BANK CREDIT A STUDY OF THE PRINCIPLES AND FACTORS UNDERLYING ADVANCES MADE BY BANKS TO BORROWERS BY CHESTER ARTHUR PHILLIPS, PH.D. PBOFESSOR OF ECONOMICS IN DARTMOUTH COLLEGE AND PROFE88OB OF BANKING AND FINANCE IN THE AMOS TUCK SCHOOL OF ADMINISTRATION AND FINANCE £fom Cork THE MACMILLAN COMPANY 1931 v COPYRIGHT, 1920, BY THE MACMILLAN COMPANY. All rights reserved — no part of this book may be reproduced in any form without permission in writing from the publisher. Set up and electrotyped. Published August, 1930. .RUNTED IN THE UNITED STATES OF AMEXICA BY BERWICK * SMITH CO. PREFACE The purpose of this study is two-fold: to develop the principles of bank credit considered in the abstract and to set forth the main factors underlying the loans made, the credit extended, by banks to borrowers. Part One is devoted mainly to an explanation of the way in which cash in banks becomes the basis of mani- fold loans and deposits, and to a statement of the rela- tion of loans to the other principal items of the bank balance sheet. The burden of Part Two is a consideration of the factors underlying and affecting the soundness of the contents of banks' portfolios. It has seemed natural and logical to give a somewhat detailed account of recent changes in our bank credit arrangements, in- cluding the evolution of the form of the bank borrow- er's obligation, the growth of the note brokerage busi- ness, the establishment of the bank credit department, and the rise of the new business department and its effects on the quality of bank loans. The work of note brokers acting as middlemen between borrowers and banks has been given what seems a deservedly large place. The structure of Part One is built in part on old and familiar foundations, and in part on foundations newly laid. The main sources of Part Two are the Pro- ceedings of the American Bankers' Association, pro- vi PREFACE ceedings of the various state bankers' associations, reports of the Comptroller of the Currency, and banking periodicals. Information embodied chiefly in chapters VII-XI and XVI, and unobtainable from the ordinary sources, was secured by extensive corre- spondence and interviews with bankers and note brok- ers, to whom my sincere thanks are due. For invaluable suggestions I am grateful to Profes- sors Ray B. Westerfield, Fred R. Fairchild and Irving Fisher, of Yale. CHESTER A. PHILLIPS HANOVER, N. H. TABLE OF CONTENTS CHAPTER PASS I. INTRODUCTION 1 The Nature of Bank Credit 1 The Bank Acceptance as Bank Credit 1 Are Deposits Bank Credit 2 Bank Credit vs. Commercial Credit 3 The Legitimate Scope of Bank Credit Extension 4 PART 1 QUANTITATIVE ASPECTS OF BANK CREDIT II. THE NATURE OF COMMERCIAL BANKING 13 Banking Transactions and Accounts 13 Expansion of Loans a Prelude to Loss of Cash 20 Protective Liabilities 22 Concealed Assets and Liabilities 29 III. THE PHILOSOPHY OP BANK CREDIT 32 A Critical Analysis of the Traditional Theory 34 Loan and Deposit Expansion within the Banking System 38 Primary and Derivative Deposits Differentiated 40 The Ratio of Derivative Deposits to Loans 44 Factors Determining the Ratio of Derivative De- posits to Loans 46 Aggregate Derivative Deposits Tend to Remain Constant in Amount 52 Quantitative Determination of Individual Bank Loan Expansion Traceable to Acquisition of Prim- ary Deposits 54 vii viii TABLE OF CONTENTS GHAPTEB PAGE Qualifications of the Formula 57 The Distribution of New Reserve as the Foundation of Manifold New Loans 59 Relation of Loans to Deposits 63 How the Withdrawal of Cash from an Individual Bank Effects a Wide-Spread Contraction of Loans and Deposits 64 Why Banks Compete for Deposits 66 The Assimilation of an Individual Bank to the System 68 The Essential Difference between the Old Theory and the New 72 Anticipated Criticism Answered 74 IV. INTEH-RELATIONS OF CASH, LOANS AND DEPOSITS 77 Cash in Relation to Loan Expansion in Individual and Collective Banking 77 Regulation of Ratio of Cash to Deposits in Individual Banking 79 Ratio of Cash to Deposits and to Loans in the Bank- ing System 82 V. SUBPLUS IN RELATION TO LOANS, DEPOSITS AND RE- SERVES 84 A New but Erroneous Doctrine of Surplus 84 The Doctrine Disproved 87 The Relation of Cash or Reserve to Surplus 94 The Ratio of Cash to Deposits and of Surplus to Creditor Liabilities 96 The Relation of Cash to Deposits vs. the Relation of Surplus to Creditor Liabilities 102 VI. BANKEBS' BANKS AND CBEDIT EXTENSION 103 The Nature of Bankers' Banks 103 Bankers' Banks Dilute Cash 104 Federal Reserve Banks Illustrative 104 Future Credit Expansion under the Federal Reserve System 112 The Rediscount Rate as a Factor in Credit Extension 114 Commercial Banks as Bankers' Banks 119 TABLE OF CONTENTS ix PART II QUALITATIVE ASPECTS OF BANK CREDIT CHAPTER PAGE VII. RECENT CHANGES IN OUR BANK CREDIT ARRANGE- MENTS 123 Evolution in the Form of the Borrower's Obligation. 