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Harch 3, 1950

Board of Governors
Subject: Financing problem of
small business and the O'Mahoney

From: Mr* Young

The attached memorandum provides for the Board's
information a background outline of the financing problem of
small and medium-sized business and the principal provisions
of the OfMahoney bill#

It is understood that the Board may

wish to discuss the O'Mahoney bill at a meeting in the near
future {f

March 3, 1950


I. The Problem of Small Business Financing
A. Evidence of Financial Need* Quantitative data are not available to
show the character and magnitude of small and medium-sized business
financial requirements* There is, however, a cumulative mass of
circumstantial evidence, including the reports of Professors Viner
and Hardy, the Temporary National Economic Committee and other
Congressional Committees, and the Committee for Economic Development,
which points to the existence of unsolved financing problems in the
small business area. More specifically, the evidence suggests that
small and mediums-sized business concerns encounter great difficulty
in obtaining long term credit and equity capital needed for launching
new projects, expanding productive facilities, and broadening the
market for their products and services, and that very small concerns
often have difficulty in financing their short-term working capital
B. Origins of the Problem. The problem of small and medium*sized business
financing is not new, but it has been intensified in recent years by:

1. Federal income and inheritance taxes. The present level of
Federal personal and corporate income taxes reduces the amount
of business earnings available for reinvestment and serves as
a deterrent to individuals who might otherwise invest a portion
of their savings in small business concerns. Present estate and
inheritance taxes tend to force the liquidation or sale of
closely^held small and medium-sized enterprises to meet substantial lump sum tax payments. A thorough approach to the
problem of facilitating small business financing should provide
for review and revision of the tax structure as well as broadening
of loan and equity financing opportunities.
2. High cost of small business financing. Even if there were a
broad investment market for the debt and equity securities of
small business concerns, which there is not, the high cost of
preparing and publicly marketing such issues would seldom, if
ever, justify this type of financing* Similarly, in the case
of loans to small business, the cost of investigating credit
applications, and of servicing small loans are so high in
relation to the income received as to discourage large institutional investors from this type of lending. Some of the life
insurance companies, such as Metropolitan, as well as some of
the larger banks, are now experimenting with programs to reach
the area of potential credit need*

- 2 3* Changes in investment preferences o£ individuals* There have
been indications in recent years of & trend attay from investment in equity securities to life insurance, Government security
and other liquid assets holdings on the part of individuals•
Such a trend complicates the problem of small business financing,
since life insurance companies do not purchase or hold equity
shares in any substantial amount and are not prepared, because
of the cost aspect, to lend directly to small business on any
extended scale•
II. Types of Small Business Financial Assistance Now Under Consideration

Insured bank loans* Short and intermediate term loans of small
amount which would be granted on fairly liberal terms and conditions
by local banks and insured by some private or quasi-public institution* Such an insured loan program would provide for small business needs in cases where (l) local banks consider themselves "loaned
up" on certain types of industrial and commercial credit (2) borrowers
are good character risks but have inadequate collateral or lack
proven earnings records.

B. Larger loans, requiring participation of other banks. Many small
banks are unable to provide their customers with credit in amounts
or with maturities suitable for their needs. In such cases provision
should be m d e for participation of other banks in the loan, with
the originating bank handling the credit investigation and servicing
the loan.
^' Purchases of debentures and equity shares* In a number of instances
small and medium-sized business require long term financing with
repayment and interest dependent on earnings, or equity capital*
Commercial banks are not in a position to advance long term credits
or to make equity capital investments, but by reason of their close
association with business concerns in their community, are well
qualified to conduct credit investigations and to service investments, provided that funds can be obtained from some outside source.
III. Institutional Framework Required for Small Business Financing
A. Role of the commercial bank. Most small and medium-sized business
concerns maintain close and continuous contact, both as depositors
and as borrowers, with commercial banks in their own or neighboring
communities. As a result of this close association, the local banker
relies as much upon his own knowledge of his customers1 character and
business abilities as upon the analysis of financial statements and
earnings prospects in appraising the applicant's credit-worthiness*
With the banker and borrower located in the same community, servicing
and supervision of loans is a relatively simple matter. Moreover,
the local banker has long been accustomed to appraising the prospects
of sound local business concerns which require additional long-term
credit or equity capital. These contribute investment opportunities

