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CONSUMER INSTALMENT CREDIT ■by Dr* Ernst A, Dauer Division of Research and Statistics Federal Deposit Insurance Corporation Presented at the Conference of Examiners of the Fifth Federal Deposit Insurance Corporation Examining District, Atlanta, Georgia Decenher 5, 1946 C01TSUM3H IMSTALMMHT CPMI)IT I was Very pleased when our mutual friend and associate Clyde Rooerts askea that I cone to Atlanta to participate in your conference. In the first place, I hope to hoc one accjuaintod with a great nany of you teiore this conference is over. Aside fron the sheer pleasure of meeting you, I also welcome this as an opportunity to "get a haircut". X will have to explain what I mean hy this expression. On several occasions when Mr. Sari, Chairman of the Corporation, has introduced me to someone, he has said, "You will notice that Mr. Dauer is not one of those long-haired economists whom you have heard about." ITow in all seriousness, I know of two excellent wav sell ent w 'ays for an- 5DIC ec on or;list to avoid becoming impractical, or long- iair ed versing with the examiners — |Danks, the .ne One way is by m eeting and con- .gaged IP fro:nt 1 ine- duty in. the Shore is only one better way to keep down to ear th, to keepi closely |in touch with the facts of banking 1 ,fe 'as the e:Gardners f ac e them when th o~r go into the bank, That bettor way ii i to go i1110 the bank wi th you occasion— oily » and take part in an examina- . /our problems fron you runs it a < e socond Meet! :ig i d.th you , Cvüd heeri ng about Thor-:for e, I am pic a„sed - u w e r I can ?gct a. hair— cut" by neeting with you or by participating in Ian oxanina.tion. In the tine available to ne X shall (l) indicate the dollar nagni| dcs lilvolvod in consumer instalment credit; (2) describe briefly tho | 'lods or ?dalls which baiks are using in their efforts to secure as much iof thi involved. r, possible; and (3) touch on the examination problems 2 We know that consumer financing on an instalment “basis goes “back at least a.s far* as 1910, when the Morris Plan originated. Reasonably good figures on volume are not available, ho never, until 1929. 3y tha„t time such credit had grown to over $3 hill ion. With the ensuing drop in business activity, it was cut in half by 1932; it increased ranidly thereafter, shoving a dip iron the fall of 1937 to the spring of 1939, but otherwise growing con tinuously, until the fall of 1941 wheiu it amounted to over $S billion. Prom/ tnat peak of $6 billion at the beginning of the war, the amount outstanding dropped sharply to $2 billion in 1943 -where it remained until the fall of 19n5. In the last yean there has boon an exceptionally rapid increase of about 75 percent to $3.5 billion at the end of October 1946. Pho figures I am quoting include consumer instalment credit only, figures for total consumer credit have shown the same necks and dins as instalment credit and have been from $3 to $5 billion longer. I have not included cnarge accounts .at department stores, which show the shanu'est season— aL x luct.ur,tions and are now at their peak of about $2,5 billion. I have not inclu.de0 . so-called service credit consisting of doctor bills, hotel bills, etc,, nn.ich nave been extremely regular' in amount and hove never exceeded $1 billion. Petal non-instalment consumer credit, at $5 billion, is larger now tnan.it has ever been. However, the widespread, current interest of banners in consumer credit is not directed toward those non— instalment types of credit, but rather toward the instalment type; it is the latter to which tfo will limit our discussion. In the la.st .year, bankers have talked and written more about con sider instalment credit than about any other area of lending activity» It has not always "been thus; in fact, most "banks did not "become actively inter— ested until repair and m entersd d the the instalment field at an ever increasing rate and "by 1941, 88 percent of all insur t^at 6ate ba loans11, i.e., the type of loan in which the "borrower receives cash. Retail instalment salo cruo.it, the type designed to finance the sale of a specific commodity and in which the borrower ordinarily does not handle the money, has traditionally been the province of the sales finance companies, and even oy 1941, banks held less than one— fifth. Instalment sale credit amounted to almost two-thirds of the $6 billion of instalment credit outstanding in 1941. This is the form of in stalment credit which fluctuates the most and is expected to show the wreateri increase when durable goods becomes available in quantity. It is not sur prising then that for the last yean banker interest has been focused noon it. II Current