealer customers, they usually
did so through separate corporations with specialized management
and segregated capital.

In supplying consumer credit, assistance from some financial
agency clearly was necessary. Among the established agencies the
commercial bank was the most likely credit source, but until the
early 1930*8 the part it played was primarily that of supplementing
the equity capital of the new agencies with loan funds. It did not
assume a direct financing role for several reasons: the business
presented many new risk factors, not the least of which was the
financing of dealers who carried relatively heavy inventories and
whose financial position was relatively weak} the limitations on bank
rates of charge to customers, imposed by law and convention, made
it difficult to cover the costs of loan administration which were nec-
essarily high because of the measures needed to limit risk, the small
average size of individual credits, and the monthly payment fea-
tures ; operations were likely to be unprofitable unless individual
banks could get a volume of business larger than seemed possible
within the local markets to which they were limited by law; and,
finally, other demands for bank funds were more attractive to the
banks.

Sales finance companies, in contrast, were free from all these
limitations. At the beginning of their development the f \inds they
used were somewhat more expensive than those acquired by banks
through public deposit. Their activities, however, were less affected
by legal restraints and limitations of corporate powers; their
management was prepared to experiment with new credit extension
techniques; their freedom to organize national cc branch financing"
systems gave them many competitive advantages; their use of a
wide margin of equity capital and the fact that they were not subject



INSTITUTIONS SUPPLYING CREDIT 113

to bank examination were strongly conducive to risk-taking; and
finally, while their operating costs were high, they were free from
legal limits on customer charges and, in many cases, received sub-
stantial subsidies from manufacturers.

Commercial Finance Companies 2

Another important development in the business credit market was
the rise of the commercial finance company, which in many respects
merges into the sales finance company; in fact, the two agencies are
frequently combined in one general "finance company." In this
study a "commercial finance company" is defined as an agency with-
out a bank charter which performs one or more of the following
functions: advances funds to business concerns by discounting
accounts receivable, usually without notice to the trade debtor;
makes loans secured by chattel mortgages on machinery or liens on
inventory; and finances deferred payment sales of commercial and
industrial equipment.

The first type of lending, non-notification accounts receivable
financing, originated even before automobile financing; a company
was chartered for this purpose in Chicago in 1905. By 1940 com-
mercial finance companies ranged all the way from small concerns
specializing in either non-notification financing of accounts receiv-
able or the instalment financing of income-producing equipment
for small businesses, or in some combination of these two functions,
to companies with nearly a billion dollars of assets, conducting a
broadly diversified program of business and consumer financing.

Like consumer credit agencies, the development of commercial
finance companies was encouraged by a combination of circum-
stances. The principal basis of the demand for their equipment
financing services is found in the rapid progress of technology.
Better and more economical equipment for commercial and indus-
trial establishments was introduced, and competitive conditions
compelled all concerns, even those with modest financial resources,
to install it or lose their positions in the market. The acquisition of
this equipment presented no special financial problem for most

2 For more detailed discussion see Raymond J. Saulnier and Neil H. Jacoby, Financ-
ing Equipment for Commercial and Industrial Enterprise and Accounts Receivable
Financing (both studies of National Bureau of Economic Research, Financial Research
Program) .



114 BUSINESS FINANCE AND BANKING

large concerns, but such purchases proved burdensome for many
small and medium-sized companies, especially in the trade and
service industries where the vast majority of concerns are relatively
undercapitalized. For enterprises in this group the new equipment
which was essential to efficient technical operation could be acquired
only on a deferred payment basis, designed to enable the buyer to
amortize the debt out of income earned as the equipment was used.
In satisfying this demand for credit the commercial finance com-
pany, like the sales finance company, had certain definite advan-
tages. Its legal position permitted it to operate as a national "branch
financing" organization, which was particularly important in solicit-
ing the instalment paper generated through the sales of a manufac-
turer producing for a national market, and it was free of limitations
under which it would have operated had it been organized as a bank.
In general, the commercial bank kept out of the field of equipment
financing, except as a lender to the finance company 5 and manufac-
turers and dealers chose to discount their receivables with finance
companies for much the same reasons as those cited in the discussion
of consumer sales financing above.

