Institutional Financing of Small Business in Nova Scotia 9781487583606

This study aims to determine whether the financial institutions operating in Nova Scotia provide credit for the purposes

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INSTITUTIONAL FINANCING OF SMALL BUSINESS IN NOVA SCOTIA

UNIVERSITY OF TORONTO PRESS

Institutional Financing of Small Business in Nova Scotia

John T. Sears

ATLANTIC PROVINCES STUDIES A series of studies, edited by John F. Graham, sponsored by the Social Science Research Council of Canada, and published with financial assistance from the Canada Council.

1 Fiscal Adjustment and Economic Development: A Case Study of Nova Scotia. BY JOHN P. GRAHAM 2 A Leader and a Laggard: Manufacturing Industry in Nova Scotia, Quebec and Ontario. BY ROY B. GEORGE 3 Institutional Financing of Small Business in Nova Scotia. BY JOHN T. SEARS

© University of Toronto Press 1972 Toronto and Buffalo Printed in Canada Reprinted in 2018 ISBN

0-8020-1778-9

ISBN 978-1-4875-8225-8 (paper)

Microfiche ISBN 0-8020-0096-7 70-185738

LC

Preface

This study of institutional credit financing of small business was originally undertaken as a doctoral thesis. The interviews which constitute the major part of the data in chapters 3 to 6 were conducted in 1961 and 1962, while the remainder of the data has been updated to 1967. An effort has been made throughout to integrate the relevant developments that have occurred as a result of the hearings and Report of the Royal Commission on Banking and Finance, and the subsequent revision of the Bank Act. Chapter 1 describes the objectives of the study and the research methodology and limitations, provides a brief outline of the problems of the Nova Scotia economy, describes manufacturing activity in Nova Scotia, and outlines the so-called small business financing problem. Chapters 2 to 6 deal with the chartered banks as credit sources, chapter 7 with government loan programs for business, and chapter 8 with a group of private organizations which might be suppliers of funds to small business. The principal reference item for chapters 3 to 5 is A.B. Jamieson's Chartered Banking in Canada (Toronto: Ryerson Press, 1953), because it was the only comprehensive treatment of the subject prior to the Royal Commission on Banking and Finance, and because it was referred to frequently by the branch bank managers interviewed. The general conclusions and recommendations arising out of this study are presented in chapter 9, and are related to those of the Royal Commission on Banking and Finance at that point. Over the many years of intermittent effort on this project a substantial number of organizations and people have provided significant assistance. Direct financial assistance has been provided by the Canada Council, the Social Sciences Research Council of Canada, and the

vi

Preface

Harvard University Graduate School of Business Administration; less direct, but fully as real, financial support has resulted from the nature of my appointment at St. Francis Xavier University over a period of eight years, and at the School of Business Administration, University of Western Ontario, where I enjoyed a one-year appointment as Visiting Associate Professor while on sabbatical leave from St. Francis Xavier. To all of these institutions I am most grateful. Particular thanks are due to Professor John F. Graham, Dalhousie University, who, as Editor, Atlantic Provinces Studies, has provided consistent support over an extended period of time. And, while it may be somewhat trite, my wife has had to spend an awesome proportion of these several years living with the writing, revision, and updating of a project which was initially expected to take 'only a year'; in this she has been extraordinarily patient, a virtue for which I am thankful always. This book has been published with the help of a grant from the Social Science Research Council of Canada, using funds provided by the Canada Council. J.T.S.

Contents PREFACE

V

1 Introduction

3

2 The Canadian Banking System

26

3 Legal Factors Restricting the Credit Available to Small Business

47

4 Restrictive Practices of Branch Bank Managers

80

5 Restrictive Organizational Features of Chartered Banks

99

6 Interviews with Senior Regional Officers of Three Chartered Banks

130

7 Availability of Credit from Public Non-Bank Financial Institutions

142

8 Availability of Credit from Private Non-Bank Financial Institutions

198

9 General Conclusions and Recommendations

218

APPENDIX A

226

APPENDIX B

232

APPENDIX C

235

BIBLIOGRAPHY

237

INDEX

241

INSTITUTIONAL FINANCING OF

SMALL BUSINESS IN NOVA SCOTIA

A creative financial system is one which does not just passively accommodate the usual- instead, it is one in which active and inventive eflorts are constantly being made to meet the sound requirements of lenders and borrowers, regardless of how untried or unusual such needs may be. If the markets and institutions are not sensitive to changing needs, newer lines of activity will find themselves unable to obtain adequate financing at reasonable rates, terms and conditions in relation to the risks involved, while older enterprises will be favored ... [Financial institutions] cannot by themselves assure us of growing markets and production, satisfactory employment and increasing efficiency ... If as a nation our costs are too high, or we lack initiative, are short of trained personnel, or are unwilling to save enough to ensure our economic progress, a sound banking system and a highly developed network of other financial intermediaries will not solve our difficulties. From Report of the Royal Commission on Banking and Finance (Ottawa: Queen's Printer, 1964), pp. 8, 93, 89.

1 Introduction

One of the views which underlies much of the body of this study is the assumption that the small businessman is not well informed on sources of financing, the terms and purposes for, and the costs at which funds are provided. The criticism directed at small business because of its high failure rate, generally blamed on 'poor management,' always leaves the author wondering what is expected of the small businessman. Generally he is not a highly skilled 'finance man,' but one who relies instead on production or sales skills. While training and development programs will broaden his skills, the small firm will not be able to avail itself of highly skilled management in the several functional areas until it has grown enough to enable it to undertake an economic division of management labour. It appears most likely that the financial institution which first realizes that lack of skill in financial management is a reality of small business will be in a favourable position to develop a 'product' to suit this particular market - a market that may have more profit potential than conservative financial analyses indicate. It also appears that the 'product' to suit this particular market will be one that permits investment in the small firm at an attractive yield without compromising the freedom of the management. If the small entrepreneur wanted to work under another's direction, he would have been an employee and not an entrepreneur. The primary objectives of this study have been to determine whether the financial institutions currently operating in Nova Scotia provide credit for the purposes and terms likely to be required by small manufacturing firms in various phases of development, and to determine the factors influencing the extension of credit to such firms. The final re-

4

Institutional Financing of Small Business in Nova Scotia

search questions have been designed to reflect the initial research evidence that most lending officers have had very limited experience in lending to small manufacturing firms . Thus, we hope to answer questions concerning small business, with specific reference to small manufacturers where practical. The research questions are the following: la For what purposes and terms do financial institutions provide credit for small businesses? b Are small businesses likely to require credit for purposes and terms which are not provided? Which small businesses? 2a Once lending officers decide that the proposed purpose and term of a credit are acceptable, what criteria do they use in their lending decisions? b Are the criteria used in reaching lending decisions such that it is unlikely small business would be able to meet them? Which small businesses? 3 Does the competition between, and the legal framework and organization of financial institutions encourage them to provide credit to small businesses? Which small businesses? 4a Are the criteria used in lending decisions consistent with those described in general business, business finance, and financial institution literature? b If there is a lack of consistency, of what relevance is it to small business? 5 If the availability of institutional credit to small businesses in Nova Scotia is restricted, can the factors restricting it be overcome within the existing institutional structure? It was felt that if these questions could be answered they would provide bases for appraising the businessman's bargaining position in dealing with institutional lenders and the responsiveness of the financial institutions to the needs of small manufacturers. The author considers this to be the first effort at describing the lending practices of Canadian financial institutions based upon personal interviews with lending officers of the branches of those institutions. The focus on the branch level provides hitherto unavailable data on how branch managers, particularly of the chartered banks, see and discharge their responsibilities, and it provides bases for determining the nature and effect of constraints placed upon them by higher levels of management. Such data are essential to identify the indigenous factors which may result in restricted availability of credit. Some of the author's objectives have been achieved by the Royal

Introduction

5

Commission on Banking and Finance (Porter Commission) which began hearings in 1962 and concluded with a Report1 in May 1964. The various written and oral submissions to the Commission and the Report provide a wealth of information on Canadian financial institutions not available previously. In addition, the Commission reached conclusions on the problem of small business financing by type and term of financing, and on the restraints which financial institutions, particularly the chartered banks, face in providing credit to such firms. Despite the data produced for and by the Commission, additional data relevant to the businessman are needed. In presenting these data, evidence presented to the Commission has been used throughout and the major conclusions from the Report have been utilized in this chapter and in chapter 9. However, we shall deal primarily with the data gathered in the course of interviews undertaken from 1960 to 1962. The research undertaken consisted of an examination of literature on the subject and personal interviews. Late in 1959 an examination of the writings on the problems of small business financing was begun. The initial literature studied concerned United States small business financing problems, and the institutions with which such firms dealt. Subsequent investigation revealed that there was virtually no material available on any of the problems of small business in Canada, and very little on the activities of financial institutions. In an effort to obtain a starting point on the demand side of small business financing, a mail questionnaire was sent to 208 small manufacturers in Nova Scotia early in 1960. The questionnaire was prepared with three purposes in mind: (a) to obtain a profile of small manufacturers in the province; ( b) 'to obtain information identifying the institutional credit sources used and the frequency of use by a number of firms; and (c) to secure a sampling of the opinions of these manufacturers on the influence of credit availability on their profitability. The 208 firms were selected from the Directory of Manufacturers in Nova Scotia, 1957, a booklet distributed by the provincial government's Department of Trade and Industry. In preparing the mailing list three types of firms were deliberately excluded: (a) firms operating swamills only; (b) firms engaged in processing only one variety of food or fish product; and (c) firms which the author knew, through personal experience or research, to be multi-plant operations, employers of more than 100 people, holders of assets of $5 million or more, or subsidiaries of non-Nova Scotia companies. Of a total of 795 product classifications listed in the t Report of The Royal Commission on Banking and Finance (Ottawa: Queen's Printer, 1964), 587 pp.

6

Institutional Financing of Small Business in Nova Scotia

Directory, 514 (65 per cent) were produced by firms on the mailing list. Of a total of 1,356 manufacturing establishments2 in Nova Scotia in 1957, 526 were classified as 'sawmills,' 345 as 'food and beverage' processors, and 126 as 'fish processors.' On the basis of this and other evidence, it was estimated that the three groups excluded reduced the universe to approximately 500. Within this group the firms for the mailing list were chosen at random from the remaining product classifications. The 208 firms on the original mailing list provided 59 usable returns, and a subsequent re-mailing (April 1960) to 38 non-respondents of the original mailing list resulted in 11 additional usable returns (see Appendix A for a tabulation of all respondents). In mid-1960, while still holding the objective of examining the demand or small manufacturing side of the credit market in detail, a sample of twenty-four firms was drawn from the total of seventy providing usable returns to the questionnaire. The sample was selected primarily to reflect the distribution of three features of the respondent group: employee-size, age of firm, and type of ownership. It was felt that the sample chosen was representative of the type of manufacturing firm with which the research was concerned, and that it would provide an adequate basis for the kind of qualitative conclusions, on the demand side, which were the end point of the considerations. The proposed personal interviews with the twenty-four small manufacturing firms were to focus only on those demands actually made for financing when the management believed that the reception given the demand would result in an increase, or prevent a decline, in the payroll of their respective firms. Six of the proposed total of twenty-four interviews were actually completed prior to September 1960. During the ensuing nine months it was decided to abandon the interview program with small manufacturers in order to reduce the time and financial demands of the research. The principal reason for abandoning this aspect of the program was not that it was viewed as unimportant or even less important - it was simply because it appeared to be impossible to complete it and also investigate the supply side of the credit market for small manufacturing firms in the time believed to be available. In view of the biases common to mail questionnaires, the rate of response (33 per cent), the fact that the respondents represented approximately 14 per cent of the universe, and the factual nature of 2 In Survey of Production, 1956, p. 6, the Dominion Bureau of Statistics notes that 'each unit of an enterprise is treated as a separate entity [establishment] and classified to the industry in which it operates.'

Introduction

7

most of the data indicate that the information provided is reasonably reliable. One bias was inherent in that the twelve firms on record as having been financed by Industrial Estates Limited up to the date of the mailing were included in the list. Of these twelve, six responded to the questionnaire. Therefore all aspects of these particular data are biased. It should be noted that the purpose of the questionnaire was largely exploratory; it provided indications of general tendencies only, and, given its design, should not be relied upon for other purposes. The interviews with small manufacturers were too few to provide bases for any significant conclusions; nevertheless, certain similarities between the data from the questionnaires and interviews and the material in the literature are noteworthy, and tend to support the reliability of the questionnaire data. In June 1961 it was finally resolved that the interview program should be confined to financial institutions engaged in the direct supply of credit to small manufacturers in Nova Scotia, with particular attention to the branches of the chartered banks. The reason for this emphasis was the obvious importance of the banks as credit suppliers to such firms. The financial institution interviews were broken into two groups. During the summer of 1961, thirty-eight branch bank managers were interviewed, and the conclusions drawn from these interviews were used as a basis for interviews, at the end of the summer's work, with responsible officers of the four chartered banks' main provincial branches. During the summer of 1962 the second group of interviews was held with eleven non-bank credit suppliers and officers in the regional offices of three of the four chartered banks. The financial institution interviews were aimed at determining the purposes and terms for which credit was provided and the factors influencing the extension of such credit, particularly the extent to which the factors were weighted by the lending officer's interpretation of the policies of his head office. The interviews with the main branches and regional office personnel were designed to obtain an evaluation of the conclusions drawn from branch manager interviews. While the financial institution interviews did not have a formal structure, answers were sought to the following general questions.

a For what purposes do such institutions extend credit? Do they appear to have any preference for one type of credit over another? Is the preference such as to effectively exclude certain credit services? Do they prefer one type of credit over another because of risk factors? If not, what factors dictate preference?

8

Institutional Financing of Small Business in Nova Scotia

b What security do the institutions seek and what term do they offer on each type of credit? Do they relate certain types of security and/or term to high risk? Do they modify security demands with different purposes? With different terms? c What information do they want applicants to provide? What information do they use in making credit decisions? Does the information vary by purpose of the loan? Security offered? Term? d Do they appear to prefer one type of industry over another? One location? One level of experience? e Will they bargain on security allowance? On term? On interest rate? f What is the nature of the internal organization of the lending institutions? Does the internal organization influence the availability of credit?

The managers of financial institutions were also questioned on their impressions of the action taken by other lenders, to indicate their knowledge and opinions of the field. Table 1/1 summarizes the subjects upon which branch bank managers expressed opinions. The branch bank sample was chosen with the basic objective of reflecting the views of managers in the branches in the largest communities, as well as in the various regions of the province. The branches in the largest communities were assumed to be the largest and most active and, consequently, those with the most experience in business lending. The 38 branch bank managers interviewed were out of a total TABLE 1/1 Subjects dealt with in branch bank manager interviews Total interviews Lending criteria Type and age of firm Manufacturer Small business New business Appropriate security Security Three C's Substitution Risk reflection Financial data Protection of borrowers Covenants Rejections

30 21 21 31 18 12 14 29

Interest ceiling

34



Excludes main branches

32 7 31

Total interviews Types of loans Overdraft Compensating balances Non-term loans Tenn loans SBL Act Branch operation Manager evaluation Manager-supervisor relationship Loan limits, profit Competition Banks Non-banks Other lenders Total branches interviewed•

29 19 19 29 28 9 27 17 32 7 21 38

Introduction

9

of 164 in the province at the end of 1960, and of a total of 78 in the immediate area of the 13 communities visited. At the time of the 1956 census, these 13 communities were among the 20 largest in the province, ranging in population from 3,500 to 93,300. They contained 31 per cent of the province's total population, and 54 per cent of its total urban population. Miscellaneous data concerning the 11 counties in which the 38 branch banks were located indicate the dominance of these counties in the economy of the province (Table 1/2). It is clear that the sample branches encompassed the major areas of the province's economy. This tends to support the assumption that the managers of such branches would have the most business lending experience. TABLE 1/2 Miscellaneous data concerning eleven counties in which branch bank managers were interviewed (based on 1956 census data)

Item Counties Population Income reported by individuals filing income tax returns Manufacturing establishments Manufacturing employment Manufacturing salaries and wages Selling value of factory shipments

Total for province 18 695 thousand $479. 2 million 1,402 30,937

Proportion of total in eleven counties (%) 85 93 77 90

83 . 9 million

95

$384 .4 million

94

The branch manager interviews generally were arranged from two to twenty-four hours before being held, and were generally of one to one and one-half hour duration. The typical procedure was to have the manager respond to general questions on any one of five main subjects (see Table 1/1). The first question was concerned usually with the types of credit provided; subsequent questions sought further details on the particular subject under discussion. A formal questionnaire schedule was not used in the interviews or were notes taken at the time. 3 Since there was so little information on the activities of managers, a formal questionnaire would have required a predetermined set of priorities, criteria, and processes with no data upon which to base them. The objectives of the main branch and regional officer interviews 3 Early in the interview program it was noticed that reading from a list of questions and/or taking notes made the interviewee feel ill at ease, and for that reason the practice was discontinued.

10

Institutional Financing of Small Business in Nova Scotia

have already been noted. Generally the interviewee was asked to comment on a rather extreme conclusion drawn from the branch manager data, because this appeared to be the most effective means of eliciting a response from the respondent (see Appendixes Band c for statements used) . The interviewees were most co-operative, particularly in providing time from obviously heavy workloads. 4 The eleven non-bank financial institution interviews were with responsible officers of the only federal and the two existing provincial agencies which offer business financing. The other eight consisted of three trust companies, three life insurance companies, an industrial finance company, and a central credit union. The eleven non-bank institutions included all types of non-bank financial institutions which had legal provision for business lending. In the majority of interviews with this last group the main objective was to confirm an earlier impression that the institution was not active in business lending, and to determine the conditions necessary for their active entry into the field. In the remaining cases the purpose was essentially the same as in the branch manager interviews. The available literature was used to provide background information concerning all institutional lenders interviewed, and to provide information concerning those organizations discussed in chapter 8 which did not have Nova Scotia offices prior to 1963. Certain specific limitations of the interview data will be noted in the discussion of the data in subsequent chapters. It should be stated that no attempt was made to take a precise measure of the amount of credit unavailable, the number of credit applicants, the magnitude of their aggregate demand, the number of credit applicants rejected (some idea of proportions is available), the consequences of limited credit, or the consequences of the conditions under which credit is provided. Also, the range of credit needs discussed here had its basis in the literature on the subject and empirical data, rather than on what small manufacturers in Nova Scotia were discovered to have sought. Finally, it should be noted that the interview sample does not offer any way of determining whether the conclusions apply elsewhere in Canada. There was no opportunity for testing the reliability of branch managers' descriptions of their lending activities. Probably more important, the validity of the responses regarding small manufacturers is problematical because the majority of branch managers were not familiar with such firms, despite the fact that the branches were chosen because it was thought that they would have had experience in this 4 The seven interviews with these two groups were out of a possible eight; it was impossible to arrange an interview at one bank's regional office.

Introduction

11

field. This is not surprising when it is realized that there was approximately one branch bank for each nine manufacturing firms ( of the type included in the mail questionnaire) which had borrowed from banks in the eleven counties in which branch managers were interviewed. In general, then, the conclusions must be based on what managers say they would do in an area of lending in which they have no experience, and on a projection of present business lending practices to another lending area. While this obviously adds no conviction to the conclusions, the following appear to be relevant: (a) the managers' inability to provide knowledgeable answers is inherent and the lack of experience germane; (b) the managers generally did not differentiate lines of business, implying or saying that they treated all credit applications in the same way; (c) managers generally expressed an opinion on how they dealt with credit applications from new businesses, again not differentiating lines of business; (d) most managers seemed primarily concerned with business ability, investment in the firm by the owners, and personal character, rather than with the firm, per se; and ( e) almost all of those with little or no experience expressed an opinion regarding their probable treatment of manufacturer-borrowers consistent with the practices which they said they used in dealing with other types of business borrowers. Possibly the major limitation of the validity of the data stems from the respondents' lack of familiarity with the role in which the interview placed them. The interview questions frequently appeared to raise issues to which they had given little previous thought, although the literature deals with them as a matter of course and the questions seemed, logically, to concern subjects with which responsible financial officers could be expected to be familiar. It also seems important to note that the bank interview sample and program were not planned with an statistical tests in mind. It was felt that the research objectives did not require such tests in that the study was basically a diagnostic survey. THE NOVA SCOTIA ECONOMY

Before discussing the business lending activities of the financial institutions operating in Nova Scotia, note should be taken of three factors which are directly related to this subject: (a) the economic setting which prompted this study; (b) small manufacturers in that setting; and ( c) the small business financing problem. The Nova Scotia economy has long been characterized by a labour force more dependent than the Canadian average on primary occupa-

12

Institutional Financing of Small Business in Nova Scotia

tions (farming, fishing, mining, logging), and by above average unemployment, relatively low rates of participation in the work force, low levels of output and personal per capita income, and low rates of investment in fixed assets in the private sector. 5 The factors which generally have been identified as causes of these problems are a scarcity of natural resources, distance from mass markets, and a relatively low proportion of the population in the 15-65 age group. However, during the initial period of this investigation the distribution of the Nova Scotia work force experienced significant change. In 1941, 1951, and 1961 the proportion of the Canadian labour force engaged in the primary occupations was 30.5, 19.5, and 12.8 per cent, respectively, whereas the distribution of the Nova Scotia labour force for the same three years was 35.1, 22.6, and 12.8 per cent, respectively. Thus, during this time the dependency of the Nova Scotia economy upon the primary industries declined significantly.6 Nevertheless, the disparities in unemployment, participation in the work force, and personal income have remained. While Nova Scotia was failing to catch up in employment and personal income levels, it also experienced a decline in the relative importance of its manufacturing activity, as well as an absolute decline in the number of manufacturing establishments and in manufacturing employment in the 1949-60 period, and a further decline between 1960 and 1965. By every measure of manufacturing activity ( establishments, employees, salaries and wages, value added, and gross value of products), Nova Scotia accounted for a smaller proportion of the Canadian totals in 1960 than in 1949, and for still smaller proportions in 1965 (Table 1/3). At the same time, the manufacturing establishments in Nova Scotia in 1960 were smaller than the Canadian average, and diversification of manufacturing activity in the province was significantly less than in the country as a whole. In 1960, on an average per establishment basis, Nova Scotia's manufacturing establishments had 63 per cent of the average number of employees of Canadian establishments in this category, 51 per cent of the salaries and wages, 48 per cent of the value added, and 49 per cent of the gross value of products. By 1965 all of these values had increased: the average number of 5 See A.K. Cairncross, Economic Development and the Atlantic Provinces (Fredericton: Atlantic Provinces Research Board, February 1961), pp. 21-7. The Economic Council of Canada reported in 1968 that per capita income in Nova Scotia in 1964 was $1,384, or 75 per cent of the Canadian average and 64 per cent of the Ontario average. 6 The primary cause of the similarity of the 1961 figures for Canada and Nova Scotia was a decline in dependence on coal mining in Nova Scotia. This transfer of labour resulted from a combination of failing markets, depletion of reserves, and a mining disaster.

Introduction

13

TABLE 1/3 Nova Scotia manufacturing activity as a per cent of Canadian manufacturing activity 1949, 1960, and 1965 Per cent of Canada

Quantities

1949 Establishments Employees Salaries and wages (000,000) Value added (000,000) Gross value of products (000,000)

1960

1965

1949 1960 1965

1,480 1,278 944 28,606 29,311 32,100 $ 54.7 $ 92 .3 $ 127.6 $ 102 .3 $ 174.8 $ 222. 7

4.1 2.5 2.1 1.9

$ 247 .6 $ 406.2

2.0 1.7 I. 7

$ 563.2

3.5 2.2 1.8 1.7

2.8 2.1 1.6 1.5

SOURCE : Canada Year Book, 1962, pp. 616-17; 1968, pp. 698-9.

employees reached 72 per cent, salaries and wages 58 per cent, value added 53 per cent, and gross value of product 59 per cent. Thus, overall, the average Nova Scotia manufacturing establishment had grown from about half the size of the average Canadian establishment to almost 60 per cent of the size between 1960 and 1965. On an average per employee basis, in 1960 Nova Scotia's manufacturing establishments showed 80 per cent of the average for Canada in salaries and wages per employee, 75 per cent of the value added, and 77 per cent of the gross value of product; by 1965 these last two proportions had changed to 73 and 81 per cent, respectively, while the first was unchanged. In terms of manufacturing diversification, in 1960 the ten major types of manufacturing industries, in value of shipments, accounted for 61 per cent of establishments and 64 per cent of employment in Nova Scotia, and 18 and 24 per cent, respectively, in Canada; by 1965 Nova Scotia activity had become more concentrated whereas the nation's had became slightly less so (Table 1/ 4). In summary, Nova Scotia's unemployment and income problems, already serious because of basic economic and social factors, probably have been aggravated by a declining share of manufacturing activity. Second, to the extent that growth in the manufacturing sector is dependent upon the growth of existing firms, relatively small firms must expand. Third, the relative concentration of Nova Scotia manufacturing activity probably makes the provincial economy highly susceptible to economic fluctuations. While the employment and income benefits of increased manufacturing activity can be forecast with considerable confidence, it is more difficult to establish the feasibility of expanding existing industry and

14

Institutional Financing of Small Business in Nova Scotia

TABLE 1/4

Ten leading industries, by selling value of factory shipments, as a per cent of total industries ( Canada and Nova Scotia 1960, 1965) Ten leading industries as a per cent of total for all industries Canada

Establishments Employees Salaries and wages Value added Selling value of products SOURCE :

Nova Scotia

1960

1965

1960

1965

18.4 24.0 28.5 31. 7 37.3

15.6 24.4 28 .1 30.7 36.6

60.9 64.0 63.7 56.5 53 .7

88.0 79.8 74.4 74.6 71.1

Canada Year Book, 1962, pp. 631-2, 654; 1968, pp. 698-9, 707.

attracting new industry. The absence of data on provincial trade balances precludes a precise identification of the types of industry which might find a significant market for their products by concentrating on the regional market. Nevertheless, opportunities undoubtedly exist for increased manufacturing activity in Nova Scotia in supplying certain consumer and industrial products currently imported into the Atlantic Provinces. The nature of present manufacturing activity, an apparently unfavourable balance of trade, and personal experience suggest that the quantity and variety of products imported may be substantial. The size of the regional market - in 1961 the population of Nova Scotia was 737,000 and the population of the Atlantic Provinces was 1,898,000, up to 760,000 and 2 million, respectively, in 1966 - would probably make the absence of economics of scale a requisite of industries which might be established or expanded and operated profitably in Nova Scotia. Such industries would probably be labour oriented, and initially faced with problems of securing ( or training) skilled labour and capturing at least a share of the existing markets, creating new ones, or finding Canadian or foreign 'export' markets. However, the present wage levels in the province would permit somewhat lower initial productivity while maintaining a competitive cost structure. Again, the same distance that makes the large markets of central Canada relatively inaccessible to Nova Scotia manufacturers also provides some intraregional transportation advantages for provincial firms. Thus, low initial productivity per man-hour could be partially offset by lower wage rates and lower transportation costs. In short, Nova Scotia currently appears to be importing some manufactured products which could be produced competitively by small-scale, labour-oriented manufacturers in the province.