123 The Growth of Note Brokerage 131 Seasonal Demands for Funds in Relation to the Growth of Note Brokerage 138 Independent Banking and the Rise of Note Broker- age 139 The New Attitude of Bankers toward Brokers' Paper 141 The Rise of the Credit Department 142 The First Phase of the Development of Credit Re- search 144 The Development of the Credit Department since 1900 146 The Underlying Forces 148 The Rise of the New Business Department and its Relation to the Credit Department 152 The Influence of the Federal Reserve System upon the Kinds and Quality of Bank Loans 156 VIII. THE BANK BORROWER'S STATEMENT: ASSETS 160 Cash on Hand and in Banks 165 Accounts and Notes Receivable 169 Merchandise or Inventory 173 Real Estate, Machinery and Equipment 179 Other Assets 182 Stocks and Bonds 183 Trade-Marks, Patents, Goodwill, etc 184 Life Insurance 186 IX. THE BANK BORROWER'S STATEMENT: LIABILITIES 189 Bills Payable for Merchandise 189 Bills Payable to own Banks 189 Bills Payable for Paper Sold 190 X TABLE OF CONTENTS CHAFTBB PAGE Open Accounts 191 Chattel Mortgages 192 Bonded Debt and Interest Thereon 192 Deposits of Money with Us 193 Other Liabilities 194 Capital and Surplus, Proprietorship Interest, or Net Worth 196 Ratio of Quick Assets to Current Liabilities 197 Relation of Net Worth to Credit Worth 198 X. THE BANK BORROWER'S STATEMENT: THE INCOME ACCOUNT 199 Insurance 201 Salaries and Cash Withdrawals 201 Depreciation 202 Sales 204 Net Profits 205 Dividends. 206 The Borrower's Capacity 207 Reciprocal Benefits of the Bank Borrower's Statement 209 Significance of Refusal to Render Statement 211 XI. INVESTIGATING THE CREDIT RISK 214 Handbooks as a Source of Information 215 The Mercantile Agencies 215 The Trade 216 Banks 219 The Interview 221 The Method of Investigation in a Particular Case 222 XII. SECURED LOANS 224 Warehouse Loans 226 Cotton Loans 229 Crop Loans 230 Real Estate Mortgage Security 231 Urban Real Estate 231 Farm Land as Security 232 XIII. OVERDRAFTS 235 Objectionable Features 237 In State and National Banks 238 TABLE OF CONTENTS JÙ CHAPTER PAGB Rules for Controlling Overdrafts 239 Depend upon Bank Supervision 240 An Index of the Soundness of the Bank 241 XTV. LOANS OF COUNTRY BANKS 242 Distinctive Features of Country Bank Loans 242 Rules for Reducing Slow and Past Due Paper 248 Loans to Tenants 249 The Rate of Interest 250 XV. LOANS OF BANKS TO BANKS 253 Methods of Lending 253 Investigating the Borrowing Bank 256 A Particular Case 258 XVI. COMMERCIAL PAPER HOUSES AS INTERMEDIARIES BE- TWEEN BORROWERS AND BANKS 260 Characteristic Features 261 The Paper 262 The Volume of Note Brokerage Business 264 Ten Days' Option 265 The Broker's Profit 265 Advantages of the Note Brokerage System to Bor- rowers 267 Disadvantages to the Borrower 270 Advantages of the Note Brokerage System to Banks 271 Disadvantages to the Bank 277 Weaknesses of the System 277 Correctives 287 XVII. BANK SUPERVISION IN RELATION TO BANK CREDIT 295 National Bank Supervision 296 State Bank Supervision 299 Clearing House Bank Examination 302 The System Described 304 Influence upon Loans of Small Banks 309 Effects upon Loans to "Double" Borrowers in Large Cities 311 Incidental Effects upon Loans - 312 Internal Bank Examination 315 Conclusion 318 xii TABLE OF CONTENTS CHAPTER PAGE APPENDIX A. Questions, Exercises, and Problems 319 APPENDIX B. Borrowers' Statement Forms Designed and Ap- proved by the American Bankers Association, Including the Report of Committee on Credit Forms 356 [...]