A second focus of interest for the new private financing agencies
was the purchase of open accounts receivable. Commercial finance
companies began buying the open accounts of small and medium-
sized concerns before World War I, but the principal development
took place during the thirties. Perhaps the basic factors accounting
for the increase in the thirties were that many small and medium-
sized concerns suffered an erosion of working capital during those
years, as a result of successive years of operating losses, and that new
and growing concerns found it difficult to obtain adequate financing
in view of the general uncertainty regarding economic conditions.
For both types of concerns the techniques of receivables financing
often offered the most favorable basis on which they could obtain
needed funds j and they naturally would look for financing facili-
ties to an agency prepared to take higher than average risks, and to
make loans on the basis of specially designed security devices.

Several considerations favored commercial finance companies in
the development of this credit area. In the first place, the new
agencies had complete freedom to introduce the somewhat novel
and highly specialized credit extension techniques essential to suc-
cess in such lending operations. Second, the regional or national



INSTITUTIONS SUPPLYING CREDIT US

coverage of the companies enabled them more easily to acquire the
volume of business necessary to cover overhead expenses and to
provide the needed diversification of risks. Third, state laws, such as
those relating to the taking of assignments of accounts receivable on
a non-notification basis, were much more favorable to the operations
of commercial finance companies than to those of commercial banks.
Fourth, finance companies were able to charge rates commensurate
with the administrative costs and risk factors peculiar to this credit
area, whereas if they had been organized as banks they would have
been limited to much lower levels of customer charges. Finally,
they were better placed to undertake high-risk financing because
of their substantial equity positions, and their freedom from re-
sponsibility for depositors' funds and from the bank examination
which performance of the deposit function entails.

Effects of the Rise of New Private Lending A gencies
on the Business Credit Market

The relation between consumer credit agencies and the business
credit market is indirect, yet the growth of these agencies had im-
portant effects on that market and especially on the position within
it of the commercial bank. First, through these agencies credit was
extended in increasing amounts into the consumption process,
thereby enabling producers and distributors to sell for cash. As a
result sellers did not need to carry a large amount of consumer
receivables, a condition that is closely related to the demand for
short-term business credit, since a low ratio of receivables to sales
is usually associated with a low ratio of notes payable to sales and
to total assets. 8

Second, the way in which consumer credit agencies financed them-
selves influenced the business credit market. In 1940 sales finance
companies used equity funds to finance about 25 percent of their
total assets, and short-term borrowings were used to finance between
60 and 70 percent. For personal finance companies equity funds

8 For example, the automobile industry has one of the lowest ratios of receivables to
sales, and its ratio of notes payable to sales is among the lowest of all industrial divi-
sions. See Walter A. Chudson, Tlie Pattern of Corporate Financial Structure: A Cross-
Section View of Manufacturing, Mining, Trade, and Construction, 7957 (National
Bureau of Economic Research, Financial Research Program, 1945) Chart 4, p. 42
and Chart 5, p. 51.



116 BUSINESS FINANCE AND BANKING

provided about 60 percent of the financing needs, and notes payable
supplied the remainder, except for national companies which used
some long-term debt in 1940. In general, the use of equity funds in
consumer instalment financing would be expected to have a restric-
tive effect on the total demand for bank credit, whereas the use of
bank borrowings would alter the industrial composition of such
demand. That institutional developments after the early 1920*8
produced this latter effect is revealed by the changes in the relative
importance, as users of bank credit, of intermediary finance agencies
and manufacturing companies, referred to in Chapter 3.

Direct participation by commercial banks in the field of consumer
instalment financing exerted a contractive influence on business
demand for bank credit. The extension of credit into the economic
system through such a channel may restrict to some degree the
demands for business credit arising from other segments of the
economy, subject, of course, to the qualification that any given ex-
tension of funds, if it is expansive in regard to total economic activ-
ity, need not on balance contract the demand for funds by other
lines.

Until the early 1 930*8 the finance companies in both the consumer
instalment credit and the business financing markets conducted their
business with little direct bank competition. Indeed, the finance
company worked side-by-side with the commercial bank, each doing
a type of business for which it was especially designed and qualified.
The newer concerns became specialized "retailers" of credit, de-
pending on the banks and on their own equity resources for the
funds which they needed, while the commercial banks acted as
"wholesalers."