Introduction

15

If industry of the type noted is to develop in the province, with consequent improvements in employment and income, there are several prerequisites, one of which is the availability of adequate financing from financial institutions in the province. If the services currently available from these institutions to existing industry are inadequate, and have exercised a significant influence on their growth, it would appear that these inadequacies would retard, or possibly discourage completely, the desired growth of both existing and new industry. SMALL BUSINESS FINANCING

Any discussion of small business problems must concern itself at some point with an attempt to define small business, and there are almost as many definitions as there are discussions. The most comprehensive quantitative classification system for small business has been developed by the United States Federal Reserve Bank's study, Financing Small Business;1 no comparable data exist in Canada. In 1960, 91 per cent of all Canadian manufacturing establishments had less than 100 employees (and 35 per cent of all employees), and 84 per cent of the establishments had sales of less than $500,000; in 1964 the proportion with less than 100 employees was unchanged, while the proportion with sales of less than $500,000 had declined to 78 per cent. Only 1.6 per cent of those with sales of over $500,000 were proprietorships or partnerships. 8 Using income tax data, we find that 77 per cent of fully tabulated manufacturing companies had assets of less than $500,000, 86 per cent had assets of less than $1 million, and 96 per cent had assets of less than $5 million, 9 proportions which were virtually unchanged in 1964. If we use total assets of $1 million as a cut-off for small manufacturing firms, we would have had 14,689 (86 per cent of the total) 'small' manufacturing companies in 1960 and 16,211 ( 86 per cent) in 1964. Add to this the 17,607 ( 48 per cent of the total) manufacturing 1 Financing Small Business (Washington: Federal Reserve Bank, 1958), pp. 150-71. 8 Canada Year Book, 1963--64, pp. 666-7, 662; 1967, p. 700. No data are available by asset size of establishment. Data with respect to type of ownership of manufacturing firms are not available for more recent dates. 9 Taxation Statistics, 1962 (Ottawa: Queen's Printer). In 1960, there were 36,682 manufacturing establishments, of which 18,158 ( 49.5 per cent) were limited companies; the taxation data covered 17,013 profit and loss companies, and the disparity of 1,145 between establishments and companies can be explained largely by the fact that the taxation data are for companies while the other data are for establishments, several of which may constitute one company.

16

Institutional Financing of Small Business in Nova Scotia

establishments which were organized as proprietorships and partnerships in 1960, 10 and we have roughly 33,000 establishments, or 90 per cent of all manufacturing establishments. Thus, it would appear initially that $500,000 sales (84 per cent of establishments in 1960), 100 employees (91 per cent of establishments), or $1 million assets (86 per cent of companies) would be suitable cut-off points for measuring the Canadian small manufacturing population. However, these cut-off points for small manufacturing business are not entirely satisfactory. Examination of the data for various asset size classifications (Table 1/5) indicates that manufacturing companies with assets of less than $1 million have an average sales to asset ratio of approximately two to one. This would indicate that the typical manufacturing company with assets of $1 million would have sales of approximately $2 million; thus, $2 million would appear to be a more appropriate sales limit for a 'small' classification. Since the average asset size of manufacturing firms with assets ofless than $1 million was $158,800 in 1960 (up to $169,900 in 1964), a sales limit of $2 million is not likely to expand the number of 'small' establishments appreciably .11 On the basis of the available data, it would appear that the most appropriate quantitative classification for small manufacturing firms in Canada would be as follows: less than 100 employees, assets of less than $1 million, and sales of less than $2 million.12 An estimate that 33,000 manufacturing establishments - 90 per cent of the 1960 total - were 'small' seems to be appropriate. The financial structures of small businesses appear to have distinct characteristics. An examination of the composite balance sheets of manufacturing companies (Table 1/5) with assets of less than $1 million indicates that the proportions in the asset and liability accounts do not differ significantly from the proportions for firms with assets of less than $500,000. However, there are significant differences between manufacturing companies with assets of less than $1 million and those with assets of over $100 million. The largest companies allocate significantly larger proportions of funds to fixed assets and other assets ( particularly investments in affiliates), and significantly smaller pro10 The great majority of these undoubtedly have assets of less than $1 million, because only 1.6 per cent of all establishments with sales of over $500,000 were partnerships or proprietorships, as noted earlier. 11 Unfortunately, data are not available on the number of companies or establishments having sales of up to $2 million. 12 A more refined classification system, giving recognition to leading or dominant firms in manufacturing subgroupings, would require data not available currently.

Introduction

17

portions to accounts receivable and inventory. The largest companies also finance their assets differently, with significantly larger proportions of their financing coming from equity and non-current debt, and significantly smaller proportions supported by current liabilities. Given the larger dependence on equity financing, and the lower asset turnover ratio for the largest companies, 13 the smaller companies could realize significantly larger returns on equity investment with the same percentage return on sales. Overall, this was not the case in 1960, but did occur in 1964. All small (less than $1 million assets) manufacturing companies' profits on net worth were 10.41 per cent, compared with 10.39 per cent for the largest companies in 1960; in 1964, the rates were 9.96 and 4.97 per cent, respectively. The largest companies reporting a profit had a return on net worth of 11.99 per cent, compared with 19.3 per cent for the small companies reporting a profit in 1960, and the relative difference was more pronounced in 1964 when the largest earned 6.67 per cent, while the small companies earned 17 .10 per cent. Thus, profitable small manufacturing companies have higher rates of return on net worth than large manufacturing companies. The higher rates of return on net worth realized by profitable small manufacturing companies would partially compensate for the risk arising from their heavy reliance on current debt, including bank loans. The heavy reliance on short-term credit is reflected in their substantially lower working capital ratios. 14 When the analysis is restricted to profit companies, the working capital ratio differences are slightly less pronounced. 16 The general characteristic of all companies (see Table 1/5), as contrasted with manufacturing companies, is that they are generally less liquid, less profitable, and more dependent on credit than the manu13 The turnover ratio for the less than $1 million group was 1.88 in 1960, and 2.01 in 1964; for the largest group it is 0.89 in both years. 14 The high asset turnover ratios and low equity ratios are probably produced by limited equity investment, and by a tendency to sell to good acounts, sell on order, buy hand-to-mouth, rent rather than buy equipment, and to acquire low-cost and second-hand equipment, practices which also result in low working capital ratios. See Gordon Donaldson, Financial Management in the the New Small Scale Manufacturing Enterprise (doctoral thesis, Harvard Business School, 1955), chap. 5, where he notes that this is typical of new small firms, but he notes that as they grow they do less hand-to-mouth buying. 15 It may be interesting to note that in the United States in 1957 manufacturing firms with assets of $250,000-$1 million had a working capital ratio of 2.07, and firms with assets of more than $ 100 million had a working capital ratio of 2.44. The same sac groups had returns on net worth of 10.0 and 12.5 per cent, respectively. See Financing Small Business, p. 57.

TABLE 1/5 Asset and liability distribution, and miscellaneous data for fully tabulated Companies ( 1960, 1964)

Manufacturing companies Assets less than $500,000

Assets

Assets

less than $1 million

All

manufacturing companies

more than $100 million

Per cent of total assets

Cash Accounts receivable Inventories Other current assets Total current assets Land, buildings, equipment (net) Other assets Total non-current assets TOTAL ASSETS

Bank loans Accounts payable Other current liabilities

Total current liabilities

Mortgage debt Other funded debt Other liabilities Total non-current liabilities Preferred stock Common stock Surplus (net) Total net worth

TOTAL LIABILITIES AND NET WORTH

1960

1964

1960

1964

5.3 23.4 26.9 3. 9 59.5 29.9 10.6 40 . 5 100.0

6. 2 26.1 25 . 3 4.0 61.6 26.8 11.6 38 . 4 100.0

4.8 23.3 26 .8 4.7 59.6 30. 1 10.3 40 .4 100.0

5.7 25 . 3 26.9 3.6 61. 5 27 . 4 11.1 38 . 5 100 .0

2.0 7.8 17.1 5.2 32 . 1 47.2 20. 7 67 .9 100.0

13 . 3 16 . 6 9.2 39 . 1 3. 2 1.9 12.5 17 .6 8.2 13 .0 22 . 1 43 . 3 100 .0

14.4 18.1 9 .9 42.4 2.8 1.5 14 .0 18 . 3 7 .2 9 .6 22.5 39.3 100.0

13 . 6 15.4 8 .2 37 .2 2.8 1. 8 13 . 6 18.2 8.0 12.9 23 . 7 44.6 100.0

14.7 17 . 1 8.6 40 .4 3.1 1.6 14. 9 19.6 6.7 9. 1 24 .2 40 .0 100.0

0.8 5.0 3.2 9 .0 0. 1 17 .7 9 .9 27.7 3.2 21.6 38 . 5 63.3 100.0

1960

1964

1960

1964

2. 1 9.2 15 .2 5.6 32.1 42.3 25.6 67.9 100.0 1.8 6.5 2.9 11.2 0.1 12.8 13.6 26.5 2.3 21. 3 38.7 62 . 3 100.0

3 .0 12. 3 22.8 5. 4 43.5 39.8 16 . 7 56.5 100.0

3.3 13 .9 21.2 5.0 43 . 4 36 . 6 20.0 56. 6 100.0

4 .9 7.1 4 .4 16.4 0 .6 10.9 13 . 8 25.3 4.8 16.8 36 . 7 58.3 100.0

5.5 8.6 4.6 18.7 0 .6 9.0 16 .5 26 . l 3. 7 15.7 35.8 55.2 100.0

TABLE 1/5 (Concluded) Manufacturing companies Assets less than $1 million

Assets less than $500,000

Assets more than $100 million

All manufacturing companies

Per cent of total assets

Companies number per cent of total Working capital ratio all companies profit companies Sales/assets Average sales ($000) Average assets {$000) Return on net worth all companies (%) profit companies (%)

1960

1964

1960

1964

13,107 77

14,283 75

14,689 86

16,211 85

1960

1964 40 0 . 24

1960

17,013 67 0.35 100 .0

1964 19,077 100.0

1. 52 1. 75 1.99 224.3 112.7

1.46 1.66 2.04 240 . 1 117.5

1.60 1.84 1.88 298.8 158 . 8

1. 52 1. 70 2.01 340. 8 169.9

3. 55 3. 57 0.89 165,535 .0 185,290.0

2.83 2.85 0.89 167,779 . 1 188,813.4

2. 64 2. 88 1.17 1,450.7 1,242.7

2 . 31 2.43 1.18 1,784.1 1,511.5

10.26 20 .00

9.86 18.10

10 . 41 19.30

9.96 17.10

10 . 39 11 .99

4.97 6. 67

11.84 14 . 80

7.22 9.60

35.7

39.8

35.6

53.2

All companies TOTAL NET WORTH AS A PER CENT OF TOTAL ASSETS

Companies number per cent of total Working capital ratio all companies profit companies Sales/assets Average sales ($000) Average assets {$000) Return on net worth all companies (%) profit companies (%)

38.9 82,707 86

106,765 86

89,040 93

115,034 93

104 0.11

51.3

49.5

46.3

95,817 162 124,171 0.13 100.0 100.0

1.42 1.63 1. 70 173.1 101.8

1.33 1.49 1.62 169.0 104.0

1.49 1. 70 1.60 218.0 136.0

1.39 1. 54 1. 58 218.3 138.4

2.98 2.95 0.44 97,719.2 220,747.1

2.86 3.00 0.46 112,353.7 245,367.3

2.26 2.48 0 . 87 610.7 704.6

2. 10 2.33 0.81 635.9 781.4

9. 94 19.29

10.08 17.87

9.32 18.09

9.22 16.31

7.34 8.18

3.94 4.78

8.36 11. 71

5.20 7.54

souaca: Taxation Stotistlc1, 1961, pp. 136-7, 152-7; 1966, Port 1, pp. 64-7,

20

Institutional Financing of Small Business in Nova Scotia

factoring companies, in every size classification. Thus, it would appear that manufacturing companies, on the average, are better credit and investment risks than the composite of all companies. An effort was made to compare the financial structure of companies on an interprovince basis. Throughout the 1949 taxation year, Taxation Statistics provided data by province as well as by type of activity. These data indicate that in 1948 and 1949, on an interprovincial basis, Nova Scotia's incorporated companies were typically small, tended to rely upon funded debt as a source of funds, and on the whole were less dependent upon both bank loans and owners' investment. 16 li this situation has persisted over the years since the late 1940s, the Nova Scotia company is by comparison a poor risk, in that it has a relatively small equity base and a relatively large funded debt - a structure that would tend to make such a firm unattractive, particularly to term lenders. Unfortunately, these data are not available for more recent periods. It is obvious that increased levels of manufacturing activity do not have any exclusive features in creating higher levels of employment, and that the availability of financing is but one factor in determining the success or failure of economic development. In fact, the 'financing problem' of the small business or the small manufacturing firm is open to debate. Without anticipating our conclusions, it seems clear that on the demand side the 'financing problem' exists for a relatively small number of firms and that it can be resolved by the adaptation of, rather than radical change in, present financial institutions. The findings of the mail questionnaire and interviews with small manufacturing firms do not indicate that the managers of those firms feel that they have been particularly restrained by the credit available to them. Among the respondents to the mail questionnaire, 52 per cent thought that their operations had been assisted by the outside financing available to them; 12 per cent felt that it had not influenced the profitability of their operations; and only 17 per cent considered that limited outside financing had restricted their profitability (see Appendix A for a detailed tabulation). The impressions drawn from the six small manufacturing firm interviews were that all of the firms had some distinct and attractive feature at one point in their life span at least, and that they were not successful on any great scale because they did not know when or where to turn for managerial or financial assistance or that they chose an unqualified source which did not provide effective guidance or the type of financing required. 16 See Taxation Statistics, 1950, and 1951 (Ottawa: King's Printer).

Introduction

21

In both Canada and the United States the principal area of small business financing difficulty has been identified as the long-term sector, with a consensus that the short-term sector is generally well provided for. 17 The Porter Commission concluded that the expansion of lending activities to small business by a variety of institutions 'suggests that some deficiencies have existed.' The Report continued: However, the modest expansion of guaranteed bank loans to small business under the Small Businesses Loans Act of 1960 and the complaints we received that the IDB was merely displacing other lenders, also indicate that the problems have been relatively modest ... Our conclusion is that there has not been a wide gap in Canadian financing facilities for small business.18 Io general, short term lending facilities appear to have been adequate ... The main problems seem to be encountered by firms with assets in the range of $20,000-$250,000, and sometimes higher, with borrowing needs scaling up from $10,000 to, say, $100,000. Even here the problem is not of general application and is often reflection of the need for management advice and guidance as well as finance.19 We recognize the risk of lending to 'one-man' operations lacking in specialized management and research facilities and we are aware that such firms are often vulnerable to a single unforeseen event because of their lack of size, diversification and financial strength. Nevertheless, we believe that there is still some room for private and public lenders to expand their operations on a selective basis in small business financing despite the improvements which have already taken place. 2 0

The conclusions of the Commission were essentially the same as those of the United States Federal Reserve study which said, 'There is some evidence that there is an unfilled margin, perhaps a rather thin one, between the volume of funds available to small concerns in general, and to new firms in particular and the volume that could be put to use without prohibitive risk.' 21 The Federal Reserve's report also suggested that the problem was mainly in the long-term area, with some slighter problem in the one to ten year term area. 17 Report [of the Porter Commission], pp. 43-6; Financing Small Business, pp. 1-19. 18 In 'Small Businesses Get A Raw Deal Financially' (The Halifax ChronicleHerald, 2 May 1962), reporter Don Handright wrote that in five provinces the

Commission 'has been told that small businessmen can't readily get long term debt or equity financing needed for expansion.' He also reported that one commissioner said that there was 'a Canadian "tendency to weep" over small business.' One might conclude that this commissioner approached the subject with some preconceptions. 19 In 1963, the Department of Trade and Commerce began a self-help program for small business. The program emphasizes management training and provides course material for any interested group. 20 Report [of the Porter Commission], pp. 45-6. 21 Financing Small Business, pp. 18-19.

22

Institutional Financing of Small Business in Nova Scotia

Mr Michael Koerner, in a brief to the Porter Commission, contended that the small business financing studies of the late 1950s and early 1960s in the United States probably had significant validity for Canadian small business, that the 'gap' was in intermediate and long-term credit and equity capital, and he recommended Small Business Investment Company-type legislation for Canada. He was of the opinion that the problem was most significant when the brunt of inadequacy was borne by new and growing firms. He concluded that two developments were required: ( 1) Larger regional sources of debt and equity capital through regional or provincial development companies or more national investment institutions, partially or wholly oriented toward the long term capital needs of small business, and (2) Education of small business management in the use and the derived benefits of such sources of capital. Neither of these objectives has any validity until the financial needs of small business can be clearly defined. 2 2

Two other submissions to the Porter Commission support Koerner's contentions. The Province of Manitoba's Submission said that 'institutional facilities have not developed sufficiently in Canada to supply adequate equity and loan capital to small business.' Firms whose needs exceeded normal working capital requirements, but which were too small for a public issue, were faced with few and inadequate sources of funds 'precisely at the point where new firms may enter into optimum growth.' 23 The Canadian Manufacturers' Association (CMA) reported on a survey of their membership which indicated a modest amount of term lending to small business, and that both applications for and success in obtaining term loans increased with size (Table 1/6). With particular reference to the Atlantic Provinces, Cairncross said: 'There are still a small number of ventures every year that are deterred from starting by shortage of capital and others whose expansion is slowed down at a critical stage. I doubt whether there is any need to set up a new financial institution to deal with the problem but there may be some changes that could usefully be made in existing ones.' 24 Accepting Koerner's argument that the small business financing problems identified in the United States are equally common in Canada, some approximation of the number of firms experiencing problems can be developed. The mail questionnaire indicated that 17 per cent of the respondents felt that the limited availability of outside financing had 22 Royal Commission on Banking and Finance, Submission by Michael M. Koerner, Vol. 13A (Toronto: Official Reporters) , p. Al149.

23 Royal Commission on Banking and Finance, Hearings Held at Winnipeg,

Vol. 8A (Toronto: Official Reporters), p. A453. 24 Cairncross, Economic Development and the Atlantic Provinces, p. 29.

Introduction

23

TABLE 1/6 Experience in seeking term loans, private companies controlled in Canada

Sales class of respondent Under $250,000 $250,001 to $1,000,000 $1,000,001 to $10,000,000 Over $10,000,000 All size classes

Proportion of size class applying for term loan (%)

Proportion of size class unsuccessful in application for term loan (%)

16.9

45 .5

14 . 5

27.8

17.4 33.3 16 .6

10 .0 Nil 23.1

Submission of the Canadian Manufacturers' Association to the Royal Commission on Banking and Finance (August 1962), p. 41.

SOURCE:

restricted their profitability. In its Submission the CMA reported that among the Canadian controlled private companies with sales of less than $250,000 18.5 per cent felt that they received insufficient shortterm capital, and 40 per cent felt that they received insufficient longterm capital; of the firms with sales of $250,000 to $1 million, 10.5 per cent thought that they received insufficient short-term capital, and 33.9 per cent that they received insufficient long-term capital. 25 Given the general asset turnover ratio of two, these data embrace firms with assets of up to $500,000. A 1954 United States Department of Commerce survey of 15,500 companies, of which 95 per cent had fewer than 50 employees, indicated that 20 per cent of the firms had unmet financial needs. 26 A 1955 National Association of Manufacturers survey, covering 3,559 United States firms, indicated that 11 per cent of the firms that had experienced at least one failure in seeking funds between 1949 and 1954 had fewer than 100 employees. 27 Again, 18 per cent of the sample in the Federal Reserve study of corporate manufacturers 'reported an unsatisfactory financing experience in one or more financing areas,' and three-fifths of these 'indicated that failure to meet financing needs satisfactorily had some adverse effect on current business operations or expansion plans.'28 25 The number of respondents was 65 and 124, respectively. See Submission of the Canadian Manufacturers' Association to the Royal Commission on Banking and Finance, p. 63. 26 Paul Donham, 'Whither Small Business?,' Harvard Business Review (MarchApril, 1967), p. 77. 21 Financing Small Business, Economic Series No. 70 (National Association of Manufacturers, 1956), pp. 5, 10-11. 28 'Small Business Financing: Corporate Manufacturers,' Federal Reserve Bulletin (January, 1961), p. 20.

24

Institutional Financing of Small Business in Nova Scotia

Taking these various findings together, it appears safe to conclude that the small manufacturer financing problem involves between 15 and 20 per cent of the small manufacturing population, and that this number of firms - approximately 7,000 manufacturing establishments, using the earlier estimate of 33,000 small manufacturing establishments - are being retarded in their growth because of restricted availability of financing. Extending this same proportion to Nova Scotia would result in a total of approximately two hundred manufacturing establishments with unmet needs, or approximately seventy-five establishments of the type included in the mail questionnaire. The possibility that the 15-20 per cent figure understates the proportion of small businesses with unmet needs should not be ignored, despite the conclusions of the Porter Commission. It seems reasonable to suggest that the average small businessman might not be well informed on sources of financing, and that he may bypass profitable opportunities of which he could avail himself because he is unaware of the range of sources of financing. For example, note the small proportion of small firms which seek term loans (Table 1/6). Koerner remarked, after reviewing the sources of credit and capital which do exist in Canada: 'It would be intriguing to know how many capital short, small business managements in Canada are familiar with such sources and have made a concerted effort to learn on what terms long term capital might be available.' 29 In summary then, Nova Scotia's small manufacturing firms are smaller than the national average, and manufacturing activity in Nova Scotia has been declining in relative national importance in recent years. Nevertheless, there appears to be a portion of small manufacturing industry activity which is viable, with the proportion roughly comparable to that common on a national level and in the United States, i.e. approximately 20 per cent of the total population of small manufacturing firms. These firms with unmet needs for funds probably have fund requirements in the range of $10,000-$250,000, and have a 29 Koerner, Submission, pp. A 1136-42. The Federal Reserve study of financing small corporate manufacturers reported that needs for short-term credit were not related to age, but that the need for long-term credit and equity declined as age increased; that success in obtaining both short- and long-term funds increased with age; that many new firms did not attempt to obtain the funds they needed ( two-thirds of those which needed funds did not attempt to acquire them); but that when new small firms did try to obtain funds they were almost as successful as the older firms. See 'Small Business Financing: Corporate Manufacturers,' pp. 17-18. The SBA, in 'Small Business in Vermont' (Management Research Summary, 1963), reported that 'availability of capital was the most crucial problem of Vermont small business ... Sources other than banks ... were not well known or well supported.'

Introduction

25

preference for taking such funds in the form of long-term loans rather than in the form of equity investment. For the extension of term loans to such firms to be profitable to both the lender and the borrower it will be necessary for the two to work closely together in defining the nature and amount of the need, and in formulating a loan program. Small firms are in a position to offer a reasonable equity 'cushion' to such lenders, and are in a position to pay a relatively high rate of interest for such loans.

2 The Canadian Banking System

The banking system in Canada consists of the government-owned central bank, the Bank of Canada, and eight chartered banks which operated approximately 5,800 branches and subagencies in Canada at the end of 1966. The purposes of the government-owned Bank of Canada are set forth in the preamble to the Bank of Canada Act as follows: 'To regulate credit and currency in the best interests of the economic life of the nation, to control and protect the external value of the monetary unit and to mitigate by its influence fluctuations in the general level of production, trade, prices and employment, so far as may be possible within the scope of monetary action, and generally to promote the economic and financial welfare of the Dominion.' The Bank of Canada was founded in 1934, chiefly on the recommendations of the Royal Commission on Banking and Currency (Macmillan Commission), and came under complete control of the government of Canada, in two stages, in 193 8.1 The responsibility for the affairs of the Bank rests with a Board of Directors composed of a governor, a deputy governor, and twelve directors. The Deputy Minister of Finance ( a top-level civil servant) also sits on the Board and provides liaison between the Bank and the Department of Finance, but he has no vote. One noteworthy feature of the operation of the Canadian banking 1 Mcivor reports that the chartered banks were 'strongly opposed' to the establishment of a central bank, and that they had 'effectively discouraged an earlier effort to introduce such an institution at the end of World War 1.' The banks' main objection was that the times were not propitious for 'experimenting' with the idea of a central bank. R.C. Mcivor, Canadian Monetary, Banking and Fiscal Development (Toronto : Macmillan Company of Canada, 1958), p. 236.

