Readings in Money and Banking / Selected and Adapted

by Chester Arthur Phillips

The Banks and Railway Finance

[230]Close relationships of railways with banks or other credit institutions have grown up naturally through the need for new capital constantly imposed upon an expanding railway system. Some railways have been fortunate enough to possess a relatively stable body of stockholders whose confidence in the management is so complete that new funds can be raised by direct appeal of the management to the stockholders without the intervention of outside financial interests. But these cases have thus far been rare in American railway finance. When the policy calls for the raising of funds by the issuance of bonds rather than stock, the appeal is to a wider and to an anonymous public rather than to a corporation's own stockholders. Frequently the appeal must be to a class of investors situated in another section of the country or even in a foreign country. Most railways have not the technical organization nor the established market necessary to handle their issues easily, and usually it is found that in spite of the often exorbitantly high commissions which the bankers exact for their services, the net result is more satisfactory than that secured through the railway's own efforts. To the extent that this is the case, the bankers are performing a service of genuine economic value, and it must be concluded that under present conditions such service cannot readily be dispensed with.

Assuming this service as a necessity, the next step is for the banker to seek representation upon the railway board. His house has made itself responsible for a large issue of securities. It appeals to the investing public, not technically guaranteeing the issue, but practically doing so because of solicitude that its reputation for the handling of high-grade securities shall not be impaired. It seeks therefore to protect its own standing, and at the same time to make the securities more attractive to its customers, by demanding a place on the board of directors from which it can follow in detail the employment of the funds secured through its assistance. Large investors like life insurance companies, savings banks, fire insurance companies, guaranty companies, trust companies, demand as a prerequisite to purchase of securities that the underwriting house shall be represented on the board. The railway's credit—its ability to sell its issues—is dependent frequently upon the presence on its directorate of this representative. However, the banker is not in the position solely of a spectator or a detective. His expert advice is sought and usually followed. Often he is in a position where he can stipulate conditions under which alone he will undertake to provide the funds required, and such stipulations are frequently of immense influence in furthering efficient railway management. A recent example is found in the furnishing of money to the Chesapeake and Ohio Railway Company by Kuhn, Loeb & Co. under a stipulation that the road must put back into its property each year a certain amount of its earnings. Instances might be multiplied in which railway corporations have been saved from disaster and set upon their feet through the aid of those who have furnished the funds, and who have stipulated in connection therewith that in order to insure their knowledge of all transactions, and to give them a position from which they might bring their influence to bear, they should be granted representation on the railway board.

Of course it must be admitted that the power of the banker may be misused to his own private advantage. The power is there—the power to refuse funds—the power that comes from command of enormous sources of capital, the prestige gained by years of successful experience. Men who have attained such a position have the personal qualities that give them naturally a commanding place in any council of business men. When such men dominate the policy of a railway and the results are disastrous, it is exceedingly difficult fairly to fix the responsibility and assess the blame. The line between good faith and good judgment or between personal ambition that amounts to breach of trust, and a misplaced optimism concerning the outcome of a specific policy, is a very difficult line to draw. Although praise and blame cannot be assigned with any precision between Mr. Morgan and Mr. Mellen in the unfortunate New Haven situation, it is the prevailing opinion of the New England public that it has not been benefited greatly by the presence on the New Haven board of the distinguished banker member. Generally speaking, however, the powerful banking interests have thrown their influence in the direction of railway efficiency and the public advantage. If our judgment as to the desirability of the relationship of railways and credit institutions is to be determined solely by results, we must conclude that the balance swings heavily in favor of the continuance of the present policy.

However, opposition to the close association of financial houses and railways has not sprung from any such favorable relationships as we have here described. It grows rather out of the concentration and monopolization of credit. A powerful banking house which has identified its interests with that of one railway system is in position, because of its direct influence on the railway and its close affiliation with all other sources of credit, seriously to hamper if not altogether to prevent the securing of credit by a rival interest. This power over credit is not confined to one city or to one section of the country, but it reaches every section and even extends beyond national boundaries into the foreign sources of investment funds. Local or small enterprises requiring only moderate underwriting are frequently financed independently, but it is an acknowledged fact testified to by the large bankers themselves that with rare exceptions issues of securities in large amounts, except when taken up by the stockholders, must receive at least the tacit approval of the big financial group. Participation by the smaller banking houses in future underwritings depends upon loyalty to the syndicate in whatever enterprises are now being offered. The little fellows are inclined to respect a suggestion not to assist an enterprise of a character likely to interfere with undertakings already financed by the large interests. This informal but none the less effective network of alliances tends to destroy the competitive market for capital, and to restrict the railways to one source of credit. There does not appear to be any serious competition among the large bankers, but rather an understanding in the nature of a division of the field. A railway obtains the services of a single banking house which acts as its fiscal agent, underwrites its securities, receives its deposits, and has a representative on the railway's board of directors. When the railway becomes involved in financial difficulties, the same banking house organizes protective committees, devises reorganization schemes, and creates voting trusts. As Mr. Brandeis has put it, it adds to its duty as midwife also that of undertaker.

Is this relationship potentially dangerous for the railways and the public? The late Mr. Morgan, in his illuminating testimony in the money trust investigation, took the position that the situation might be dangerous in the hands of the wrong men, but he clearly implied that there had been no bad results thus far and there were not likely to be in the future with a continuance of the present leadership. His argument reminds one of the young lady who "when she was good was very, very good, and when she was bad she was horrid." Yet this view is that of most of the financial leaders who appeared before the Pujo committee....

Mr. Davison and Mr. Schiff both opposed the policy of concentration through interlocking at the point where the representative of the two interests might wield a dominating influence, but they found it difficult to fix that point.

Mr. Baker, who took the position that safety lies in the personnel of the men, that in good hands interlocking could not do any harm, but in bad hands would be very bad, concluded nevertheless that the movement of concentration had gone about far enough. And Mr. George M. Reynolds, of Chicago, thus frankly expressed himself: "I am inclined to think that the concentration, having gone to the extent it has, does constitute a menace." And again, "I think a more wide distribution of the power of credit ... would really be better in the long run." When asked the direct question, "Do you approve of the identity of directors or interlocking directorates in potentially competing institutions?" he replied, "Personally I do not believe that is the best policy."

It should be kept in mind that there is no evidence on record that this power has been used oppressively otherwise than in the rate of commission charged. Many of the bankers insist that the monopolization of credit is a physical impossibility.... There is, nevertheless, a concentration of credit in comparatively few hands.

If the conclusions thus far established are sound, it becomes clear that the real evil resulting from the interlocking of railways and credit houses, if any evil exists, arises primarily out of the relation of credit institutions to each other, rather than out of their relation to the railways through representation on railway boards. Were this interlocking of railways and banks to be wholly prohibited without any alteration in the organization of the credit market, I am unable to see how the situation would be changed materially. The tendency on the part of the bankers would still be to follow the law of "banking ethics" and divide the field; a railway would still employ a single banking house as its fiscal agent, and this banking house would still exercise a powerful influence in determining the policy of the railway. At the same time the railway would be deprived of the presence on its board of a financial expert whose experience might be drawn upon in the detail of management day by day.