This situation changed markedly during the early 1930*8. By
that time business loans of commercial banks had decreased sharply }
bank earnings had declined, partly because of changes in the char-
acter of bank assets and partly because of declining yields on high-
grade loans and investments. The interest of the banks in new types
of lending was stimulated by the fact that banks had had an oppor-
tunity to observe the successful operation of finance companies}
also, successful and profitable experience with Federal Housing
Administration insured loans had made a significant impression on
bankers* views as to the soundness of the instalment payment
method. As the techniques appropriate to the new types of lending



INSTITUTIONS SUPPLYING CREDIT 117

became more widely known, better tested, and more or less con-
ventionalized, many of the barriers that had once kept the banks
from direct participation were removed. By 1940 they had acquired
a fairly substantial interest in the instalment financing of income-
producing equipment and in lending on the security of assigned
accounts receivable 5 in fact, in 1940 the banks surpassed the com-
mercial finance companies in the volume of business done in these
fields.

Tendencies in Inter- Agency Competition

A statement of institutional developments on the supply side of the
business credit market would be incomplete if note were not taken
of the fact that the newer business lending agencies showed an in-
creasing tendency to extend credit in areas customarily served exclu-
sively by commercial banks, just as commercial banks tended, much
more extensively it should be observed, to do a "finance company"
type of business. As a result, functional distinctions became blurred
and in some instances almost completely disappeared. This tendency
toward mutual penetration of market areas was most pronounced in
the relationships between commercial banks, industrial banking
companies, and commercial finance companies j it was present, but
less markedly so, in the relations between personal finance com-
panies and commercial banks.

Commercial banks and commercial finance companies came closer
together, in part because the commercial finance companies broad-
ened their functional basis to include such activities as term loans,
made on a pattern similar to that followed by commercial banks, and
in part because of the widening of commercial bank activities. The
institutional adjustments involved an extension into areas of larger-
size loans and higher quality credits by the finance companies and
industrial banking companies, and greater activity in the field of
smaller business loans and higher risks on the part of commercial
banks. This process of institutional adjustment also affected the
personal finance and sales finance companies, the former through
a tendency to increase the portion of loans made to small proprie-
tors, the latter through a tendency to undertake commercial finance
company functions. Each type of agency had, of course, a market in
which competition from other agencies was relatively insignificant,
but increasingly these areas tended to narrow while the areas of
inter-agency competition tended to widen.



118 BUSINESS FINANCE AND BANKING

RELATIONSHIPS BETWEEN

OLDER PRIVATE BUSINESS FINANCING AGENCIES
AND COMMERCIAL BANKS

While certain adaptations in bank lending policies can be traced to
the rise of new private agencies in the fields of consumer and busi-
ness financing, others grew out of changes in banks' relations with
established business financing institutions such as life insurance
companies, investment banks, and factoring companies.

Life Insurance Companies

Until the early 1930*8 there was little direct competition between
commercial banks and life insurance companies in the field of busi-
ness lending. Such competitive connections as did exist were limited
to life insurance company holdings of corporate bonds and to their
relatively insignificant holdings of mortgage loans secured by indus-
trial properties. In 1933, however, and more definitely in 1934, the
two agencies tended to come closer together in those functional
aspects most closely related to business financing.

This tendency was due to several developments. First, the grow-
ing participation of commercial banks in the term loan market in-
creased considerably the average maturity of business loan assets
of banks and brought them closer in character to the medium-term,
if not to the long-term, investments of insurance companies. 4

Second, direct financing of businesses by insurance companies
was increased through their purchases of privately placed debt
securities, especially those of medium term, and by an expanding
program of direct loans to industry secured by mortgages on plant
and equipment. In many cases there is actually little difference in
economic character and effect between the private purchase by an
insurance company of an issue of medium-term securities to be
amortized on an instalment payment or serial basis, and the exten-
sion of business credit by a commercial bank under a term loan
agreement. The similarity between industrial mortgage financing
by insurance companies and term lending by commercial banks also
is great. In this type of financing the insurance company takes a

4 For a discussion of the development of term lending by commercial banks see
Chapter 5, pp. 139-42.



INSTITUTIONS SUPPLYING CREDIT 119

mortgage on the industrial plant as security, but the credit is weighed
with less regard to real property values than to the insurance com-
pany's estimate of the ability of the borrower to repay the loan in
instalments out of the proceeds of business operations. The basis of
the loan is exactly the same as that underlying the term loan, with
the exception that the industrial mortgage may have a somewhat
longer maturity.

Industrial mortgage financing by insurance companies was only
beginning in 1940-41 j at that time one large life insurance com-
pany and two others of smaller size were actively interested in de-
veloping such loans and had organized special departments for
this purpose. Although the volume of credit extended was not large,
it attracted considerable attention since it indicated a trend in insur-
ance company loan policy which might be continued. In any event
the practice supplements insurance company acquisitions of private
placements of medium-term securities as a development in loan
policy which brings the insurance company into closer functional
relationship with the commercial bank.