Canadian Banking System

27

system is the generally very limited use made by the chartered banks of the standing arrangement under which the Bank is prepared to provide temporary advances to the chartered banks. For example, in only three of the years (ending 31 December) from 1953 through 1967 were the chartered banks indebted to the central bank, and in none of those years (1955, 1958, and 1967) did the total liability exceed $3 million, against total chartered bank assets of $10.8, $13.8, and $25.3 billion, respectively. 2 In its Submission to the Royal Commission on Banking and Finance (Porter Commission) the Bank noted the limited use made of the advancing facilities, and pointed out that the interest rates on advances, set at that time at one-quarter of one per cent above the average tender rate on the preceding week's issue of 91-day Treasury bills, was set at a level to provide a certain amount of penalty, but not sufficient to scare the banks away completely. 3 It appears that the chartered banks have been scared away and have used their government bond portfolios as the principal means of adjusting their cash positions. The continuous employment of a policy of not borrowing could restrict the availability of credit for all types of borrowers. The chartered banks have placed a long-standing emphasis on seasonal loans of a self-liquidating nature, and lending for seasonal needs appears to absorb the bulk of funds which the chartered banks allocate to commercial lending purposes (see below and chapter 3). If the banks are to keep their funds fully employed, there would have to be a precise co-ordination of the seasonal needs of the various segments of the national economy. Since a high degree of precision is not likely and some degree of overlap is a distinct possibility, it would seem that the banks would have to hold reserves to meet the various segments' demands. However, if they were to use the discounting facilities of the central bank, they could be more fully loaned in each season and turn to the central bank when the phasing in of one seasonal need was more advanced than the phasing out of another. In addition to its responsibilities as a central bank, the Bank of Canada is obliged to manage the Industrial Development Bank (IDB), a wholly owned subsidiary of the Bank of Canada and the only activity 2 In fact, in the 48 months of the 1958-61 period, the chartered banks were indebted at only four month ends, and not at any month end after March 1959. See Bank of Canada, Statistical Summary Supplement, 1961, p. 16. In the 48 months of the 1964-7 period, December 1967 was the only month at the end of which the banks were indebted to the Bank of Canada. See ibid., 1967, p. 21. 3 Submission by the Bank of Canada to the Royal Commission on Banking and Finance (Ottawa: Bank of Canada, 1962), pp. 35-6.

28

Institutional Financing of Small Business in Nova Scotia

in which the Banlc deals directly with the public. The at some length in chapter 7.

IDB

is discussed

THE CHARTERED BANKS

The 'main functions' of the chartered banks have been identified as '(a) to provide a safe depository for the funds of individuals and business concerns across Canada, and ( b) within the limits of prudent banlcing to make these funds available to facilitate production and trade.' 4 Chartered banking began in Canada in 1817 when the first charter was issued in Quebec City. The provisions of this first charter and many which followed were taken directly from that of Alexander Hamilton's first Banlc of the United States, including provision for the time limit of charters, prohibition of mortgage security, and provision for branch banlcing. 6 At the time of Confederation in 1867 there were 162 branch banlcs in Canada, and Canada's banking system was said to be 'truly national ... with uniform facilities and banking standards in every part of the country.'6 The first legislation governing banking activities on a national scale was the Bank Act of 1871, said by Jamieson to have 'embodied the fundamental principles of the charter of the first Bank of the United States, and the first charters granted in Canada, and all the more important of the new provisions included in subsequent charters.' Thus, the first Bank Act continued provisions for ten-year charters, pledge of inventory as security of loans, prohibition of mortgage security and real estate loans, and an interest ceiling which held at 7 per cent until the 1944 revision of the Act reduced it to 6 per cent. In all there have been nine revisions of the Bank Act (1880, 1890, 1900, 1913, 1923, 1934, 1944, 1954, and 1967) and five sets of amendments (1889, 1908, 1912, 1916, and 1924). The structural means by which Canadian banks have attempted to carry out their main functions has been a national branch banking system. In the 1880s and again in the early 1900s Canada's branch banking system was compared most favourably with the unit banking system in the United States. Around the turn of the century, it was argued that the western part of the United States suffered substantially because of the lack of mobility of surplus savings in the east, while in Canada the net savings of communities of the Maritimes, Quebec, and 4 A.B. Jamieson, Chartered Banking in Canada, Revised (Toronto: Ryerson

Press, 1953), p. 205. 5 'Chartered Banking - Origins and Early History,' White Bulletin (September 1961), p. 3. 6 Chartered Banking in Canada (Toronto: Canadian Bankers' Association, 1958), p. 4.

Canadian Banking System

29

the Prairies were said to be readily available to the more enterprising communities in other provinces. 7 It was also implied that the inability of United States unit banks to see beyond community horizons caused them to call loans outstanding outside their communities at the slightest provocation, while Canadian banks had 'interests which it is no exaggeration to describe as national.' 8 Possibly indicative of how little change has taken place in attitudes regarding the suitability of branch banking for Canada is the 1955 statement by the Canadian Bankers' Association that 'a branch banking system is better suited to a young, growing and expanding nation than a unit banking system.'9 Jamieson and Muir 10 also refer to the following features of branch banking: the (apparently) unique ability to shift surplus savings to the place where they will be most effectively employed; the opportunity for every community to enjoy the complete services and resources of a large bank; the geographic spread of branches which gives better loan portfolio diversification; and the unique opportunities for training staff. To this list Hood adds the improved liaison between the chartered banks and the central bank which he argues is a by-product of the smaller number of banks made possible by branching.11 All of these features led Muir to conclude that 'Canada has a banking system which, for efficiency and dependability, is not surpassed, if indeed it is equalled, by any other country in the world.' The CBA, in White Bulletin (September 1961), alleges that 'the Canadian banking system ... [is] one of the most efficient commercial banking 7 See B.E. Walker, Requirements for Banks in Canada and the United States (pamphlet, publisher unknown, probably the Canadian Bank of Commerce, Toronto, 1890), p. 11; and A.A. Lash, 'The Banking System of Canada' (Address to the Third Year Law School, University of Toronto, Toronto, 1907), p. 11. 'Branching' has long been a much debated subject in the United States, but seldom has national branching been suggested. The Commission on Money and Credit recommended in 1961 that banks and thrift institutions be allowed to establish branches with geographical trading areas instead of having to abide by artificial county or state barriers. See Business Week (17 June 1963). 8 Walker, Requirements for Banks, p. 11. 9 Chartered Banking in Canada (Toronto: Canadian Bankers' Association, 1955), p. 12. 10 James Muir, The Canadian Banking System (Montreal : The Royal Bank of Canada, 1956), p. 15. Also see F.E. Lounsbury, Financing Industrial Development in the Atlantic Provinces (Fredericton: Atlantic Provinces Research Board, 1960), and Financing Canadian Industry (Ottawa: Department of Trade and Commerce, undated, about 1960), both of which cite similar advantages for branch banking. It appears that the bulk of the original material was compiled by Jamieson. 11 William C. Hood, Financing of Economic Activity in Canada (Ottawa: Queen's Printer, 1958), p. 388. For an extensive analysis of the differences between unit and branch banking, see P.M. Horvitz, Concentration and Competition in New England Banking (Boston: Research Report to the Federal Reserve Bank of Boston, no. 2, 1958).

30

Institutional Financing of Small Business in Nova Scotia

systems in the world,' an argument which it is as difficult to support as to reject. It is certainly clear that Canadian bankers have few qualms when reciting the virtues of the structure which they have produced. And there can be no denying that Canadian banks have served their depositors safely. In the years since Confederation only 26 banks have failed in Canada, the only one since 1914 being the Home Bank in 1923. 12 This bank's failure was attributed to 'unsound speculative lending,' also held by Mcivor to have been the cause of 'many earlier bank failures.' This failure precipitated the Bank Act amendments of 1924 which were principally concerned with establishing a system of public auditing for banks. Probably because of the absence of failures, Canadian banking has been able to proceed with remarkably little public criticism and apparently little, if any, critical self-examination. Mcivor has remarked that 'it is unfortunately true ... that " ... criticism of the Canadian banking system, even criticism in the sense of scientific appraisal, has always been taboo ... but it would be passing strange if there were no room for improvement, if like all other human institutions it did not need to evolve and develop as conditions changed ... " ' 13 Mcivor also criticized the banks, on the basis of their testimony before the Macmillan Commission in 1933, for implying that 'there can be a particular banking system that can be the "best" system under all circumstances.' He was particularly shaken by the banks' failure to recognize that a banking system that had served eastern Canada's mixed farming, fishing, and logging economy might not serve western wheat farmers as well. He also criticized bankers, again on their testimony before the Macmillan Commission, for their 'failure to recognize that the consequences of credit decisions taken according to their "intelligent self-interests" might seriously conflict with broader economic objectives,' and noted the bankers' 'ill-disguised antagonism toward their critics.' Mcivor also noted that the people from the Maritimes and the Prairies complained before the Commission about the availability of credit to meet their needs, and the 'levels and rigidity of bank rates' of interest. 14 12 Seven others have failed since 1900; one each in 1905 and 1906, three in 1908, and two in 1910. 13 Mcivor, Canadian Monetary, Banking and Fiscal Development, p. 136, quoted from an unpublished document within the Department of Finance, Ottawa, 1934, Memorandum on Monetary Reconstruction, Pt. II, p. 29. 14 One witness was quoted in Mclvor's work as saying that he had paid 6 per cent for all the bank borrowing he had done over his 42 years in business.

Canadian Banking System

31

The Province of Manitoba was still unhappy with the banks in 1962. The province charged that the banks were using a 'philosophy of finance ... essentially conceived in the 1860s,' that the lending philosophy employed by the banks was that 'security was comprised of carefully protected capital,' and that the way 'to judge the soundness of an investment [is] in large part by the degree to which risk can be minimized.'15 They were also critical of the 'concentration of power and decision-making in Eastern Canada,' because the banks' chief officers 'are far more likely to be responsive to the needs of industry' in their immediate areas; of the banks' comparatively slow adjustments to the changing needs of the various regions; and of the banks' national application of uniform policies. 'For the transitional economies with a high proportion of small business, with few alternative sources of capital funds, the effects [of "blanket" policies] are most significant.' The Submission went on to suggest that special loan programs passed by Parliament were not being effectively carried out by the banks, that the banks should publish regional statistics, and that the banks were in a position to do more term lending than they were doing. This brief historical sketch of chartered banking has been intended to show some of the principal features of the Canadian banking system: the fact that the system's spokesmen have invariably cited advantages for Canadian branch banking compared to United States unit banking; that the system has been remarkably free of bank failures; and that the system has escaped with very little critical comment, those noted being virtually the only ones which have come to the attention of the author in a careful perusal of the literature. The legal framework under which the chartered banks carry out their activities is, as already indicated, the Bank Act, a federal statute which is revised every ten years, setting forth in 162 sections and 19 schedules (nine of which apply to section 88) what the banks may and may not do. The significant sections will be discussed below. The Bank Act is actually the charter for each of the banks operating in Canada, and the compulsory decennial revision means that each bank's charter is granted for a ten-year period only (section 6). Lash said that the banks were offered perpetual charters at the turn of this century but declined because 'they believed that ten-year charters and decennial revision of the Bank Act were in the best interests of the banks and banking, as well as the nation.' 16 While the ten-year charter is a club in the hands of Parliament, one 15 Royal Commission on Banking and Finance, Hearings held at Winnipeg, Vol. 8A (Toronto: Official Reporters), p. A450. 16 A.A. Lash, 'The Banking System of Canada,' p. 3.

32

Institutional Financing of Small Business in Nova Scotia

wonders if the banks are not better off than they would be if their activities and the regulations under which they operate were subject to more spontaneous review. It appears that the banks have, so far as the Bank Act is concerned, a ten-year holiday during which the possibility of change is remote. The following passage underlay the rationale of the banks in accepting ten-year charters at the turn of the century, and may well be still the rationale for ten-year charters from their point of view. If after long and full discussions with the banks and the overhauling of the

whole system and the consideration of amendments and suggestions from all quarters and the passing of the Act agreed upon by the Government and the banks, any one should during the next few years suggest further amendments the natural reply is: 'The whole subject was considered only a few years ago and until we see how the changes then made work out it is too soon to make further changes.' If a few years before the expiration of the ten years anyone should propose amendments, the natural reply is: 'It will only be a few years before the whole subject must be reconsidered and we prefer to wait till then rather than deal with it now.' Of course, if during the ten years some new development or pressing reason calls for further or new legislation the Banks themselves would either ask for it or assist in having it passed in the best form. There are several instances of this kind, but, speaking generally, the system is left at rest so far as legislation is concerned until the ten years are up.n

Jamieson supported decennial revision, and Mcivor said that decennial revisions provided an opportunity for widespread discussion and review, and that bankers have developed a 'remarkable sensitivity to public opinion' with regard to the revisions. 18 The CBA contended in its 1958 publication, Chartered Banking, that decennial revision ensures that 'the basic banking laws keep in step with the nation's growth, development and banking needs,' particularly in a 'young, growing and expanding nation.' It is conceivable that the nine revisions of the Bank Act from 1871 to 1967 were sufficient to keep in tune with the times, but some evidence suggests the contrary. At the time of the 1954 revision of the Bank Act, section 82 was added to provide for the use of hydrocarbons as security similar to the existing provisions under section 88. The CBA, in 1958, offered the addition of this section as an example of the utility and wisdom of decennial revision of the Act. Prior to the revision the banks had been 'forced into involved and expensive methods of assisting the oil indus17 Ibid., pp. 3-4. It has already been noted that there have been only five occasions when the Bank Act was amended. 18 Mcivor, Canadian Monetary, Banking and Fiscal Development, p. 68. This is somewhat at odds with his view, noted earlier, that criticism of the banks is 'taboo.'

Canadian Banking System

33

try,' since in Canada it had been relatively unimportant at the time of the previous revision in 1944. However, it reached major importance three years later with the discovery of the Leduc oil fields. It seems rather nonsensical that the banks had to act under 'involved and expensive methods of assisting' the industry for seven years. The lending and borrowing powers of the banks, as well as their authority to take security and liens, are covered in sections 75-90 of the Bank Act. Section 75 sets forth the general powers of the banks and provides that they may open branches, discount and make advances against the security of bills of exchange and promissory notes, and upon the security of stocks and bonds and other negotiable instruments. The section also contained, until the 1967 revision, general prohibitions against lending money or making advances on the security of real or immovable property; some of these prohibitions were partially overruled by subsequent sections, and others were overruled by other Acts. Two were actually exempted in the same section by subsection (5) which permitted loans and advances secured by mortgage bonds of corporations, and a second subsection ( 6) which made household property, including cars and any personal or movable property, 'to any individual other than a manufacturer thereof or dealer therein,' acceptable security. This subsection (6) was first placed in the Act in 1954, and largely explains the increase in personal lending noted below (see Table 2/4). The long-standing prohibition on other mortgage security will be dealt with in detail in chapter 3. Section 78 of the 1954 Act provided the banks with the limited conditions under which they could take real property security for commercial loans: 'Where a debt or liability has been incurred to the bank in the course of its business, the bank may subsequently take, hold and dispose of security of any kind for such debt or liability upon any real or personal, immovable or movable property, except shares of the capital stock of the bank .. .' Sections 82 through 90 deal, generally, with the security which may be taken on loans and advances made by the banks. Section 86 of the Act provides the banks with authority to take warehouse receipts and bills of lading as security for any loan, and section 87 gives a bank the rights and titles of an owner of the goods (under section 86) when the receipt or bill is received from an agent of the owner. Section 88 invariably receives considerable attention from commentators on chartered banking. It permits loans on the security of merchandise in the hands of specific types of borrowers, including manufacturers on the security of goods manufactured by them or in the process of manufacture or acquired as raw materials to be manufactured. The

34

Institutional Financing of Small Business in Nova Scotia

section sets forth in some detail the procedures required of the banks in taking security under it. Muir said that 'Section 88 of the Bank Act, it is agreed by all competent authorities, has contributed enormously to the development of Canada in production, in manufacturing and trading. Dr F . Cyril James, Principal of McGill University, in his book "The Economics of Money, Credit and Banking," declares that "looking backward ... it would be quite impossible for Canada to have developed in the way [it] has developed, without Section 88." ' 19 Jamieson refers to section 88 as 'one of the most outstanding of the distinctive features of Canadian banking.' Three sections ( 91-93) of the Act deal with interest and charges which the banks may levy. Section 91 of the 1954 Act stated that 'no bank shall in respect of any loan or advance payable in Canada stipulate for, charge, take, reserve, or exact any rate of interest or any rate of discount exceeding six per cent per annum and no higher rate of interest or rate of discount is recoverable by the bank.' The Macmillan Commission of 1933 recommended by a four-to-one vote that the ceiling on interest rates be removed, but no such action was taken. 2°Furthermore, the early drafts of the Bank Act of 1944 set the interest rate on personal loans, with certain types of security, of less than $500 and requiring monthly instalments, at 5 per cent discounted, or about 9¾ per cent effective. The objective was to encourage the banks to be more active in the small loan field, but the provision was withdrawn by the minister of finance because of parliamentary opposition to allowing rates in excess of 6 per cent. 21 The interest ceiling will be dealt with in detail in chapter 3. The growth of Canada's chartered banks has been rather substantial over the past several years. The eight chartered banks had total assets (including net foreign assets) of $15,665 million and operated a total of 5,224 branches and subagencies in Canada at the end of 1961; by the end of 1967, assets had increased to $25,340 million and branches to 5,879. The growth of the chartered banks in the period 1952-67 is evident in Table 2/1. Total assets are up by 175 per cent over the period and total loans are up by 311 per cent. However, the banks' total deposits have not increased as rapidly as assets or loans, showing 19 Muir, The Canadian Banking System, p. 19. The origins of the pledge type security of section 88 date from an amendment made in 1861 of the general act passed in 1859. See Jamieson, Chartered Banking in Canada, p. 163. 20 Report of the Royal Commission on Banking and Currency in Canada (Ottawa: King's Printer, 1933) , pp. 72-3 . 21 The maximum rate was actually reduced from 7 to 6 per cent in the Bank Act of 1944.

Canadian Banking System

35

TABLE 2/1 Ratio analysis of chartered banks' assets and liabilities, principal items only, 1952, 1961, 1967 (years ending December 31)

Total assets and liabilities (millions) Ratios (per cent of total assets) Government of Canada direct and guaranteed securities Treasury bills Other Canadian securities* Loans in Canadian currencyt Total Canadian dollar depositst Personal Savings Deposits Other notice deposits Public demand deposits Shareholders' equity Percentage increases (1952 = 100) Total assets Government of Canada direct and guranteed securities Treasury bills Other Canadian securities Loans in Canadian currency Total Canadian dollar deposits Personal savings deposits Other notice deposits Public demand deposits Shareholders' equity

1952

1961

1967

$9,223

$15,665

$25,340

28.7 1.5 9 .0 36.5 93.6 49.9 4 .0 36.6 4.1

16.8 7.4 6.7 43.1 90 .6 48.6 5.9 30.0 6.8

11.5 6.8 5.1 54.6 89.4 46.4 12 .8 25.6 5.2

100

100

275

100 100 100 100 100 100 100 100 100

131 838 126 198 166 165 286 139 281

110 1250 155 411 262 256 1002 192 343

Compiled from Bank of Canada, Statistical Summary Supplement, 1961, pp. 16-18, 48-9; 1967, pp. 20-3. Includes provincial, municipal, and corporate securities . Includes provincial, municipal, grain dealers, Canada Savings Bonds, instalment finance t companies, and general loans. i Includes advances from Bank of Canada, Government of Canada, provincial governments, other banks, personal savings, other notice, and public demand.

SOURCE :



an increase of only 162 per cent over the period. Total loans comprised 37 per cent of assets in 1952, moved up to 43 per cent in 1961, and increased to 55 per cent in 1967. In the corresponding years, total public deposits fell from a combined total of 91 per cent of assets to 85 per cent in 1961, and held at that percentage in 1967. In addition to the increases in total assets and liabilities, there were changes in the composition of both. Within total deposits, personal saving deposits have continued to fall from their 1952 proportion of total assets, with this decrease more than offset by the increase in the proportion of total assets in the form of 'Other Notice Deposits.' The major relative decrease was in 'Public Demand Deposits' which declined from 37 per cent of assets in 1952 to 30 per cent in 1961, and to 26 per cent in 1967.

36

Institutional Financing of Small Business in Nova Scotia

It should be pointed out that the relative decrease in demand deposits in this period occurred in the face of active bank promotion in the late 1950s of personal checking (demand deposit) accounts. Some of the funds transferred to personal checking accounts undoubtedly were held formerly in savings accounts, which also have checking privileges. Thus, the demand deposit decline was probably reduced by increased non-commercial use of such accounts. The distribution of bank assets has undergone more significant change during this time than the distribution of their liabilities. Total loans and securities, including advances to all governments, decreased by only two percentage points of total assets (76-74 per cent) in the 1952-61 period, but increased by four percentage points (to 78 per cent) in the 1961-67 period. However, securities fell from 39 per cent of total assets in 1952 to 31 per cent in 1961, and to 23 per cent in 1967, whereas loans increased from 37 to 43 per cent over the 1952-61 period, and rose to 55 per cent in 1967. The securities portfolio, in the 1960s, had a larger proportion of short-term governments. The 35 per cent increase in the number of branches of the chartered banks over the 1952-61 period (Table 2/2) approximately equals the population increase over the same period, and in the 1961-7 period the 13 per cent increase in branches was approximately matched by the 12 per cent increase in population. With the increases in assets and deposits exceeding the increases in population and branches in both periods, it would appear that the average branch bank was doing a larger volume of business in 1967 than in 1961, and in 1961 than in 1952.22 However, in Nova Scotia the increase in number of branches over the 1952-61 period (17 per cent) exceeded the population increase ( 11 per cent), giving Nova Scotia more branches per capita than it had formerly; and this pattern was duplicated in the 1961-7 period when population increased 3 per cent, while the number of branches increased 10 per cent. The dominance of Nova Scotia banking by four of the eight chartered banks continued throughout the period. These four banks operated 98 per cent of all branches in the province in 1952 and 1961, and 97 per cent in 1967. 22 The United States experienced a decline in bank population, from 14,073 at the end of 1952 to 13,426 at the end of 1962, and an increase in bank offices with 5,463 branches opening in the ten-year period ending with 1962. See 'Changes in Banking Structure,' Federal Reserve Bulletin (September 1963), pp. 1191-8. There was one branch bank for every 3,800 people in Canada in 1954, one for every 3,630 in 1959, and one for every 3,500 in 1963 and 1967. Comparable United States and United Kingdom figures for 1958 were one branch for every 8,200 and 4,000 people, respectively. The recent low point in branch bank numbers in Canada was in 1944 when the number fell to 3,099 from a 1920 high of 4,726. See White Bulletin issues of September 1958 and May 1964.

Canadian Banking System

37

TABLE 2/2 Chartered banks' branches and subagencies, 1952, 1961, 1967

Branches and subagencies

1952

1961

1967

Total Canada Total Nova Scotia Survey bank branches in Nova Scotia Commerce Montreal Royal Scotia Total

3,848 148

5,224 174

5,879 192

20 16 63 41 145

25 25 70 50 170

26 28 79 54 187

SOURCE :

Canada Year Book, 1955, 1961 ; 1968; Annual Reports of four chartered ban.ks.

The general trend in the financial structure of the chartered banks over the 1952-61 period would appear to have been as follows: a substantial growth in assets and deposits, usually in excess of population increases, with branch openings matching population increases; a shift from securities to loans as the principal investment outlet; increasing emphasis on short-term governments; a slower rate of growth in, and decreasing reliance on, demand deposits; and a relatively larger shareholder investment. In the 1961-7 period the only interruptions of these changes were slight relative reductions in short-term governments and shareholders' equity. The most noteworthy changes in the loan portfolios of the chartered banks (Table 2/3) over the 1952-61 period were the substantial growth in personal loans, the more modest increase in business and industry loans, and the declining relative importance of these loans which accompanied the increased relative importance of personal loans in the banks' overall loans portfolio. All of these trends persisted in the 1961-7 period, with the growth in personal loans increasing at a more rapid rate. 23 The data on business loans of less than $100,000, available since 1956, initially indicated a slightly upward trend. Whereas these small loans to business were almost consistently from 21 to 22 per cent of general loans, they increased from 31 per cent of business loans in 1956 to 34 per cent in 1962. However, by 1967 they had fallen to 13 per cent of general loans, and to 22 per cent of business loans; the latter decline was steady and uninterrupted from 1961 to 1967. When the banks' loan and deposit data are taken together, it appears that the importance of the individual depositors and borrowers is increasing more rapidly than that of business depositors and borrowers. While both businesses and individuals became smaller net depositors 23 The growth in personal loans followed the 1954 revision of the Bank Act which permitted the banks, for the first time, to take chattel liens to secure personal loans.

38

Institutional Financing of Small Business in Nova Scotia

TABLE 2/3 Chartered banks' general loans, 1952, 1961, 1967

Years ending 31 December (dollars in millions)

Total general loans• Total personal loans Total business loanst Total industry loans Business loans outstanding under authorized limits of less than $100,000 Percentage increases (1952 General loans* Personal loans Business loanst Industry loans

= 100%)

1952

1961

1967

$2,551 500 1,632 795

$5,647 1,431 3,523 1,369

$11,832 3,590 6,919 2,995

n.a.

