CHANGES IN THE TECHNIQUES OF

SUPPLYING BUSINESS CREDIT DURING

THE TWENTIETH CENTURY



THE FORTY YEARS PRECEDING World War II witnessed a number
of noteworthy shifts in American business credit technology. These
changes can best be understood by first gaining an understanding of
the ways in which short-term and long-term credit operations were
conducted around 1 900.

SHORT-TERM BUSINESS CREDIT TECHNIQUE, 1900 1

At the opening of the present century commercial banks were the
predominant financial institutions supplying short-term credit to
American businesses. Note brokers and commercial paper houses
performed the function of middlemen in distributing among the
banks the promissory notes of a limited number of medium-sized
concerns, but they were satellites of the banks rather than com-
petitors in the extension of short-term credit. Trade credit pro-
cured from business suppliers was also an important medium of
short-term business financing. Because the processes of transporta-
tion and communication were slower at that time than at present,
the terms of trade credit were somewhat longer and the cost some-
what higher, measured by discounts from cash prices. 2

Commercial banking relationships with business around 1900
generally conformed to what may be termed the "classical" theory,
which had evolved from British banking experience during the

1 This section is based both on a review of the literature relating to banking and
business credit practices around 1900, and on interviews with a number of individuals
whose personal experiences as loan officers extend back to that time.

2 Detailed information on trade credit around 1900 is lacking, but a reasonable
assumption is that its nature and uses at that time reflected gradual developments
after 1860, a period described by Roy A. Foulke in The Sinews of American Commerce
(Dun & Bradstreet, Inc., 1941) PP- 154-57-

131



132 BUSINESS FINANCE AND BANKING

nineteenth century. Briefly, this theory held that bank credit to
business should take the form of short-term advances to finance
the production, storage, or movement of goods, the ultimate sale
of which would provide funds for liquidating the loans. The ma-
jority of loans of American banks ran for 30, 60, or 90 days, al-
though many portfolios contained obligations maturing in nine
months or one year; the average maturity of outstanding business
loans has been put at 60 days. The notes were usually given under an
agreed upon "line of credit," arranged each year between banker
and businessman, and they were frequently renewed if the need
continued.

The actual uses to which businesses put the advances were sig-
nificantly different from those sanctioned by "classical" theory.
Short-term bank credit was used to a large extent for meeting endur-
ing needs for working capital or for financing the acquisition of
fixed assets, as well as for meeting temporary bulges in current
assets. It was customary for each borrower to "clean up" all out-
standing indebtedness annually, as a test of ability to achieve inde-
pendence of outside sources of funds. In many instances this con-
dition was attained by temporarily borrowing from some other
lender, which merely proved the ability of the borrower to obtain
bank credit from more than one source. Commercial loans would
never have become an important asset of the American banking sys-
tem had they been limited to genuine self-liquidating advances.

American short-term banking credits around 1900 were ordi-
narily based upon single-name promissory notes. In contrast, Brit-
ish commercial banking usually involved the discounting of two-
name trade bills, drawn by the seller upon the purchaser of
goods, presented to the buyer (either directly or through his bank)
for his acceptance, and then discounted by the seller at his bank
in order to place himself in funds for further operations. Because
it tied credit extension to a particular business transaction, the trade
acceptance as the legal basis for bank credit was more likely to lead
to results consistent with classical commercial banking than was the
promissory note.

The primary reason for the use of single-name promissory notes
in American banking was the vast size and rapid development of the
country. Bankers could readily learn the facts necessary to appraise
the credit standing of a limited number of large wholesalers and



TECHNIQUES OF SUPPLYING CREDIT 133

manufacturers, but they found it difficult to do so for a vast number
of small retailers. Consequently, the name of the vending business
on the credit instrument was considered sufficient, while the name
of the purchasing business was believed to add little, if any, secu-
rity.

In addition, business operations were extremely profitable and
vendors had alternative employments for their funds which were
very remunerative. Hence they were willing to offer large cash dis-
counts for prompt payment of accounts or, what amounts to the
same thing, they were able to include in the prices of their goods
relatively high charges for banking accommodation. To the extent
that sales were financed by extensions of trade credit, sellers were
likely to borrow from banks on their own single-name promissory
notes. In cases where buyers paid cash and took trade discounts, the
buyers often financed their purchases by borrowing on their own
single-name notes. In either case, in contrast with the trade accept-
ance, bank credit was injected into the commercial process on the
promise of one obligor to make repayment, and without tying the
credit to a particular business transaction.