These adaptations in life insurance company investment policies
reflected, basically, a vast increase in the resources for which the
companies had to find investment, as a greater portion of the savings
of the community was channeled into use through the medium of
these institutions. Another influence was the tendency, which began
in 1934, for a larger proportion of corporate debt issues to be placed
privately with institutional investors.

A third influential factor is that commercial banks tended to make
increasing amounts of loans on the security of life insurance policies,
much along the lines of the "policy loans" that had been made for
years by life insurance companies themselves. The relative impor-
tance of policy loans and premium notes among life insurance com-
pany assets, as well as their absolute amount, declined regularly
after 19335 this development can be attributed in part to the in-
creased activity of commercial banks, but more to improved eco-
nomic conditions, which tended to lessen the demand for loans of
this kind, and to the increasing availability, at declining costs, of
credit for personal needs through a widening range of consumer
credit agencies. In 1933 policy loans and premium notes, amounting
to nearly $3.5 billion, comprised 17.8 percent of the total assets of
49 legal reserve companies holding over 90 percent of the assets of



120 BUSINESS FINANCE AND BANKING

all companies. At the end of 1940 these life insurance companies
held approximately $2.8 billion, or approximately 10 percent of
their total admitted assets, in policy loans and premium notes. No
estimates have been made of the volume of life insurance policy
loans held by commercial banks although it is reasonably certain
that they amounted to a negligible sum before 1935. However, as a
rough estimate, the liberal assumption that policy loans held by
banks at the end of 1940 equaled 10 percent of their personal loans
outstanding at that time would place commercial bank holdings at
but 2 percent of those of insurance companies. 5 Therefore it is im-
possible to conclude that commercial banks played a significant in-
vestment role in this field ; their competitive influence was felt pri-
marily through their offering loans at rates below the 6 percent
rate customarily charged by insurance companies, and through their
satisfying in part, by their personal loan services, the type of credit
demand met by the policy loan. More extensive direct participa-
tion by banks in the policy loan field was restricted by a number of
conditions, including the relatively high administrative costs of
lending on this basis.

Along with these evidences of competitive relationships, com-
mercial banks and insurance companies showed tendencies to engage
more extensively in cooperative financing arrangements. Such
arrangements may provide, for example, that out of a given issue
of securities a bank or group of banks will take those that have the
short- and medium-term maturities, and one or more insurance
companies will take the longer-term portion. Because of the short-
term nature of bank deposit liabilities and the long-term and more
stable liabilities of the insurance companies, this cooperative sharing
of credit extensions is mutually advantageous.

Factoring Companies*

For many years factoring companies played a unique role in the
financial system of this country. By the mid- 1930*8, however, the

5 Total personal loan outstanding^ of commercial banks at the end of 1 940 amounted
to $586 million (Federal Reserve Bulletin, June 194.4, p. 606).

6 For a discussion of the history of factoring companies and their 1940 status, see
Accounts Receivable Financing, of. tit., pp. 1820, 39-47. See also Chapter 5, pp.
14244, below.



INSTITUTIONS SUPPLYING CREDIT 121

uniqueness of their position tended to be lost, although it had by no
means disappeared. This came about for two reasons: other agencies
offered services similar to those customarily associated with the
factoring business, and the factors themselves made certain ad-
justments which brought them to a closer functional similarity with
the commercial banks and the commercial finance companies.

While evidences of changing relationships among financing
agencies in this area are numerous, a few developments are out-
standing. First, after limiting their activities to the textile indus-
try for nearly a hundred years, factoring companies in the 1930*8
began to finance other industries; some companies went into non-
textile fields to purchase open accounts with full, or with only
partial, assumption of risk. Second, some commercial finance com-
panies, which were originated to finance open accounts receivable
on a non-notification basis and without assumption of risk, began to
offer a factoring service quite like that of the "old-line" factor,
most frequently for clients outside the textile industry. Third,
after 1935 or thereabouts commercial banks developed non-notifi-
cation financing of accounts receivable on an increasing scale and, to
a lesser extent, a few banks undertook regular factoring functions
for textile and other mills. In summary, the tendency was for all
three types of agencies factors, commercial finance companies,
and commercial banks to become more alike functionally, al-
though each agency still retained a functional position which was
in most respects unique.