controversy among bankers revolves about the method of ¿ttuing as large a share as possible of this instalment sales business, away non the sales finance companies. Most attention has boon devoted to auto mobile instalment sales credit, because in prewar days its total was as long Us all otner types combined, I think most bankers would prefer to finance Instalment sales by means of direct loans to customers. Many, of these same &u,ers .are convinced, however, that it is necessary to acquire paper indi— ~Stly througn dealers, and to adopt most or all of the methods of the sales nance companies in order to compete with them effectively. Essentially 4 thcro. arc only those two ncthods, although there arc any number of variants « o -p o b otv;eon 1. The Ira©ricen Bank Credit U bc ) : effort of banker s to con-oletcly no et the ground. The ABC Plan is sponsored . by th ration, a, wholly--owned s-ub si diary of the (Arthur J. Morris, founder of the Morris Plan Banks, is its originator), ns of the m d d l e of October about lib hanks with 75 branches had agreed to nar— ticljate- in the Plan in the 10 northeastern States on which the ABC sponsors have concentrated to date. This Plan provides for a, central orgonizn,tion which will make contracts with r..anufacturors, provide field non to develop new business, and maintain contacts with the dealers, and to supply advice and assistance to tno banks. These field non will handle defaults and repossessions and check dealers* inventories. The central office will also *orovide insurance for all care through a subsidiary, Tlius the central office functions in a, nannor office sinilar to the head/of a sales finance company, Ma,ch bank which joins the group acts-»*-so far as this business is concerned— very nuch like the branch office of a sales finance conpany. It will have the franchise in its community to discount the paper originated by local automobile dealers and to finance the unsold cars on the dealer's floor. The dealer makes out all the papers on retail transactions and de livers then in finished form, to the bank. Credit risks not acceptable, to the local bank nay be refused, and are then to be referred to a bank which supervises activities within the res-ooctive district. 5 As an exanrrjlo of the same approach, the Hash-Kclvinator and tho Iiitcrne/tional Harvester plans may "be mentioned. Local dealers are asked to select either a, local "bank or a sales finance company which will finance loth wholesale and retail paper. The local hank agrees to pay sight drafts for Hash autos* Xelvinator refrigerators or agricultural implements shipped to the dealer; the hank makes its own arrangements with the local dealer on rat c s, etc » As you readily recognise, many variations of the same procedure are possible for the financing of time safes, and of floor inventories of retailers of household appliances, and other durable goods JL/ In each such plan regardless of its details, full cooperation with the retail dealer is contemplated; his inventory is to ho financed, and he is to ho allowed such rebates of finance charges as the sales finance comparnies customarily allow in that particular industry. Fxcept in tho A3C plan, the full responsibility for making contacts with "dealers, checking dealer inventories, and handling defaults and repossessions rests with tho banker. 2. At the other extreme, stands the second approach which proposes direct loans to purchasers in all cases, with tho borrower paying the ly Lafly this year we hoard a great deal about the national Sales Finance •Plan, (sometimes called the Bank of Manhattan Group) consisting of 12.large banks in strategic canters, and 1,100 of their correspondent banks in- 30 States, cant of tho Rockies. A central office was established to make contacts with household appliance and implement manufacturers, to aid the local banks in securing retail and wholesale business of their distributors. In October the dissolution of the national office nas announced, on the grounds that the- organizers had not been able to secure--' assurance that their activities would not be in contravention of the Federal anti-trust laws, It wa,s. stated thAt each of tho signatory banks and their correspondents would continue to Participate actively in the sales finance field. - 6 - retailer in cash for the iten purchased# This procedure involves the least deviation fron the nethods used by hanks in nailing ordinary cash loons. The hanker relies on his own ability to attract borrowers through advertising — — without any cooperation fron the retail dealer. To aid in bringing eustoners directly into the bank, the American Bankers Association has cooperated with the National Association of'"Insurance Agents in