The narrow use of the trade acceptance in the United States at the
turn of the century was due partly to the nation's marketing struc-
ture. Around 1850 the custom was for retail merchants in the in-
terior to make one or two journeys annually to a wholesale distribu-
tion center to purchase in large lots their requirements of merchan-
dise, for which they paid with one or a series of drafts drawn upon
them by the vendor. By the beginning of the century wholesalers
and jobbers had developed corps of traveling salesmen who called
upon their retail customers and took orders for goods. The transac-
tions were relatively small in amount, and buying for cash or on
open book account was far more convenient than using the more
cumbersome device of the trade acceptance. The trade acceptance
was inconvenient since it required as a minimum that the vendor
send the draft to the purchaser and wait for its return before taking
it to his bank for discount. In many cases this process was compli-
cated by the interposition of the respective banks of vendor and
purchaser in the presentation of the draft for acceptance and in
subsequent collection. In fact, these disadvantages were so acute
that after 1900 they brought about a decline in the use of the trade
bill in England and displacement by the bank overdraft, which is



134 BUSINESS FINANCE AND BANKING

the British counterpart of the American commercial loan on a prom-
issory note.

The granting and renewal of short-term unsecured bank loans
around 1900 was ordinarily a highly informal process. The banker
relied heavily upon his personal knowledge of the principals of a
borrowing concern, and there was an absence of elaborate credit in-
formation or analysis of financial statements. Business concerns
tended to be smaller than at present, unincorporated enterprises
were relatively more important, and ownership was more closely
identified with management all of which made for a more per-
sonal credit relationship. Credit departments and credit files were
just beginning to appear in the larger metropolitan banks.

Commercial banks also injected credit into business enterprises
through collateral loans and real estate mortgage loans, although
to a minor extent. The principal forms of collateral security were
stocks and bonds, bills of lading, warehouse receipts issued against
the deposit of staple commodities in public warehouses, and accounts
receivable. The loans were generally repayable either on demand or
within thirty days to six months, and they differed from discounts
of unsecured customers 5 notes in that the full face amount of the
note was advanced to the borrower, interest being added to the
principal at time of repayment. They were an important method of
financing traders and speculators in the basic agricultural commodi-
ties. Loans secured by mortgages on real estate were not used widely
as a normal and accepted basis for business credit} they were taken
generally to strengthen the position of a loan otherwise secured
or as a device for dealing with borrowers in distressed conditions.
The National Bank Act severely restricted the volume of such loans,
which were frowned upon by orthodox bankers on the ground that
they did not rest upon a foundation of "saleable merchandise or
collectible debt."



LONG-TERM BUSINESS CREDIT TECHNIQUE, 1900

The long-term business credit market in the United States at the
turn of the present century was much more limited than the short-
term market, both in size and in the range of businesses served. Elec-
tric utility, manufacturing, and trading corporations were only be-
ginning to become important issuers of long-term bonds and notes.



TECHNIQUES OF SUPPLYING CREDIT 135

Railroad, telegraph, and traction companies dominated the corpo-
rate bond market. Long-term loans secured by real estate mort-
gages were available from local capitalists, insurance companies,
and savings institutions, but not to an important degree from com-
mercial banks. Commercial banks extended long-term business
credit through their purchases in the open market of corporate
bonds, notes, and debentures, and through their participation in
security underwriting. However, their outstanding short-term busi-
ness credits around 1900 were probably five times greater than
their long-term credits. 8

As members of banking groups and syndicates, the larger com-
mercial banks purchased new issues of debt securities directly from
business corporations and distributed those issues to the public. In-
vestment banks, insurance companies, and wealthy individuals also
participated in the syndicates; and banks and insurance companies
frequently took for their own investment accounts part or all of
their respective participations in such groups. Britain and Western
Europe still were important sources of investment funds.