EMERGENCE OF PUBLIC BUSINESS
FINANCING AGENCIES

Before World War II various government agencies had come to
play important roles in the business credit area. For the most part
these agencies came into existence in the early thirties when the pro-
tracted depression affected both business needs for funds and the
abilities of established private agencies to meet those needs.

The activities of public business financing agencies were of two
general types: (i) direct lending, in which the public agency ex-
tended credit to a business concern, and (2) loan guaranteeing and
financing undertaken cooperatively with private agencies.



122 BUSINESS FINANCE AND BANKING

Reconstruction Finance Corporation

The Reconstruction Finance Corporation was established by Act of
Congress in 1932, to check the deflationary tendencies then current
in the economy j it was empowered to make loans or advances to
"any bank, savings bank, trust company, building and loan associa-
tion, insurance company, mortgage loan company, credit union,
Federal land bank, joint-stock land bank, Federal intermediate
credit bank, agricultural credit corporation, or live-stock credit
corporation . . . " 7 In the same year the Emergency Relief and
Construction Act extended these powers to include the right to make
loans for the promotion of public housing and slum clearance, for
low-income housing activities, and for the financing of certain types
of public works. 8 The direct business lending activities of the agency
did not begin until 1934 when the agency was empowered to make
loans directly to industry, or in cooperation with banks or other
lending institutions, whenever it appeared that the employment of
labor would thereby be maintained or increased} loans were to be
adequately secured, they were to be made only to "established"
businesses and solvent borrowers, and were not to exceed $300
million in aggregate, or $500 thousand in individual, amount. 9

The business lending powers were granted for a number of rea-
sons. First, it was believed that the RFC could fill gaps in local
financial facilities caused by bank failures and by the generally
tightened conditions of the business credit market j in fact, the
legislation restricted RFC activities to making loans only "...
when credit, at prevailing bank rates for the character of loans
applied for, is not otherwise available . . ." 10 Second, it was
thought that direct loans by the RFC might be required where
operating losses had so depleted the working capital of business
concerns that they were unacceptable credit risks for private financ-
ing agencies.

The business lending activities of the RFC increased fairly

T Reconstruction Finance Corporation Act, Federal Reserve Bulletin, February 1932,
p. 95.

8 Emergency Relief and Construction Act of 1932, Federal Reserve Bulletin, August
1932, PP. 5*0-27.

9 An Act relating to direct loans for industrial purposes by Federal Reserve banks
and for other purposes, Federal Reserve Bulletin, July 1934, p. 432.

10 The Reconstruction Finance Corporation Act as amended, Section 5 (d) (United
States Congress Supp. VII, Title 15, Ch. 14).



INSTITUTIONS SUPPLYING CREDIT 123

steadilyj outstandings of direct loans to commercial and industrial
enterprises rose from approximately $6.2 million at the end of 1 934
to $112 million at the end of 1940 (exclusive of loans to aid in
national defense). Since RFC loans to business were made pre-
dominantly on a term basis, their relative importance can be judged
best by comparing them with the term loans of commercial banks j
at the end of 1 940 RFC industrial loan outstandings equaled nearly
6 percent of commercial bank term loans.

The second of the business lending activities of the RFC, namely,
making commitments to take up loans made by private lending
agencies when and if the latter wished to turn over all or part of the
loan, and taking participations in loans made in part by private
agencies, also grew in the period 1934-40. As of the end of 1940
the RFC had participations in outstanding loans amounting to
nearly $6.3 million and outstanding agreements to purchase par-
ticipations of nearly $3 million. It will be noted that this activity
was complementary rather than competitive as regards the inter-
ests of private agencies in the business credit market.

The development of this cooperative lending, which was de-
signed to support and supplement private institutions in the credit
market, is of interest for two reasons. First, it tended to maintain
rather than change the institutional structure of the market and,
second, it exerted a direct influence on the operating policies of
private agencies. The latter resulted from the fact that commit-
ments were made or participations taken by the RFC or other public
lending agencies only when the private lending agency associated
with the transaction extended the credit on terms that conformed
to standards laid down by the public body. These standards usu-
ally pertained to rates of interest, maturity, and repayment terms.