- 3 which the local bank cannot take advantage of, but can evaluate
on the basis of its detailed knowledge of local conditions, the
business, and its management. Such low cost credit administration
and financial analysis cannot be duplicated by any organization
whose regional coverage is less thorough than that of the commercial
banking system. Any proposed new facilities or institution for
facilitating small and medium-sized business financing should
provide for maximum utilization of commercial bank experience and
facilities, and for the greatest possible participation by commercial banks in the extension of credit.
B. Meed for new institution* In order that small and medium-sized
business may obtain the long term borrowed and equity capital
which it needs and which commercial banks are unable, and individual
investors unwilling, to provide, some intermediary institutiox* should
be created especially for this purpose.
C. Criteria for new institution
1. Ultimately, such institutions should be privately owned and
managed, but in order to encourage their formation and provide
initial capital, some public or quasi-public organization may
have to assume responsibility at the beginning.
2. Their lending and investment activities should be conducted in
close cooperation with commercial banks and provide for actual
participation by commercial banks wherever possible.

In order to meet their current operating expenses, establish
appropriate reserves and provide their stockholders with a
reasonable return, such institutions would probably have to
conduct certain loan insurance and lending operations in addition
to investment functions.

k. The number of such institutions, or branches of one institution,
should be large enough to provide adequate geographic coverage
and some measure of competition among themselves, and the amount
of their initial capital should be adequate to permit effective
IV. Outline of OfMahoney Bill (S.2975), Providing for the Establishment of
Corporations to Facilitate the Financing of Small and Medium-Sized
Business Concerns.

/NOTE.—The following outline is restricted to points
of major importance and covers (A) form and organization of the proposed corporations, (B) sources of
their capital, (C) insurance, lending and investment
authority, (D) tax status of proposed corporations,
and (E) miscellaneous matters. In addition to stating

• kprovisions of the present bill, the outline includes
alternative provisions contemplated by its drafters,
as well as comments on other provisions which are still
being studied with a view to possible modification^/


Form and organization of proposed corporations*
1. Number, and procedure for organizaing, corporations*
a. Present provisions - bill provides for a maximum of 36
corporations, equal to the number of Federal Reserve banks
and branches. Five or more individual subscribers to
shares coulcl enter into articles of association and request
a charter which would be issued by the Board of Governors
of the Federal Reserve System with advice of the Secretary
of Commerce.
b. Contemplated provisions - a limited number of corporations
(between 12 and 36) would be specified by statute. Rather
than permit any group of 5 individuals to apply for a
charter, the revised bill would provide that Federal
Reserve banks take the initiative in establishing such
2. Succession and corporate powers - such corporations would have
succession for 30 years, unless sooner terminated by action
of stockholders, Congress, or in violation of law. They
would enjoy the usual corporate powers and would report annually
to the Board of Governors.
3» Directors
a. Present provision - each corporation would have 9 directors,
3 to be appointed from the public by the Federal Reserve
bank in whose district the Corporation's head office is
located, and 6 to be elected by stockholders.
b. Contemplated provision - each corporation would have 9
directors, all of whom would be elected by the stockholders,
(in the event that a Federal Reserve bank were to provide
the major part of the initial capital of a corporation, most,
if not all, of the directors would be elected by the Federal
Reserve bank, but as stock was acquired by private individuals and institutions, control would pass from Federal
Reserve to private hands).

B. Sources of capital of proposed corporations

1. Equity capital

- 5a. Present provisions - bill provides that shares of these
corporations would be eligible for purchase by: member
banks, up to 1 per cent of their capital and surplus;
Federal Reserve banks, up to 1 per cent of capital and
surplus of member banks within their respective districts;
nonmember banks, other financial institutions, corporations
and individuals subject to approval of Board, the amount
held by any one stockholder not to exceed 10 per cent of
a corporation^ outstanding shares* Minimum paid-in
capital and surplus of each corporation to be one million