Because of the concentration of domestic savings among a rela-
tively small investing class, the distribution of new issues was much
narrower than it became later. Since surpluses of individual savings
tended to be largest in the New England and Atlantic Seaboard
States, the eastern banks were the principal participants in long-term
credit operations around 1 900, although such centers as Cleveland,
Chicago, and St. Louis were becoming important. Commercial
banks participated in purchase groups and syndicates initially
through their bond departments and later through the security
affiliates which they organized. Frequently, they acted as the origi-
nating banker and syndicate manager.

The techniques of appraising long-term business credit were
much less formal than they came to be in the twenties and after the
advent of federal regulation under the Securities Act of 1933. The
use of independent auditors, engineers, or other outside experts was
seldom resorted to, and industrial surveys and analyses of balance

8 In 1900 the 10,382 reporting banks of the United States held $1,963 million of
bonds other than federal obligations, while their loan portfolios were valued at
$5,658 million. Because a considerable portion of bond holdings represented munici-
pal and other nonbusiness credits, it is safe to say that the outstanding long-term business
credits of banks were no more than one-fifth of the short-term loans, Annual Report of
the Comptroller of the Currency -, 1900, Vol. I, p. xxxix.



136 BUSINESS FINANCE AND BANKING

sheet, profit-and-loss, and other financial statements were less in-
tensive than in later years. The prospectuses made available to po-
tential purchasers of a new issue were amazingly brief, when judged
by standards of the 1930*8 after the establishment of the Securities
and Exchange Commission. The name and reputation of the bank-
ing house sponsoring or selling a new issue were regarded by the
public as important evidence of the worth of the security.

FORCES SHAPING CHANGES IN TECHNIQUES, 1900-1940

Broadly speaking, the underlying forces that shaped the demand for
business credit during the period 1900-1940, and which called
forth the alterations in the institutional structure of credit supply
noted in Chapter 4, also explain the changes in the techniques of
business lending. These underlying forces, which will be treated in
detail in Chapter 6, were rapid growth in the dimensions and com-
plexity of the American economy, rising importance of fixed capital
instruments in the productive process, enlarged use of consumer
durable goods, instability in business activity, expansion of gov-
ernment as an agency of capital formation, and a tendency toward
lower interest rates after 1930. While these factors were of basic
importance, certain other forces influenced more directly the
credit decisions of the loan officer of a commercial financing institu-
tion such forces as growth in the corporate form of business
organization, development of business accounting, lengthening of
the average term of business credit, and emergence of "mass financ-
ing" methods in consumer lending.

The increase in the relative importance of the corporation as a
form of business organization is indicated by a sample drawn from
annual issues of the Reference Book of Dun & Bradstreet, Inc.
Five percent of the total number of enterprises in 1 900 were corpo-
rations, II percent in 1920, and 12 percent in 1940, with corpora-
tions being especially frequent in manufacturing, wholesaling, and
mining industries. Among manufacturing industries, corporations
accounted for 65 percent of all business transactions conducted in
1899 and for 93 percent in 1939. In trade, 16 percent of the net
worth of all concerns with net worth under $i million was owned
by corporations in 1900, whereas 40 percent was so owned in 1940.

The significance to the business credit market of the increased im-



TECHNIQUES OF SUPPLYING CREDIT 137

portance of the corporation lay in the fact that incorporation limited
the risks of ownership and increased those of creditorship, and
that it facilitated the separation of ownership from management in
business enterprise. Moreover, the growth of the corporate holding
company and tangled corporate interrelationships complicated the
task of credit appraisal. More elaborate appraisals of creditworthi-
ness were called for. Banks were virtually compelled to formalize
their methods of collecting and filing credit information, and to
adopt standard procedures of credit analysis. In many cases these
functions became so important that separate credit departments
were created within bank organizations. A few such departments,
mainly in the case of large banks, came into existence after the turn
of the twentieth century, but they did not become numerous until
after the establishment of the Federal Reserve System in 1913. By
1940 most medium-sized and large banks had specialized credit
departments.