Federal Reserve Banks

The original purpose of the Federal Reserve banks, namely, that
they should serve as "bankers' banks" and that it was not their func-
tion to make direct loans to industry, commerce, and agriculture,
was sustained without exception until 1934, when the Federal Re-
serve Act was amended to initiate a program of direct lending to
commercial and industrial enterprises. The reasons for the initiation
of the program were the same as those that led to the expansion of



124 BUSINESS FINANCE AND BANKING

RFC powers} indeed, both agencies were granted additional powers
in the same Act of Congress. The amendment to the Act empowered
the Federal Reserve banks "In exceptional circumstances, when it
appears to the satisfaction of a Federal Reserve bank that an estab-
lished industrial or commercial business located in its district is un-
able to obtain requisite financial assistance on a reasonable basis
from the usual sources ... [to] ... make loans to, or purchase
obligations of, such business, or [to] make commitments with re-
spect thereto, on a reasonable and sound basis, for the purpose of
providing it with working capital, but [that] no obligation shall be
acquired or commitment made . . . with a maturity exceeding five
years." 11 The limitations to working capital loans and to loans of
maturities not over five years, it will be noted, were restrictions on
the lending powers of the Federal Reserve banks which were not
imposed on the RFC. The reserve banks were also empowered to
make credit available indirectly through banks and other financial
institutions by discounting for, or purchasing from, those agencies
obligations originating in the extension of credit to businesses and
made on the same terms that were applicable to direct loans. These
"take-out" arrangements could be entered into provided the pri-
vate financing agency obligated itself to absorb at least 20 percent
of the loss that might arise from such loans. The reserve banks
were also empowered to participate in loans where the private fi-
nancing agency was taking 20 percent or more of a credit extended
and assuming an obligation for loss on a proportionate basis.

The industrial advance program, however, never assumed very
large proportions, even when compared with the relatively modest
program of the RFC. Its high point was reached at the end of 1935
when industrial loan outstandings of the Federal Reserve banks
amounted to $32.5 million; by the close of 1940 they had fallen
to $9.2 million. A similarly minor role was played by the Federal
Reserve banks in their loan participation and commitment program;
at the end of 1940 they had $5.2 million of commitments and $6.4
million of participations outstanding. Thus, more than in the case
of the RFC, a major effect of the Federal Reserve bank program on
the business credit market was exerted through supplementary or
cooperative credit activities. Like the RFC activity, this program

11 An Act relating to direct loans for industrial purposes by the Federal Reserve
banks, and for other purposes, Federal Reserve Bulletin, July 1934, pp. 43034.



INSTITUTIONS SUPPLYING CREDIT 125

expedited certain adaptations in the lending policies of private
financial agencies.

United States Maritime Commission

After 1936, when the United States Maritime Commission was
formed and took over about $ 100 million of ship construction loans
and ship sales notes from the United States Shipping Board Fleet
Corporation, public lending activity in this field declined sharply.
At the end of 1940 ship construction loans of the Commission
amounted to $36 million, nearly all of which had been made by the
Shipping Board.

The Maritime Commission made little use of its power to extend
insurance on ship mortgage loans made by private financial agencies,
where the ship financed and the terms of the loan met certain stand-
ards laid down in the enabling legislation. On October i, 1940
there were only four approved applications outstanding, amounting
to $1.3 million, on which the Commission had either extended in-
surance or had committed itself to do so.

Export-Import Bank of Washington

The Export-Import Bank of Washington was created in 1934 by
Executive Order, and was continued until January 22, 1947 by an
Act approved January 31, 1935, subsequently amended. 12 After a
series of increases the lending authority of the Bank was set, as of
September 26, 1940, at $700 million.

The usual function of the Bank, which was organized with the
single original objective of facilitating trade between the United
States and Soviet Russia, was to finance export trade in agricultural
and industrial products. In this connection it made direct loans to
exporters, and it financed exports indirectly through loans to for-
eign governments and to their central banks. Also, it purchased and
sold participations with private banks. The Bank's powers were ex-
tended in 1940 to cover loans to governments, central banks, or ac-
ceptable banking institutions and, where guaranteed by the same, to

12 The Export-Import Bank of Washington was made a continuing independent
agency of the government by the Export-Import Bank Act of 1945. Since the present
discussion is concerned only with developments through 1940, the expansion of lending
authority under the 1945 Act is not discussed here. The text of the Act and a general
policy statement of the Bank may be found in the Federal Reserve Bulletin, August
*945> PP 767-69 and October 1945, pp. 1000-1005.



126 BUSINESS FINANCE AND BANKING

any political subdivision, agency, or national, where the purpose
was to assist "in the development of the resources, the stabilization
of the economies, and the orderly marketing of the products of
the countries of the Western Hemisphere."

