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FOR RELEASE ON D E LIV E R Y Testim ony of C. Canby Balderston, V ice Chairman, Board of Governors of the F ed eral R e se rv e System, before the Subcommittee on Small Business of the Senate Com m ittee on Banking and Currency, May 11, 1955. The inquiry with which your Com m ittee is concerned is one of vital public interest. The long-run health of the economy requires the continual fostering of young en terprises. With full appreciation of what la rge companies contribute to the standard of livin g through their creation of mass m arkets, through the economies of mass production, and through their ability to finance and c a rry on research, the economy needs the fle x ib ility of companies that are sm all. They are flexib le enterprises in that they can change direction and policy quickly. Th eir existence perm its the adventure in risk-taking which is so necessary to a dynamic, fre e en ter p rise economy. Such sm all businesses are w ell suited to many types of production and s e rv ic e activity, and they provide m illions of job opportuni ties for labor. The general question of the adequacy of financing fa cilities for sm all business is a la rge one, and at the outset a word of caution m ay be appropriate. This relates to the mistake som etim es made of evaluating the adequacy of financing fa cilities from the comments or complaints of disappointed applicants fo r credit. It is the nature of a fre e enterprise system that many individuals should work in sm all businesses and should wish to expand. In general, they w ill be applicants fo r financing. In general, too, the sum total of their applications w ill exceed the supply of loanable funds available to them. - 2- Even if the question of adequacy of fa cilities cannot be measured relia b ly from the response of unsatisfied applicants fo r credit, there are two com plem entary approaches to an analysis of it. One approach is to judge whether or not the organization of our financial institutions is set up in a way to foster adequate credit for sm all business. The other approach is to gauge adequacy on the basis of the number of sm all business loans that are actually made by these institutions. F rom the standpoint of both of these tests, the Am erican economy is distinctive in the adequacy of its fa cilities fo r short- and in term ediate-term loans. Concerning the test of financial organization, this country can be said to be unique in the w orld in that its banking services are provided, not by a handful of la rge branch-banking system s, but by fourteen thousand banks. Most of these are sm all and tied to their resp ective lo c a lities. These sm all unit banks, scattered over the length and breadth of the land, are a significant source of short- and interm ediate-term credit fo r sm all b o rrow ers, In addition, the lending activities of la rge banks are directed, in part, to serving the financing needs of sm all firm s . H ow ever, these big banks also serve the needs of la rg e r businesses that sm all banks are not equipped and cannot aspire to accommodate. Thus, it is certain ly true that, to the extent the financial needs of sm all business are suitable for com m ercial bank lending and investing, our banking system is w ell designed to m eet them. - 3- With respect to the second test~~that is, the number of loans to sm all business actually made, --the F ed eral R e se rv e System in late 1946 made a survey of the business loans of its m em ber banks. The survey showed both a broad participation in the sm all business loan m arket by banks of all sizes and a wide va riety of loan patterns designed to m eet the special financing problem s of sm all firm s. Since that «u rv e y was made, there have been significant developments in the business lending activities of com m ercial banks. They have expanded their business lending consider ably, created new patterns of lending, and some la rge ones have m odified their organizations to stimulate lending by establishing specialized sm allbusiness loan departments. Because of the importance of these changes, the F ed era l R e se rv e System is planning another survey of m em ber bank business lending, probably to be undertaken this coming fa ll. The careful preparatory work which is n ecessary for the conduct of such a survey is already in process, One of the bills before your Com m ittee, namely, S, 383, would have the purpose of making short- and in term ediate-term credit fa cilities m ore gen erally available by providing for the insurance of loans to sm all business under such term s and conditions as the F ed eral R e serve Board of Governors may p rescrib e. We doubt that there is sufficient real need to supplement existing short- and interm ediate-term business financing fa cilities with Governm ent-sponsored insurance. - 4- Banking institutions, which are the principal source of shortand interm ediate-terin credit to sm all business, are encouraged by income tax regulations and by bank supervision to maintain loss reserves against loan portfolios. In this way, banks them selves are providing a form of self-insurance against norm al loss expectancies. Such loss res erve s are in addition to the capital and general re s e rv e protection that is essential in the banking field to prudent risk assumption. If a bank considers its loss reserves to he adequate, it is not going to seek additional risk p ro tec tion through a national insurance fund. Thus, the incentives for the participation of lenders in sm all business loan insurance protection are not strong. It can be argued that a sm all business loan insurance program is still needed to help strengthen credit availability to m arginal or h igh -risk sm all business b orrow ers, especially newly established enterprises of uncertain prospects. But an insurance loan fund lim ited in operation to such risks would present difficult actuarial problem s. Certainly, the premium charge for the insurance would need to be v e ry high in order to be commensu rate with the high average risk of insured loans. The short- and interm ediate- term business credit field d iffers in important respects from the home repair and m odernization field where short- and interm ediate-term loan insurance has already been experim ented with. F or one thing, it is a much less standardized credit field; in fact, its d iversity would present many problem s from the standpoint of risk insurance. - 5- If the financial fa cilities fo r sm all business are inadequate, the inadequacy, it seems to us, is not in the bankable credit area, but rather in the area of capital requ irem en ts--eith er lon g-term loan or equity capital. F ro m experience, we know that the sm aller the size of the business, the grea ter its difficu lty in raising lon g-term