The enlargement and elaboration of business accounting records
during the present century made more readily accessible to lending
institutions, at relatively short intervals of time, detailed informa-
tion about the operations and financial positions of businesses, and
thus made it possible for lenders to advance credit by methods im-
practicable in earlier times. The increase in volume and quality of
business records occurred for a number of reasons. One was the
growth in size and breadth of ownership of business concerns and in
the separation of ownership from management, which made neces-
sary more precise information, both as an aid to management and as
a method of appraising the effectiveness of management. Another
cause was the passage of the Federal Reserve Act in 1913, which
prescribed that banks had to maintain credit files on customers
whose acceptances were presented to Federal Reserve banks for
rediscount. Even more important was the stimulus of heavier taxa-
tion and more comprehensive governmental regulation of busi-
nesses 5 in this connection the emergence of the federal tax on corpo-
rate net income in 1913 was especially significant.

The increase in long-term business credit during the twentieth
century also influenced credit technology. Commercial banks ex-
panded their open market purchases of corporate bonds and notes,
particularly after World War I, and the larger banks intensified
their underwritings and distributions of corporate securities through



138 BUSINESS FINANCE AND BANKING

affiliated corporations. One of the reasons why banks desired grow-
ing portfolios of marketable corporate securities, particularly during
the 1920*8, was that they were making an effort to maintain or in-
crease earnings in the face of increased deposits and relatively
declining commercial loans. This adaptation was encouraged by the
theory that bond portfolios provided commercial banks with "sec-
ondary reserves" that is, with liquidity additional to that
afforded by the "primary reserves" of cash maintained in a bank's
own vault or in the central bank.

Closely related to these developments was the expansion during
the 1920*8 of bank lending on stock and bond collateral and on real
estate mortgages, which gave impetus to the formulation of long-
term credit standards and methods. As a result, personnel skilled
in the extension of long-term credit became essential in commer-
cial banking. The organization of securities or investment depart-
ments of the larger banks dates from this period. In many cases the
personnel of these departments later were used in the extension of
term loans and in the purchase of private placements of corporate
securities.

The emergence of consumer instalment sales financing during
the 1 920*5 and its adoption by commercial banks in the 1 930*8 caused
banks to learn those special techniques of loan extension and collec-
tion which may aptly be termed "mass financing.** Banks tended to
emulate the credit methods previously worked out by the cash loan
and sales financing agencies, whose success in the consumer sales fi-
nancing field unquestionably led banks to enter the producer equip-
ment financing field and the accounts receivable business, both of
which involved use of a similar technique. In fact, many banks
assigned the administration of these new types of business loans to
the instalment financing departments which they had previously
established.

At the beginning of the present century an obvious schism be-
tween theory and practice existed in bank credit relationships with
business enterprises. Short-term credit forms were used in connec-
tion with the advance of funds performing long-term functions in
borrowing concerns. But while orthodox theory held that only the
trade acceptance was an appropriate commercial banking asset, banks
did, in fact, hold somewhat less than one-half of their earning
assets in 1900 in the form of business loans (excluding agricultural



TECHNIQUES OF SUPPLYING CREDIT 139

and real estate loans) and business securities. After 1900 sanction
was increasingly given to the use of bank funds in other kinds of
assets. This transition in viewpoint was due in part to the greater
prominence given to "secondary reserves." The expansion, after
1914, of savings and time deposits also accentuated the develop-
ment.

While commercial banking theory was being liberalized, new
techniques of financing business were being developed. After the
1920*8, it was gradually discovered that extension of credit is a tech-
nology which, like other technologies, is subject to adaptation,
innovation, invention, and research. It is not an overstatement to say
that in the two decades from 1920 to 1940 debt financing went
through a technical revolution as far-reaching in its significance
as technical advances in industrial production, transportation, or
agriculture. The roots of this change may be traced back many
years, but the great deflation of the 1930'$, the subsequent recon-
struction and revitalization of the financial system, and the drastic
fall in interest rates all accelerated its progress. The essence of this
technical revolution in debt financing consisted of the development
of more effective methods of meeting the needs of business for
short- and medium-term credit, particularly the needs of small and
medium-sized enterprises. Among these methods were four of
special significance, namely, the term loan, the accounts receivable
loan, the loan secured by field warehouse receipts, and the loan
financing the sale of commercial and industrial equipment. Each
emerged as a commercial bank activity in the early thirties, and each
represented an adaptation of commercial banking to changed eco-
nomic conditions.

