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BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Office Correspondence To Mr* Eccles D a te APrii 27,19*9 Subject: Mr* Carpenter At the meeting of the Board on April 5, 1949, Mr* Vest was requested to prepare a memorandum discussing the reasons for and against having authority in the Federal Reserve Banks to make direct loans and to guarantee loans under the provisions of -section 13 or 13b of the Federal Reserve Act. The memorandum prepared in accordance with this request is attached and the matter is being placed on the docket for consideration at the next meeting of the Board. Attachment PROPOSALS FOR AMENDING SECTION 13b OF THE FEDERAL RESERVE ACT It is the purpose of this memorandum to review briefly the background of proposals to liberalize the authority of the Federal Reserve Banks to make loans and commitments to business enterprises; to indicate some of the questions which have arisen in this connection, including particularly the question as to the desirability of including a provision for direct loans; to list possible alternative approaches to the problem; and to consider some of the other factors involved in any proposal for legislation on this subject, A. BACKGROUND Early Proposals. - Since about 1938 the Board has consistently favored some form of legislation to make more effective the ability of the Reserve Banks to assist in the financing of business enterprises, either by eliminating the more hampering restrictions of section 13b of the Federal Reserve Act, or by setting up within the Federal Reserve System a separate industrial loan corporation• At first all proposals of this kind provided for the making of both direct loans and guarantees of loans made by commercial banks. However, during 1944. and 1945, the Board recommended the so-called Wagner-Spence bill which would have eliminated authority for the making of direct loans and would have provided only for guarantees and commitments on the theory that the guarantee principle so successfully embodied in the V-loan program could likewise be applied to peacetime conditions. S. 408. - In the Spring of 1946 the Board gave consideration to a new draft of a bill which would have included authority for both direct loans and guarantees and that draft was submitted to the Reserve Banks for their views; but the proposal was not presented to Congress. In January 1947 the Board recommended to Congress a bill which again eliminated authority for direct loans and provided only for guarantees and commitments• That bill was introduced by Senator Tobey as S. 408. It would have repealed section 13b in its entirety and would have added a new paragraph to section 13 authorizing the Reserve Banks to guarantee financing institutions, up to 90 per cent, against loss on loans made to business enterprises with maturities not exceeding 10 years. Support for S. 408. - The bill S. 408 was favorably reported ty the Senate Banking and Currency Committee in April 1947 and it received support from several bankers associations, the then Under Secretary of Commerce, the Research and Policy Committee of the Committee for Economic Development, the Small Business Advisory Committee -2of the Department of Commerce, and the National Federation of Small Business. In this connection, it should be noted that the Research and Policy Committee of the Committee for Economic Development, while endorsing guarantees of business loans by the Federal Reserve Banks, also recommended that special capital banks be set up under the Federal Reserve System for the purpose of supplying equity and long term capital to businesses• Opposition to S. 408. - On the other hand, the American Bankers Association took a position in opposition to the bill. The Federal Advisory Council, which had at first endorsed the bill, stated in November 194-7 that it would oppose the bill "if Congress should decide to continue the Reconstruction Finance Corporation without greatly curtailing its loan and guaranteeing powers." In May 1948, the RFC was continued without uncurtailed authority to make business loans and guarantees until June 30, 1954. Recent Developments. - In November 1948, the Board advised the Bureau of the Budget that this subject was under review by the Board for the purpose of determining what proposal might be appropriate for submission to Congress at the present session. Recently, members of the staffs of the Council of Economic Advisers and the Budget Bureau consulted with the Board's staff as to the adequacy of Governmental financing programs in the business field for meeting problems of the availability of credit and equity funds in the event of an extended contraction of economic activity. It is our understanding that the Council may actively pursue some studies of this problem and may desire to have the cooperation of the Board's staff in carrying them out. It might be mentioned that some interest in this matter was recently evidenced by Representative Patman, Chairman of the House Select Committee on Small Business in a letter addressed by him to the Board on April 1, 1948, asking for full information regarding direct loans made tsy the Reserve Banks under section 13b. In addition, the Treasury Department has recently stated that it is interested in obtaining legislation to provide for the return to the Treasury of amounts paid the Reserve Banks under section 13b and for the elimination of the unexpended balance of appropriations for industrial loans from the books of the Treasury. B. HOOVER COMMISSION RECOi#lENDATIONS Task Force Report. - The Task Force Report on Lending Agencies submitted to the Hoover Commission in January 1949 recommended that the RFC be discontinued and that the Reserve Banks be authorized to guarantee business loans made by private banks. Favoring the elimination of the direct lending authority, the Report stated: w# * #y e recommend also that the Banks1 present authority to make direct loans to business enterprises be