sponsoring the Bank and Auto Agent Plan, supplying forms, publicity, advico and directions to local banks and local insurance agents.l/ This plan is based upon the self-interest of local bankers and local insurance agents in referring customers to each other, with each handling his part of the transaction. The bank makes out all pan or s cover ing the loan, itself, unless it provides sone forms to insurance agents, III Now what are the problems fron the viewpoint of a bank examiner m this,renewed activity of banks in consumer credit? Briefly, there are hrood problems (l) relative to paper acquired fron retailers, (2) relative to floor financing of dealers, (3) relative to direct loans, and (4) relat ive to all consumer lending. 1/ The Consumer Credit Department of the American Bankers Association has published 4 booklets within the last year, entitled "Direct Automobile Financing", “Homo Appliance Financing", "Farm Equipment Financing", and "Aircraft Financing", describing credit requirements and operating procedure, as part'of its program to assist the local banker, I:t proposes to issue other booklets and guides and has made surveys to determine the number of banks which propose to make personal loans, and to acquire through .direct or indirect means, automobile paper, other equipment paper, and noderniza/bion manor. X* Problems relative to retail gales •paper acquired from dealers» A banker who acquired retail paper from dealers instead of malting direct loans attain low acquisition costs and a relatively substantial volume of business once the necessary contacts with retailers have been made* But with the high volume comes the temptation to accept all of a dealer* s paper even though some is below the bank* s normal credit standard. There is oven a temptation to accept any paper sent in by the dealer, without adequate scrutiny to determine whether it meets acceptable credit standards. Thus such a bank will be relying less on the credit of the retail purchaser, and more on the dealer’s reserve or repurchase agreement or the resale value of the repossessed article. We recognize, to bo sure, that sales finance companies have not experienced a substantial rate of loss by operating in this mannerf When banks which discount dealer paper thus adopt the methods of. sales finance companies, as they must, you as examiners will want to be sure that they have mastered the incidental maze of technical problems, For example, on all car credits, particularly used cars, it is essential that the purported sales prices of cars be checked against official or recognized lists of value. Over-valued car contracts should preferably not be accepted, or» at any rate, be protected by a dealer’s repurchase agreement. °rS’ yOU V7an-fc As exajnin- in<miro into the character and value of the dealer’s contingent liability, if any, looking into both the adequacy of the dealer’s reserve and the credit worth of the retailor. It is desirable to look into rapidity with which the banker acts after a default occurs because it is ^ ° s t axiomatic that a borrower who neglects to pay also neglects to maintain tlle article which can be repossessed* 8 As you can well imagine, the sales finance conroanios have not looked with favor upon the energetic entry of hanks into this field. One of their most effective weapons has Tboen to cut their charges on wholesale paper, or to allow higher relates to the retailer. At this game they have all the advantage, because they have been in the business longer and should know their costs Getter than the banks which arc relative newcomers. Yet men within that industry, addressing a recent convention of sales finance companies, have sta.ted that rales have been cut too far. How you as examiners will want to be sure that the banks are not cutting rates, or splitting the gross income with the retailer or with others, to a "point where the business becomes un-* profitable. $• Problems relative to floor financing of doalors. Any banker who acquires retail *oa*oor indirectly * also has the problems of its Siamese twin-— floor financing of dealers, Here the two chief problems are over-extension of credit and the subsequent inability to move inventories. Today there is still a sellers1 market for most commodities, lot scattered price cutting is already in evidence in furniture, table model radios, costume jewelry, some foods, and cotton drosses; in addition tlioro have ooei more sales recently to reduce inventories or to move then faster. harming signs on the horizon indicate that lesser known brands in all fields nay have heavy sledding. Buyer resistance to top prices for used cars has also appeared. Taken as a, whole, those developments indicate that yesterday* s ¿¿antic