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SMALL BUSINESS M P ITS CREDIT PROBLEM
By
ERNEST G. DRAPER,
MEMBER, BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTM.

Published in the Washington Post
of Sunday, October 1, 1939-

SMALL BUSINESS AND ITS CREDIT PROBLEM
May I say at the outset that the opinions expressed
below are my personal views, and in 1 0 sense represent an offi1
cial viewpoint of the Board of Governors of the Federal Reserve
System.
How small is small business?

Nobody knows and nobody

will ever know because, in this instance, size is purely relative.
A large concern in Noroton, Connecticut, looks small in Hew York
City.
We can make the picture somewhat clearer by having our
definition of small business cover both small and medium-sized concerns. Even then the argument will be endless. So let ug make an
arbitrary ruling.

It will not satisfy everybody but it will come

closer to the facts. Let us say that, speaking broadly, a small
Or medium-sized concern is one which hires 500 or less employees
Or has total assets of less than £1,000,000.

If we use these

guides -- and they seem to me to be fair — we discover come interesting facts.
Before attempting to give any statistics, may I say that
there are a number of ways by which to gauge the relative importance
of small business in the national economy.

If, for instance, you

are a private individual and are thinking of purchasing a small
concern, you naturally center your efforts upon finding out the
asset value of the company, its earning power, the scope of its

market, either present or potential, and other facta cf that
nature.

But if you are looking at this problem of small business

from the standpoint of the public interest, then the information
that you seek will be of an essentially different character. From
" h standpoint of the public interest — that is, of the people
te
as a whole —
business.

there are three essential facts to know about small

First, what proportion of those employed in industry

are employed in small business?

Second, what proportion of the

national income is earned by small business and third, what percentage of the total number of corporations and unincorporated
enterprises in this country have total assets of less than 1 million dollars?
According to a recent survey made by the Twentieth Century Fund — an impartial agency devoted to the dissemination of
factual information upon a variety of economic subjects — we find,
First, that - of those employed in 1929 (the latest date available)
in all manufacturing industries, more than 62% were employed in
Plants hiring $00 workers or less.
We find, Second, that of the total national income, approximately 60 per cent is produced by small unincorporated enterprises and corporations with total assets of less than 1 million
dollars.
We find, Third, that of all the corporations in this
country, about

have total assets of less than 1 million dollars.

-3In giving these figures, I do not wish to mislead you
by exaggerating the importance of small business.

For instance,

it is true that 95% of all corporations are small. But it is also
true that these 95$ own only ±1$ of the total corporate assets in
the country whereas the remaining % of large corporations own 86$
these assets. But, when we are judging a problem of this character from the public interest standpoint, we must remember that
assets, while most important, do not tell the whole story. The whole
story must also include the number of employees dependent upon the
successful functioning of small business and also the relative importance of small business in providing the nation with its yearly
income.
From these two vital standpoints, our country has a stake
^ h small business and a responsibility toward it which our Government should not shirk. While it may be true that a general recovery
cannot be stimulated merely by stimulating small business, nevertheless it is likewise true that we shall never get a broad recovery of
large and lasting proportions if we do not see to it that the credit
flow to small business is continuous and of sufficiently generous
proportions as to satisfy the legitimate needs of all classes of
sound small business.
Also, it may be true that, as a result of the European war,
all business will expand and that will have its temporary stimulating effect upon small business as well as large industry. Undoubtedly

something of this sort may take place. But we must also remember
that war conditions will bring about innumerable dislocations, some
of more or less violent nature. A small business that was recently
^gaining a good earning basis may, through no fault of its own,
b© thrown off balance or permanently crippled by the indirect but
devastating effects of a European conflict.
Based upon a wide variety of information which includes
Government and private surveys and reports, testimony of various individuals in Government hearings and many unsolicited letters from
Sfoall businessmen, it is my opinion that there are two groups of
business enterprises whose needs are not adequately met by existing
financial machinery:
1. Those who need short and intermediate credit but whose
credit standing at the present level of business activity does not
make them acceptable risks for banks. These are not misconceived,
mismanaged, or insolvent businesses, but businesses whose prospects of success are dimmed by the current economic situation.
2.