1,198

1,531

100 100 100 100

221 290 217 172

464 718 424 377

Ratios (expressed as percentage of total general loans) Personal loans Business loanst Industry loans

19.6 64.0 31.1

25.3 62.4 24 . 3

30.3 58.5 '25 . 3

Ratios (expressed as percentage of total assets) General loans* Personal loans Business loanst Industry loans

27.6 5.4 17.7 8.6

36.0 9.1 22.4 8.7

46.7 14.2 27.3 11.8

48.4

74.9

106.7

n.a.

34 .0

22.1

Miscellaneous ratios Business loans as a percentage of demand deposits Amount of business loans of less than $100,000 to total business loans

Bank of Canada, Statistical Summary Supplement, 1955, 1956, 1957, 1958, 1961, 1967. Following data computed : total business loans, and personal loans, 1952. • Includes personal; business; farm; and religious, educational, health and welfare institutions. t Includes (1) industry, public utilities, transportation and communications, construction contractors, merchandisers, and other business; (2) loans under Small Business Loans Act of $23.7 million at December 31, 1961, and of $75.6 million at December 31, 1967.

SOURCES:

over the period, the decrease was greater for the former. Business loans were $48 per $100 of demand deposits in 1952, increased to $75 per $100 of demand deposits in 1961, and to $107 per $100 in 1967; personal loans were $11 per $100 of personal savings deposits in 1952, increased to $19 per $100 in 1961, and to $33 per $100 in 1967.24 Data on revenue, expenses, and loan losses of the banks ( Table 2/4) 24 If the earlier conjecture that the relative decrease in demand deposits was offset by transfers from personal savings to personal checking accounts is

Canadian Banking System

39

TABLE 2/4 Chartered banks' earnings, expenses and losses (fiscal years of banks ending in calendar years), 1957, 1959, 1961, 1967

Per cent of total operating earnings 1957 Current operating earnings

Interest and discount on loans Interest, dividends and trading profits on securities* Exchange, commision, service charges and other current operating earnings TOTAL

Current operating expenses

Interest on deposits Remuneration to employees Other current operating expenses TOTAL

Net current operating earnings Provision for losses and additions to inner reserves Provision for income tax Net earnings available to shareholders Current operating earnings (total* millions of dollars) Losses on loans and investments for 25-year period ending in year (millions of dollars*) Ratio of average annual loss experience to related assets* Net earnings to shareholders as a percent of shareholders' equity

1959

1961

1967

62.5

61.0

61.5

68.2

19.4

22.6

22 .4

18 .0

18 .1 100.0

100.0

16.4

16.1 100.0

13 .8 100.0

30.1 30.9 18.6 79.6 20.4

32.4 28.4 17.6 78.4 21.6

33 .0 27.6 17.8 78.4 21.6

43 .2 24 .8 15 .8 83.8 16.2

0.5 9.3

4.3 8.7

-1.2 12 . 6

2.9 6.5

10.6

9 .1

10.4

6.8

$609

$747

$880

$1,716

$198

$181

$161

$32

0.253

0.198

0 . 151

0 . 190

8.9

7.3

9.4

8.9

Bank of Canada, Statistical Summary Supplement, /961 , p . 34; 1967, p. 5 I. Changes in the Bank Act in 1967 altered the manner in which banks reported these data. Income from securities has been increased by $3.3 million, which was reported as an addition to operating earnings ("Balance of Revenue"), rather than as revenue ; and loan loss data are for a five-year period average.

SOURCE:



indicate slightly increasing efficiency in their operations in the 1957-61 period, probably reflecting the fact that the number of branches increased by only 35 per cent, while assets, deposits, and loans each increased by at least 65 per cent from 1952 to 1961 (see Tables 2/1 valid, the change is even more pronounced for businesses. The change is less pronounced if we use demand and other notice deposits, the bulk of which may well be business deposits. The 1952 ratio of business loans to demand and other notice deposits was $44-100, compared to $63-100 in 1961, and $71-100 in 1967. A shift from personal savings to personal checking accounts by individuals would result in the above figures for individuals being an overstatement of the shift in individuals' net depositor position.

40

Institutional Financing of Small Business in Nova Scotia

and 2/2). Net earnings available to stockholders have held fairly constant at approximately 10 per cent of total earnings, and net earnings produced a return on stockholders' equity which ranged from 7 .3 (1959) to 9.4 per cent (1961). 25 Between 1961 and 1967, however, the banks had decided shifts in their operating results, as income from loans increased to a larger proportion of total revenue, while income from securities and other income fell off relatively. Operating expenses took an additional 5.4 cents of each dollar of revenue because of larger interest costs ( up by 10.2 cents per dollar of revenue), while the combination of staff costs and other operating expenses took 4.8 cents less of each revenue dollar. These increased expenses reduced the proportion of revenue available to shareholders to 6.8 per cent. Given the fact that branches per capita were virtually the same in 1961 and 1967, one can conclude that net income was reduced by some combination of higher cost funds ( note the decrease in demand deposits as a percentage of assets in Table 2/1) and unwarranted branch expansion. Various ratios for 1961 for the four chartered banks in the interview survey group are presented in Table 2/5 to indicate the resource base and allocation practices of the banks represented by the interviewees. There were notable differences between the four chartered banks on virtually every one of the major asset and liability account items. The most noteworthy differences were between the Bank of Nova Scotia and the other three banks. The Scotia was approximately in the middle of cash assets, but substantially lower than all on governments and NHA loans, well below all but the Royal in personal savings accounts, and had the lowest equity investment. It was substantially higher than all in loans, call loans, and total deposits, and equal to the highest on demand deposits, all expressed as a percentage of assets. The Bank of Commerce and the Bank of Montreal were approximately the same in their overall financial structure, with the Royal generally falling between these two and the Scotia. If, as appears probable, demand deposits are a measure of commercial (as contrasted to personal or individual) business, then the Royal and the Scotia were relatively much more dependent on commercial 25 It is possible that part of this increase in earnings resulted from changes required in bank procedures for determining inner reserve additions, since the list of 'eligible' assets and the rate on them were reduced in 1960. One report speculated that these changes would encourage the banks to make investments (e.g., personal loans) which would be eligible for inner reserves, and pointed out that in 1961 there was actually a net decrease in the provision for losses and inner reserves for the year, resulting in turn in a return for that year which was above any of the previous four years. See 'Why Bank Stocks Look Sad,' Financial Post (2 June 1962).

Canadian Banking System

41

TABLE 2/5 Selected data on/our survey banks (1961)

Total assets (millions) Selected accounts as a percentage of total assets Cash assets Government of Canada direct and guaranteed securities Loans, net* Call loanst NHA

Total deposits Personal savings deposits Public demand deposits Shareholders' equity and reserves Net profits, after taxes and reserve appropriations

ImperialCommerce Montreal

Royal

Scotia

$4,584

$3,950

$4,955

$2,269

16.7

19.3

13 .8

15.8

21.2 44.4

21. 7 44 .6 4.4 5.9 92.3 44.3 41.1 5.3

18.7 39.9 7.5 5.6 90.9 33.2 48.9 6.2

13.4 48.3 10.9 3.2 93 . 5 36 .7 48.9 5.2

5.5

5.1 92.1 43.5 42.9 5.6 0.39

0.37

0.42

0 . 35

6.1

5.7

6.8

5 .6

47.3 6.9

48.0 7.0

36.5

39.3 6.7

Other ratios (per cent) Capital accounts to total deposits Personal savings deposits to total deposits Net profits to capital accounts Branches Total Domestic

1,268 1,248

887 875

6.8

1,040

960

601

566

Annual Reports of four chartered banks for 1961. Includes NHA loans, current and non-current loans (excluding call loans) . Includes day-to-day, call, and short loans to investment dealers and brokers.

SOURCE:



t

firms than the Commerce and Montreal. However, only the Scotia carried out the pattern of commercial dependency on the asset side with its relatively large loan portfolio. Also, the available data indicate that the deposits of the Royal and the Scotia would put them in a position where they would lean more heavily towards the liquidity of short-term governments. In fact, both were less heavily involved in governments than the Commerce and the Montreal, but offset this with larger investments in call loans. The major points of note to be drawn from Table 2/5 are the different investment outlets used by the Scotia compared with the other three Canadian banks and the difference between the Royal-Scotia and the Commerce-Montreal deposit compositions. Data on the Canadian chartered banks and the United States commercial banks for 1950 and 1960 are given in Table 2/6. The principal elements of note in this table are the composition of total deposits in both years in both countries, and the rates of growth in deposits in the

TABLE 2/6 Chartered banks' and insured commercial banks' deposits, income, and expense accounts, 1950, 1960

Deposit accounts as percentage of total deposits Demand deposits Time deposits Total deposits Principal income and expense accounts as per cent of total income Total current operating earnings Interest and dividends on securities Interest and discounts on loans Service charges, commissions, fees, collection and exchange charges, other current operating earnings Total current operating expenses Salaries - officers Salaries and wages, employees Interest on time and savings deposits Recurring depreciation Other current operating expenses Taxes other than on income Net current operating earnings SOURCES:

1960 as a per cent of 1950

United States

Canada

1950

1960

1950

1960

Canada

United States

73.7 26.3 100.0

65.2 34.8 100.0

42.9 57.1 100.0

39.7 60.3 100.0

150.0 170.9 161.9

131.3 197.1 148.6

100.0 31.5 50.3

100.0 22.1 62.5

100.0 35.9 44.3

100.0 21.6 62.4

298.6 180.0 420.2

272.8 190.9 339.0

8.2 62.2 11.3 19.2 8.7 1.5 17.4 3.3 37.8

5.6 64.7 9.0 17.1 16.7 2.0 15.9 2.7 35.3

19 .8 79.0

16 .0 76.7

241.2 289.6

40.3 20.5 2.4 15.8

28.8 32.2 2.2 13.5

113.5 467.9 274.6 254.9

21.0

23.3

254.9

188.8 283.6 116. 7 142.3 520.4 357.3 250.0 223.1 255.1

-

-

-

-

-

-

Bank of Canada, Statistical Summary Supplement, 1954, 1961; Bank Growth Goals, New York: Francis I. duPont & Company, 1961.

Canadian Banking System

43

two countries. The banks of both countries had a smaller proportion of their total deposits in the form of demand deposits in 1960 than in 1950, and larger increases in time deposits than in demand deposits over the same period. The lower growth rate of total deposits in the United States would indicate that the higher rate of growth in time deposits ( compared with Canada) was not sufficient to offset their lower rate of growth in demand deposits. The chartered banks, like the commercial banks, became more dependent upon revenue from loans over the period, but the rate of increase was significantly higher in Canada than in the United States. The substantially higher operating expenses (as a percentage of total revenue) for Canadian banks is noteworthy, as are their higher costs for salaries and for interest on time deposits. The higher salary costs probably reflect the larger number of branches per capita in Canada, and the tendency for branch banks to be opened under conditions which would be more uneconomic for a unit bank. The higher interest cost on savings deposits is related to the larger proportion of total deposits made up of time deposits in Canadian banks, offsetting somewhat higher rates of interest on time deposits in the United States. 26 Possibly the most interesting aspect of the data in Tables 2/5 and 2/6 is that on the average the nature of the deposit liabilities of Canadian banks places them in a position to undertake less liquid investments than those open to United States banks. With a larger proportion of total deposits in the form of savings accounts subject to withdrawal after notice, the deposits of Canadian banks are less subject to demand withdrawal than those of United States banks; thus, Canadian banks appear to be in a better position to undertake term lending. Possible explanations for the fact that Canadian banks have not made term loans are a conservative attitude, reluctance to enforce the notice requirement on withdrawals from savings accounts, unwillingness to use the discounting facilities of the central bank, and the possibility of the supply of funds available to Canadian banks being adequate only for short-term needs. 26 Several of these findings differ from those of studies comparing unit and branch banks in the United States. In the United States it has been found that while branch banks have higher operating expenses than unit banks, they offset this with higher gross earnings derived from higher loan-to-deposit ratios and larger proportionate holdings of instalment and mortgage loans. Also, studies in the United States have indicated 'some economics of increasing size in banking.' See 'Research into Banking Structure and Competition.' Federal Reserve Bulletin (November 1964), p. 1393. Since the Canadian data reviewed above are for large banks whereas the United States data include some small unit banks, one would expect the former to have higher profit to gross earnings ratios.

44

Institutional Financing of Small Business in Nova Scotia

TIGHT MONEY AND SMALL BORROWERS

As a final component of the background on banking in Canada, a brief review of the relevant consequences of the last two periods of tight money in the 1950s is necessary. There are two ways in which tight money influenced the situation. First, there is evidence that the burden of one of these tight money periods fell particularly on small borrowers, business and personal, and on some regions more than others, because of their remoteness from the centres of activity and/or because they have a disproportionate share of small borrowers. Secondly, the latest tight money period did not end until mid-1960; thus it existed during the period in which the mail questionnaire was answered and preceded by one year the period of the branch manager interviews. Since roughly half of the five-year period ending with the bank manager interviews was one of tight money, it seems likely that this experience coloured their responses. The Canadian economy had three readily identifiable tight money periods from 1950 through 1961. The first was in 1951-2; the second from mid-1956 to late 1957, roughly seventeen months in duration; and the third from mid-1959 to mid-1960. Over the seventeen months of the 1956-7 squeeze, business loans of less than $100,000 fell by 6 per cent, while those of more than $100,000 increased by 21 per cent. Over the same period personal loans fell by approximately 11 per cent. Most of the decrease in small loans to business and in personal loans occurred in the first half of the period, while most of the increase in large loans to business occurred in the last half of the period. In the 1959-60 tight money period business loans of less than $100,000 were virtually unchanged, while business loans of more than $100,000 increased by only 3 per cent and personal loans by 5 per cent. Thus, it seems reasonable to conclude that the small borrower, both business and individual, bore the brunt of the 1956-7 credit squeeze, but such borrowers fared as well as large borrowers during the 1959-60 squeeze. There is no statistical evidence to identify any variation in the regional impact of credit restraint, but it seems probable that areas such as Nova Scotia, which have smaller than average business firms, were more severely hit in 1956-7 than parts of the country with larger business firms. The mail questionnaire responses should be only slightly biased by the direct consequences of tight money in that the significant cutback in credit preceded the questionnaire by three years. Cairncross suggested some indirect consequences of tight money

Canadian Banking System

45

which could bear upon both the mail questionnaire and the branch manager interview data. He said that branch managers used tight money as an excuse for getting rid of term loans and for generally tightening standards, even to the extent of rejecting credit-worthy borrowers who took up too much of their time. 27 The possibility exists, therefore, that mail questionnaire respondents had recently experienced difficulty in obtaining bank credit simply because branch managers did not want to spend time with them. The branch manager interview data probably reflect the fact that recently they had had an opportunity to do things they wanted to do but could not defend on objective grounds. In addition, tight money periods characterized by high prime interest rates virtually require branch managers to allocate credit on a non-price basis. With average yields on Treasury bills ranging from 4.33 to 6.16 per cent- long Government yields ranged from 4.7 to 5.05 per cent over the last nine months of 1959, and a maximum rate on business loans of 6 per cent, the banks were loaning to their poorest risks at this rate when they could have been directing such funds to better risks. SUMMARY

The history of banking in Canada has been characterized by an extolling of the virtues of a national branch banking system, a small number of bank failures, an absence of criticism of the system, and through to mid-1967 retention of virtually all of the significant legal framework of the first bank legislation. The significant elements of the legal structure which were retained, until 1 May 1967 were an interest ceiling on bank loans and prohibition of mortgage security for business loans; still retained are decennial revision of the Bank Act and special provisions for taking inventory security. The first two of these bear on the availability of credit to small business, and the third restricts the adaptability of the banking system. An analysis of the financial structure and performance of the chartered banks was hampered by the lack of data provided on their activities, a situation partially overcome by new reporting requirements under the 1967 Bank Act. On the basis of the available data it is clear that the growth of the chartered banks' assets and deposits in the 1952-61 and 1961-7 periods was substantial, exceeding population growth over the same periods; branch additions approximately matched 27 A.K. Cairncross, Economic Development and the Atlantic Provinces (Fredericton: Atlantic Provinces Research Board, February 1961), p. 11. He also commented that branch managers seemed to regard term loans 'somewhat shamefacedly' as a departure from acceptable practice, and to regard termination of such a practice as 'a form of casting out sin.'

46

Institutional Financing of Small Business in Nova Scotia

the population increases. The major growth accounts during the period were personal savings and personal loan accounts. A comparison between the chartered banks and United States commercial banks indicates only minor differences in the composition of liabilities and income and expense items. Those differences which do exist suggest that Canadian banks may have less need for liquidity than their American counterparts, although they appear to maintain more liquid investment portfolios. While one of the two tight money periods during the latter part of the 1952-61 period did burden small borrowers especially, these periods are more significant, for our purposes, because of the actions which they allowed branch bank managers to take.

3 Legal Factors Restricting the Credit Available to Small Business

The availability of bank credit for the short- and long-term requirements of small firms, of all ages and stages of development, engaged in manufacturing is our focus point. 1 Restraints on the credit available to such firms can arise out of the legal framework in which the chartered banks must operate, the practices of the branch managers of the banks, and the internal organizational features of the banks. Underlying each of these restraints is the demand and supply situation in which each operates, as described in general terms in chapters 1 and 2. This chapter deals with the most clear-cut historical restraints on the availability of credit to small business - the prohibition on mortgage security and the ceiling on bank lending rates set out in the Bank Act. Both of these features of the Bank Act had the same effect, the restriction of the credit available to small business, and in particular to small firms wishing to borrow for terms of over one year, to new small firms, and to small firms wishing to borrow for fixed asset expansion. Four non-legal features of bank operation which may restrict credit availability will be dealt with briefly in this chapter. These four are the move away from overdraft lending, compensating balance requirements, demand loans, and personal lending activity. THE PROHIBITION OF MORTGAGE SECURITY

The credit restraints which revolved around the mortgage security prohibition can be separated into four parts, each of which restricted 1 As indicated in chapter 1, many of the conclusions on small manufacturers have to be inferred from the data on small business in general.

48

Institutional Financing of Small Business in Nova Scotia

the availability of term credit and all of which reflected the longstanding concern of the banks with liquidity. First, there were reservations about security which might be illiquid and/or subject to significant variation in liquidation value in any time period. Second, there were reservations about financing assets, on any security, which were by their nature illiquid. Third, there were reservations about financing any project, regardless of security, where the term was 'long.' Fourth, Canadian banks traditionally have been interested primarily in loans which would be repaid in the normal course of business by conversion of current assets, rather than by repayment out of earnings. These were all essential parts of the term credit problem because the attitudes which initiated and perpetuated the mortgage prohibition2 have, until recently, resulted in less than an objective appraisal of term lending. The modest amount of term lending done by chartered banks is particularly noticeable when compared with that of United States banks. A 1961 survey conducted by the CBA indicated that at that time term loans made up 3.3 per cent of total loans outstanding under authorized credits of $1 million and over. 3 In contrast, 38 per cent of total loans of all Federal Reserve member banks were term loans in 1957, and 57 per cent of the business loans of large New York banks were term loans early in 1961. 4 After commenting that Canadian bankers might be surprised at the growth in term lending in the United States up to 1957, one Canadian writer forecast that such lending would grow more slowly in other countries, despite the fact that granting term loans at the outset 'is perhaps a commonsense recognition of what was already a fact.' 5 Recognition of the actual liquidity of nominally shortterm loans in the 1929-33 period taught United States banks 'the lesson that the short term of a loan was not necessarily an assurance of liquidity for a bank.' 6 2 For example, see A.A. Lash, 'The Banking System of Canada' (Address to the Third Year Law School, University of Toronto, Toronto, 1907), p. 16; Sir Edmund Walker, 'Banking in Canada' (Address to the Institute of Bankers, London, 1911); A.B. Jamieson, Chartered Banking in Canada, revised (Toronto: Ryerson Press, 1953), pp. 209-10; Chartered Banking in Canada (Toronto: Canadian Bankers' Association, 1958), p. 23. 3 Submission to the Royal Commission on Banking and Finance, the Canadian Banker, Supplement (Spring 1963), p. 25. 4 Hunt et al., Basic Business Finance, revised (Homewood: Richard D. Irwin, Inc., 1961), p. 262. This work also provides a good short history of term lending in the United States. See pp. 260-62. 5 C.S. Howard, 'Medium Term Credit,' the Canadian Banker (Spring 1961), pp. 55-8. 6 Notes from the Commercial Banking Industry, Monograph Prepared for the Commission on Money and Credit (Englewood Cliffs: Prentice-Hall, Inc., 1962), p. 147.

Legal Factors Restricting Credit

49

The first notice the banks gave of a change of heart concerning term lending was in their Submission to the Porter Commission in 1962. It argued strongly for removal of the prohibition on mortgage security, after rejecting what they admitted to be their traditional arguments the liquidity problem, the difficulties avoided over the years, the need for specialized skills, and the existence of specialized institutions providing mortgage loans - against mortgage secured lending. The revised position of the banks was that existing government-guaranteed loan programs and prudent lending practice would minimize liquidity problems; that lack of concern for liquidity on the part of depositors was reflected in the growth of financial institutions which invested extensively in mortgages; that competition for and supply of mortgage loans would increase with banks in the field; that limited precedents had been established by earlier revisions of the Bank Act; that regular amortization reduced average risk exposure; and that, actually, problems experienced by United States banks in the 1930s were only partially caused by their mortgage loans. 7 Two major advantages which the banks felt would arise from removal of the prohibition were that they would be able to assist borrowers whom they would otherwise have to refuse, and, second, that they would be more adaptable to changes in the requirements of business borrowers. 8 In general, the banks argued that they should be permitted to lend on any security they thought acceptable at any interest rate they thought appropriate. They rejected the suggestion that deposits should be classified, with only certain types available for term lending. They did concede that different types of deposit accounts had different velocities, but they thought that a classification system would introduce rigidities which would impede the competitive process. Both in their Submission and in subsequent testimony the banks indicated that they would still give priority to short-term lending. The Commissioners appeared to be particularly concerned about three aspects of bank mortgage lending: the needs it would serve, the competitive position in which it would place existing mortgage lenders, and the consistency of the banks in the field. In addition to adding to service available in smaller communities, the banks said in their testi7 Submission to the [Porter Commission], the Canadian Banker, pp. 26-8. It appears that at least one member of the banking fraternity was not yet ready to absolve mortgage lending as the cause of United States bank problems in the 1930s. See Royal Commission on Banking and Finance, Evidence, vol. 63, p. 7994. 8 'Submission to the Canadian Bankers' Association to the Royal Commission on Banking and Finance, Summary and Recommendations,' the Canadian Banker (Spring 1963), pp. 93-4.

50

Institutional Financing of Small Business in Nova Scotia

mony before the Commission that mortgage loans could be made to finance both working capital and fixed asset requirements of businesses, particularly small businesses, and that the entry of the banks into the field, accompanied by removal of the interest ceiling, would possibly lower interest rates by increasing competition. The banks did not feel that they would be at a significant competitive advantage vis-a-vis existing lenders because their own cost of funds would increase as they passed their higher earnings on to depositors in the form of higher interest rates. Finally, they did not expect that they would be 'in and outers' in the mortgage lending field once they had become established because they could use the cash flow from outstanding loans to provide funds for new loans. The banks received some significant support for their request for removal of the mortgage prohibition before the Porter Commission from the Governor of the Bank of Canada who said in his testimony that government mortgage loan programs were 'prima facie evidence that there is a lack of specialized institutions for that purpose ... particularly ... outside the main centres.'9 The Canadian Manufacturers' Association ( CMA) in its brief to the Commission was also in favour of removal of the mortgage prohibition. However, the Investment Dealers Association (IDA)1° and two national sales finance companies expressed opposition to the removal in their testimony. The prohibition was removed in the 1967 Bank Act. The comments of branch managers on several subjects bear upon the mortgage prohibition and term lending. 11 It is clear that, first, the branch managers regarded the provision of short-term loans for working capital as the primary lending function of banks; second, that the branch managers had made few term loans; and, third, that term loans were made under restricted conditions. The primacy attached to shortterm lending for working capital and the small number of term loans indicate that mortgage secured term lending by the banks is likely to become significant only when the attitudes of branch managers are changed, and their lack of experience in term lending is overcome. Short-term loans for working capital were discussed in only 17 of the 38 branch manager interviews because the literature on chartered banks and the early interview experience indicated clearly that this was 9 Bank of Canada, Evidence of the Governor Before the Royal Commission on

Banking and Finance, p. 36. 10 Submission to the Investment Dealers' Association of Canada to the Royal Commission on Banking and Finance, Appendix H, p. 15. 11 'Term loan' as used here is a loan with a maturity of one to ten years, with the principal and interest amortized by regular periodic - monthly or quarterly -

payments.