discontinued, the authority to enter into guarantee -3agreements being deemed an adequate aid to business enterprises, and a more desirable form of aid than direct lending by either the Federal Reserve Banks or the Government." The Task Force recommended that the authority of the Reserve Banks to guarantee loans should be unrestricted as to purpose, that maturities of loans eligible for guarantee should be limited to 10 years, and that the guarantee program be set up on a self-s\xstaining basis with loans to be financed primarily out of a guarantee fund created by the collection of fees* The opinion was expressed that such loan guarantees "would be adequate to meet the entire need for Federal Government assistance in the financing of business enterprises during normal tines, and during all but the most extensive periods of economic stress" and that the principal need for Government assistance to business entersprises "is the need for stand-by authority that can be used in periods of economic uncertainty tp support the extension of private bank credit to businesses," Hoover Commission Report* - The report of the Hoover sion on Federal Business Enterprises submitted in March 194-9 disagreed with the Task Force recommendation for the liquidation of the RFC and the raaking of guarantees by the Reserve Banks. The coromission's report stated that the Commission "believes it preferable that the Corporation be reorganized to guarantee loans by commercial banks." Expressing the view that direct lending should be absolutely avoided except for emergencies, the Commission recommended that Congress review the power of the RFC and of the Federal Reserve Banks to make direct loans and "that in non-emergency periods, the Congress place restrictions on direct loans in order to insure that the normal channels of credit are utilized to the maximum extent possible, or, alternatively, provide for the guarantee of loans made by private ov other established agencies." The Commission's report stated, however, that no guarantee should be made on terms more liberal than those for direct loans, and that "the Government should not engage in direct lending where loans can be obtained from private sources on reasonable terms." C. RELATIVE MERITS OF DIRECT LOANS H N D GUARANTEES The principal question which has arisen vrith respect to the contents of any proposal on this subject has been whether the legislation should be limited to guarantees, or whether it should include also some form of authority for direct loans, or possibly whether it should authorize only direct loans and not contain authority for guarantees. As above indicated, S. 4.08 would have eliminated the direct lending authority of the Reserve Banks; but several of the Reserve Banks have expressed the view that the retention of that authority is desirable. Among the arguments which have been advanced in favor of direct loans and against guarantees on the one hand and in favor of guarantees and against direct loans on the other hand are the following: Arguments for Direct Loans 1. Accommodation of Borrowers in Unusual Cases. - It is said that there are many unusual cases in which the financial assistance needed by a business enterprise can best be provided by a loan made directly by a Federal Reserve Bank, either alone or in participation with a commercial bank, particularly in cases in which a worthy borrower does not have sufficient net assets to enable it to obtain a loan from a commercial bank, even though the loan might be guaranteed by the Reserve Bank, 2 - Advantage in Servicing. - Industrial loans are ordinarily of a complex and technical kind which require a special type of servicing, including analyses of cash flow sheets, profit and loss budget, etc., which many commercial banks are not properly equipped to handle. Through direct lending or participation with commercial banks, the Reserve Banks can foster the application of improved techniques in handling credit risks of this kind. ?• Guarantees Encourage Excessive Loans. In a number of instances financing institutions have applied for guarantees simply in order that they may make a loan in an amount which statutory loan limitations would not otherwise permit them to make. In other words, the guarantee is desired by the commercial bank, solely in order to enable it to exceed the statutory limitations. Without the guarantee, the excess part of the loan would ordinarily be taken by one or more correspondent banks. 4. Misunderstandings Incident to Guarantees. - It is stated that the use of guarantees rather than direct loans might lead to misunderstanding and disturbance of good relationships between a Reserve Bank and the lending banks because attempts at supervision in serious cases of guaranteed loans might be resented by the lending banks* 5. No Threat of Competition with Private Banks. ~ It is argued that authority for direct loans by the Reserve Banks would not necessarily subject the Reserve Banks to criticism on the ground that they are competing with commercial banks, since it would be wall known that the Reserve Banks would raeke such loans only where the commercial banks were unwilling to make them, and also that the Reserve Banks have in the past made special efforts to assist the borrower in making his loan bankable and would return the loan to regular credit channels as soon as possible. Arguments for Guarantees -*-• Competition with Private Banks. - The mere authority to make direct loans places the Reserve Banks, which are quasi-public institutions, in competition with the private banking system; and -5consequently the possession of such authority will subject the Federal Reserve System to criticism, both by Congress and by the public, r.nd especially by correspondent banks. 