Loans And Discounts

Banks exist, as we have learned, in order that the surplus wealth which is stored up may be loaned out and put to use through commerce, trade and industry in the production of more wealth. Banks perform this function through the medium of loans and discounts. The difference between the two terms is purely technical. All bank investments, whether by the discount of promissory notes, straight loans, mortgages or bonds, are loans.

We can best understand this subject from the viewpoint of the borrower. A purchases $1,000.00 worth of leather from B, which A intends to manufacture into shoes, which he will sell at a profit. The whole operation, from the time the leather is secured until the shoes are sold, will take A three months, let us say. He, therefore, executes a note in which he promises to pay B $1,000.00 ninety days from date. B, however, prefers not to wait until the note matures, that is to say, the time A will have received the money for the shoes with which he will pay for the leather used. B can use the money in his own business at the present time. He takes the note, A's promise to pay, to the bank and the bank "discounts" it; that is, the bank gives B credit for the amount of the note less the interest for ninety days. In effect, the bank has loaned B $1,000.00 for three months, but at the end of that time, when the note falls due, it is A who repays the bank and not B. Discounting may be defined as the process through which future maturities are converted into immediate cash.

In the above case the bank has loaned B money on the security of A's note. This transaction, in which three parties are involved, A, B and the bank, is commonly called "discount." The technical term "loan" is applied when there are only two parties directly concerned, the bank and the borrower. For instance, let us suppose A, a regular customer of B, has bought $1,000.00 worth of leather. Two other methods of making payment in which banking is involved are possible in addition to the first example given. B may offer A a discount if the bill is paid in cash within ten days. In order to take advantage of this discount, A will go to the bank and borrow the $1,000.00 with which to make immediate payment. He makes the note payable to the bank instead of to B, secures the money and makes payment, thus getting the advantage of the discount offered by B. It will be noticed that B is put to practically the same expense in either case. Still another practice would be for B to extend credit to A on what is known as "open account." That is, for a certain period agreed upon between buyer and seller, B's books will show that A owes him $1,000.00. But B needs cash. He does just what A did in the preceding example: he borrows money from the bank on his own note.

In the case of the discount, if A fails to pay the note when due, the bank may look to B, who has endorsed the note, upon the strength of which B was able to borrow from the bank. In the case of the loan, however, with no third party involved, the bank often requires protection in the shape of collateral, such as stocks, bonds, warehouse receipts or any other negotiable paper. Or the security may be real estate, if the bank is permitted by law to make loans secured by real estate.

There is a wise provision in the National Bank Act which limits the amount a bank may loan to one individual or interest to 10% of the bank's capital and surplus. Many states have a similar law, the purpose of which will be discussed in a later chapter. It becomes necessary, therefore, for large industries which borrow heavily to distribute their loans among many banks. This is accomplished through note brokers, who "buy" the notes of such firms and then "sell" them to any bank having more funds than there is demand for from their own local customers. These notes are known as "commercial paper." Banks often find themselves in the same need of cash for reserve or other purposes as individuals or corporations, and they, too, take advantage of the process of discounting by re-discounting their loans with the Federal reserve banks.

Loans are of several kinds in addition to the ordinary commercial loans or discounts which we have been discussing. People who deal in goods, such as manufacturers, jobbers, retailers and the like, need money at certain seasons to buy raw materials, replenish stock, pay for labor, etc. Loans for these purposes have fixed maturities because the money will be "turned over" in a definite time, represented by the period between the production and consumption of the commodity dealt in. Dealers in credit and money, investors, brokers and kindred lines borrow money for indefinite periods, since there are no certain rules which govern the demand for their goods. A man will buy an overcoat in the fall of the year, but he may buy a bond or a piece of property at any time. Hence we have the "demand loan" which may be paid at any time at the option of either the borrower or the bank. The "call loan," usually found in cities where there is a stock exchange, is of the same nature. Call and demand loans are almost invariably secured by collateral. Mortgage loans are loans secured by a pledge of real estate or personal property. In the West growing crops or live stock are frequently used as mortgage security.

