Readings in Money and Banking / Selected and Adapted

by Chester Arthur Phillips

Restrictions on Loans and Discounts

The desirability of some legal limitation on the extent of the liability to a banking institution which any one person, firm, or corporation may incur is largely due to the fact, that, since the American banking system is a system of independent banks, the resources of many of the banks are necessarily small in comparison with the needs of some of their customers for loans. A large manufacturing concern located in a small town may very well be able to use all the assets of the local bank. If the local bank were the branch of a larger bank, the mere fact that a large loan was wanted by a manufacturer in a small town would be of no significance, since the amount of the loan would be small compared with the total assets of the bank.

Moreover, in many banks a controlling interest is held by a person, firm, or corporation that is actively engaged in other business enterprises. Such control is far more likely to be found in small banks than in large, and in a system of independent banks than in one of branch banks. One consequence of the close identification of interest thus brought about between banking and other business enterprises is the probability that loans will be made directly or indirectly to some one borrower to an amount larger than a proper distribution of risks would justify.

The national-bank act in its original form provided that the total liabilities to any national bank of any person, company, corporation, or firm for money borrowed should not exceed one-tenth of the amount of the paid-in capital stock of the bank. The liabilities of the members of the firm or company were to be included in the liabilities of the firm or company. It was provided, however, that "the discount of bills of exchange in good faith against actually existing values and the discount of commercial or business paper actually owned by the person negotiating the same" should not be considered as money borrowed. This section of the national-bank act remained unchanged until 1906, when it was amended so as to permit a single liability to be contracted equal to one-tenth of the capital and surplus, instead of one-tenth of capital only, but it was also provided that the liability should not, in any case, exceed 30 per cent. of the capital stock.

In the banking laws of seven States the limit on the amount of single liability is the same as under the national-bank act. The banking laws of almost all the other States permit a larger amount to be loaned on a single liability than is permitted by the national-bank act.

In nearly all of those States in which trust companies have acquired full banking powers the provision limiting the amount of any single liability applies to both banks and trust companies. In only one State or Territory—New Mexico—is there such a provision for trust companies and none for state banks. In a few States—Kansas, Michigan, Minnesota, Missouri, Montana, Oklahoma, New Jersey, Nebraska, and Wisconsin—there are limitations on the amount of a single liability for banks, but none for trust companies.

LOANS TO DIRECTORS AND OFFICERS

In almost all the banking institutions of the United States the directors or a part of them are actively engaged also in other business enterprises; and in many cases they borrow from the banks or trust companies in which they are directors. Moreover, in some banks one or two of the directors own a controlling interest, and are at the same time large borrowers. The possibility, in such cases, that larger loans may be made than the credit of those directors warrant is very considerable. The national-bank act contains no provisions regarding loans to directors, but in the laws of about one-half of the States attempts have been made to devise rules which would prevent the making of loans to directors in excess of the amount to which their credit entitles them. The requirement that loans to directors shall be formally approved by the board of directors is the one most frequently found. It has been thought that directors would be reluctant to vote for excessive loans to other directors if their vote is to be recorded.

REAL ESTATE LOANS

There is no more characteristic difference between state banking laws and the national-bank act than the fact that, in almost all the States, state banks and trust companies may make loans on the security of real estate, whereas national banks are [were] prohibited from doing so [before the passage of the Federal Reserve Act]. In some States, where the influence of the example of the national-bank act was strong enough at the beginning of state-bank regulation to secure the insertion in the state banking laws of the prohibition of real estate loans, it has later been found desirable to amend the laws in this respect. The Pennsylvania general banking law of 1878, for instance, did not permit banks to loan on real estate, but was amended in 1901, so as to permit such loans to be made. In North Dakota and South Dakota, also, similar changes have been made in the banking laws. In 1910 trust companies in all the States and Territories where incorporated under general laws were allowed to loan on the security of real estate. State banks so incorporated may also loan on real estate in all the States and Territories except New Mexico and Rhode Island. In Rhode Island, however, banks may loan on real estate part of their savings deposits.

A few of the state banking and trust-company laws contain provisions limiting the amount which may be invested in real estate loans.

Not withstanding the disadvantages of real estate as a convertible asset, the power to loan on the security of real estate is a valuable one to many of the state banks.[142] Many banks, particularly those in the smaller towns and cities, if restricted to loans on personal security, find it difficult to fully employ their funds. There are not sufficient local loans of this kind to employ all the funds of the bank; and the amount not so employed, if it is to yield a revenue, must either be invested in outside commercial paper or deposited with banks in the great commercial cities.