2. Desirability of Financing by Local Banks* - Guarantees are desirable because all loans would originatq with local banks dealing with local people whom they know and with whose character and capacity they are familiar. Credit judgment and responsibility would remain primarily with the local bank and only where the requisite financial assistance could not be obtained by a business from the usual sources would the Reserve Bank enter into the picture, and then only at the request of the local bank. 3. Adequacy of Guarantees. - The V-loan program proved thst financing through guarantees of loans made by commercial banks is an effective method of providing businesses with needed capital. Such guarantees should be sufficient to provide for most instances of credit assistance necessary in peacetime without the retention of additional authority by the Reserve Banks to make direct loans. U. Monetary Effect of Direct Loans. - The making of direct loans would have a tendency to increase the credit expansion potential in the economy since funds loaned directly by the Reserve Banks to business enterprises, when deposited in commercial banks, would constitute additional banking reserves with the Federal Reserve Banks, which in turn would provide a basis for multiple credit expansion. Under existing conditions of high banking liquidity, additional reserves during periods of deflationary tendencies are neither desirable or necessary. In fact, the main effect at such times of additional ease in bank reserve positions might be merely to press down an already low level of market interest rates. D. POSSIBLE ALTERATIVE APPROACHES Having in mind the question discussed above as to whether authority for direct loans should be included, legislation on this subject might tcke any one of at least three different forms. 1. It might merely amend the present section 13b by eliminating the restrictiv3 provisions of present law but by retaining existing authority to make direct loans in exceptional circumstances, as well as the authority to purchase, discount, or enter into commitments with respect to laons made by financing institutions. Conceivably, it might eliminate authority for guarantees and provide only for direct loans. 2. It might be drafted along the lines of S. 408, so as to provide only for .guarantees of commercial bank loans without any provision for direct lending by the Reserve Banks. -63. It might provide for guarantees and commitments and also contain a provision for direct loans in cases involving exceptional circumstances in which a Reserve Bank finds that a business enterprise is unable to obtain requisite financial assistance on a reasonable basis through a loan guaranteed by the Reserve Bank, 4* As another possiblity, consideration might again be given to a proposal considered by the Board several years ago under which a separate industrial loan corporation would be established within the Federal Reserve System with authority to make industrial loans and guarantees. E. QUESTIONS FOR DETERMINATION BY THE BOARD Direct Loans or Guarantees* - The major issue for determination by the Board relates to which of the alternative approaches stated above should be adopted with respect to the inclusion of authority for direct loans or guarantees or both* Certain subsidiary questions are mentioned below. Standby Basis, - The bill could be so drafted as to confer authority upon the Reserve Banks on a standby basis for use only when the Board> or possibly the President of the United States, might determine that business conditions require the assistance of the Reserve Banks in providing financing to business enterprises, or it could be drafted on the basis of authority to be used at any time. Percentage of guarantees up to 90 per Reserve Banks, however, desirable to retain the effect in present law. Guarantee. - S. AQ8 would have authorized cent for the amount of a loan. Some of the have expressed the view that it would be 80 per cent limitation which is contained in Use Only Where Financing Cannot be Obtained from Usual Sources. - Present law limits direct loans to those cases in which the requisite financial aid cannot be obtained on a reasonable basis from the usual sources. When S. 4.08 was pending in Congress the Federal Advisory Council recommended that a like limitation be placed upon the authority of the Reserve Banics to guarantee loansj and this recommendation was adopted by the Senate Banking and Currency Committee. A number of the Reserve Banks have expressed the view that such a limitation should be included in any legislation in order not to arouse opposition on the part of correspondent banks. Limitation on Aggregate Amount* - S. 4-08 limited the aggregate amount of guarantees outstanding at any time to the combined surplus of the Federal Reserve Banks and provided further that not more than 50 per cent of the aggregate amount of guarantees outstanding at any time should relate to loans individually in excess of $100,000. It is assumed that such a provision would also be included in any legislation that might be recommended* Time Limitation, * The Senate Banking and Currency Committee inserted a provision in S. 4-08 limiting its duration to five years, and the question arises whether a similar limitation should bs included in any new bill. Elimination of Restrictive Provisions• - Presumably any new bill on this subject would eliminate present requirements that loans be made for working capital purposes and that they be made only to "established" businesses; would permit maturities up to ten years; £nd would eliminate the industrial advisory committees. It is also assumed that provision would be made for the return to the Treasury of the $27,500,000 heretofore paid to the Reserve Banks and the cancellation of the unexpended balance of the appropriation on the books of the Treasury. Form of Bill. - "Whatever approach is adopted, the bill could take the form either of an amendment to present section 13b or of a complete repeal of section 13b with the addition of a new paragraph to section 13* S. 408 was in the latter form, but some of the Reserve Banks have expressed a preference for a bill which would merely amend section 13b.
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