TERM LOANS AND PRIVATE PLACEMENTS
OF SECURITIES 4

A term loan is a credit extended directly by a lending agency to a
business concern, and part of it is legally repayable after one year.
A private placement of debt securities is a term loan, except that
the transaction takes the technical form of sale and purchase of

* This section is based principally upon the materials in Neil H. Jacoby and Raymond
J. Saulnier, Term Lending to Business (National Bureau of Economic Research, Finan-
cial Research Program, 1942), which traces the historical development of the term
loan.



140 BUSINESS FINANCE AND BANKING

negotiable securities. Both credit forms by-pass the public money
markets and are not readily shiftable by the lending institution
through sale.

Banks gradually have developed specialized credit standards
and methods of appraising and limiting the risks in term lending.
Because the appropriate credit appraisal methods are closely akin to
those used in investment banking, term lending has caused many
banks to consolidate the functions of their investment and credit de-
partments. The comparatively large size of term loans and their
lack of marketability have meant that lenders cannot rely to any
considerable extent upon diversification to limit risks, nor can they
usually look to a public market for a continuing appraisal of the bor-
rowers' credit. Banks therefore have attempted to compensate for
this by the care with which they scrutinize each loan application, the
foresight with which they frame the loan agreement, and the dili-
gence with which they "police" the loan.

The preliminary investigation of the applicant for a term loan of
substantial size is necessarily quite thorough. The prospective bor-
rower is required to furnish audited balance sheets, operating state-
ments, budgets when available, and other financial information
running over a number of years preceding the loan application, and
the physical condition of the applicant's properties often is surveyed
by engineers. All data are analyzed to determine whether the bank's
financial standards can be met, and to estimate the prospective an-
nual earning power of the enterprise, especially the amount of cash
that can be "thrown off" each year to amortize the loan. Repayment
provisions even the maximum term of the loan itself are gen-
erally geared to the cash "throw-off" ability. The secular trend of
the industry of which the applicant for a loan is a member, the com-
petitive strength of the applicant in that industry, and the compe-
tence of its management are all carefully reviewed. 6

Many term loans are extended under so-called "revolving
credit" arrangements, whereby the borrowing business acquires the
right to borrow a specified maximum amount for a stated term of
years, but the actual indebtedness at any time is represented by notes

5 Sec Airline Finance, a brochure prepared by Bankers Trust Company, Mutual Life
Insurance Company of New York, The Chase National Bank of the City of New York,
and New York Trust Company (New York, 1945) and dealing with the commercial air
transportation industry, for an example of the technique of industrial and company
analysis utilized by term lending institutions.



TECHNIQUES OF SUPPLYING CREDIT 141

of shorter term which may or may not represent that maximum. As
these notes mature, they may be replaced by other short-term obli-
gations, so that the credit "revolves" in the sense of being repre-
sented by a series of legal instruments. At the same time, the com-
mercial bank is committed to advance the maximum amount, and
the borrower ordinarily pays a commitment fee in return for this
"call" on the lending capacity of the bank.

Nearly every bank term loan is accompanied by an agreement
under which the debtor covenants to conduct his business in pre-
scribed ways during the term of the loan. 6 While "tailor made" to fit
the circumstances of the borrower, the agreement commonly con-
tains restrictions on the borrower's total indebtedness, requires the
borrower to maintain certain financial ratios and to furnish financial
statements periodically to the lender, provides for acceleration of
the entire debt under certain circumstances, specifies any collateral
security that is required, and may subject capital expenditures to
the review and approval of the lender. Term loan agreements are
premised on conditions obtaining when the loans are made, but pro-
vision may be made for alterations when necessary in response to
unforeseen changes in these underlying conditions.

The special virtue of the term loan as a legal basis for business
credit, when contrasted with the traditional short-term note, is that
it embodies the idea of "planned credit." The process of making a
term loan requires borrower and lender to consider the problem of
repayment beforehand, and to adopt a realistic schedule of debt
amortization that is consistent with the operations of a business. The
factors that bear upon the continued use of the term loan as a device
for financing business are treated at length in Chapter 8.

From the time of its inception, the term loan has been a method
of injecting long-term bank credit directly into medium-sized and
large businesses that were nevertheless smaller than those whose
bonds and notes were sold publicly. At the outbreak of World War
II, the bulk of term-loan credit had been extended to large con-
cerns, although commercial banks had shown a definite shift be-
tween 1936 and 1941 toward the making of term loans to medium-
sized and small businesses. By mid- 1941 more than 55.3 percent of

8 See Association of Reserve City Bankers, Term Lending by Commercial Banks
(Chicago, 1945) pp. ii-i5> for a draft of a term loan agreement containing typical
terms and conditions.