Legal Factors Restricting Credit

51

viewed as the principal purpose for which banks provide credit. Eleven managers commented directly on the importance to banks of shortterm loans for working capital ( which they refer to as 'operating loans' ); six of these felt that providing short-term loans should be the only lending activity of chartered banks, while the other five thought that it should be the primary activity. The managers who held the opinion that banks should only make short-term loans for working capital rested their case on the history of the banks. Reflecting the common attitude was one manager's comment that 'we have only enough resources to meet operating needs. I think that Alexander Hamilton had the right idea about banks when he said that the ideal bank credit was one that was short term and self liquidating. The last 100 years and the fact that our banking system has stood the test of time better than any other in the world shows the wisdom of just lending for short terms.' Only two of the managers who thought that short-term loans should be primary in bank lending activity expressed a willingness to provide continuous financing for increased working capital requirements by means of revolving credit. Six other managers specified that they would be reluctant to provide such financing. Managers also mentioned five other sets of conditions under which they would be reluctant to provide current asset financing. 12 The comments of the branch managers indicate that term loans are made under normal money market conditions to 'good accounts' only, and that term loans are cut back substantially, if not completely, during periods of tight money. A 'good account' is probably best described as an applicant who can exert significant pressure on the bank. One manager said that banks were not interested in making term loans, 'but when they are put on the spot by a good account they will.' The principal evidence that banks make few term loans was provided by direct statements to that effect. Table 3/1 provides a summary of the statements of frequency of term lending by twenty-eight managers who discussed term lending. Their comments on the subject varied widely. Yes, we make capital loans. Our bank and the other banks make capital loans to small business. They aren't common yet, and they are marginal, depending upon the bank's liquidity position. But all banks make them. 12 The five were : required funds could be squeezed out of existing working capital; working capital needs growing faster than managerial and financial resources; funds required to finance instalment receivables; firm's assets consisted primarily of working capital; only security offered was accounts receivable; and doubt that the venture would assist the area.

52

Institutional Financing of Small Business in Nova Scotia

TABLE 3/1 Branch managers' opinions on the frequency of term loans Bank Frequency of term loans Make term loans Make term loans, but marginal Make term loans, but marginal and few in number Rarely (virtually never) made to businesses Heard of them but never made one No answer Total respondents

Total 7

8

A

B

C

D

1

3 1

2 2

1 4

1

3

2

5 3 2

3 1

28

6

1 1 2 6

10

6

TABLE 3/2 Branch managers' term loan criteria Bank Criteria Normal money market conditions prevailing Customer having 'some standing' or 'established' Background and capacity of borrower proven Evidence of ability to pay over term Pressure borrower can bring to bear on bank TOTALS*



Total

A

11

7

2

5 3

2 1

27

6

B

C

D

2

4

4

3 2

5

9

7

Ten managers mentioned one criterion, seven mentioned two, and one mentioned three.

I have heard of capital loans being made to businesses, but they are mostly to church groups and the like. Banks are willing to make capital loans, I guess. But in four branches I have been in I have only seen one.

Evidence of the restricted conditions under which term loans are provided was given by eighteen managers whose comments indicate that established firms may be able to borrow under normal (undefined) money market conditions, but that new firms are unlikely to be successful under any conditions (Table 3/2). Further evidence of the small volume of term lending is provided by the thirteen managers who suggested maximum maturities for term

Legal Factors Restricting Credit

53

TABLE 3/3 Branch managers' opinions on maximum maturities of terms loans

Bank Maximum maturity 18 to 24 months Up to 5 years Up to 7 years, sometimes 10 Within 5-10 years Up to 10 years Up to 10 years, 3-5 more common TOTALS

Total 1

6

1 2 2 1

13

A

B

C

D

1 1

2

1 1

2

1

1

3

3

1 4

3

loans ( Table 3/3). It is reasonable to suppose that, if there was a significant amount of term lending, there would be some uniformity in these estimates; at the very least, there would be uniformity on an intrabank basis. There is neither. The absence of uniformity also suggests that term lending is so unusual that head offices have not promulgated any policy on the subject. Further evidence of the absence of a policy on term lending is provided by the comments of four branch managers of one bank. Two of these managers said that banks should not and did not make term loans; the other two managers said that banks should not but did make term loans. Again, the variety of intrabank responses on the frequency of term loans (Table 3/1) suggests an absence of explicit policy. Thirteen managers gave six different reasons for not wanting to make term loans, only one of which makes direct reference to the legal restraint (Table 3/4). The first four reasons cited in the table do not appear to be supportable on rational grounds. There is no more valid reason for owners' investment and non-bank long-term debt matching fixed assets than there is for them to be more or less than fixed assets. Principles, per se, are not a reason at all. Limited resources are a questionable deterrent for many reasons: higher yield term loans would probably enable banks to increase their resources; the necessity of a priority for short-term loans is not established; and, most important, the probability exists that some portion of the supposedly short-term loans would be replaced by loans made explicitly as term loans. Questions concerning the actual liquidity requirements have already been raised in chapter 2 and above. The significant point to note here is that branch managers' attitudes concerning term lending reflect what has been written on the subject, particularly by Jamieson, and these attitudes would have to be altered before term lending becomes common;

54

Institutional Financing of Small Business in Nova Scotia

TABLE 3/4 Branch managers' reasons for not making term loans Bank Reasons Businesses and/or other sources should provide fixed capital requirements Not in accord with principles of banking system Banks do not have the resources to serve both short and long-term requirements Liquidity requirements do not pennit them Banks cannot take mortgage security Never encouraged by Head Office TOTALS

Total

7

A

B

C

D

2

1

3

1

4

3

2

1

2 2 1 18

1 1 3

4

1 1

1

9

2

that is, that tradition (or habit) is more critical than Bank Act prohibition. Additional evidence of reservations on the part of branch managers in the term lending area is provided in their views on terms loans for refinancing, acquisition of a business, and on fixed asset security. The possibility of a 'stretch-out' of existing short-term obligations by substituting a bank term loan was discussed with several managers. The general view was that such credit was frequently required, but that it was not the function of the banks to provide it. Tenn credit for the acquisition of a business was commented on by a small number of managers, most of whom said that they would consider such requests. One manager spelled out the general view. I will lend money to buy a business if the fellow looking for the money has been a long-time employee of the successful company he is going to buy, or when a man has a substantial backing from one of our customers. In the first case we would not expect the man to put up much of the money, but we would expect the seller to take part of the purchase price in the form of redeemable securities. We aren't really lending to the borrower in either case though - we are lending to the successful business or the backer.

One of the managers indicated his lack of enthusiasm for such a loan with the comment that he was 'amused by people who come in to borrow money to buy a business.' Twenty-six managers were asked about the types of loan security acceptable to them. In total, they suggested twelve different kinds of security a total of ninety-one times (Table 3/5). Two types treated as

Legal Factors Restricting Credit

55

TABLE 3/5 Types of loan security acceptable to branch managers

Security Type

Mentioned by

Inventory Accounts receivable Personal guarantees Government bonds, 'good' stocks, and bonds Mortgages and fixed asset equities Owners'equity in business Life insurance, and its csv Co-maker or endorser Fire insurance Assigned contracts Earning power

10 6 6 5 3 2 1

Managers

26

Mentioned by managers mentioning a total of - types

2

3

4

5

6

9 1 1 1

19 15 13

1

6 4 5

4 4 3

3 3 2

3 3 2

11

1

2

2

3

2

1

2

2

3 2 1

3

1 1

1

5

2

2

1 3 1 1 8

2 4

3

3

1 1

1 1

1

one in Table 3/ 5 are relevant here: mortgages and fixed asset equities.13 An analysis of the suggested types indicates that mortgages and fixed asset equities were most often referred to by managers mentioning several other types of security: of those who referred to mortgage security/fixed asset equities, 80 per cent mentioned at least three other types of security as well. It seems likely that, if managers were thinking frequently in terms of mortgage security and fixed asset equity, they would mention them when the subject of loan security was brought up; instead they appear, by the broad context in which they mention it, to give it relatively low status. Even in those instances where mortgage security and established equity in assets were mentioned they were seldom regarded with enthusiasm. One of the more enthusiastic comments was the following: 'We can't take mortgages, but if we know the borrower has substantial equity in his fixed assets we don't ignore it. That improves the strength of your general claim at least and you can take a mortgage later if it goes sour.' A less enthusiastic comment was: 'I wouldn't make a loan to anyone because I knew that later on - if it went a little bad - I could take a mortgage. If a manager looks at it that way - it is shaky, but if it 13 The former refers to the mortgages which the banks take on outstanding loans which are showing possibilities of default. The latter refers to unencumbered fixed assets and fixed asset values in excess of lien obligations. Significant equity in fixed assets would strengthen a bank's claims unsatisfied by liquidation of security it held.

56

Institutional Financing of Small Business in Nova Scotia

goes bad I can take a mortgage on these things - if he thinks it is that questionable he shouldn't make the loan.' Before summarizing the term lending situation, we shall review the comments made on the subject by the assistant managers of the main branches. Officers of three main branches of the chartered banks in Nova Scotia were asked to comment on the following statements bearing on term lending: 1 Banks do not concern themselves with the purpose of a loan as long as the term and security are acceptable to them. 2 Banks lend for three identifiable terms: (a) short term, specifically under one year; ( b) revolving credit, on a demand basis, seldom paid out; ( c) term, specified orally at three to six years, payment monthly to annually. Two of the officers disagreed with the first statement on purposes, and the third qualified it. One of the officers who disagreed said that the banks would be unconcerned as to the purpose of a loan only if it was fully secured. However, he felt that with a short-term loan it would only be necessary to confirm the fact that it was for expansion of current assets; the allocation of the funds to support different current assets through the production cycle would be of no consequence to the manager. The second of the dissenting officers would not even agree that loans made on the security of accounts receivable could go for other purposes, such as inventory. He said that, if a loan was secured by one type of current asset, he would expect the loan balance to vary approximately with variations (reductions) in that account. The third officer agreed that the banks were generally unconcerned about the purpose of a loan, but said he would become concerned if some of the loan was going into fixed assets, or if the annual low point in the loan account was high relative to the low point of the previous year. The three officers basically agreed with the second statement, on terms of bank loans. One agreed with all three parts without qualification. The second commented that the short-term loans could be on a demand or time basis, and since a portion of revolving credits might never be paid off they were, in effect, term loans.14 This second officer said that term loans were rare, and that five years was the commonest upper limit. He also said that term loans were occasionally made to new 14 This contention does not seem to be valid since the credit was not initially made for a term of over one year, and because the revolving nature has the effect of continuously retiring older credits.

Legal Factors Restricting Credit

57

firms when the bank thought 'highly' of the applicant's ability, but indicated that most term lending was to institutions and for second mortgage, or 'bottom money,' on real estate projects. The third officer wanted to reword the first statement on terms to read 'short term specifically under one year on a time note, or expected within one year on a demand note.' He agreed with the statement on revolving credits, and with the third part, except that he said payment on term loans were monthly, and added that a borrower could have both a term loan and an operating loan at the same time. He added that term loans of over three years were 'rare today, although common some years ago,' and that they were available only to 'established customers.' One of the officers discussed term loans further, saying that he did not approve of term lending because in his opinion the banks could use their resources to better advantage by providing more credit to small borrowers than by committing large sums for periods of over one year. He said that 'there is little term lending done today,' and that only one term loan had been requested ( and rejected) at his branch in the preceding four months. He thought that term loans were made only when requested by an 'important' customer, in which case the bank had no alternative but to go along. Thus, there appears to be very clear evidence that term loans are rare, and that those provided are available only to established customers for periods more appropriately described as 'intermediate' term. The reasons given for not making term loans reflect the simple fact that the banks and branch managers have had so little experience with them. The most obvious reason for this limited experience has been the prohibition on mortgage security. If this prohibition had not existed, it is likely that even conservative management in Canadian banks would have 'tried the water,' dispelled some of their notions, and in some small measure duplicated the post-1934 United States term lending experience. As already mentioned, removal of the mortgage security prohibition is but a first step in providing term loans. Branch managers will have to be capable of undertaking a different type of analysis than they now do. It will be noted from Table 3/5 that managers emphasized security of a self-liquidating nature. This is consistent with their long-standing emphasis on self-liquidating, seasonal loans. Term loans, regardless of the security, must look to earnings and cash flows for repayment, yet only one manager mentioned earning power as security for a loan again, a natural reaction when the traditional type of loan is considered. Second, if managers are to feel comfortable in extending such loans, there must be some means at their disposal for marketing seized

58

Institutional Financing of Small Business in Nova Scotia

mortgage security. Their views on secondary mortgage security and fixed asset equities make it clear that they do not think of these as security, and that when they do only a minority recognize the problem of disposal stemming from the absence of a significant number of manufacturing firms which might provide a market for seized security. The problem of security realization also exists in taking inventory security ( chapter 4), but would be more significant with fixed assets. If managers can learn to think in terms of earnings and cash flows and feel comfortable with mortgage security, the removal of the prohibition will provide substantial increases in the availability of credit, particularly term credit, to all small firms. Established firms would be able to borrow on the security of assets previously useless for this purpose and all new small business borrowers (be they new firms or new borrowers from established firms) would present the banks with a situation where they would have to be somewhat less dependent (because of the greater ease of policing fixed assets) upon the character and capacity of the borrower. However, until such time as managers adopt a different approach to means of repayment and feel comfortable with mortgage security, removal of the prohibition will do little more than provide the banks with more security on the same amount and type of loans they are now making. 15 THE SMALL BUSINESSES LOANS ACT

The Small Businesses Loans Act ( SBL Act) was passed by Parliament late in 1960. It provided that the chartered banks could make term loans for up to ten-year terms to small businesses for capital expenditures. The Act overrode the existing prohibition of mortgage security on real and movable property. Thus, this legislation would appear to offer a test of the demand for term loans by small business, and of the benefits to be derived from removal of the mortgage security prohibition. Under the Act, the loans are limited to firms which had no more than $500,000 (increased from $250,000 in 1967) in sales volume in the previous year, and no firm is permitted to borrow more than $25,000 or more than 80-90 per cent16 of the cost of the acquisition. The Act also specified that interest on loans made under its conditions 15 The reasons for concluding that branch managers must feel 'comfortable' will be brought out in chapters 4 and 5. Essentially, the absence of incentives requires managers to take the initiative, and they are unlikely to do so if they are not 'comfortable.' 16 The 80 per cent limit applies to fixed or movable equipment, and the 90 per cent limit to improvement of premises and acquisition of alternative premises.

Legal Factors Restricting Credit

59

TABLE 3/6 Small Businesses Loans Act distribution of loans made through 31 May 1962 Percentage distribution of loans

To manufacturers To wholesalers To retailers To service businesses For movable equipment For immovable equipment For premises In Nova Scotia

Nova Scotia

Canada

Number Amount

Number

Amount

20

18

20

29

25 54 n.a. n.a. n.a.

20 3

7

44

n.a. n.a. n.a.

3

4 31 45 21

22 57

3.4

26 51

12

20

58

3.4

SOURCE: W. A. MacDonald, 'Small Business Loans,' Canadian Banker (Autumn 1962), pp. 74-5.

was to be at the rate of 5.5 per cent, and the government guaranteed to reimburse the banks for losses up to 10 per cent of the aggregate of loans made by each bank. The Act excluded loans for refinancing, acquiring, and starting a business. Fifteen months after the SBL Act was passed it was amended to add the construction of alternative premises to the previous list of acceptable purposes. 17 The total amount outstanding under the Act increased from $1.9 million at the end of the first quarter of 1961, to $17 .3 million at the end of the third quarter, and to $33.5 million at the end of the second quarter of 1962. Detailed data published by the Canadian Banker indicate that 4,094 loans for an aggregate of $35.1 million were made through 31 May 1962, with 140 loans totalling $1.2 million in Nova Scotia18 (see Table 3/6). While the majority of managers obviously had little experience with SBL Act loans up to the time of the interviews ( third quarter of 1961), by early 1962 many of them must have gained some experience in view of the 140 loans made in Nova Scotia. However, since there were only 40 loans to manufacturers in Nova Scotia through May 1962, the majority of branch managers still had little experience with that type of borrower. The emphasis in lending under the SBL Act has been on loans to the service industries, wholesalers, retailers, and on loans for acquisition and improvement of premises. 17 Acceptable purposes were: 'purchase, instalation, renovation, improvement, or modernization' of movable property or equipment, and the 'renovation, improvement, or modernization of premises or the alteration or extension of premises.' 18 W.H. MacDonald, 'Small Business Loans,' the Canadian Banker (Autumn 1962), pp. 74-5.

60

Institutional Financing of Small Business in Nova Scotia

One spokesman for the bank group before the Porter Commission said that a partial explanation of the slow growth of SBL Act lending was that 'the potential for these loans was not as great as was indicated by all the talk and conversation, and all the various other matters that related to them before they were instituted.' While holding that there had not been many rejections, he implied that branch managers were not making loans for the same reason that they had not made them before the Act - the borrowers were not creditworthy. Throughout their testimony the banks did not appear to have any general reservations about the structure of the Act. Loans under the Act continued to grow slowly through the first quarter of 1964. At the end of 1962 the total outstanding was $42.0 million ( 1.02 per cent of the total business loans of the chartered banks), up to $54. 9 million ( 1.24 per cent) at the end of 1963, and $67.1 million (1.34 per cent) at the end of 1964. By the end of 1967 total Small Business Loans outstanding for all chartered banks stood at $75.6 million (1.08 per cent of all business loans), for an increase of only $8.5 million over the 1964-7 period. Clearly this program is less than a spectacular success. The banks indicated that the lack of success reflects the lack of demand, but alternative explanations arise from the comments of the branch managers. Their comments indicate that they felt at the outset of the SBL Act ( the interviews were held eight months after the program was initiated) that small business would benefit from the legislation, but their actual experience indicated that small businesses were not rushing in for such loans. Seventeen managers thought the Act would benefit small business, while ten did not see any benefits for such businesses from it; twenty-one of twenty-seven managers commenting on the subject said they had had some experience with lending or applications under the Act. The twelve managers who specified benefits and the eleven managers who specified criticism of the legislation offer some indication that the demand for such credit does exist and some indication of why the program did not make spectacular progress ( see Table 3 /7). Three suggested benefits - longer terms, mortgage security, and new purposes - and one criticism - exclusion of refinancing and acquisition credit - indicate that the managers were aware of needs for term financing which were going unmet prior to their inclusion under the Act, as well as term credit needs which were still being unmet. Criticisms of the legislation indicate that lack of progress with the program could stem from three sources. First, the attitudes of the managers towards such financing could stifle it. If managers feel that

Legal Factors Restricting Credit

61

TABLE 3/7 Branch managers' views on benefits and weaknesses of the Small Businesses Loans Act Benefit Longer terms can be offered Banks will lend to borrowers they would not lend to before because of the guarantee Can now take mortgage security Can finance new purposes Serves unmet need (not identified) More liquidity on term loans for banks Total number of managers Weakness Money needed for refinancing and acquisition, not provided Area already covered by banks Not enough publicity Sales limit ($250,000) too low No help if economy of area not sound Does not cover enough lines of trade Use same standards used without guarantee Looked good until details provided Interest rates too low for term lending Too long a period for banks to loan Paper work on government programs scares people off Requires mortgages, people here don't like giving them

Total number of managers

No. of managers 7

4 4 3 I 1 12

5 3 3

3 2

2 I I I I

I 11

the area is already covered adequately by the banks, that the whole economy of the region has to be strong, that they must use existing criteria which apply to short-term credits, that the terms are too long, that the paper work is excessive, or that 'people here don't like mortgages,' it is most unlikely that they will promote such a program with their customers. Secondly, inherent deficiencies in the legislation could have worked against its early success. Excluded types of financing and lines of trade, many now removed, narrowed the number of potential applicants to less than the total number of small businesses. The $250,000 sales limit, which would indicate an asset size limit of approximately $125,000, restricted the availability of financing under the program to only the smallest manufacturing firms and certainly would not include all firms which could be described as 'small,' in the sense implied here. Inadequate publicity and unfavourable details could leave latent demand untouched and discouraged demand at the applica-

62

Institutional Financing of Small Business in Nova Scotia

tion level. Thirdly, the low interest rate could be a major factor in the modest growth of the program. Two factors indicate the possibility that the 5.5 per cent rate on loans under the SBL Act has been a factor inhibiting the growth of such lending. First, over most of the program period, prime rates were in excess of 5 per cent, so that banks could make loans without the guarantee at equal or better yields. Also, the cost of making small loans probably would be greater than that of large loans; thus, the banks were being asked to make loans which would be less profitable than other possible loans. Second, the interest rate was only slightly below the ceiling which the banks were at the time attempting to have removed. Lack of loan activity under the Act may have resulted from top bank management not pushing the program with branch managers, in the hope that lack of success would encourage Parliament to recognize the interest rate ceiling as a deterrent to lending. The four officers of the main branches were asked to comment on the following tentative conclusions regarding the SBL Act loan program: 1 The SBL Act has not been particularly successful to date (August 1961) and most branches have not made any loans. 2 The reasons for the lack of success of the SBL Act are: (a) the $250,000 sales limit is too low; ( b) banks are reluctant to accept 5.5 per cent interest rates; ( c) banks are already covering the acceptable term loan risks with their own term lending. Three of the four officers agreed that the SBL Act loan program had not been particularly successful in its first eight months. The officer who disagreed said that his branch had made 'several' and that, when a borrower had nothing other than mortgage security to offer ('nonbankable'), it was frequently suggested that he apply under the Act. Three officers commented on the suggested explanations for the modest amount of lending under the SBL Act. The officer who said that his branch had made 'several' loans under the Act attributed the modest beginning to the reluctance of branch managers to familiarize themselves with the provisions of the Act and to do the paper-work which processing of an Act loan application entailed. He minimized the importance of the sales volume limit and the interest rate, and doubted that banks were already providing the type of credit provided under the Act. The second officer commenting on reasons for the initial lack of success of the SBL Act agreed that the limit of $250,000 was too low, because he did not think that businesses that small were capable of planning a project which would require monthly payments for up to

Legal Factors Restricting Credit

63

ten years. He .also thought that the banks were not particularly enthusiastic about the program because it had been forced upon them as the government's means of quieting a 'noisy pressure group.' He felt that the ten-year bank charters, plus the fact that banks 'are still a popular whipping boy,' forced the banks to do things they would rather not do. In his opinion, top management might be unenthusiastic because they feared that branch managers would be 'careless' in extending credit when there was a guarantee; the consequent losses would make the banks 'uneasy' but not poorer. He did not think that the interest rate was an important factor. The third officer commenting on the reasons for the SBL Act's initial lack of success said that banks were already serving the need, and that the main reason for the small number of applications was that borrowers did not want to go through the necessary 'red tape.' All things considered, the SBL Act cannot be written off completely. Managers recognized that it would serve unmet needs, and its design (particularly in the exclusion of refinancing and acquisition loans), the interest rate, and the lack of publicity, resulted in its being available initially to closely circumscribed needs for a small number of firms at rates unattractive to the banks. To maintain that the SBL Act was a test of the demand for term credit from small business, and particularly small manufacturers and new small firms, is quite unrealistic. The experience under the Act does make two distinct points: first, banks are rate or price sensitive; and, second, they have not taken appreciable risks under the program - through 1966 losses were 0.5 per cent of lending. THE INTEREST CEILING ON BANK LOANS

A brief sketch of the long history of Bank Act limits on lending rates was provided in chapter 2. The chartered banks, through the CBA, testified before the Macmillan Commission (19 33 ) that it had been their aim to maintain interest rates at a stable level so that business could 'make their commitments without fear of their interest cost being subject to violent fl.uctuations.' 19 Mcivor commented that this view indicated that the notion that flexible rates might perform a useful monetary function was thus completely lacking in [bank circles]. A serious defect arising from the concentration of Canada's financial business within a relatively few power19 R.C. Mcivor, Canadian Monetary, Banking and Fiscal Development (Toronto: Macmillan Company of Canada, 1958), p. 135.

64

Institutional Financing of Small Business in Nova Scotia

ful banks, insurance companies and loan companies was ,that while this provided the economic 'stability' for which these institutions claim credit, it' ... resulted in a lack of open, competitive business and an emphasis upon personal banker-customer relationships; upon customer rates and published rates at the expense of market rates in the capital market.' 20

In their Submission to the Porter Commission, the CBA offered the following major arguments in favour of removal of the ceiling: the general level of interest rates had been moving nearer the ceiling, and under this situation rates could not be used to ration credit; the rate ceiling discriminates against the banks, vis-a-vis other financial institutions which do not have a ceiling; bank competition in lending activities yielding over 6 per cent probably would lower the average market rates of such lending; when credit becomes tight and interest rates high the ceiling encourages all borrowers to tum to the banks for their required funds; the ceiling precludes the earnings which are necessary to compete for savings; and removal of the ceiling would have the general effect of providing free competition between financial institutions. Among those supporting, in one way or another, the removal of the ceiling before the Porter Commission were the Bank of Canada, both in its Submission and the subsequent testimony of its governor, the trust companies, the Province of Manitoba, and the CMA. Editorials in the major financial weeklies - Financial Post and the Financial Times - also supported removal. The major arguments offered in support of removal of the ceiling by the above groups were that it restricted the credit available to small business21 and produced imperfections in the capital markets. 22 There is, in reality, only limited evidence that the interest ceiling has restricted the credit available to small business, and that is the trend in small loans to business during the 1956-7 tight money period. In the next tight money period it is rather clear that the banks did 'make their decisions in the light of broad public interest.' 23 To do so, however, they had to employ direct rather than price rationing. The direct rationing was necessitated, in part, by the fact that when interest rates were 20 Ibid., pp. 10-11, quoted in part from Plumptre, Central Banking in the British Dominions (Toronto : University of Toronto Press, 1940). 21 Submission to the Royal Commission on Banking and Finance by the Canadian Small and Independent Business Federation, p. 2. 22 Summary and Brief of the Trust Companies Association of Canada to the Royal Commission on Banking and Finance, p. 5; and Royal Commission on Banking and Finance, Hearings at Winnipeg, Vol. 8A (Toronto: Official Reporters), p. A456. 23 'Chartered Banks Hike Interest Today,' Halifax Chronicle-Herald (3 July 1962).

