stock. Borrowing rates on risks comparable to credit corporations would exceed the prime rate, probably by 1 or 2 percentage points at the minimum. No return has yet been paid to stockholders of credit corporations and there is little likelihood of dividends in the future. Therefore, according to the full-cost principle, credit corporation lending rates should be higher than at present. How does the 6- or 7-percent rate paid by borrowers from credit corporations compare with rates paid by borrowers from other institutions? According to business loan surveys, commercial banks charge rates substantially exceeding 6 or 7 percent to borrowers whose credit ratings almost by definition are higher than those of credit corporation borrowers. Some banks have set up small-business loan sections in their installment loan departments and charge discount rates of 5 or 6 percent, or about 10 or 12 percent simple interest annually. Commercial finance companies, which lend predominantly to small manufacturers and wholesalers, but usually make short-term advances on accounts receivable or equipment loans up to 5 years, charge rates of 12 to 14 percent, and even 24 percent, annually. While part of this charge represents investigating and processing costs, especially on accounts-receivable loans, part represents risk and servicing costs. Another approach in making comparisons is to consider credit corporation loans as partly equity and partly loaned funds. This is appropriate, since their borrowers generally lack adequate capital and thus credit corporation funds substitute for the capital deficiency. Among large industrial corporations, equity accounts for at least three-fourths of total long-term funds, and borrowing for only onefourth. Equity funds through stock sales cost from 12 to 16 percent before taxes-the after-tax earnings-price ratio is 6 to 8 percentwhile borrowed funds (Aaa bonds) cost 4 to 5 percent, again before taxes. Thus a representative slice of long-term outside funds (threefourths stock and one-fourth bonds) costs from 10 to 13 percent. Even if a 50–50 equity-to-debt ratio is used, the average cost is still 8 to 10 percent. For smaller corporations, such costs would be substantially higher. Finally, there is a broader aspect of the rate problem which is connected with the working of a free economic system. Loanable funds are a scarce resource, and in a free competitive economy they are allocated according to yield in relation to safety. The highest yield can be bid by borrowers who can make the most effective use of the funds. Funds, and the resources they represent, put to one use are removed from some other use. For example, when the Government borrows from banks and the capital market and uses the funds for, say, small business financing, some other potential borrowers in the economy are denied the use of these funds. In an expanding economy such as the United States, a credit rationing device in the form of interest costs that cuts off some would-be borrowers is an essential part of our free-enterprise system. Variations from the market-determined pattern of interest rates interfere with the operations of a free-enterprise system. Computed from composite balance sheet in Financing of Large Corporations, 1951–55, Federal Reserve Bulletin, June 1956, p. 886. While the case for unsubsidized rates for credit corporations is strong, obstacles are encountered in actual application. There is some feeling that loan rates should not go much above 6 percent; certain State laws reflect this feeling. In 1949 and 1953, when the credit corporations commenced operations, a 6-percent rate was relatively higher in relation to comparable rates than at present. In addition, credit corporations operate in the same area as the Small Business Administration which lends at 51/2 to 6 percent. Most credit corporations have exceeded the traditional 6-percent ceiling on loans although some have done it indirectly by adding a 1percent service charge the first year. The Rhode Island corporation, whose rates vary with specific cases, has found some borrowers quite willing to place subordinated debentures at 12 percent. Some other corporations sell capital stock of their corporations to the borrower, whenever possible, as part of the lending operation, and this in effect represents a higher lending rate. There appears to be little problem in acceptance by borrowers of some upward flexibility in rates. A rather modest increase in lending rates of credit corporations would improve their operating positions substantially. For most corporations, net interest income, which is income less borrowing cost, ranges from 3 to 5 percent of loaned funds. A 1 percentage point rise in lending rates would increase net interest income by about onefourth. The additional income would be most helpful for expanding operations, for increasing reserves, or for attracting additional funds. An alternative technique of expanding the operating margin is to increase the subsidy element by lowering the interest rates paid on credit corporation borrowings. To reflect the public-interest nature of their support of development credit corporations, the member institutions in Connecticut and New York have recently accepted lower rates on their loans to the credit corporations. The New York corporation lowered its interest cost on borrowed funds from 41⁄2 to 32 percent. The Connecticut corporation lowered its cost from the then-existing prime rate of 412 to a level one-half percentage point above the Federal Reserve discount rate, making the current (March 1958) borrowing rate 234 percent. The interest rate problem is obviously a difficult one. The appropriate lending rate may evolve in time out of the operating experience of credit corporations. An adequate lending rate would reduce the subsidy element in making funds available to marginal borrowers. Increasing financial resources Funds available to credit corporations may be limited by an inadequacy of either capital or credit. Usually a ratio of about 1 to 8 is maintained between capital accounts and borrowings from member institutions. There has as yet been no shortage