142 BUSINESS FINANCE AND BANKING

the number of term loans by commercial banks were to concerns
with assets of less than $5 million. In meeting the long-term
credit demands of promising small businesses, term loans can be
a most useful device, because alternative financing methods have
not been readily available to such concerns.



ACCOUNTS RECEIVABLE FINANCING 7

Receivables financing falls into two well-defined categories, fac-
toring and non-notification financing. Factoring involves purchase
by the factor (lender) of a concern's accounts receivable, generally
without recourse on the vendor for any credit loss on the accounts,
and with notice given to the trade customers that their accounts have
been purchased. 8 "Non-notification financing" is conducted mainly
by commercial finance companies and commercial banks. It entails
the purchase of receivables, or their assignment as collateral security
for loans, without notice to the trade customer and with recourse by
the lender on the borrowing business for payment of any of its
assigned accounts that become overdue. Because banks do not gener-
ally engage in factoring operations, the following discussion is con-
fined to financing of the "non-notification" type.

Accounts receivable financing presupposes a continuing arrange-
ment with a rapid turnover of trade receivables, and a formal con-
tract is usually drawn between banker and business borrower. Under
the contract, the banker agrees to advance cash to the borrower upon
the security of an assignment of acceptable accounts receivable,
whose value as collateral usually ranges from 70 percent to 90 per-
cent of their face value, depending upon their quality. The bank has
recourse to the borrower if the borrower's trade customers fail to pay
their accounts. The statutes of certain states require that a debtor
whose account is assigned must be notified before the assignment
can become valid. As this is a condition which is often not satisfac-
tory to the borrower, accounts receivable financing is not of large
proportions in these states. In states where notification is not a legal

7 See Raymond J. Saulnier and Neil H. Jacoby, Accounts Receivable Financing (Na-
tional Bureau of Economic Research, Financial Research Program, 1943), for a more
complete discussion of this type of financing.

8 For a brief discussion of the historical development of factoring companies, see
Chapter 4, pp. 120-21.



TECHNIQUES OF SUPPLYING CREDIT 143

requirement, the bank usually reserves the right to notify if it be-
comes necessary to do so in order to protect the loan. 9

Because the average invoice handled by the lending institution is
small, operations are routinized in the interests of economy. While
the procedure is by no means uniform, the mechanics necessarily in-
volve much detail. Standard practice requires the borrower to indi-
cate on each ledger sheet whether the account has been pledged as
security for a loan. The bank customarily receives copies of all in-
voices representing assigned accounts, and the borrower stamps on
each copy retained by him an assignment of the account. Copies of
bills of lading or other documents evidencing shipment of the mer-
chandise covered by assigned invoices are sometimes required by the
banker. A usual requirement is that the borrower turn over to the
bank daily the original checks received by him in payment of as-
signed accounts. Occasional audits of the borrower's records are
made or arranged for by the lending agency. Because the out-
standing loan balance fluctuates constantly, as advances are made
against new assigned accounts and collections are received from ma-
tured accounts, the loans require constant supervision. Although
many commercial banks have followed less formal methods of
lending against assigned accounts receivable than are indicated here,
in some instances eliminating certain of the precautionary measures,
these banks have attempted to limit their clientele to borrowers for
whom the usual precautions may be less necessary.

As might be expected, the cost to borrowers of accounts receiv-
able credit is higher than that for unsecured loans or for most types
of secured loans. The range of charges is wide, depending upon the
financial strength of the borrowing business and of its customers

9 A 1943 decision of the United States Supreme Court held that reference to state laws
determines whether an assignment of receivables taken without notice to the trade debt-
ors is a voidable preference if bankruptcy occurs within four months of assignment
This decision has led to a re-examination of state statutes on notification, as a result
of which it may be expected that both state laws and the status of the business will be
clarified. See United States Supreme Court decision, March 8, 1943, in case of Corn
Exchange National Bank and Trust Company, Philadelphia, and Edward C. Deardon,
Sr., Petitioners, vs. Norman Klauder, Trustee of Quaker City Sheet Metal Co.,
Bankrupt. State laws differ with respect to their requirements for notification. Some
require that the books of the debtor be marked to show the fact of assignment of the
account} some require the assignee to file notice of assignment with a state officer j some
require that the assignee notify the trade debtors of the assignment} and some states
are silent on the subject.