Comment - it is not yet certain what modification of the
equity capital provisions will be made in the revised
bill. Both the minimum paid-in capital requirement and
the maximum permissive subscription by Federal Reserve
banks are probably too small to permit effective operation.
One per cent of member bank capital accounts amount to little
more than 90 million dollars. In the Philadelphia District,
a capital of 1 million would not enable one of these proposed corporations to take over present Federal Reserve
bank 13b loans and commitments. In order to cover just
its normal operating expenses during the first years of
operation a corporation would have to have more than 1
million dollars invested. A revised bill may establish a
higher percentage of member bank paid-in capital and surplus
and/or provide that some portion of current Reserve Bank
earnings be invested in these corporations; with initiative
for organization of these corporations transferred from
individuals to Reserve Banks, minimum capital requirements
could be established by Board regulation*

2. Debt capital - each corporation would, subject to conditions and
limitations prescribed by the Board, be authorized to issue
bonds, debentures and promissory notes not to exceed the
amount of its paid-in capital and surplus* Member banks would
be permitted to purchase and hold such bonds, debentures or
notes in amounts not to exceed 10 per cent of their capital
and surplus.
C. Insurance, lending and investipent authority

1. Insurance
a. Present provisions - corporations authorised to insure banks
against loss on small business loans or obligations, such
insurance not to exceed 10 per cent of total loans or
obligations of an insured bank, or 95 per cent of aggregate
loans to, or obligations of, any one business concern.
Such insurance is further restricted to;


- 6(1) Not more than $10,000 of loans or obligations of
any one enterprise,
(2) Loans with a maturity of 5 years or less*
No audits or appraisals would "be required on insured
loans or obligations but banks would certify as to
borrower's good personal and business reputation notwithstanding a lack of commercial assets, collateral or
b. Comment - it is not clear whether the 10 per cent limitation
applies to outstanding loans or to total loans made from
the inception of the program, whether or not they were
still outstanding. The former would seem to be preferable
with some arrangement being made for greater insurance
coverage at the beginning* It would be desirable, if it
is possible to do so, to work out some safeguard so that
small businesses that are getting adequate private financing now would not be forced to pay an insurance fee,
and presumably a higher over-all cost for money, under
the new program.
2. Lending
a. Present provision - corporations authorized to make loans
to or purchase obligations of small business, with or
without security and with maximum maturity of 12 years,
provided that applications for financial assistance of
this kind be initiated through member banks or other
banks or financial institutions cooperating with the
b. Comment - to insure the cooperation of banks and other
existing private financial institutions with the program,
it might be desirable to restrict the new corporations to
the making of direct loans that cannot be obtained at
reasonable cost from existing private financial institutions rather than authorizing, as the bill does, that
applications be "initiated through" existing private
financing institutions.

a. Present provisions - corporations may purchase common or
preferred stocks or income bonds of small business concerns,
provided the total of such investment does not exceed 20
per cent of the combined capital, surplus and outstanding
indebtedness of these corporations. May also invest up
to 5 per cent of capital and surplus in the capital shares
of local industrial development corporations.

-7 b. Comment - if the primary purpose of these corporations is
to provide equity capital, the 20 per cent limit may be
too restrictive.
If. Limitation on large loans
a. Present provision - the aggregate amount of financing in
sums of $250,000 or more to single enterprises shall not
exceed 25 per cent of a corporation's combined capital,
surplus and outstanding indebtedness.
b. Comment - some restriction on the proportion of individual
loans in excess of a certain amount may be needed, partly
for political reasons, to assure direction of lending and
investment activities to small business, but the present
provisions may not be suitable.
D. Tax status of proposed corporations
1. Present provision - would exempt these corporations from all
forms of taxation, except real property taxes, for a period
of 15 years.
2. Comment - in lieu of such a blanket tax exemption for a 15
year period, it might be preferable to grant these corporations
the same exemption regarding income taxation that is available
to investment companies.
E. Miscellaneous - Business Lending Activities of the RFC and the
federal Reserve

1. Present provision - none.
2. Comment - if the proposed bill passes, there seems no reason
why the business lending activities of the RFC and the Federal
Reserve System should be retained. It might be desirable,
however, for the RFC or its equivalent, to retain certain
powers to provide extraordinary financial assistance such as
was suggested by Chairman McCabe in his Nov. 19^9 statement
before the Congressional Subcommittee on Monetary, Credit and
Fiscal Policies. Examples might be financing of railroads,
air carriers, large public projects, or disaster relief.
Such financing, either because of the size of the loan or
type of operation involved, would not be suitable for existing
private financial institutions or the new corporations.