Legal Factors Restricting Credit

65

high prime borrowers were likely to seek bank credit rather than issue securities, because the former was less costly. Thus, when the prime rate approached 6 per cent the small business was not in a position to compete, on a price basis, for bank credit; it had to depend upon the banks' concern for the 'broad public interest,' which lead them to reject some prime borrowers.24 It does not necessarily follow that removal of the ceiling will force prime borrowers to issue securities. To the extent that banks are concerned about retaining the goodwill of such customers - that is, their deposit balances - they might well accommodate many of them at rates above 6 per cent but below market rates. However, the prime borrower would probably be faced with a narrower spread between market and bank rates, and at least more of them would be encouraged by price considerations to go to the market. The functioning of the capital markets was impaired because the interest ceiling limited the interest rates banks could pay on savings accounts, and mortgage lenders, who did not have to face bank competition in their lending, were at a distinct advantage in price competition for deposits. Also, since those :financial institutions in an advantageous position to attract deposits are not active in business lending, the ceiling on bank lending rates inhibited the allocation of savings to the one type of institution which was and is active in business lending. Only two parties were noted as being opposed to removal of the ceiling, and one of these, the Province of Prince Edward Island, offered no reason. The other party was of the opinion that freeing the rate would encourage the banks to take risks which they ought not take. 25 There appears to be one other problem with regard to the interest ceiling that was particularly relevant for Nova Scotia. Since this province is one of the slower growing sections of the country, it is most likely that the banks generally have more attractive investment outlets in central Canada. The banks have never denied that funds are exported from the eastern and western parts of the country; rather, they have argued that there is no 'subordination of interests of one section 24 It may not be appropriate to identify the squeeze on small business with tight money exclusively. Long-term governments had yields below 4 per cent at only four month-ends between January 1957 and December 1963; and in the 60 months ending with December 1963 yields were below 5 per cent at only 15 month-ends. Thus, it appears that the banks have had to ration credit directly since early 1959. 25 Laurentide Finance Corporation Ltd., A Submission to the Royal Commission on Banking and Finance (7 May 1962) , pp. 45-7.

66

Institutional Financing of Small Business in Nova Scotia

TABLE 3/8 Branch managers' opinions on desirability of removal of six per cent interest ceiling and effect of removal on lending activity Bank Total

A

B

C

D

Removal is desirable Yes No Refused to comment ('Head Office's job')

23 6 3

5 2

5 2

7 1

6

Totals

32

7

7

8

10

Removal would expand lending activity Yes No Refused to comment

12 16 4

3 4

4 3

2 5 1

4 3

Totals

32

7

7

8

10

1 3

3

of the country to another.' 26 If this statement means that investment decisions are made on an objective (price) basis, then the ceiling restricted the ability of the slower growing regions to compete for bank funds. Thus, the removal of the interest ceiling is desirable to the extent that it will enable the banks to charge higher rates on business loans in the slower growing regions than elsewhere; otherwise, it seems unlikely that such regions would be able to compete effectively for the rationally allocated savings resources of the banks. Thirty-two managers expressed opinions on the subject of interest rates on bank loans. Their comments were in two general areas: the effect of a change in the present status of the ceiling in the Bank Act, and on interest rates on personal loans. The managers were first asked if they thought that the interest ceiling should be removed, and then if they felt that its removal would lead the banks to make more risky loans than they were currently making. In several instances, the managers were also asked whether the higher interest rates obtained on personal loans had encouraged them to take greater risks in that type of lending than they would otherwise take. Table 3/8 is a tabulation of managers' views on the desirability of removing the interest ceiling and on the effect of its removal. Twelve of the managers who favoured removal of the interest ceiling 26 Royal Commission on Banking and Currency, Final Hearings at Ottawa (14 September 1933), p. 38. While 'subordination of interest' is an ambiguous phrase, in context it was clearly aimed at the contention by Prairie provinces that their savings were being exported to central Canada.

Legal Factors Restricting Credit

67

also felt that it would expand lending activity, while ten of this group declared that it would not ( one manager who favoured removal would not comment on the effect on lending activity) . Four of the twelve who felt that removal would expand lending activity and three of the sixteen who did not agree mentioned that higher rates on personal loans had encouraged them to take greater risks in that type of lending. The primary concern of those who favoured removal of the ceiling was with the existing situation which precluded reflecting differences in risk between two borrowers offering different security. As one manager put it, 'It isn't very realistic to charge 5 per cent for a fully secured loan and only 6 per cent for one that's unsecured.' In all, nine managers gave this reason for removal. Reasons for removal, each of which were mentioned by only one manager, were : add a bargaining feature, bring securities out of hiding, make bank lending more competitive, keep the lending revenue of banks in line with their borrowing costs, and enable banks to engage in (government) lending programs ( e.g., CMHA) where the rate is fixed at over 6 per cent. Three managers mentioned the need to make currently unprofitable loans profitable, four mentioned the need to make bank operations more profitable, and five mentioned the need for banks to be able to pay more on savings deposits. Three reasons were given by managers for saying removal of the ceiling was not desirable : banks are making money on their loans now at 6 per cent, shading rates would create chaos in banking, and customers would be unhappy if they found out that other borrowers were paying lower rates. One manager, who was opposed to removal of the ceiling, said that he was opposed to anything that would result in higher cost money, and added, 'The banks make money on all their loans at 6 per cent. They wouldn't make any more loans at higher rates.' Another manager said, 'We have always made loans at 6 per cent so in the long run the ceiling hasn't hurt us.' Managers gave two reasons why they thought removal of the ceiling would expand lending activity : ten thought that removal would make otherwise unattractive risks attractive, and one of these managers also thought that banks would make more term loans if higher rates were permitted. One of the managers who thought that higher lending rates would make some situations more attractive had a potentially significant qualification. He said, 'Expansion won't occur until banks stop thinking that they should not have losses on loans, until they recognize that you may have increased losses with increased business, but that that is not necessarily bad.' A typical comment of the managers who related their expectations of more activity to personal lending experi-

68

Institutional Financing of Small Business in Nova Scotia

ence was : 'I feel we would take more risks. We make personal loans at 10 per cent we wouldn't touch at 6 per cent. The higher rate on business loans could be set to offset any increase in losses.' The managers who thought that lending activity would not be increased with removal of the ceiling gave four reasons: three managers said that interest rates did not enter into credit decisions; two said that all acceptable risks were being served; two said that banks should not accept more risk; and one said that removal would only make currently marginal loans profitable. Comments by two managers who said that interest rates did not enter into credit decisions are both interesting and surprising: 27 'All the loans I make are made because they will be repaid. I wouldn't make any more at 10 per cent!' and 'Removal of the ceiling won't lead me to make any more loans. I never think of the rate when I make a loan. We do make personal loans we wouldn't make at 6 per cent, but it wouldn't make any change in business lending.' The minority of managers who thought that removal would expand lending activity certainly offered significantly more logical arguments for their position than did the majority who anticipated no increase. Managers who favoured removal of the ceiling also thought that the rate should be regulated. One said that the CBA should supervise the new rate structure and 'set rates to match risks - it wouldn't be up to the manager to decide.' Another manager said, 'If the rates are freed they would have to be tied to the rediscount rate.' The four officers of the main branches were asked to comment on the following tentative conclusions with regard to removal of the interest ceiling. Removal of the ceiling would (a) enable banks to be more competitive in seeking savings accounts; ( b) permit use of interest rates to reflect differences in security; ( c) result in no new lending because managers are supposed to minimize loan losses rather than maximize profits. All four officers agreed with (a) without qualification, and three of four agreed with ( b) without qualification. The only qualification in the latter case was that one officer doubted that there would be different rates for fully secured loans and unsecured loans to prime borrowers; 27 Possibly these comments should not be too startling. A SBA Management Research Summary ('The Factors Market for Small Firms,' 1963, p. 2), commenting on interview data gathered in interviews with fifty bankers in the mid-western United States, reported that 'the findings of the study seem to indicate ... that bankers typically make only a single decision about a firm whether to lend to it or not. If this basic decision is favorable, a standard interest rate is charged. In other words, banks do not typically compensate for higher risk by charging a higher interest rate [on commercial loans]. The result is that marginal small business may find Jong-term funds unavailable at any price.'

Legal Factors Restricting Credit

69

it was his opinion that both of these types of loans would bear the same interest rate. One officer did not seem to be able to express himself on ( c), commenting only that he did not know what head office policy would be. A second officer argued that minimizing loan losses did result in maximum profits, and felt that removal of the ceiling would expand lending. A third considered the conclusion as probably accurate and a desirable contrast to the attitude of finance companies. The fourth officer agreed with ( c), contending that banks were currently making loans which should not be undertaken at any interest rate; that is, that there were no additional acceptable risks for banks. He also said that the only effect higher interest rates would have would be to increase bank profits, and he would not allow that there was a difference between a policy of loan loss minimization and profit maximization. In summary then we had the banks, through the CBA, and various groups and public figures arguing for removal of the interest ceiling on bank lending. We also had the implied approval of such a practice in the ease with which the banks have circumvented the Bank Act in their personal lending rates. 28 The consensus of the branch managers is that the removal of the ceiling would increase lending activity. Finally, we had the experience of personal lending programs where some combination of the opportunity to take chattel mortgages and to obtain higher yields has resulted in significant growth in recent years.29 It is obvious that a great number of consequences could follow the removal of the interest ceiling, both on the asset and liability sides of bank balance sheets, as well as in their income statements. A thorough analysis of these possible consequences is beyond the scope of this study. The most likely consequences to be forecast prior to removal would be that rates on and the volume of savings deposits would increase, that bank profits would increase, and that the banks would allocate a larger share of their loan portfolios to higher risk investments, after meeting the necessary reserve requirements. These invest28 This is in spite of the fact that Parliament rejected moves aimed at removal of the interest ceiling in revision of the Bank Act in 1934, 1944, and 1954. 29 The growth of personal lending may not be completely valid evidence in attempting to predict the consequence of removal of the interest ceiling and/ or mortgage security prohibition. It is possible that there is actually a third factor accounting in part at least for the growth of this activity. Faced with significant competition for savings deposits from near banks, it is possible that the chartered banks undertook personal lending programs to obtain public goodwill and increased traffic in their branches in the hope of eventually obtaining more public deposit accounts. To the extent that this was a promotional effort, undertaken to encourage another type of business, the growth of personal lending is not relevant in an examination of freed interest rates and removal of the prohibition on mortgage security.

70

Institutional Financing of Small Business in Nova Scotia

ments will be both long and short term, with the former the principal means of increasing the yield and the latter of preserving the desired degree of liquidity. Implicit in these forecasts are the assumptions that the banks will seek higher yields, that some of the higher yields will be passed on to depositors, that the supply of deposits available to the banks is elastic, and that the additional deposits will be more than enough to meet the additional loan demand which will emanate from borrowers previously serviced by the savings which have been reallocated to the banks. The obvious effect of removal of the ceiling on small business borrowing is that its cost will increase, particularly if the prime rate is near 6 per cent. This increase, by itself, would have discouraged any suggestion for removal of the ceiling. If the interests of small business are to be served, removal of the ceiling has to increase the credit available to small business, particularly for term purposes and for new small firms. In point of fact, bank profits increased appreciably in 1967 and again in 1968. However, general loans increased very slightly from the 1966 levels of 46.2 per cent of assets, to 46.5 per cent in 1967, and 46.7 per cent at the end of November 1968; personal loans, in the three periods, were 13.4, 14.2, and 14.7 per cent, respectively, of assets; and business loans, in the three periods, were 27 .2, 27.4, and 27 .3 per cent, respectively, of assets. Most discouraging, from the point of view of the small firm, is that small loans to business have fallen from 34.1 per cent of business loans in 1961, to 24.2 per cent in 1966, and to 22.1 per cent in 1967. Loans of less than $1 million held constant, as a proportion of business loans, from the end of 1967 to the end of November 1968, after a substantial drop off - from 53 to 48 per cent - from 1966 to 1967. Early indications are that removal of the ceiling has not assisted small firms, to the extent that smaller business loans reflect the accommodations given them. Conversely, J.H. Coleman, chief general manager of the Royal Bank of Canada, reported in June 1968 that mortgage secured loans of $1 million and over, for terms of up to ten years, were 8.7 per cent of business loans at the end of 1967, up from 4.3 per cent a year earlier. The fact that 'the trend is continuing and will expand' offers little solace to the small firm. There should be fewer problems at the branch level in initiating higher interest rates than in taking mortgage security, largely because of managers' experience in obtaining higher rates on personal loans. However, there are obvious problems. One has already been noted many existing borrowers will probably pay more for credit than they were paying and their rates will probably be more in line with market

Legal Factors Restricting Credit

71

rates, rather than virtually always at 6 per cent. Another problem will arise in that the risks on particular loans will not be reflected precisely in the rates charged. Rather than incur the ill-will of borrowers and face the problem of having branch managers set loan rates, banks will probably set a single rate for the entire country ( or at least regions) for a wide range of loans on many types of security, and / or several specific rates for small business loans of varying terms. 30 In either case, some particular borrowers will be discriminated against. 31 The suggestion of higher interest rates was, as could have been predicted, anathema to the politicians who had to approve the changes necessary in the Bank Act before the interest ceiling could be removed. And it could have been predicted, with equal confidence, that most representatives of the small businessman would be upset at the suggestion that firms in an underdeveloped region pay higher rates of interest. However, all of this ignored reality. Why should one businessman who does not want to pay high rates of interest expect that another businessman ( a banker) is going to allocate funds to him at relatively low rates of return? Even if the rates were to double to 12 per cent from the previous 6 per cent, the small manufacturing concern subject to a 30 per cent tax rate (which gives recognition to some surtax applicable to over $35,000 of taxable income) would only have to earn 8.4 per cent on its investments to cover the higher interest rates; such firms averaged 10 per cent return on net worth in 1964 (see Table 1/5, chapter 1) . It should be kept clearly in mind that such changes will not give particular regional economies an incremental advantage, but will only place the banks in a position to serve the demands of higher-risk, slower-growing areas. LEGAL RESTRAINTS- CONCLUSIONS

At the time of the branch manager interviews (1961) it was clear that branches of the chartered banks in Nova Scotia did virtually no term lending to any small business for any purpose. Furthermore, the prohibition on mortgage security precluded the new small firm offering any fixed asset security in lieu of its lack of established reputation, and 30 See P.M. Horvitz, Concentration and Competition in New England Banking (Boston: Research Report of the Federal Reserve Bank of Boston, no. 2, 1958), p. 147, where he points out that 'most branch managers do not have the ability, training or experience to set up an interest rate structure that would result in maximizing profits in either the short or long run.' 31 The same situation prevailed in personal loans where an individual who was in a strong bargaining position and informed could borrow for terms of over one year on a demand loan at 6 per cent, while others, many with the same security, borrowed under personal loan 'plans' at 10 to 11.5 per cent.

72

Institutional Financing of Small Business in Nova Scotia

the interest rate ceiling precluded the banks offsetting the higher risks of term lending and lending to new small firms. Without the removal of these two restraints from the Bank Act, there would continue to be restricted availability of credit to small business generally, and of term credit and credit to new small firms in particular. Removal of the interest ceiling alone should increase credit availability somewhat, but removal of the mortgage security prohibition alone would probably have had a minor influence on it. Removal of the interest ceiling was critical because there was some substantial doubt that 6 per cent was adequately compensating the banks for their shortterm lending to established small business; there was no doubt that 6 per cent was inadequate for mortgage secured term lending to any small firm. It is only when the banks are encouraged by appropriate security and attractive yields that it is likely they will actively promote term lending to small business by means of pressures on their branch managers; pressure appears to be necessary if the reservations of all managers about term lending are to be overcome. Thus, the actual demand for term loans will not be known until three conditions prevail: (a) branch managers learn to think of loan repayment in terms of earnings and cash flows rather than conversion of assets; ( b) branch managers learn to live comfortably with mortgage security; and (c) the availability of term credit is publicized to businessmen in language they can understand. The removal of the prohibition on mortgage security and the interest ceiling on bank lending from the Bank Act, by themselves, are not sufficient. Further, to argue, as some members of the banking fraternity have, that the banks did not get into term lending because of presure from the Bank of Canada is to place, for bankers, significantly more emphasis than is typical on 'recent' than 'ancient' history; the more likely explanation is that the banks did not enter the field because they were, collectively and individually, riskaverse oligopolists in a sellers' market. With regard to the SBL Act, it appears that it should be continued, but modified with respect to the interest rate, possibly to permit rates of 1.5 percentage points above the prime rate. The interest rate should not penalize the banks for allocating funds to small business, but should be set to reflect both the government guarantee and the high overhead cost of servicing smaller business loans. It does not seem important that the sales volume limits or the limits on amounts of loans be increased; with the mortgage prohibition and the interest ceiling removed, larger firms and amounts can be serviced by the banks. However, consideration could be given to having the guarantee limited to the 'bottom' $25,000 or 50 per cent of the loan, whichever is less, of loans extended

Legal Factors Restricting Credit

73

to manufacturing firms with sales of more than $500,000 but less than $2 million. OVERDRAFT LENDING

In addition to the restraints of a mechanical nature arising out of the Bank Act, the move away from overdraft lending, the possibility of requiring compensating balances, the extensive practice of extending credit on a demand loan basis, and personal lending activity, all tend to restrict the credit available to small businesses. The subject of overdrafts was discussed in twenty-nine of the branch manager interviews. Long a characteristic of Canadian banking, at the time of the interviews substantial attempts were being made to eliminate overdraft lending from the banking scene. The various reasons for this, from the managers' point of view, will be discussed below, but the move is bound to present problems for borrowers, particularly small firms. The overdraft, which may or may not be secured, can be authorized or unauthorized. If the overdraft is authorized, it appears to mean only that the manager is aware of the borrower's plans to overdraw his account, both have some idea of how much and for how long, and the manager is willing to go along by paying cheques for which there are no funds. The unauthorized overdraft appears to be more common, and certainly is of more concern to the managers. In this case, the borrower is drawing cheques without adequate funds and without the manager being aware of the plans of the borrower, and the manager's major concern is whether to pay the cheques and thereby extend credit he had not planned or to refuse to honour the cheques and risk the loss of a customer. The twenty-four managers ( of the twenty-nine who discussed the subject) who expressed a desire to end overdraft lending gave a variety of reasons for wanting to be rid of it. 32 Most of the reasons represented administrative considerations; the remainder were financial (Table 3/9). It should be noted that their principal objections were directed at overdrafts of the unauthorized type described above. Despite their desire to end overdraft lending, fourteen of the twentynine managers were not optimistic about it happening in the near future. They were pessimistic because of anticipated pressure from their customers to continue the practice and the reluctance of any one bank to 32 In addition to the three who opposed termination, one manager refused to comment on the subject, and another thought the prospect was too remote to consider seriously.

74

Institutional Financing of Small Business in Nova Scotia

TABLE 3/9 Branch managers' reasons for wanting overdraft lending terminated

Banlc Reasons Administrative

No control of account More work for manager Each check an unauthorized loan Do not know purpose of loan Complications in calculating interest No evidence of debt Impossible with accounting machines Delayed posting procedure precludes remedial action Bad way for manager to start day Financial

No free balance Collect less interest More costly to administer

Total

A

B

C

D

21 11 6 3 2 2 1

5 3 1 1 2

2 2

6

8

6

1

1

1

7 4

3 1

1

4

2

2 1

1 3

1

2

1

take the initiative in its discontinuance. For example, three managers felt that the only way to end overdrafts was through federal legislation prohibiting them. One manager said that he was trying to avoid overdrafts with established customers by 'setting a maximum amount we'll extend, say $50,000, and break it down into a number of smaller amounts, say $10,000. We let the overdraft go up to $10,000 and then have a demand note signed for that amount. Then he starts all over again. The borrower keeps this up until he has reached his total of $50,000 and we have five demand notes for $10,000 each, rather than a red balance in a chequeing account.' This system would appear to offer the borrower many of the advantages of overdrafts while overcoming some of the managers' objections. There can be no doubt that there is a decided trend away from overdraft lending, or that it will adversely affect small businesses. The principal disadvantage of complete elimination of overdrafts is the higher borrowing costs which follow, a cost which would increase more with the removal of the interest ceiling. A second consequence, which would in all probability be viewed as a disadvantage by small businesses, is that note borrowing requires more management time in undertaking the financial planning made necessary by formal arrangements for bank credit. While the additional time spent on financial planning could hold significant benefits for the small business and possibly even reduce borrowing costs by producing closer financial control, there is real doubt

Legal Factors Restricting Credit

75

that the average small businessman in Nova Scotia is capable of undertaking such planning. Furthermore, the traditional practice of overdraft lending, without formal and careful consideration of the maximum requirement or timing of the borrower's needs, has provided branch managers with scant opportunity to acquire qualifications for assisting the small businessman in such planning. Thus, it would seem that credit availability will be restricted, at least in a short-run period of several years, for small business, with a shift to more formal lending arrangements, because of the problems on both sides of undertaking such arrangements and the substantial probability of greater rigidity at the margin of a borrower's credit requirements. Another observation on overdraft lending is suggested by some of the managers' comments. It appears that there are many ways in which banks could extend credit by means of an overdraft while overcoming several of the problems they cited: an obvious way is by establishing a line of credit and obtaining demand notes to replace the overdraft, in stages or at once. The branch managers contend that they are forced by competition to continue overdraft lending, but there appears to be little reason, other than lack of initiative, why their present problems could not be largely overcome. Certainly one would hope that there are more profound reasons than those noted by most of the managers for seeking an end to overdrafts, and that the administrative problems noted were not a major factor in initiating the move away from overdrafts. COMPENSATING BALANCES

It was noted above (Table 3/9) that seven branch managers were anxious to end overdraft lending because it resulted in no free balance, and four were concerned with collecting more interest. To obtain further information on this subject and to determine the possibility of compensating balances being required in the future, branch managers were asked whether these balances were currently required. 33 The prin33 For an interesting discussion of compensating balances, see Donald R. Hodgman, Commercial Bank Loan and Investment Policy (Champaign: Bureau of Economic and Business Research, University of Illinois, 1963), pp . 24-5, 106- 10, and 138-43. The principal points of note are that compensating balances are generally in the 10-20 per cent range, moving to the top of the range during tight money periods, but generally required only of the largest borrowers from the largest banks; a means of raising the interest yield under some circumstances; a source of deposits which can, under some circumstances, support a larger volume of lending; and, principally, by virtue of the relationship between the required minimum compensating balance and loans to large borrowers, a means of restricting interbank price competition for demand deposits. See chapter 5 below for further discussion of bank competition in Canada.

76

Institutional Financing of Small Business in Nova Scotia

cipal implications of required compensating balances for small business would be increased interest costs from additional borrowing and, quite possibly, smaller usable credits. In all, eighteen managers commented on compensating balances; seven were currently looking for compensating balances; nine, the majority of whom had never heard of compensating balances, do not require them or expect to require them; and two said other banks sought them, but they did not. Several managers recognized the difficulty of getting customers up the two steps from overdrafts to compensating balances, and indicated that their immediate objective was a credit balance. And of the entire eighteen managers, only four mentioned specific percentages of compensating balances which would be or were required: three suggested 10 per cent and the fourth 15 per cent. From the information available, it appears that compensating balance requirements are neither common nor likely to become so soon. The CMA reported to the Porter Commission that only 31 of the 557 respondents (5.5 per cent) to its membership questionnaire had been required to maintain compensating balances, but it is interesting that 18 of these 31 were in the group~ with sales of less than $1 million. However, it concluded that the requirement was bargainable. The CBA told the Porter Commission that it would prefer a higher interest rate on the loans and service charges as compensation for credit and account activity, because such devices made the cost of the credit clearly understood and the cost of services commensurate with the activity of the account. No mention was made in its Submission of the actual use of compensating balances. Another reason why compensating balances are not likely to be required in the near future is that overdrafts will have to be eliminated first, and any progress in that direction will probably be slow. Furthermore, the absence of any generally understood policy on compensating balances, managers' opinions that they will be difficult to obtain from small business, and the general inertia of managers, particularly in implementing something that holds no advantage for them, all suggest that compensating balances do not pose an immediate threat to the availability of credit to small business. DEMAND LOANS

Both published sources34 and branch managers' comments indicated that virtually all of the short-term and all of the term loans they make 34 Small Business Manual (Ottawa: Queen's Printer, 1959), p. 70.

Legal Factors Restricting Credit

77

to businesses are on a demand basis, necessitating an orally arranged repayment schedule. 35 Demand borrowing creates an atmosphere unlikely to stimulate the careful projection of financial requirements which could assist the overall efficiency of the borrower's business. While more formal loan arrangements would probably have a restrictive influence on credit to small business, they would encourage more efficient management of small business and ultimately result in greater credit availability to worthy borrowers. PERSONAL LENDING

The spectacular success which has been recorded in the growth of personal loans has been indicated in chapter 2 (see Table 2/3), where it was noted that personal loans increased by 190 per cent between 1952 and the end of 1961, and by 618 percent between 1952 and 1967, compared to an increase in general loans of 121 per cent and 364 per cent, and in business loans of 117 and 324 per cent over the same periods. However, the 1961 level of personal loans is even more outstanding when it is noted that after the tight money period of 1956-7 ( that is, 19 57 year end), they increased by 97 per cent compared with increases of 39 per cent in general loans and 23 per cent in business loans over the same period. In the period from 1955 to 1961 (the 1954 revision of the Bank Act permitted the banks to take household durables as security) the personal loans of the banks secured by household property increased to $224 million, or from 0.1 per cent to 4 per cent of general loans. A finance company, which subsequently applied for a bank charter, told the Porter Commission that the 'chartered banks have become the most aggressive competitors of the sales finance and consumer loan industry in recent years.' It then noted that the banks had 'capitalized' on their reputation for integrity 'by allowing the public to gain the impression that [personal loans were] being made available at an interest rate of 6 per cent per annum.' This Submission went on to explain that the banks were in an advantageous position in competing for consumer loans because of their frequent contact with the public, because they had the competitive advantage of familiarity, more extensive and effective advertising, and lower cost of funds. 36 35 Probably indicative of the absence of fixed period lending and of the preponderance of demand note lending is the fact that only 11 per cent of the respondents to the mail questionnaire who had borrowed from banks reported doing so on a fixed period basis (see Appendix A). 36 Laurentide Financial Corporation Ltd., A Submission, p. 23.