... Credit The bank acceptance, which is a draft or bill drawn upon and accepted by a bank, differs from a loan in the fact that the accepting bank makes no actual advance of funds; it meets its obligation at the maturity l 2 BANK CREDIT of the draft out of funds provided by the drawer The accepting bank has faith in the willingness and ability of the drawer to provide the funds required to meet the draft when... detail the nature of the process involved in the manufacture of bank credit, the relation of loans to other magnitudes in the balance sheet in both individual and collective banking, the recent evolution of our bank credit arrangements, the bases of bank loans, and the influence of certain institutions and practices upon the quality of the contents of the banker's portfolio A brief study of banking operations... reserves of banks; actual advances affect both items directly Hence, from the standpoint of banking theory, the acceptance credit is comparatively unimportant Are Deposits Bank Credit? It happens, also, that borrowers extend credit to banks, when either cash or the proceeds of loans are lodged with their banks Deposits are obviously closely related to loans, both in an individual bank and in a banking... a deposit balance created The primary reasons for the maintenance of balances on de- THE NATURE OF COMMERCIAL BANKING 15 posit with banks in centers to which the locality of a given bank is commercially tributary are (1) that the local bank may be able to sell drafts on those centers, for the accommodation of its customers who may desire to remit drafts as means of payment, and (2) that the local bank. .. five years and interest at 6 per cent is made payable annually but not in advance The amount of the loan is taken by the borrower in cash and paid to the seller of the land, who deposits it in a bank in a neighboring town Cash is reduced $5,000 by this transaction; loans and discounts, increased by $5,000 Another customer of the bank pledges stock in a local corporation as security for a loan of $10,000... meet all other liabilities, including capital stock and undivided profits Surplus differs from capital or capital stock in not being represented by stock certificates, although the magnitude of the 1 Federal Reserve banks are banker's banks owned by national banks, state banks, and trust companies THE NATURE OF COMMERCIAL BANKING 23 surplus tends to be reflected in the market value of the relative stock... deposits to loans, a discussion of the deposit item in its relation to loans, surplus and cash is given in later pages Bank Credit vs Commercial Credit The fundamental factors affecting the question of security or safety are essentially the same in mercantile and bank credit The banker and the wholesaler and jobber are about equally concerned with such matters as the ratio of quick assets to current liabilities,... worth, the moral hazard, etc Both the banker and the business man who sells on credit, tap substantially the same sources of credit information Methods of investigating the credit risk are substantially the same In collecting credit information the trade relies heavily on the banks and the banks rely heavily on the trade The essential difference between bank credit and commercial credit ües in the degree... the banks taken as a whole this paper, put on the market by brokers wherever buyers among banks can be found, is distinctly non-liquid From the standpoint of the borrowing concern the floating of paper continuously in the market is almost tantamount to the issue and sale of bonds From the standpoint of the banking system the floating of such paper is also almost equivalent to the sale of bonds to the. .. individual deposits are the main item, are from four to twenty times the cash or reserve Expansion of Loans a Prelude to Loss of Cash Now as loans increase, in the case of an individual bank, cash tends to diminish This is true partly because a few borrowers take all or part of the proceeds of their loans in cash An attempt on the part of an individual bank to expand its loans is normally met by an immediate . BANK CREDIT A STUDY OF THE PRINCIPLES AND FACTORS UNDERLYING ADVANCES MADE BY BANKS TO BORROWERS BY CHESTER ARTHUR PHILLIPS, PH.D. PBOFESSOR OF ECONOMICS. deposits, and to a statement of the rela- tion of loans to the other principal items of the bank balance sheet. The burden of Part Two is a consideration of the factors