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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
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