78

Institutional Financing of Small Business in Nova Scotia

Thus, it is clear that the banks have been very active and very success-

ful competitors in the personal lending field: at the end of 1962, the

chartered banks held 32 per cent of consumer credit outstanding ( excluding retail instalment and charge accounts, oil company credit cards, and loans by credit unions), but increased their 'share' of the market to 44 per cent at the end of 1967 and to 47 per cent at the end of October 1968. Their desire to increase the outstanding amounts of higher yield personal loans was particularly understandable prior to removal of the 6 per cent ceiling. 37 Faced with the prime rate near the interest ceiling, and the competition for savings from near banks, the bank coupled an already established practice of circumventing the interest ceiling with the 1954 revision of the Bank Act which provided them with the opportunity to take mortgage security on personal loans, and used their personal loans as a means of raising the average yield on their portfolios and of attracting individuals who might later be depositors - practices that they have accentuated since the new Bank Act became effective. The increase in personal lending activity bears on small business credit in three ways. First, loans extended to individuals sop up credit which might be allocated to small business, at the same time placing the banks in a position where they can state that they are meeting the requirements of 'small borrowers.' Second, the personal lending activity reduces the time available for other functions, including examination of other loan applications, by branch managers. Third, a branch manager can develop the loan volume of his branch, even in the smallest communities, by focusing on personal lending rather than business lending. And there would be a tendency to do this because appraisal of a personal loan application would be far less demanding than the appraisal of a business loan application. It would appear that if a business loan program, particularly for term lending, could be developed along the lines of the existing personal loan programs, small business could benefit substantially. For example, the First National City Bank of New York has reported substantial success in its program of instalment lending to small business. The average term of these loans was twenty-four months, and losses 37 Four United States studies indicate that instalment loans are generally quite profitable. See 'Instalment Loans - How Profitable?,' New England Business Review (February 1962), pp. 5-7; 'District Operating Ratios in 1963,' Federal Reserve Bank of Chicago Business Conditions (April 1964), pp. 4-5; 'Time Deposit Operating Results, 1962,' New England Business Review ( June 1963), p. 3; and 'Bank Profits - Costs and Returns for Major Functions, 1965,' Federal Reserve Bank of Chicago Business Conditions (October 1966), pp. 4-11.

Legal Factors Restricting Credit

79

amounted to 0.375 per cent of the amount loaned. 88 A formal business loan program could have clearly defined procedures which would facilitate control and communication in Canada's branch banking system, and thus provide an inducement to making loans requiring complex analysis and document preparation. 39 NON-LEGAL MECHANICAL RESTRAINTS-CONCLUSIONS

To recapitulate, of the four non-legislative restraints on bank lending to small business discussed here, compensating balances do not appear to be likely to have any significant effect soon because it is unlikely that they will be required. If they are, they will impose a particularly heavy burden on small businesses. Each of the other three factors now has an effect on such businesses. It seems that the termination of overdraft lending and a shift to notes with specific maturities would encourage more careful financial planning by both businessmen and branch managers, while the termination of overdrafts would result in higher interest costs to the businessman. Major problems in any changeover to more formal lending would be the training of branch managers and managers of small businesses in the preparation of cash forecasts and pro f orma financial statements. On balance, the shift to note lending with specified maturities would be in the best interests of the viable small businesses. The author's expectation was that the attention given to personal loan programs would probably diminish when the banks were permitted to make any loan on mortgage security at a free interest rate. However, the apparent propensity of branch managers for personal loans has continued, probably because their qualifications are oriented towards extending personal rather than business credit. And even with the freeing of the interest rate on business loans, it appears that the head offices of the banks have not exerted presure on branch managers to encourage them to promote business lending on the same scale. Such promotion would be facilitated by a formal program of small business lending with specific criteria and procedures, and top management support.

38 See J.A. Painter, 'Small Business Lending,' Burroughs Clearing House (September 1959), pp. 39-41. 39 See Check List: Revolving Credits and Term Loan Agreements (New York: Hanover Bank, 1939), for an example of carefully established procedures.

4 Restrictive Practices of Branch Bank Managers

Branch bank managers have several lending practices which restrict the credit available to small business. These practices involve the evaluation of security and of financial condition, the development of loan covenants and of appropriate criteria for lending to small manufacturers, and the 'protection of borrowers from themselves.' The practices of branch managers in these areas restrict the credit available to small business generally, but to viable small businesses and small manufacturers particularly. PRACTICES IN THE EVALUATION OF SECURITY

It appears that the most valuable item of 'security' which a credit applicant can have to offer a branch bank manager is an established reputation of good character. Not only is good character a requisite for all borrowers, but without it an applicant's offer of inventory or accounts receivable as security, of an endorser, and of equity investment in his firm, are of limited value. This emphasis on established character restricts the credit available to new firms particularly, but also restricts the credit available to first-time borrowers who are not necessarily new businessmen. The limited availability of credit to new small businesses is indicated in several ways. Jamieson does not even discuss the financing of new firms, but does offer cautions to branch managers who are lending to firms borrowing for the first time. His suggestion that managers obtain financial statements for 'several years' before extending such credit clearly indicates that he is not discussing new firms. 1 A booklet prepared 1 A.B. Jamieson, Chartered Banking in Canada, Revised (Toronto: Ryerson Press, 1953), p. 208.

Restrictive Practices of Branch Bank Managers

81

by the Province of Manitoba as an aid to small businessmen comments that 'borrowing in particular is very restrictive for entirely new ventures,' a situation which they attribute to such firms not having a 'record of success.'2 Donaldson reported that four firms in the process of organization in his study in the Winnipeg area were refused bank loans, and one received a 'token loan' of one-third of the amount requested, despite the fact that this firm had experienced management and an assured market.3 Five firms were also refused bank credit during their first year of operation, while six others were successful because of 'special security features which those who obtained loans had to offer.' 4 He also noted that the loans which were made did not reflect substantial confidence in the new firms since they were secured by specific current assets, subject to frequent review, on a demand basis, sometimes secured by personal assets, and modest in relation to the security offered. Branch managers' comments also indicate that there is restricted availability of credit for new small businesses, and, in some instances, for new borrowers operating established firms and for past borrowers entering a new line of activity. Thirty managers were asked to compare new to established borrowers, and all thirty said that there were differences in the way the two were treated. The problems and requirements which the managers associated with lending to new businesses are listed in Table 4/1. The need for applicants to have demonstrated capacity both in business as a whole and in their own special line of activity is evident, as is the need for established character and substantial equity investment. In those cases where credit is extended it appears to be related primarily to the collateral security which the borrower has to offer. As one manager put it, 'until a man has established himself as a man of integrity and proves he has business ability, he cannot get bank credit unless he can make it fully secured. By "fully secured" I mean secured by csv of life insurance and good quality securities.' Only three managers indicated an appreciation of the consequences of 'fully secured loans only' for small new businesses. One said: 'Most of the new businesses don't have collateral security to provide, so we look at what they can offer - a general assignment of accounts receivable, a section 86 or 88 lien on inventory. We look at those and can do something for some of them sometimes.' 2 Financing Your Business, Small Business Management Aid no. I (Winnipeg: Province of Manitoba, Department of Industry and Commerce, undated), pp. 11, 17. 3 Gordon Donaldson, Financial Management in the New Small Scale Manufacturing Enterprise (doctoral thesis, Harvard Business School, 1955), p. 108. 4 Ibid., p. 154.

82

Institutional Financing of Small Business in Nova Scotia

TABLE 4/1 Branch managers' opinions on differences between new and other borrowers and on problems and requirements associated with new borrowers

Problems and requirements associated with new borrowers Initial borrowing limited to collateral security Character must be established Successful business record must be established More specific data on purposes, plans to repay, personal history 'Worthwhile investment' by owners* Successful business record in line of activity must be established Must have financially strong guarantor Some expand too fast for finances and management Too early entry invites losses for bank Must show stronger working capital ratio Probable neither borrower nor lender know anything about new activity •

Total

15

14

11 8 7

5

3

3 3 2

1

Lowest figure mentioned was '40 per cent of assets supported by equity,' with over 50 per cent indicated by the other six.

One manager's comment on the need for experience in the line of activity indicates the restraints which may face experienced businessmen. He said : 'If a fellow who has been a borrower and has been successful in the lumber business came to me to borrow money to go into another line, I would not loan simply on the basis of his past success.' It appears that the major problem, at the practical level, is for just such a group of borrowers - borrowers who, in a sense, have 'passed' a managerial competence test - because managers' comments indicate that they have very few credit applicants who are new businessmen. The basic reason for new small businesses having to borrow on a fully secured basis is that they have no established reputation of good character and business capacity; of these two, it appears that character is more important. The literature suggests that absence of good character precludes credit extensions. Jamieson begins, 'granting good character .. .' and immediately moves on to discuss management ability. The CBA comments that while the banks have to be 'certain about pledged security ... even more important ... is the character and capacity of the borrower.' The federal government's Small Business Manual and the Province of Manitoba's booklet make essentially the same observations. Of nineteen managers who ranked character, capacity, and capital in importance, fourteen (74 per cent) said that character was most important, two said it ranked second, two considered it third, and one

Restrictive Practices of Branch Bank Managers

83

manager said that the three ranked equally. And of the twenty-three managers who discussed character, capacity, and capital, twelve said that all three had to be established before there could be bank borrowing, while seven others said that new borrowers could only borrow on a fully secured basis. Two representative comments on the importance of character were as follows: 'Character is basic, and unless the borrower is a man of integrity there is no point in going further'; 'Security depends upon the character of the person. If you don't have any confidence in his character you can't have any in his security.' One manager who questioned the practice of lending exclusively on character offered a reasonable explanation of why the practice was prevalent : 'In Nova Scotia you have an opportunity to know your customers, their families and their habits, and because you can and do, you are willing to lend on those bases. But you can't put character at the top. I don't think a manager can loan on anything so subjective as his assessment of a man's integrity and morality. I have loaned money to people I wouldn't give two cents for.' The capacity of credit applicants, which one manager described as 'having good business sense,' did not elicit any significant comments from managers, and only one manager commented on capital (by which he meant the owners' investment) saying 'You can't lend on capital alone.' While managers generally insist upon collateral security for a first loan to any business, nineteen of them also indicated quite clearly that once character and capacity, particularly the former, are established, they would extend more credit on the same security as well as extend credit on other security. The most common comment, made by nine managers, was to the effect that initially a firm borrowed on the collateral security it could provide, but later it borrowed on its record of integrity and capacity- that is, security offered became less important with the passage of time.5 This comment is not too significant, however. As one manager observed, 'If the borrower develops a "record,'' his security is increasing because he has more money in his business.' Thus, both the literature and the managers indicate the importance of a borrower being 'established' before bank credit is advanced. The 5 Donaldson notes the same pattern in his study of manufacturing firms in the Winnipeg area, where he found that in the early years of a firm's life the

banks required collateral, and loans were related directly to the collateral. With the passage of time - 'for the majority of new enterprises ... several years' - it became general credit, with more allowed on the security, additional types of security accepted, and less policing. He attributed the additional credit to profitability and reinvestment of earnings, with these two factors demonstrating confidence and potential while adding to security. Ibid., pp. 212-16.

84

Institutional Financing of Small Business in Nova Scotia

comments of managers on the subjects of character, capacity, and capital, and their reservations about lending to new business, establish the same point: the borrower must be established before he receives bank credit, which results in restricted availability of credit to new firms and new borrowers. The insistence that a borrower provide some basis for evaluating his character and capacity is reasonable. However, it appears to be carried to such an extreme that it precludes substitution of alternative security. If an applicant had inventory, accounts receivable, an endorser, or a substantial equity in his business to offer as security, why could he not offer one or a combination of these as a substitute for the character and capacity which were not established? In fact, it seems that this is not possible. Nine of nineteen managers mentioning inventory security said, in effect, that its value depended almost entirely upon the integrity of the borrower or that it was, in reality, moral security. One manager said: 'There are two types of security - collateral and moral. Inventory and accounts receivable are only moral security. You can have an expert make an appraisal and check up on the inventory every three months, but what happens in between times depends upon the borrower's integrity.' A second manager who felt that he had to depend upon the integrity of the borrower asked, 'How would I know how much a pile of logs or lumber or a catch of fish was worth? Even if I did know, how would I have the time to go and look in the first place and to check up later on?' However, one manager said: 'It is foolish for a banker to say that inventory is only moral security. I have loaned money to people with no integrity.' While the legal status of a bank's lien under section 88 is quite clear, it appears that they (the banks) are reluctant to take legal action. Their reluctance to do so is undoubtedly related to concern for goodwill in the community, and to the expectation that the misappropriating small businessman is unlikely to have alternative sources from which to make restitution. The problems of policing and assessing value are other major reasons for relying on the borrower's integrity; if the manager has faith in the borrower, he does not have to concern himself with these problems. Nevertheless, heavy reliance on established integrity virtually excludes the new business and the new borrower, and casts some doubt on many of the arguments regarding the allegedly unique features of section 88 security. Seven of fifteen managers who mentioned accounts receivable as security also mentioned the integrity of the borrower. One of these managers said: 'Accounts receivable are only as good as the man who

Restrictive Practices of Branch Bank Managers

85

offers them. If he does good work you know you have a chance of collecting it all rather than a part. But, if the borrower is not honest he will collect all the good accounts and leave the bank with the ones that cannot be collected. We have to depend on the borrower to check on the collections because I do not have the time.' Another manager identi• fled a further problem which he also related to the integrity of the borrower. 'If an account receivable is assigned to us, the borrower often says to himself, "If I go out and collect this I will only have to pass it over to the bank - why should I bother?" ' Only three managers said that they were primarily concerned with the quality of the accounts receivable offered as security, all three saying that they examined the names and amounts in the receivables ledger. Two other managers said that their only concern was the total dollar amount of accounts receivable. Again, then, with accounts receivable there is the relating of the value of security to integrity and an absence of any particular concern with collectibility. Again, time and skill requirements are understandable explanations of why integrity is a major factor in determining the value of security; goodwill and limited alternative resources are reasons for not wanting to have to act on an assignment of accounts receivable; the responsibility for protecting a bank's security is passed over to the borrower, and the careful appraisal of security is passed up by the majority of managers. Consequently, there is restriction of the credit available to new firms, and no differentiation between firms which have varying qualities of accounts receivable. 6 Four of the five managers suggesting endorser security were from one bank. Two managers said that the arrangement was only attractive when the endorser was a 'person of means.' One of these two commented that he would lend to a new firm if it offered personal guarantors 'who have enough to really guarantee the note, but I don't just want names.' However, another manager was more reserved: 'It does not make any difference who the endorser is - we won't make the loan just because he is strong. It has to look like a good loan too. ' 7 In general, an endorser is attractive when the manager thinks that he is a better risk than the borrower and will lend, indirectly, to the endorser. 8 6 Possibly managers would react differently if they were accustomed to lending on the security of accounts receivable due from businesses, comments generally referred to accounts due from individuals. To the extent that managers continued to focus on the integrity of the borrower, rather than on the paying practices of his debtors, the reaction would be unlikely to change. 7 One manager, in discussing pressure of competition, said that an endorser could 'pressure' a bank into making a loan it would prefer not to make. 8 A possible restraint on small business formations arises out of the practice of having the officers of limited companies guarantee loans to their companies

86

Institutional Financing of Small Business in Nova Scotia

There is some inconsistency between the relationship of character, inventory, and accounts receivable security on the one hand, and disregarding of 'names only' for endorsers. It would appear that endorsers of good judgment (character) could, despite modest means, recommend the character of the borrower by endorsing his notes. Apparently the managers are not attracted to third-party assessments, and new borrowers without security must know someone of means who will endorse their notes; an endorser known to the bank is not sufficient. Only six managers mentioned owners' equity as a type of security which could exist behind a loan. In view of the usual pattern of small firms having a relatively large equity investment, ignoring this 'cushion' for loans to new firms precludes their capital investment substituting for their lack of established character and capacity, thereby restricting the credit available to them. There are several possible explanations of the managers' infrequent mention of owners' equity as security, one of which is that their attention is given almost entirely to the current accounts in the upper portion of the balance sheet. Another is that they are primarily concerned with self-liquidating loans, and disregard all accounts not directly related thereto. A third possible reason is that when a borrower's character is not established, branch managers are afraid that the owners might reduce their investment in the business by excessive drawings, salaries, and/or dividends. In any event, ignoring owners' equity restricts the credit extended to new borrowers and firms which might have adequate capitalization. The four main branch officers generally agreed that 'new businesses with inexperienced management borrow on security while established businesses ( and new businesses under experienced managers) borrow on character and capacity.' The only qualifications were (a) that both old and new needed character, capacity, and capital, but that old were less rigidly held to security ( one officer) ; and ( b) that there was a shift in emphasis but the new borrower must also demonstrate capacity and character ( two officers) . by means of personal endorsement of notes. This is a practice which the majority of managers appear to regard as routine. While, as one manager suggested, 'it is a poor man who won't ride his own horse,' it is highly probable that the personal endorsement is only significant when the borrower is hesitant in giving it and/or when he has substantial assets outside the business. For the small businessman of average means the personal guarantee is a requisite with little bearing on the amount of credit he receives, yet it is a requisite which eliminates any of the supposed benefits of the limited liability feature of incorporation. In this way it may tend to discourage some entrepreneurs who would otherwise start a business, but are reluctant to commit their entire wealth to it.

Restrictive Practices of Branch Bank Managers

87

In summary, the two striking features in managers' comments directly on the subject of lending to new businesses are the impression that new business borrowers are few in number, and the strong evidence that they would not get substantial support from the banks. In all probability the apparent absence of new firms represents a situation analogous to that of small manufacturers noted below; that is, there are a small number of firms founded ( of which only a portion are founded by new borrowers) , and this small number, spread out over all branches, does not provide managers with any significant exposure to such borrowers. Additionally, of course, there is a strong possibility that there is a further diminution of the number of potential applicants because of their preconceptions about what is acceptable to banks. Taken together, the evidence indicates that credit available to small new firms is restricted significantly, and that there is some degree of restriction of credit available to new firms managed by experienced businessmen, because of the managers' practices in the evaluation of security. The primary reason in both instances is their practice of disregarding security items which might substitute for the unestablished status of such borrowers. The refusal to consider the realizable value of security can only produce unnecessary restraints on the credit available to some financially sound small and new firms. It seems most likely that the new small business could, at some stage before it achieves a fully established status, offer some non-collateral security, particularly inventory or accounts receivable, which would be sufficiently attractive to offset remaining doubts about character and capacity. This would require more careful policing and more skilled assessing, but it seems unreasonable that the new entrepreneur has to face restricted credit availability because of the conservatism and inadequate skills of the bank managers. More attention to the marketability of inventory and the collectibility of accounts receivable might well tighten credit lines to some 'established' borrowers, but the consequent greater attention to the management of these assets would be beneficial for all concerned in the long run. EVALUATION OF FINANCIAL CONDITION

The approach which managers take to financial analysis is such that it discriminates against new firms, and does not give recognition to financial prospects or the marketability of security items. Also, their relatively modest concern with audited financial statements could indicate that they are lending to borrowers whose integrity they do not question;

88

Institutional Financing of Small Business in Nova Scotia

alternatively, it could indicate that they place so little weight on the statements that their accuracy is not vital. Jamieson describes the analytic procedures open to managers at some length, and he remarked on the subject of financial analysis generally that it is given particular attention only when 'the financial position of the borrower ... is an important consideration' in the credit application; there is a strong implication that financial condition is not invariably a credit criterion. In those cases where analysis is considered important he suggests a comparative analysis of the statements to determine whether steps have been taken to overcome any unfavourable trends. He says that branch managers should insist upon audited financial statements, 'except in the case of small business.' He goes on to discuss ratio analysis at some length, referring to the working capital ratio as the most important 'by far.' Twenty-one managers who commented on financial and operating data which they sought from credit applicants mentioned balance sheets and income statements. Only seven of these said that they wanted audited statements, and only four said that they required them. In all, eight of the twenty-one managers specified the time periods that should be covered by financial statements required, with three years the most common period. A manager commenting on audited statements, which he required, said that they had 'to be prepared by an independent auditor, preferably a CA.' He emphasized that the auditor had to be independent because he thought that in small towns many auditors had business interests and might be disposed to prepare false or misleading statements. However, one manager did not feel too strongly about the need for formal statements: 'I prefer audited statements, but I will take down the data they give me verbally, if need be.' The twenty-two managers identified, in addition to financial statements, twelve other information items which they would request (Table 4/2). The wide range of the non-statement data wanted by managers can also be noted from the table, and, when considered with the lack of pressure for audited statements, it is clear that the information required of applicants by branch managers is modest in terms of its relevance to meaningful financial analysis. Of the twenty-one managers wanting financial statements, thirteen offered reasons (Table 4/3).9 The variety of reasons on an intrabank and interbank basis suggests 9 The information wanted and managers' reasons for wanting it tend to reflect more concern with financial considerations than was evident in their comments on character. Undoubtedly this was inherent in the immediate subject matter, and it should be recalled that the comments were made with respect to borrowers who had established their character to the satisfaction of the managers.

Restrictive Practices of Branch Bank Managers

89

TABLE 4/2 Loan applicant data used or requested by branch managers

Bank Data

Total

Balance Sheet and income statements 21 4 Personal assets Previous activities• 3 Evidence of borrower's planning 2 Source and application of funds statement for large credits to 2 large firms Proforma balance sheet and details of owners' investment from new 2 borrowers Inventory and accounts receivable composition to determine security value Personal observation of firm to appraise capacity 1 Amount, purpose, means, and period 1 of repayment of loan Evidence loan can be repaid out of 1 earnings 1 Nature and condition of fixed assets Personal observation of principals 1 to appraise character Totals (22 respondents) 40 Number of information items required

Financial statements only Financial statements and one other Financial statements and two others Financial statements and three others Two other items only TOTAUI



A

B

C

D

6 1

2 1

8 1 2

5 1

I

1

-

1

1

1 1

12

8 9 3

1 4 1

1 22

6

I

1

1

1 4 16

4 3

2

1 1 9

8 3 1 1

5

From organizations such as Dun & Bradstreet, Better Business Bureaus, and own and other banks' files.

that managers are left 'to their own devices' in devising credit criteria.

It indicates as well the danger of generalizing on what banks want from

a credit applicant. The one manager who gave five reasons for wanting financial statements commented as follows: We compute various ratios and a source and application of funds statement for the most recent years from the financial statements. A source and application statement can show us if the money for working capital went into big capital expenditures. On the statements themselves we look at the working capital and the working capital ratio, and to see if the business is leaning in the right direction, if it is healthy, if its sales and profits are holding at least the same relationship, and if there is too much going out in dividends.

90

Institutional Financing of Small Business in Nova Scotia

TABLE 4/3 Branch managers' reasons for requesting financial statements

Bank Total To determine: If firm is making progress Upper limit on credit to grant Size of owners' investment If overhead is in line Turnover of receivables Cash income Turnover of assets If sufficient credit has been requested Amount of working capital To compute 'various' ratios Basis for preparing source and application of funds statement for small firms Totals (13 respondents) Nunber of reasons

One Two Three Five

Totals

7

3 2 2 1 1 I 1 1 1

3 23 8

2 2 1 13

A

B

C

D

2

2

3 2 1 1

1 1 1

1 1

1 1 1

1

1

4

6

9

4

2 1

1

3

2 1

3

1 2

2 5

3

With regard to the relative attention given the balance sheet compared to the income statement, the manager who was concerned with asset turnover remarked: 'When the turnover is low you pay more attention to the balance sheet, but when it is high I think that to restrict credit to balance sheet values is unfair to the borrower.' The officers of the main branches agreed with the tentative conclusion that banks want a statement of personal worth as well as a balance sheet and income statement, and that the statements should cover at least three years. One officer said that new customers would have to provide financial statements for the preceding five years. They all stated that banks made a practice of obtaining a report of borrowers' credit standing from suppliers, and they agreed with· the contention that banks seldom prepare a complete source and application of funds statement, in most cases restricting their analysis to working capital changes. One of the four officers indicated that source and application of funds statements were not common, but thought 'they would help us a lot.' When the officers were asked which ratios, other than working capi-

Restrictive Practices of Branch Bank Managers

91

tal, were prepared, two said that working capital was the only one. Both of the others mentioned receivables' turnover, and one of these two mentioned inventory turnover. However, one of these latter two said that he did not consider ratios very useful, whereas the officer who mentioned three ratios indicated that he prepared them because the bank's forms provided a space for them - 'I don't put much emphasis on them.' From the foregoing statements, it seems that the small business credit applicant should be prepared to present his bank with audited balance sheets and income statements for at least a three-year period, or since he began operations, whichever is the shorter period. While the call is not great, it also appears that the applicant may improve his bargaining position by presenting a proforma income statement and balance sheet, and/ or a cash flow forecast, covering the period up to at least the maturity of the credit being applied for. Although an annual audit is not required by the branch managers, the small businessman may realize many benefits from one performed by a competent auditor, and certainly loses nothing by it when applying for credit. The interest expressed by a minority of managers in forecasts of ability to pay is encouraging, but the more common practice, when any forecasting is done by managers, appears to be one of transposing historical data to the future rather than a projection of financial data based upon a careful analysis of plans and expectations. The use of historical rather than projected data is beneficial to successful but stagnant firms, and to firms which are in or about to complete their growth periods; it is a distinct disadvantage to firms which are about to grow, be they old or new. The casual approach to financial statements, reflected in limited concern for audited statements, very limited ratio analysis, and limited attention to projections, would indicate that the applicant with a sound financial condition and prospects gains little from those facts, per se. 10 PRACTICES IN THE DEVELOPMENT OF LOAN COVENANTS

Given the prevalence of demand note lending and the absence of term loans, it is not surprising that the majority of managers indicated that written covenants were virtually non-existent in bank lending. 10 Throughout the discussion of financial and operating data at all levels of bank management the impression was strong that bank managers and their superiors were most reluctant to provide borrowers with any definitive material on their financial analysis methods or criteria. This could reflect a reluctance to make implicit commitments, or it could reflect the absence of such material.