of borrowed funds for the New England corporations. Several corporations cannot utilize their pledged lines of credit fully, however, because of insufficient capital funds, since borrowed funds already are about eight times capital and surplus. In these cases, further expansion depends on additional sales of capital stock, which is probably the chief immediate problem facing these credit corporations. In general, future growth depends on availability of additional capital and larger pledged lines of credit. As these corporations are now operated, funds cannot be attracted by dividend payments or increased interest rates. Therefore, these corporations have to depend on their ability to obtain increased support on the basis of the public interest nature of their activities. Current and potential membership is shown in table 8. Commercial banks have the highest percentage of potential membership-55 percent by number and 73 percent by amount of credit lines. Most of the larger commercial banks are members. The membership percentages are quite low in the cases of savings banks and insurance companies. Part of the difficulty in enrolling insurance companies has been their feeling that they are nationwide, rather than statewide institutions. TABLE 8.—Actual and potential membership of New England development credit corporations, Dec. 31, 1957 While the potential number of additional members is large, the actual increase in the last several years has been fairly small. The New England corporations had a net increase of only 12 members—from 298 to 310-in the 2 years ended December 31, 1957. Other possible methods for raising funds for new loans include retaining net operating profits in the form of reserves for bad debts and selling seasoned loans to banks. The borrowers who had experienced an improvement in their financial position could, perhaps, take the initiative themselves in transferring their loans to a conventional source if there were a sufficient inducement through lower interest rates. Some credit corporations have been able to add to their capital base by selling stock to borrowers which, in effect, is equivalent to a loan discount. Another prospective source of funds employed at times is to take options on the borrower's stock, thus recognizing the fact that credit corporations are supplying funds of a near-equity nature at low rates. It is questionable, however, whether such options would bring forth appreciable returns. EVALUATION Development credit corporations have extended intermediate- and long-term credit to small manufacturing businesses on a somewhat more risky basis than conventional lenders. Their experience has not yet been long enough to justify any firm conclusions regarding the size and structure of credit needs toward which they are oriented or the future of the credit corporations, but it does suggest the following observations. Long-term credit to smaller concerns appears to be considered inherently more risky than short-term credit. This is indicated by a comparison of typical collateral arrangements for short- and longterm loans. Commercial credit companies grant short-term loans to marginal borrowers up to 80 percent or more of collateralized accounts receivable, when banks make long-term loans of only 50 to 60 percent of market value on a good quality first mortgage to a standard borrower. In seeking to extend their operations into the area of equity capital, credit corporations make long-term loans secured by second mortgages. Experience is still too short to permit a judgment as to the extent of the demand for the type of credit provided by the credit corporations, even with costs reduced by a certain amount of indirect subsidy. It is even more difficult to judge how much of the demand for credit is supported by willingness and ability to pay total economic costs because rates the corporations charge currently do not cover all such costs. The volume of lending by credit corporations has not been large in absolute terms. On December 31, 1957, outstanding loans of the five New England corporations totaled $8.7 million. While it must be emphasized that these loans are primarily to manufacturers, the total amount is small when compared to the $414 million in small business loans to commercial and industrial firms by first district member banks as of October 16, 1957, according to a Federal Reserve business loan survey. Thus credit corporation loans in the region are equivalent to only about 2 percent of small-business loans of commercial banks and the ratio would be smaller if all sources of small-business credit were taken into account. While contribution to small-business financing of this magnitude seems small, it may be a quite important amount at the credit margin. Moreover, lending activities of the credit corporations are expanding rapidly-total loans outstanding rose by almost one-fourth in 1957, although potential growth is limited if funds continue to be sought on the present basis. Outstanding business loans of the Small Business Administration in New England outside Vermont were even somewhat smaller-$8.1 million as of June 30, 1957-than those of the 5 credit corporations. Credit corporations have resulted from efforts of private institutions and individuals to cooperate in the performance of a credit function. The continuance of such cooperation is an important factor in the dayto-day operation of credit corporations. The local representation provided by commercial banks is especially necessary in directing funds to the best uses. State development credit corporations are young among financial institutions and they are still in an experimental stage. Some changes in operating methods are to be expected as additional experience is gained and as conditions change. APPENDIX A (See status table, p. 150 of this committee print.) APPENDIX B Statistics on northeastern development credit corporations, June 30, 19591 This replaces original appendix B, which gave comparable figures for Dec. 31. 1987 for further details on recent period, see table on p. 158. Source: Northeastern Conference Editor's note Development Credit Corporations. |