From its organization in 1934 through 1940 the Bank, including
the Second Export-Import Bank which was organized in 1934 and
liquidated in 1936, made loan commitments of about $655 million
of which $150 million were canceled. Disbursements amounted to
$210 million. Repayments brought the sum outstanding on Decem-
ber 3i,i94Oto$i3i million, of which $ 8 3 million were the Bank's
own loans and discounts, and $48 million were acceptances of other
banks underwritten by the Export-Import Bank.

RELATIONS BETWEEN PUBLIC AND PRIVATE
BUSINESS LENDING AGENCIES

As indicated in the foregoing sections, by the end of 1940 public
and private business financing agencies had relationships in the
business credit market which were complementary and cooperative
as well as possibly competitive. Consequently, the effects of public
lending agencies on the business credit market, and on private agen-
cies serving that market, were of different kinds. Quantitative ex-
pression can be given to these effects in some instances, but certain of
them, such as changes induced in the business lending policies of
private institutions, can be described only qualitatively.

At the end of 1 940 loans to business by public agencies probably
amounted to less than $200 million. This includes all direct loans to
industry and commerce made by the Reconstruction Finance Cor-
poration and the Federal Reserve banks and one-half of the loans
and discounts of the Maritime Commission and the Export-Import
Bank} the latter rough adjustment has been made since most all of
the Maritime Commission's loans were carried over from an earlier
experiment and because the Export-Import loans were partly to
public bodies. The portion of the business credit market served by
public agencies at that time can be estimated as about 3 percent of
the "commercial and industrial loans" of all commercial banks.
But since most public agency loans to business were of intermediate
term, a comparison with commercial bank term loans may be rele-
vant: the outstanding loans of public agencies equaled nearly 10
percent of the term loans of commercial banks at the end of 1 940.



INSTITUTIONS SUPPLYING CREDIT 127

A sharper comparison can be drawn, however. There is no ques-
tion that the average size of public agency business borrowers was
smaller than that of borrowers from private agencies} but the credit
standing of the former can only be inferred from certain charac-
teristics of the loans made by public agencies, which are suggestive
of relatively high risks such as greater dependence on security
devices, loss experience, and the like and the statutory mandate
under which the financing activities were conducted. An indication
of loss experience is that the RFC stated in 1940 that it anticipated
a loss of 10 percent on its then outstanding loan volume, while the
Federal Reserve banks expected that the interest income from their
industrial advances would be sufficient only to cover their adminis-
trative costs. In so far as loans of this type would not be made by
commercial banks, it may be concluded that the public agencies
operated until 1 940 in a segment of the business credit market where
they were least likely to compete with commercial banks. In some
respects the competitive effect was probably felt more directly by
commercial finance companies, since their activities were more
nearly confined to that section of the business credit market which
was also served by public agencies.

These are over-all measures of loan quality, however, and within
the totals there doubtless was a margin that was a proper sphere of
activity for private agencies. In any case, public agencies served that
segment of the business credit market which was made up of small
and medium-sized concerns the segment that produced the ma-
jority of bank borrowing customers and in which banks made the
bulk of their loans. These facts, and also the fact that commercial
banks by 1 940 were making an increasing proportion of their term
loans to medium-sized concerns, suggest that the degree of competi-
tion between the two sets of agencies was increasing.

On the other hand, the entry of public agencies into the business
credit market had certain expansive effects on loan volume and cer-
tain modernizing effects on bank lending policies and practices.
These were produced in two ways: first, through the activity of
public agencies in taking participations in loans made by private
agencies, as remarked on above. The amounts of these participations
and commitments to take participations were not great} the RFC
and the Federal Reserve banks had but $20.9 million outstanding
at the end of 1940. However, the net effect of these supporting ac-
tivities was somewhat greater than indicated by their outstandings,



128 BUSINESS FINANCE AND BANKING

since the private credit supported was a multiple of the amount of
such participations and commitments outstanding, determined by
the percentage of the latter to the total credit extended jointly.

Second, the interest of commercial banks in newer types of busi-
ness lending techniques, for use especially among concerns that are
small and relatively unattractive as credit risks, may be attributed in
part to experimentation with them by public lending agencies. In
this credit area the public agencies had to experiment not only with
the term loan technique but also with new types of security devices,
such as the trust receipt and the assignment of accounts receivable,
etc. In this sense they facilitated adaptations of certain credit exten-
sion methods useful to private agencies. To select an example from
another credit area, it has been found that the interest of commer-
cial banks in consumer instalment credit and doubtless also in the
instalment financing of business purchases of machinery and equip-
ment was stimulated by their successful and profitable experi-
ence with home modernization loans insured by the Federal Hous-
ing Administration, and by their observation of the activities of the
Electric Home and Farm Authority.