Small and medium-sized businesses which need loan or

equity capital for an intermediate or long period. The growth of
Nation-wide business units, the discontinuance of bank affiliates
a

nd of underwriting by banks, the increased cost of security issues,

a

nd the disappearance of local underwriters have made it difficult

£or this type of business concern to find long-time credit except at
prohibitive cost.

It has been said by many persons that Government should
not enter further into the field of rendering financial assistance
t

o business, because by so doing it will subsidize many mismanaged,

^profitably operated concerns.

I would never advocate that the

Government assist in making funds available to such enterprises.
However, I do believe that there are many small concerns whose liquid resources have been severely strained by a series of depression
-losses. There are others who require funds to finance the purchase
or new machinery and equipment, or to extend or improve plant operations, in order to enable them to carry on a more profitable operation.
In years past a substantial portion of outstanding commercial loans held by banks consisted of what would be termed today
capital advances, but they were evidenced by short-term paper that
was renewed from time to time as it matured.
increasing for longer-term credit.

Today the demand is

These long-term loans are open-

ing an avenue to banks for the expansion of their earning assets.
While these loans lack liquidity and marketability, nevertheless many
banks have made a number of such advances safely.
In making long or intermediate term loans, a bank not only
to consider the non-liquid and non-marketable character of such
assets, but must consider the added risks involved, such as an adverse

turn in the business cycle during their life, or management

end technical changes that may occur. The volume of such loans any

-6°ne bank con make will depend upon the nature of its deposit liabilities; the volume of its holdings of other non-liquid and nonmarketable assets, such as real estate loans; the quality of such
loans available to it; and the ratio of its capital structure to
its deposits. The risks involved are such that the Federal Reserve
banks as banks of discount for their member banks would be performing the proper functions of a central banking system in assisting
commercial banks to make this type of credit available.
Section 10b of the Federal Reserve Act now authorizes a
federal Reserve bank, under rules and regulations prescribed by
" h Board of Governors of the Federal Reserve System to make an adte
vance to a member bank on its promissory note with a maturity up
to four months, when secured "to the satisfaction of such Federal
Reserve bank".

This makes eligible as security at Federal Reserve

banks long and intermediate term loans made to business. This provision in the Federal Reserve Act, although providing aid from the
Federal Reserve System to member banks in making such loans, does
hot offer as effective cooperation as is provided for under the
limited provisions of Section 13b of the Federal Reserve Act. This
Section authorizes the Federal Reserve banks under certain circumstances and conditions to make loans to business enterprises. However, the statutory limitations of Section 13b, which provide that
loans can be made only to established commercial and industrial
enterprises for working capital purposes and that maximum maturities

-7cannot exceed five years, do not permit the Federal Reserve banks
" o operate satisfactorily in meeting the present situation.
t
In spite of the restricted nature of the present Section
+3b of the Federal Reserve Act, it may bo interesting to note what
tho Federal Reserve banks have accomplished in making direct advances, advances in cooperation with banks, and commitments to banks
covering advances made by such banks, to business enterprises since
June 1934.
The Federal Reserve banks have received over 9,300 applications, amounting to $400,000,000.
Counting to $184,000,000.

Of these, 2,750 were approved,

Approximately 1,200, amounting to

$60,000,000 were declined, because tho funds wore not to be used for
Working capital purposes as required by lav/, or because the applicants wore not established industrial or commercial enterprises. Of
^is grand total of $184,000,000, advances and commitments direct
to

borrowers amounted to only f38,000,000, whereas tho total commit-

ments to and advances through financing institutions amounted to
$73,000,000.
To the end of 193^ net earnings on industrial advances,
before making provision for losses, amounted to $2,800,000.

Deter-

mined losses charged off aggregated $160,000, and reserves set aside
to

take care of estimated losses amounted to $1,86^,000.

This left

n

°t earnings of about #770,000 for the period June 19, 1934 " o Decemt

ber 3 1 , 1938.

At the present time the Federal Reserve banks have

outstanding $15,000,000 in advances and $11,000,000 in commitments.
Of the advances outstanding about $2,500,000 are past due three
months or more.

The Reserve banks have acquired about $1,300,000

of miscellaneous assets in connection with the liquidation of defaulted obligations.