Loans and discounts are handled by an officer of a small bank, but in larger institutions a separate department has charge of the records and the mechanical details of the work, although the actual loaning of the bank's money is always done by an officer of the institution, regardless of its size or kind. A kind of journal record is kept of the loans made each day. Sometimes this book is known as the "Offering Book," in which is entered every note offered for discount. Those not accepted, or undesirable loans, are stricken off this original book of entry. The loans made are transferred to the loan or discount register. This is usually a double page book, the record extending across two pages. In columns of suitable width are entered the following records of each loan: maker, endorser (or collateral), amount, where payable, when due, rate, discount, proceeds. This record may vary as to details. For example, one register may be used for both time and demand loans, secured or unsecured, etc., while other banks may find it advisable to use a separate register for each kind of loan, or if a single register is used, further detail is provided for.

The loans are then posted on the Liability Ledger. This record consists of the "liability balance" of each borrower, either on notes he has signed or notes he has endorsed. His liability as borrower is kept in columns separate from his - liability as endorser or surety. The first record may be used in accounting, since the sum of the balances due by all borrowers will prove the corresponding figures on the general ledger, while the figures showing liability as endorser or surety are useful chiefly for credit purposes. The loans are next posted on the maturity tickler, which is simply a daily memorandum of loans as they fall due. This completes the records, the notes being then filed in a portfolio in the order of their maturity. Collateral is listed upon cards and then placed in a proper vault, or the collateral may be recorded upon the face of an envelope in which it is enclosed. Provision is made for keeping records of substitutions of collateral, and when the borrower pays the loan he signs a receipt for the collateral which is returned to him.

The bank, if it be a commercial bank, is always careful to invest its money in loans that mature in regular order. That is, unless loans are falling due each day, the bank will not be in position to extend credit to its customers as they need it. The loaning officers keep close watch on the maturity tickler which guides them in placing loans. There are seasonal demands for money, as for example, the crop moving period, when there must be plenty of money available for the needs of borrowers. Not all the bank's customers are borrowers, however; the needs of the depositor must also be taken into consideration. When a bank makes a loan, the usual practice is to increase the deposit account of the borrower by the amount of the loan. As a depositor the borrower is given the privilege of drawing checks against his balance, and the bank must be in position to meet not only normal demands, but also unusual and at times unexpected withdrawals. It would not be able to do this if all the loans were of one kind. A certain proportion of its funds may be loaned on "commercial paper," that is, notes bought from brokers which the bank is under no obligation to renew at maturity. Still another portion may be invested in good bonds that will find a ready market in case of need. These may be sold if it is necessary to increase the supply of cash. Bonds furnish such an excellent form of liquid investment in this connection that they are sometimes called "secondary reserve." Before taking up the subject of bonds and their uses, we will discuss the credit department.

Let us go back to our little country bank, situated in a town of five hundred people. Here we would find every member of the board of directors, the president, cashier and the general clerk of the bank more or less intimately acquainted with every business man in town. If a customer of the bank offers a note for discount, the cashier seldom needs to ask questions. He knows the character of the borrower, his next door neighbor, perhaps. He knows about his client's business needs and habits, because he himself does business with him. He is therefore able to decide whether or not the loan is a "safe risk" out of his own knowledge of the facts. In a larger community it would be impractical, if not impossible, for the cashier, in addition to his other duties, to keep track of every local borrower and the bank may employ a "credit man" who specializes in credits. The next step is the organization of a credit department usually in charge of one of the officers of the bank.

The credit department collects and files every available bit of information concerning people or firms that borrow money. This material consists of financial reports, press clippings, personal interviews, statements of condition and, in fact, every item that has even a remote bearing upon the standing of borrowers. It requires technical training of a high order to properly classify and analyse this data, but the fundamental idea is to get down to the same knowledge of the true facts as our country bank cashier has at his command, with respect to his neighbor. Credit is based upon character or, as bankers put it, the "moral risk." A simple, but practical definition of credit is "the ability to buy with a promise to pay." He who has "good credit" can command either goods or money because of the faith or belief that others have in his promise. The word "credit" is derived from the Latin "Credo" - I believe. It is not only essential that the borrower have the ability to pay his note when it is due; he must also have the desire or inclination to pay. To be able to loan money wisely and to those who are entitled to it, in short, the ability to distinguish between a safe risk and an unsafe one, is the quality that marks the good banker.