144 BUSINESS FINANCE AND BANKING

whose accounts are assigned, and upon the extent to which the
lender must utilize elaborate procedures for controlling risks. 10

Accounts receivable loans finance mainly businesses of small and
medium size. The proportion of equity to debt among those busi-
nesses using accounts receivable loans is smaller than in other busi-
nesses of similar size. A low ratio of equity to debt in a manufac-
turing or trading business usually signifies either rapid growth
causing inventory and other working capital needs to outstrip the
ability of the business to finance them from accumulated earnings
or past losses that have cut away part of the owners' equity.

Two factors are crucial in determining the use of accounts re-
ceivable loans in the financing of American business: the volume of
business operations and the availability of short-term unsecured
credit, long-term credit, and equity funds. If the volume of busi-
ness is contracting or is at a low level, and business profits are un-
favorable, outside short-term funds may be unavailable on an un-
secured basis. When business operations are expanding and the
earnings retained are insufficient to finance the resulting growth of
assets, external funds will be sought, and it may be necessary to
obtain some portion of these through the assignment of accounts
receivable. Unsecured short-term loans, regular term loans, or
equity funds, which are less costly, if readily available will tend to
be substituted for those obtained from accounts receivable loans.
Nevertheless, there appears to be a basis for accounts receivable
financing, whatever the state of business activity and of the finan-
cial markets, since there are always some solvent businesses desiring
to obtain and able to put to work profitably more credit than
they can get on an unsecured basis. These businesses are prepared
to pledge their accounts receivable as collateral security in order to
obtain this added margin of credit.

FINANCING INVENTORY ON FIELD
WAREHOUSE RECEIPTS 11

The establishment of a field warehouse on the premises of a busi-
ness, which pledges the resulting warehouse receipts to a bank as

10 Interest charges in 1941 are discussed in Chapter 2, pp. 49-50.

11 Based on Neil H. Jacoby and Raymond J. Saulnier, Financing Inventory on Field
Warehouse Receipts (National Bureau of Economic Research, Financial Research
Program, 1944).



TECHNIQUES OF SUPPLYING CREDIT 145

security for a loan, is a comparatively recent credit technique whose
economic function in many ways parallels that of accounts receiv-
able financing. By this method banks are able to limit the risks of
lending money to concerns with highly seasonal working capital
needs or with slender equities. American banks have long granted
credit on the security of warehouse receipts covering agricultural
and other staple commodities deposited in terminal warehouses.
But the establishment of a field warehouse on the premises of a bor-
rowing business by a concern specializing in this activity is a modern
development. The practice originated around the turn of the pres-
ent century and expanded steadily, especially after 1930. Like
accounts receivable loans, field warehouse receipt credit goes pri-
marily to small and medium-sized enterprises.

Lending against field warehouse receipts has posed unique prob-
lems of credit appraisal for bankers, and has resulted in the evolu-
tion of special credit standards and methods of limiting risks. The
credit elements embodied in such loans are of four classes: the field
warehouse company (its financial responsibility, its experience, the
form of its warehouse receipts, and the amount, coverage, and
worth of its bond) j the field warehouse (the validity of the lease
agreement, the adequacy of the physical conditions, and the com-
petence and integrity of the custodian)} the borrowing business
(the moral and financial responsibility of its principals, its financial
strength, the caliber of its management, and its past and prospec-
tive earning power) j and the warehoused merchandise (its value,
susceptibility to deterioration, breadth of market, and price fluctua-
tion). All banks give some attention to each of these elements, al-
though the emphasis placed on each factor differs among banks, and
for a given financial agency as between industries and borrowing
concerns.