capital. hard to find. The reason is not It takes time and effort to investigate an applicant for long term capital and, if the decision is made to undertake the financing, to place the resulting secu rities. The inescapable costs of this operation are v e r y la rge in relation to amounts of the size that sm all businesses need. A ccordingly, there is some reason to conclude that a gap does exist here in the financing fa c ilit ie s . One of th** bills before you, S. 381, is directed at fillin g this gap. The general approach for this purpose is, in our opinion, on the constructive side, although we do not favor all of its provision s. This b ill would authorize the organization of National Investment Companies to engage in lon g-term capital and equity financing fo r sm all business. These Investment Companies would supplement and work through the com m ercial banking system . C om m ercial banks would be perm itted to participate in their ownership, and these participating banks could help m inim ize the costs of investigating the worthiness of applicants for long term capital. Because of their experience in providing short- and interm ediate-term credit to sm all firm s, they could recom mend to an - 6- Investment Company worthy applicants fo r long-term capital with less outof-pocket cost fo r essential investigation than anyone els e. They would also be in a better position to warn sm all enterprises against expansions that might prove unsound. We are sympathetic to the approach in this b ill of providing for the F ed eral chartering of the Investment Companies, fo r examining and supervising them to see that they are soundly run, and for special tax treatment of them. Financial institutions to serve the lon g-term capital naeds of sm all business may not have developed spontaneously in this country because our business laws and tax legislation have operated inadvertently to make the e ffo rt unprofitable. F ed era l taxes make a significant impact on the availab ility of lon g-term credit and equity capital to sm all business in an even m ore important way. Small businesses re ly most heavily on the personal savings of the owners and on retained earnings to start and expand their firm s. High individual and corporate tax rates tend to reduce the supply of personal and corporate savings available for investment. In the present world situa tion with national secu rity expenditures equal to 65 per cent of the budget, it is probably im possible to low er tax rates enough for taxes not to impinge significantly upon the supply of savings. Tax changes in 1954, however, did help to make m ore equity funds available to sm all business, and this fact must be considered in any current evaluation of additional means of im proving financing fa cilities for sm aller enterprises. Low er individual income tax rates and expiration of the excess profits tax reduced the rates applicable to all unincorporated businesses and to some sm all and expanding corporations, and allowed reten tion of m ore a fter-ta x incom ei L ib e ra lized depreciation also makes possible m ore funds from internal sources and facilitates the financing of new plant and equipment. In addition, provisions of the new law rela tive to reasonable accumulation of corporate p rofits, payment of estate taxes, certain aspects of the dividend-credit feature, the option granted some partnerships to be taxed as corporations, and a tw o-year carryback of operating losses are other changes which prom ise particu larly to ease the lon g-term credit and equity capital problems of sm all business. Low ering of certain excises and granting the right to deduct research and development expenses w ere additional tax changes gen erally helpful to sm all as w ell as other business. Our particular concern about this b ill relates to the respon si b ilities it assigns to the F ed era l R e serve System in organ ising, supervising, and investing in the National Investment Companies. that the System 's role be elim inated en tirely. We would suggest The System 's present responsibilities, namely, trusteeship fo r the nation's m onetary mechanism, are v e ry different from the responsibilities that would be associated with the activities of the Investment Companies, To m ix the responsibility for monetary management with responsibility for promoting the provision of - 8- adequate capital to sm all business would be like mixing oil and water. True, both responsibilities would have to do with credit and finance. is also true that oil and water are both liquids. It They still do not m ix. In S. 381, two functions are envisaged fo r the F ed eral R eserve, one allocated to the F ed eral R e serve Board and the other to the F ed eral R e se rv e Banks, One function relates to the chartering, examination, and general supervision of Investment Companies, activities gen erally com parable to those perform ed by the C om ptroller of the C urrency with respect to national banks in the area of com m ercial banking. governm ental function. This is c le a rly a If the decision is made to go ahead with the F ed era l chartering, examination, and supervision approach, we would suggest that this responsibility be assigned to some other F ed era l agency, such as the Securities and Exchange Com m ission, instead of to the F ed era l R e se rv e Board, The other incompatible function given to the F ed eral R e se rv e is that of stimulating the organization of Investment Companies by perm itting individual F ed eral R e se rv e Banks to subscribe fo r their stock, provided that they look forw ard to the ultimate disposal of such stock to banks and other in vestors. We cannot recommend this prom otional function for the F ed era l R eserve Banks. They are established for en tirely different purposes. Neither can we recommend diversion of the capital funds of the F ed era l R e se rv e Banks into the capital of the proposed Investment Companies. P riv a te capital w ill come forw ard to finance these companies, just as it did fo r national banks, if the legislation providing for them is soundly drawn and if the economic need for them is rea l. The proposed legislation would repeal Section 13b of the F ed eral R e se rv e Act, which authorizes the F ed eral R e se rv e Banks to make loans fo r working capital purposes to established businesses when credit is unavailable on a reasonable basis from usual sources. This authorization was put into the F ed era l R e s e rv e A ct during the depression of the thirties, and has now la rg e ly accomplished the purposes fo r which it was enacted. T h erefore, the F ed era l R e se rv e would favor its repeal now. Such repeal would relea se to the T reasu ry some 27 m illion dollars which has been tied up in connection with Section 13b.
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