nemana for goods is disappearing. worm stoppages, is increasing. Production of goods, in smite of It is probable that production will overtake demand in one important class of durable goods at a time rather than occurring 9 for all at once* X can make no pretense of calling the turns. As an examin er, you will want to assure yourself that the hanker is exercising the neces sary precautions to see that the dealer does not become overloaded. As you know, the sellers1 market can become a b e e r s ' market very abruptly. The technical auditing or examination questions relative to floor financing are familiar to you. The examiner should ascertain that all forms used by the banm in its agreement with the retailers have been checked for legal loopholes. You should check or spot— check the chattel mortgage, conditional sales agreement or trust receipt covering cams on the dealer*s floor ano. demonstrators; also the fire and theft policy on both, including a collision clause on the demonstrators. The bank should also carry insurance to cover conversion or other fraudulent acts of the dealer. In the periodic verification of the inventory on the deader’s floor— which is a,n absolute essential— proper precautions should be taken to avoid collution between the tank representative and the deader, Problems relative to direct loans. A bank which limits its consumer instalment credit activities to direct loans may incur substantial advertising expense and yet build up volume slowly, If its volume remains low its operations may be unprofitable; it nay thereby be tempted to cut rates to attract business. I know of several ban*"s ln Washington who are advertising a rate on direct loans materially below that charged by the local Morris Plan bank; if the'latter composed of consumer credit specialists cannot afford the lower rate, I don’t believe the newcomers can. In that direction lies danger. The bank which makes direct loans will also have somewhat higher clerical costs than tho banks which acquire paper indirectly, s ince in the - 10 - latter case the retailer prepares all of the papers* However, it saves the rebate which is customarily allowed the retailer, which more than offsets the increased clerical costs* The outstanding characteristic of direct lending is that the bank Ican keep full control of its selection of credit risks* As an examiner you will want to be sure that the loan is .justified by the credit of the borrower; if not, if it is based in fact upon an automobile or other durable good, the problems of verification are the same, as for a loan acquired from a retailer. 4, Problems relative to all consumer lending, I should like now to consider briefly three points with respect to aJJ consumer lending: Terras, rates of loss, and operating costs. For the la.st fivo yeans, consumer credit terms have been limited by Regulation V. decreased. Since the first of this month its scope has been materially If it is relaxed further or removed, we can look for a reduction - in down payments and a lengthening of repayment periods, as a result of two influences, competition among sellers and competition among credit agencies. By way of illustration; After the urgent demand for automobiles has been satisfied, retailors will have to begin "selling" cars instcaxl of merely "delivering" orders. and reduce monthly payments* Then dealers will want to lower down payments This desire together with the competition ctween banks, sales finance companies and other credit agencies will bring about such pressure as to have only one inevitable result, a relaxation of lending terms* ¥o all recognize that with present automobile prices, a one-third down payment, and a. 15-month term results in monthly payments beyond the 11 - roach of a largo proportion of prospective purchasers.1/ The longer life 1 which cars have demonstrated during the war nay well justify longer terns, just as the higher prices nay require then. But you and I will want to watch this development closely to sec that it does not heconc excessive, To summarize, you will recognize that a reduction of the down payments or on increase in the length of the repayment period decreases the purchaser’s equity, When carried too far it definitely increases the likelihood of loss. It is not many years ago since most hankers considered consumer credit unsound and risky. But they have learned in their prewar experience that losses and change-offs on consumer instalment loans need not he high. Losses sustained hy all hanks in the State of ITew York on all loans made hy personal loan departments from 1936 through 1942 averaged slightly loss then 1/3 of 1 percent of the total loans granted, The Superintendent of Banks of Low York also reports