It is impossible to weigh the effects of these two sets of influences,
one of which was in a sense competitive and the other genuinely
complementary, but it is clear that there were two aspects to the
problem of relationships between public and private business finan-
cial agencies as of 1 940, and that competitive relations comprised
but a part of the picture.

CHANGED POSITION OF COMMERCIAL BANKS

Before a measurement of changes in the relative position of the
commercial bank as a business financing agency is attempted, the
changes that took place between 1930 and 1940 in the total out-
standing debt, public and private (of which business debt is an ele-
ment), will be traced. Shifts in the relative positions of various
credit institutions did not manifest themselves prominently until
after 1930, although the total amount of bank credit used by busi-
ness began to fall in 1929.

The outstanding fact is that total debt at the end of 1940 ($166.5
billion) differed little from that at the close of 1930 ($174 billion).
However, significant changes occurred in the composition of total



INSTITUTIONS SUPPLYING CREDIT 129

debt and in the relative importance of various institutions as credi-
tors. The most important was the relative increase in the public debt
element, which rose from 17.3 percent of total debt in 1930 to 31.8
percent in 1940. This change can be attributed almost wholly to the
federal debt, since state and local debt was only slightly higher in
1940 than in 1930.

Within the area of private debt, the segment consisting of busi-
ness obligations retained its relative position} 18 but at least one ele-
ment, consumer debt, must have risen in relative importance since
the absolute amount increased from $6.3 billion in 1930 to $8.8 bil-
lion in I94O. 14 Long-term debt rose from 64.7 percent of total pri-
vate debt in 1930 to 68.1 percent in 1940, a change which is in
keeping with the basic trends in corporate financial structure and
policies discussed in earlier chapters.

Clearly, in terms of its absolute magnitude the credit area within
which commercial banks function as business lending agencies was
smaller in 1940 than in 1930; their area of credit activities was
wider, however, in the sense that at the end of the decade they
offered a greater variety of lending services. Did changes also
occur in the comparative positions of the commercial bank and
other business financing agencies? In order to answer this question
it is useful to combine, as in Chart 24, credit extensions of the
principal business financing agencies with consumer instalment
credit, since changes in the relative positions of these elements
are referred to most often in discussions of the changing position of
the commercial bank.

The most important change was the rise in the relative position
of the insurance company as a holder of business debt. This increase,
however, is not to be interpreted exclusively as a displacement of
commercial bank credit, although this was true in some degree.
Over the period the commercial bank holdings of corporate secu-
rities fell by $4.0 billion, while insurance company holdings rose by
$4.9 billion; therefore the increase in the holdings of insurance
companies must have come in
part from holdings of the pub-
lic and from new offerings.

Another important change
was the rise in the ratio of con-
sumption to production credit,
a change which has been char-
acterized above as at least
partly substitutive in nature.
Although commercial bank
participation in the consump-
tion credit area expanded be-
tween 1930 and 1940, the in-
crease did not offset the decline
in the banks' position within
the production credit area; in-
deed, banks would have lost
ground both absolutely and as
compared with insurance com-
panies even if they had ac-
quired the entire net change in
consumer instalment debt.

It is sometimes argued that
the increase in credits extended
to business by nonbank lending
agencies and by public bodies
contributed, through a substi-
tutive process, to the decline of
the commercial loan. While
some such displacement may
have taken place, it was of
modest proportions. Changes
in the relative importance of
commercial finance companies,
factors, and government lend-
ing agencies, however significant their developments may have
been in certain sub-areas of the credit market, or in the organization
and techniques of the business credit market, were negligible when
compared with the rising importance of the insurance company and
the shift from production to consumption financing. 1930 1940

Bank Consumer Instalment Credit
dD Nonbank Consumer Instalment Credit
GZ3 Commercial Finance Companies
Government Agencies
surance Companies
Sfiffl Commercial Bank Business Credit



Major credit market changes be-
tween 1930 and 1940 were the in-
creased relative importance of in-
surance companies in the extension
of credit to business, and the rise
in consumer instalment credit rela-
tive to business credit. While busi-
ness credit extensions by govern-
ment agencies and commercial fi-
nance companies increased, they re-
mained minor elements in 1940.




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