What the final losses will be is impossible

to state at this time, but present indications are that they will
not be unduly large.
From the record cited above, you can see that the Federal Reserve System has materially aided banks in meeting the longterm working capital needs of business.

However, it is undoubtedly

true that the restrictions placed upon the Reserve banks, to which
I have referred, have prevented the granting of many loans that
could have otherwise been made.

For this reason, it is my belief

that a plan for the creation of an Industrial Loan Corporation as
an integral part of the Federal Reserve System, using the Federal
Reserve banks and branches as its field force, would be of great assistance to both, banks and business enterprises, both in the field
of long-term financing and in those other situations mentioned previously.

This is the plan originally suggested by Chairman Eccles

before a Congressional committee last Spring.
The Federal Reserve banks have offices already established
in 36 cities (12 Federal Reserve banks and 2A branches).

These of-

fices are widely distributed in the various trade areas throughout
the country, and are well qualified for such service, because of their

knowledge of business and economic conditions in their respective
districts and their close contacts with local banking institutions.
With this organization already in existence, it would be possible
to commence operations with a minimum of delay and expense. Also
operations could be expanded or contracted from time to time in accordance with changing conditions. The experience gained by the
Board of Governors and the Federal Reserve banks in connection with
industrial loan operations during the past five years would be of
Great aid to them in performing this service.
Briefly, the plan is this:

Funds in the Treasury now set

aside or used for industrial loans under the provisions of Section
13b - about $139,000,000 _ would be turned over to an Industrial
Loan Corporation.

This would, involve no additional borrowing or in-

crease in the public debt. The Board of Governors would be the Board
°f Directors of this Corporation, and the 12 Federal Reserve banks
With their 24 branches would be the field agents to pass on applications.

In this way, prompt and economical action .vould bo assured

by utilizing existing machinery and experienced personnel.
The corporation would make loans or commitments or acquire
Preferred stock, but not more than $1,000,000 to any one borrower,
intermediate or long-term loans could be made by private lenders and
insured banks protected by commitments of the corporation.

-10The corporation would have $100,000,000 of capital and
$39,000,000 of surplus.

It v/ould have power to issue $500,000,000

Government-guaranteed debentures. Upon liquidation, all remaining assets would go to the United States Government.

One important

feature of the plan v/ould be to set aside, out of its surplus
$25,000,000 for an insurance fund for small loans not exceeding
$25,000.

The Industrial Loan Corporation would guarantee 10 per

°ent of any lender's aggregate insured loans, so that the loss on
a

ny loan even up to 100 per cent would be absorbed by the corpora-

tion, so long as aggregate losses did not exceed one-tenth of the
lender's insured loans.

The principle behind this plan is the same

as that in Title I of F. H. A.

The Corporation's possible losses

insured loans v/ould be limited to the $25,000,000 set aside as
a l insurance fund.
i

It has been estimated that the aggregate cost

to the borrower, including insurance and service charges would not
exceed 6 per cent.
In making this proposal, my only object is to offer what
seems to me to be a practical plan for meeting the problem as it exists today.

This plan does not provide for the creation of a new

Government credit granting agency, but broadens the powers of the
Federal Reserve System in order to enable it to be of more effective
assistance to banks and business.
Why not get to the bottom of this problem once and for all
b

y devising legislation which is simple in character, inexpensive

-11in operation, and cooperative in its approach?

In this way, we

could meet the present situation squarely and without reliance on
an entirely new setup of elaborate and perhaps unwieldy

machinery,

but with the assistance of a flexible, permanent Federal agency
such as the Federal Reserve System. Then, if it should develop
after the passage of such simplified legislation that the need is
not as serious as anticipated, no great harm would be done and no
great expense incurred.

If, however, the need should prove to be

Greater than anticipated, the flexible machinery of this new plan
would take care of this increase in demand regardless of volume.
This plan seems to me to offer the most effective solution to the difficulties in which a large and important sector of
°ur industrial economy finds itself bogged down. The discouraging
condition of small business is not primarily a result of its own
inefficiency.

It exists because of powerful economic disturbances

over which it has no control and against which it cannot individually
wage a successful fight without some reasonable amount of cooperation
from a permanent public-interest agency.