A risk-controlling factor of prime importance to the banker is the
percentage that the amount of credit outstanding at any time bears
to the value of the warehouse receipt collateral. This "percentage
advance" determines the bank's margin of safety, or excess of col-
lateral value that protects it in case it has to liquidate the commodi-
ties to recover its money. Other factors being held constant, the
percentage advance is larger, the broader the market for the ware-
housed commodity, the smaller the degree of its price fluctuation,
the less the normal rate of its deterioration in value during storage,



146 BUSINESS FINANCE AND BANKING

and the smaller the maximum credit line granted the borrowing con-
cern in relation to its financial strength. Most field warehouse re-
ceipt loans involve percentage advances of between 65 percent and
85 percent.

The volume of lending against field warehouse receipts is de-
termined by the amount of inventory in the economy and by factors
similar to those determining the market for accounts receivable
loans. Field warehouse receipt loans serve as a device for providing
businesses with working capital, in some cases to meet peak needs of
a seasonal character, in other cases to meet enduring requirements
for liquid funds. The decline in inventories of civilian goods after
1942 produced a shrinkage in field warehouse receipt credit. In an
economy characterized by high and expanding levels of production,
accompanied by large inventory holdings by business concerns,
rapid growth of new businesses, and lack of readily accessible
sources of equity capital and long-term credit for small and me-
dium-sized enterprises, conditions are favorable to the develop-
ment of a large volume of loans collateralized by field warehouse
receipts.

FINANCING MACHINERY AND EQUIPMENT
ON INSTALMENT TERMS 12

The financing of the acquisition of machinery and equipment by
commercial and industrial business via instalment loans is a fourth
significant development in American business credit technology.
Equipment trust certificate financing of railroad equipment was,
perhaps, the earliest manifestation of this type of credit operation.
Instalment equipment financing is marked by three character-
istics: specific use of the credit by the borrower to acquire income-
producing machinery or equipment} retention by the financing
agency of title to, or a lien on, the equipment by means of a condi-
tional sales contract or bailment lease for the purpose of securing
the debt} and amortization of the debt in instalments. Commercial
banks extend this kind of credit in two ways. They purchase or "dis-
:ount" the instalment sales contracts held by manufacturers or dis-

12 This section is based on Raymond J. Saulnier and Neil H. Jacoby, Financing
Equipment for Commercial and Industrial Enterprise (National Bureau of Economic
Research, Financial Research Program, 1944).



TECHNIQUES OF SUPPLYING CREDIT 147

tributors who sell the equipment (indirect financing)} and they
make direct instalment loans to the business concerns buying the
equipment, enabling them to pay cash to the manufacturers or
distributors (direct financing). In indirect financing the equipment
manufacturers and distributors are the direct grantors of credit, and
the banks, in effect, are credit wholesalers. The banks' function is
analogous to that which they perform in acquiring assigned accounts
receivable. In direct financing the average instalment cash loan
made to finance equipment purchased is much larger than in indirect
financing, but the down-payment and repayment provisions are
similar to those found in indirect financing.

Credit analysis in equipment financing has three focal points: the
character of the equipment, the credit standing and financial re-
sponsibility of the purchaser of the equipment, and the financial re-
sponsibility of the seller. In regard to the equipment, the banker
estimates its expected service life, its usefulness and value to the
purchaser, its probable repossession value, and the Validity of the
available title or lien. The last factor requires detailed knowledge
of the particular market in which the used chattel might have to be
sold. The purchaser of the equipment requires evaluation because
he has the primary obligation of paying the debt. This evaluation
is crucial whenever recourse of the bank upon the manufacturer
(seller) is limited, when the equipment is wholly or partly nonre-
possessible, or whenever repossession is likely to involve substan-
tial costs. Attention is given to the vendor of the equipment because
he accepts responsibility for its satisfactory installation, and because
he usually has a contingent liability on the financing contract.

Equipment financing is often a mass financing operation. A proc-
ess of continuing credit supervision begins when a bank makes an
arrangement to purchase or take assignments of the numerous
instalment contracts originated by a particular manufacturer or dis-
tributor. As the arrangement proceeds, the banker periodically
"ages" the contracts he holds, calculates the delinquency and
charge-off ratios, and observes trends in the types of equipment
sold, the terms of the contracts, and the credit ratings of the buyers.
On the basis of these observations, the financing arrangement may
be altered, terminated, or extended. The bank usually advances 80
to 90 percent of the face amount of contracts that it acquires, there-
by accumulating a customer's "reserve," from which deductions
can be made if certain contracts prove to be excessively delinquent
or uncollectible.