that over a 31-year period 14 industrial hanks sustained mi almost identical average rate of loss, namely 30.8 cents per $100.00 of loans granted, on loans totaling over $400 million. In terms of average outstanding loans, it would he about double that or two-thirds of 1 wcrcent. his is not high and compares favorably with losses on commercial and agri cultural loans. However, losses are inevitable. Sotting up an adequate reserve for losses based on loans made is one way to facilitate taking those losses promptly and currently. Another fact which bankers should have learned from their pre-wax experience is that the consumer instalment business is a high cost business, ]L on ? k f d \,0hovrolo‘ or Plynouth, the Monthly pnyn.ont would ho -bout y'U—80 m the Washington area,. - 12 - "because there are many transactions each, involving a snail an omit of money. I There is a, narked lack of satisfactory inf or nation on the costs incurred "by commercial banks in ranking consumer instalment loans. The only recent figures covering a substantial number of hanks are in the report of the Superintendent of Ban-n for Hew York to which I just referred. On the average these show that operating costs, without allowance for the losses just referred to, ran from about 5-g- to 8-| percent of outstanding loans in various sized centers in 1944. In 1941, when volume was higher, operating costs were as much as 1 percent lower thc an in 1944, on reduced volume. Our own figures for insured industrial hanks also show operating costs (not including interest on time deposits) of a little less than 7§- percent of average outstanding loans for 1941» Tnose figures do not include not charge-offs of about one—half of 1 percent of outstanding loans. Since the consumer instalment business is a high cost business, it is important to streamline the handling of such loans to reduce costs, and that requires an adequate volume. I believe you will nlso agree that it would be the height of folly for a newcomer, as most banks ore, to cut rates in the hope of getting voluie, unless the bank is absolutely oiire Ox its cost figures, furthermore, it is impossible to over^ emphasize the desirability of having officers and other personnel who are trained and qualified to handle this type of loan. IV Gentlemen, I am reminded of the story of the lady organist who wanted to impress the distinguished visiting clergyman, She feared that on tais occasion, as frequently happened, the old sexton might fall to pump uough air for the organ to function properly. She therefore wrote him a aote, which wa.s handed to him at the beginning of the service. Through a - 13 - ni sunder standing the sexton gave the note unopened to the visiting clergyman, who read: ’’Kindly “blow away this norning until I give you the signal to stop,” I’ve "blown away pretty long already, so I*n going to stop "before Clyde Roberts makes ne do so. Before concluding, however, X want to answer one question which sone of you nay have, The volune of consumer instalnent credit is going to continue ito grow iron the present total, of $3,5 "billion. I should not "be surprised if Iit reaches the 1941 peak fig-ore of $6 billion in the next 18 months. In the yoars prior to 1941, the volume of consuner instalment credit amounted to 6 or 7 percent of the national income. With a national incone of $1S0 billion * this would amount to $10 billion, or about three tines the present total. That figure will probably bo reached in the next three or four years, unless legis lative or regulatory stops are taken to prevent it. Tne bank share of the business may be expected to grow at & simil^rIrate, On Juno 30, 1946, insured banks in these four States (Alabama, Florida, Georgia, and Mississippi) held $49 million of consumer instalment loans, as Icompared with $75 million in June 1941, If consuner instalment loans vjctq to triple in this area, they would bo larger than total agricultural loans | 0 nov; an(^ almost one-half of commercial and industrial loans, which is the Ilargest category in your loan schedule. Banks which wish to enter this business actively need not fear that |taose already in it have cornered all the business. But in the words traffic cop to the lady who failed to soc the change in the lights, bOing to got any greener»” of the "It ain’t In fact, competition is going to become keener, ihc sales finance companies have had loan fare waiting for automobile Production to increase, and they are aggressive and capable. As we have » 14 ~ Dircindy noted, conpetitlon nay create excesses, It will "bo your resnonsibili ty ns e:M i n e r s to guard against those excesses, and to see that the consumer insti'.lnent activities of your hanks remain on a sound basis.