92

Institutional Financing of Small Business in Nova Scotia

TABLE 4/4 Branch managers' comments on covenants on bank loans

Bank Covenants

Total

A

B

C

D

Rare None Always in writing Some in writing

9 5

1

2 2 1 1

3 2 1 2

3 1 1 2

4 5

1

In all, fourteen managers commented on loan covenants (Table 4 / 4). One of the managers who said that covenants were rare said that the only one he had ever seen was included in a loan secured by mortgage bonds; he believed that otherwise they were almost always verbal. Three of the managers who thought covenants were rare said they never actually had or saw one, and all three believed that they were made verbally, if at all. One of the managers who said that covenants were unusual, and mentioned some form of written agreement said that on a term loan 'especially' the bank might require the borrower to pledge in writing that he would not use an unencumbered building as security for another loan. Another manager said that covenants were rare, virtually never in writing, and 'never cover salaries, dividends, equipment or added debt or liens. All they are ever for is to subordinate and postpone any loans due the principals of the firm.' A second manager agreed, saying that written covenants covering salaries, drawings, and dividends were 'isolated.' However, one manager declared that while covenants were not common, 'we use them where we feel the fellow may be too ambitious.' In the context of managers' security and financial appraisal practices, probably the most relevant comment was made by the manager who said: 'When we lend money it is to the kind of fellow who will take our advice.' The officers of the main branches confirmed the impression that written covenants were virtually non-existent. However, one officer pointed out that the oral agreements on large term loans might cover dividends, capital acquisitions, and long-term debt, and that significant violations of these oral covenants could result in the bank calling the demand note on which the credit had been granted. The principal problem arising out of the absence of inducements to develop covenants would appear to be that it would result in (a) limited pressure to carefully appraise a loan request, repayment schedules and security requirements; and ( b) an absence of guide lines for both borrower and lender. It is also probable that the fact that cove-

Restrictive Practices of Branch Bank Managers

93

nants do not have to be developed is partially responsible for the casual attitude towards financial analyses and forecasts. PRACTICES IN LENDING TO SMALL MANUFACTURERS

It appears most unlikely that a small business seeking bank credit in Nova Scotia is at any relative disadvantage simply because it is small, since virtually none of the managers would have experience with large business. The only relative disadvantage for a small business would be in comparison with personal lending where, as suggested in chapter 3, the manager might feel more competent and use personal loans as a means of developing his loan business. Also, beyond the control of the managers, the head offices may be disposed to use their resources to finance large borrowers, particularly during tight money periods. In general, managers did not reveal any biases against small firms because of their size. However, there are two problems insofar as branch bank lending to small manufacturers is concerned, and only one of these is 'visible.' The visible problem arises from managers having very limited experience in lending to small manufacturing firms. This results in lack of opportunity to develop appropriate criteria for such an activity. The second problem, of which most branch managers appear to be unaware, is the restricted marketability of the inventory and fixed asset security on which they might lend to small manufacturers. Jamieson suggested a rather cautious approach in any lending to manufacturing firms, and he thought that such firms should own their machinery and be in a position to purchase at least a part of their raw materials. 'It is preferable that his plant be unencumbered but if not, the indebtedness should be low enough and repayment on sufficiently easy terms to keep it from being burdensome.' He also cautions branch managers to be certain that neither their loans nor the funds expected to be used to repay them are diverted to fixed asset acquisitions. 11 Branch managers were asked if they thought there were any problems peculiar to manufacturers which would have a bearing on their credit decisions. While several of the managers expressed an opinion on lending to small manufacturers, few had any actual experience in such lending. Of the thirty-two managers commenting on lending to manufacturers, seven said that they had experience in lending to them, but only one of these indicated any extensive experience; the other 11 Jamieson, Chartered Banking in Canada, pp. 222-3. He suggests more restricted credit to wholesalers and still more caution in lending to retailers, see pp. 225-6.

94

Institutional Financing of Small Business in Nova Scotia

TABLE 4/5 Branch managers' lending experience and views on problems of small manufacturing firms

Bank Total Lending experience

Manufacturers have same problems as other lines of business Manufacturers have more problems than other lines of business

Little or no lending experience

Manufacturers have same problems as other lines of business Manufacturers have more problems than other lines of business No opinion on problems

A

B

C

D 1

7

1

5

3

1

2

4

3

25

5

6

7

7

11

3

2

4

2

9

2

2 2

2

1

4

5

1

twenty-five managers indicated that they made very few loans to manufacturers, had not made one for several years, or had never made one. Table 4/5 summarizes managers' opinions on lending to manufacturers, as contrasted with other lines in which they invariably had more experience. One of the three managers with lending experience, who believed that manufacturers had the same problems as others, said that in his experience 'they are sometimes better than other businesses because their officers frequently have some particular pride in their firm, and keep their bank better informed.' One of the managers with lending experience who saw special problems with manufacturers said that he had to police loans to them more carefully. 'Some of these fellows always want to be buying new equipment.' A second manager in this group stated that 'you have to attach a lot more importance to what the statements show when lending to a manufacturer. With them you base about three-quarters of your decision on what the statements show about past performance - profit and efficiency. There is no need of putting so much weight on past performance with others.' One manager with lending experience saw peculiar inventory security problems in lending to manufacturers. (This manager was one of only two who mentioned this point.12) He said: 'Inventory security 12 A third manager alluded to another special problem. He described a situation where a manufacturer-borrower got into difficulties and the bank involved brought a plant manager in from central Canada. There was not a local man available to take the position, a situation which would tend to dissuade a lender much more than if alternative management was readily available.

Restrictive Practices of Branch Bank Managers

95

with manufacturers here is not very good security. It's only worth something when the firm is operating. The only way you can get anything out of a section 88 lien with a manufacturer is to operate the firm until the raw material is used up. There is no one here to buy raw material of most manufacturers.' A manager with little or no manufacturing lending experience, who saw problems peculiar to manufacturers, remarked that he bad never seen an application from a manufacturer, but that he thought such firms have 'some good operators and some poor ones.' Another considered that small manufacturers 'often have better statements and other information, and that makes for fewer rejections.' Four of the managers without manufacturing lending experience thought such firms would be at a disadvantage because of their distance from markets. 13 One said : 'Any small manufacturer who is dependent to a large degree on distant markets has some real problems to face. Besides the transportation cost, they have no labour cost savings or advantage because they have to pay union rates. They have to get volume production in the local market because, if they have to use a long railway delivery, they are in a very tough spot.' Three officers of the main branches were asked to comment on the following statement: 'The absence of any significant secondary industry makes lending experience in this activity rare, and consequently credit more difficult to obtain.' Two agreed, with one saying that he did not like the word 'difficult,' but that he would have to admit it was accurate. (He also observed that the realizable value of manufacturers' inventory and equipment would be major lending problems in the region.) One officer disagreed, saying that along the route to the managerial position there would have been some manufacturing lending experience - a view not supported by the interview data. The comments of the branch managers with regard to experience in lending to small manufacturing firms reflect the small number of such firms in Nova Scotia. The absence of manufacturing firms results in branch managers being unfamiliar with the problems and the actual potential of lending to such firms, and the personnel policies and practices of the banks (see chapter 5) do little to overcome this unfamiliarity. In lieu of his lack of experience in lending to manufacturers each manager develops criteria based on his lending experience in other lines, or the second-hand experience of others - only five of twenty-five managers with little or no experience had no opinion on problems. In either case, the criteria probably will not be valid. If these criteria are 13 The transportation problem was only mentioned by managers in the western end of the province.

96

Institutional Financing of Small Business in Nova Scotia

too conservative, the borrower is discouraged by the manager; if they are too liberal, the loan is rejected by the supervisor. In either case, the borrower, like the branch manager, has no clear idea of what criteria exist. Furthermore, the general impression gained from managers was that, when they were in doubt as to the virtue of a credit application, they rejected it. Consequently, the lack of experience which would produce uncertainty about the outcome of a credit extension probably has a restrictive influence on the availability of credit. 14 When a majority of branch managers have experience in lending to small manufacturers the problem of security liquidation may become more 'visible.' It is probable that, if managers thought of inventory purely in terms of marketability, the 'thin' local market would be a matter of major concern to them, as it was in the case noted. The marketability of manufacturers' raw and in-process inventories and fixed assets would be enhanced by the development of secondary industry, while a national branch banking system is in a favourable position to find potential buyers of finished goods inventory. However, the problems of liquidating manufacturers' specialized raw materials, finished goods, and facilities are apt to remain, whether recognized or not, for some time to come. Consequently, the restricted availability of bank credit to small manufacturers in Nova Scotia is more likely to be relieved, in the short run, by bank personnel policies which broaden the skills and experiences of branch managers. PRACTICE OF PROTECTING BORROWERS FROM THEMSELVES

Branch managers also restrict the availability of credit by their decisions to reject credit requests in order to protect borrowers from themselves. The only direct reference to protecting the borrower was found in Jamieson, where the observation was made that the manager could do their customers, their bank, and their community a service if he succeeded in keeping would-be borrowers 'out of undertakings beyond their capacity to handle.' Twelve managers disclosed that they rejected loan requests when, in their opinion, a bank loan was not in the best interests of the borrower or guarantor. One manager said, 'I have rejected quite 14 Jen concluded, on the basis of the empirical data obtained in his study of bank credit to small business, that banks in less industrialized areas were relatively less eager to meet the credit needs of their manufacturing clients. He also concluded that small firms in areas served by small banks have a higher degree of insufficiency of credit than similar risks in areas served by large banks. See F.C. Jen, The Determinants of the Degree of Insufficiency of Bank Credit to Small Business (Madison: an unpublished doctoral dissertation presented to the University of Wisconsin, 1963), p. 169.

Restrictive Practices of Branch Bank Managers

97

well secured applications when I thought it was something that would not work out for the borrower or was sending good money after bad.' Another manager said he tried to discourage borrowers, 'for their own good,' by 'asking for more security than I need.' A third manager said: 'There is no point in letting somebody lose their own money.' He added that he felt that to 'loan to a customer in excess of his needs is a disservice to him. If you do, then he will use the credit, but generally not well.' While a policy of caveat emptor would probably produce many unfortunate events for creditworthy small businessmen, it does seem that the desire of the managers to protect them is not in their best interests. First, the policy of protection assumes that the small businessman does not know the risks he is taking. This is undoubtedly a valid assumption in many cases, but the policy does not appear to allow for the exception. Second, the policy assumes that the branch manager is competent to make the judgment as to which proposed activities are likely to be successful. There is little evidence to indicate that managers have such competence. Finally, the policy places the branch manager in the position of being both judge and jury. It would be far more desirable for the businessman to seek skilled counsel outside the bank. This counsel could be more competent and would be uncoloured by considerations of risk to the branch manager. The manager could warn the borrower of the risks he sees, and advance the credit on the merits of the proposed acceptable security if the borrower insists. CONCLUSIONS

Branch managers' practices in evaluating security, in financial analysis, and in lending to small manufacturers provide major restrictions of credit availability for small businesses. The views of the managers on inventory and accounts receivable security, and on financial statements, indicate that they evaluate these in the light of their opinions of the character of the borrowers, and that they place a great deal of confidence in their ability to evaluate character accurately. The significant problem arising out of this emphasis on character is the restraint it places on the credit available to new small firms. In practice, it excludes those who could offer security in the form of accounts receivable or inventory, because established character is a requisite for making either of these acceptable security .15 It is probable that new small firms could 15 The emphasis on character stands in contrast to the situation among small manufacturers in the United States where success in securing financing was positively related to profitability and balance sheet structure. See 'Small Busi• ness Financing: Corporate Manufacturers,' Federal Reserve Bulletin (January 1961), pp. 15-17.

98

Institutional Financing of Small Business in Nova Scotia

be financed by banks on the security of accounts receivable and inventory (together or individually) without undue risk. A thorough analysis of the accounts receivable and/or· inventory, aimed at determining their realizable value, combined with the available legally enforceable liens, should provide an approximation of the amount of credit which could be extended safely. The practices exercised in financial analysis penalize two types of firms. First, the emphasis on historical financial condition penalizes the most viable small firms. The measure of success in such firms is the contrast between their financial position at the time they began to grow and after they had grown; denying them the credit which could be allocated safely to their projected financial position substantially retards their progress towards it. The speculative nature of any forecast could be reduced to reasonable proportions by skilled financial analysis ( done by the businessman or his consultants) and by leaving some 'elbow room' between the projected and required cash flows. Second, the practice of emphasizing book values of assets rather than their market value results in borrowers with liquid current assets being penalized. Managers' analyses result in virtually no differentiation between firms with highly liquid inventory and/or readily collectible accounts receivable, and other firms whose current assets do not have these characteristics. Undoubtedly a changeover to projected financial condition and marketability/ collectibility considerations, and the disregarding of character except at the lower extreme, would reduce the credit available to some firms which are now experiencing only minor difficulties. This might be a desirable change because the economy of the region would benefit from the allocation of bank resources to the most viable small firms. Branch managers' attitudes towards lending to small manufacturing firms are largely dictated by their lack of experience in such activity. This lack of experience undoubtedly results in the credit to such firms being restricted in most cases, especially in the case of new small manufacturers and those engaged ( or about to become engaged) in activities that are unfamiliar to the branch managers. The small number of manufacturing firms in the province makes it imperative that managers gain experience in lending to such firms while holding responsible positions in the more industrialized regions of the country; until such time as the banks intensify their rates of interregional transfers, and train managers so that they are qualified and willing to investigate new situations carefully, it is unlikely that branch managers will be able to undertake practices that will facilitate the provision of credit to small manufacturers.

5 Restrictive Organizational Features of Chartered Banks

There are three organizational features of the chartered banks which restrict the credit available to small business: their personnel policies and practices, their procedures and practices for dealing with loans of amounts over the limits of branch managers, and their lack of competitive zeal. The personnel policies and practices produce managers whose qualifications for their responsibilities are doubtful; the loan limits subject borrowers to two different kinds of criteria; and the lack of competitive zeal blunts the initiative that would lead to the development of 'new products' and the servicing of new 'markets.' These three practices also provide possible explanations of the restrictive factors discussed in chapters 3 and 4. PERSONNEL POLICIES AND PRACTICES

A substantial proportion of the practices generating bank financing problems for the small firm arise from the banks' personnel policies. The deficient policies appear to be (a) those concerned with recruiting and training of personnel; ( b) those used in the evaluation of managers; and (c) those applying to older managers. In addition to the problems now posed for credit availability, unnecessary risk problems for the banks will become evident with the advent of the greater risks associated with lending at higher interest rates and/or term lending. The branch managers of the chartered banks are virtually all drawn from the ranks, with progression generally up from one of several junior clerk levels through assistant accountant to accountant; the vast majority of current staff members joined the banks from high school. With respect to recruiting, the 1962 CBA Submission to the Porter

100

Institutional Financing of Small Business in Nova Scotia

Commission said that the banks generally recruit from high schools and universities, and that education requirements are 'higher than at any time in the past ... With few exceptions, banks nowadays want people with at least junior matriculation [high school juniors] standing, and are hiring more and more university-trained people.' The little emphasis actually placed on higher education may be reflected in the following opening paragraph of a booklet which one bank distributed to university placement offices in the early 1960s: 'The [bank] each year recruits a limited number of university graduates in addition to High School graduates. It is from both groups that we select those who develop the judgment and demonstrate the ability to advance to senior positions in our organization' ( italics supplied). With respect to training, it has been argued for many decades that branch banking has a unique capacity to develop managers because of the practice of interbranch transfer of junior clerks, a practice which allegedly enables the junior to become thoroughly familiar with his bank's procedures and gives him 'a ... grasp of general banking business and of the conditions existing all over the country.' Because of this type of training, it was concluded that 'the Canadian banking system ... possesses and will always produce efficient managers.' 1 Just over ten years ago, it was still being argued that the practice of branch transfers provided bank officers with a varied experience peculiar to branch banking.2 The CBA told the Porter Commission that staff members were given an introductory period of orientation, coupled, in some cases, with emphasis on job rather than branch rotation, and some were given a period of credit or inspection work at head office or at a regional supervisory office. The CBA added that the objective of the training of branch managers was 'the development of officers who can seek out lending opportunities and make good loans and the advancement of these officers depends to a significant degree on their ability to make loans.' It spoke favourably of the 'Fellows Course in Banking,' and pointed out that banks pay the way of some 'officers who are selected to attend business administration courses at certain universities.' The 'Fellows Course in Banking' was, until 1967, the only training program available to members of bank staffs generally. It is a two-part program offered by correspondence through Queen's University. In addition to this program, Jamieson reported that 'at least two of the 1 A.A. Lash, 'The Banking System of Canada' (Address to the Third Year Law School, University of Toronto, Toronto, 1907), pp. 14-15. 2 James Muir, The Canadian Banking System (Montreal: the Royal Bank of Canada, 1956), pp. 14-15.

Restrictive Organizational Features of Chartered Banks

101

banks operate staff training schools,' but his description of the programs does not indicate anything which, at the time, could reasonably be regarded as formal as a 'school.' A live-in program, described as 'the only residential staff college operated by a Canadian chartered bank,' has been conducted by the Canadian Imperial Bank of Commerce for their young staff members since 1954. This course utilizes case studies and group discussion in three- to four-week sessions, several of which are conducted each year, for branch managers and accountants. All instruction is by bank employees and the director of the school is the only full-time instructor. One bank was reported in 1962 to be considering a staff school of the same type, but some banks were reported to have reservations about taking men away from their families, and about being viewed as competitors by hotels. 3 These efforts by the Commerce seem most commendable, and the expressed reservations concerning such a program are hardly valid enough to discourage other banks. In an effort to obtain information on the frequency of interbranch transfer, which the banks argue is an integral part of their staff training programs, a record was kept of these transfers, by four chartered banks, as announced weekly in the Financial Post from 13 October 1962 to 5 October 1963. A total of 137 announcements appeared for the four banks under consideration in the fifty-two issues of the paper published in that period. 4 Details are given in Table 5/1. While the average interprovince transfers were 8 per 100 branches for all branches on a national basis, they ranged from 7 .5 per 100 in Ontario to 85.7 per 100 in Prince Edward Island. More relevant, and showing smaller dispersions from the average, are the following interregional transfers per 100 branches: National 8.3 Atlantic Provinces 9. 7 Quebec 13.1 Ontario 7.5 Prairie Provinces 9.2 British Columbia 8.1 For unindustrialized areas such as the Atlantic Provinces, personnel with experience in dealing with any significant number of manufacturers must come from outside the region. The prospect of receiving 3 'Bankers' Interest Kept at Par,' the Financial Post (9 June 1962). 4 A request for permission to send a questionnaire to branch managers concerning their education, age upon entering the bank, and upon promotion to manager, and the positions in which they had had experience in each of the provinces was rejected by the banks. Two refused flatly, and two later accepted on the condition that all agree.

TABLE 5/1 Interprovince staff transfers by four chartered banks 13 October 1962 to 5 October 1963

Province Newfoundland* Prince Edward Island• Nova Scotia* New Brunswick* Quebec Ontario Manitobat Saskatchewant Albertat British Columbia Othert Head Office TOTALS

Total staff changes (includes 318 in/out) Average staff changes per branch Total interprovince staff changes Interprovince as a per cent of all changes Average interprovince staff changes per branch

Branches of four banks 87 21 177 96 550 1,561 211 263 375 482

-

-

3,823

0.697 11. 9 0.083

Interprovince staff transfers 26 18 56 53 72 117 63 51 62 39 65 14 636§ 2,665 318§

Average interprovince per branch

Branches JI C

M

0.299 0.857 0.316 0.552 0.131 0.075 0.299 0.194 0.165 0.081

9 6 27 16 161 574 65 88 134 175

23 2 26 18 176 338 53 58 100 125

113

35 8 51 38 57 266 21 32 53 69

0.166

1,255

919

1,019

630



20 5 73 24 156 383 72 85

88

927 0.739 74

516 0.562 94

598 0.587 71

624 0.991 79

8.0

18.2

11.9

12.7

0.059

0.102

The Financial Post, various issues from 13 October 1962 to 5 October 1963. Of the 153 changes for the four Atlantic Provinces, 116 were intraregional; 37 were in/out of region (24.2%); average in/out for region was 0.097; overall average in/out was 0.401. t Of the 176 changes for three Prairie provinces, 98 were intraregional; 78 were in/out of the region (44.3%); average in/out for region was 0.092; overall average in/out was 0.207. i Includes Yukon, Northwest Territories, West Indies, United States and Europe. § The 3 I 8 changes, using all points, result in 636 in/out items, II From published figures in 1963 Annual Reports, and letter from Bank of Montreal. C, Canadian Imperial Bank of Commerce; M, Bank of Montreal; R, Royal Bank of Canada; and S, Bank of Nova Scotia.

SOURCE:

s

R

0.070

0.127

Restrictive Organizational Features of Chartered Banks

103

an average of 9.7 such people for every 100 branches (or one such person per branch every ten years) makes it most unlikely that branches in the region are going to have, by means of interbranch transfer, personnel trained in lending to manufacturers. The modest rates of interregional transfer shifts the burden of the training task to the branch manager and the individual staff member. While several of the managers in the interview group appeared to have a well-developed intuitive approach to lending, their skills had grown to fit their own needs and did not appear to be readily transferable to junior staff members. Consequently, the training responsibility came down to the individual staff member who had to have considerable initiative to follow the correspondence or extension course for three reasons: (a) he has to be willing to give up some of his free time; ( b) he receives no direct rewards for successful completion of the program; and ( c) in most communities he has nowhere to turn for assistance. Personnel policies which result in the bulk of the bank recruiting being done at the high-school level, on-the-job training under the direction of branch managers, and limited reliance upon interprovince transfer are likely to result in a group of managerial candidates with relatively low technical competence and limited breadth of experience. 5 Probably the whole structure of Canadian banking is shaped by the fact that its ranks are made up almost entirely of people who have entered the employ of the banks in their mid-to-late teens; certainly such a recruiting policy is likely to lead, particularly at the branch level, to an absolute minimum of fresh thinking and challenge of established procedures, and these tendencies are compounded by a policy of almost total reliance on within-the-family training. For small businesses the consequences of these policies are an absence of constructive and imaginative counsel, non-technical analysis of credit applications, inappropriate lending criteria, and the distinct possibility of being saddled for several years with a branch manager whose only qualification is that, as beneficiary of the banks' general reluctance to dismiss personnel, he has enough seniority to become a 'country banker' - one who found that 'the directions in the Manual of Rules and Procedures spelt safety.'6 5 A 'resentful young bank officer' was quoted as saying that 'Canadian banks spend more on buildings than they do on people, and follow old-line personnel policies.' See 'Innovator at the Till,' Business Week (6 June 1964). Several recent university graduates have expressed, to this writer, resentment with several banks' 'orientation' programs which had them acting as tellers and counting and balancing cash for their initial three to six months of employment. 6 'Country Banker,' Bank of Nova Scotia Monthly Review, September 1958 reprint of a March 1935 article.

104

Institutional Financing of Small Business in Nova Scotia

Recently the banks have begun to make a concerted effort to improve the qualifications of their staffs. The Institute of Canadian Bankers (ICB) is supported by the banks collectively and operated under a board with representatives from all chartered banks, together with four representatives of universities. The ICB has established a three-phase training program, primarily but not exclusively for its non-university employees, offered by sixteen Canadian universities in 1967-8. The program includes courses in finance, business administration, management, and economic and legal aspects of Canadian business. There were 3,700 bank employees enrolled in 1967-8, and it was expected that 23 universities would have 5,000 enrolled in 1968-9. About 28,000 of the banks' 80,000 employees are males, and the expectation that 10,000 would eventually be enrolled (at a cost to the banks of $2.5 million) means that about onethird of the male employees ( one-eighth of all employees) will at some time be involved in this special training. Recognition of the inadequacy of current levels of bank staff competence sparked this move. A report in May 1968 said : 'It may be that the older bank employee without at least one special training course will be left behind in the scramble for management jobs by the new young breed.' At the same time, an officer of one of the five major chartered banks stated: 'If we maintain an accelerated on-the-job development program starting now, it will only provide 50 per cent of the trained people required to fill jobs we know about in the next five years.' 7 (This statement might arouse some apprehension about the quality of the banks' planning processes, particularly with reference to the quality of their forecasting on the future structure and operations of their organizations.) There appears to have been some modest progress in the field of recruiting as well. The Financial Post reported ( 1 June 1968) that the banks 'recruited on university campuses more vigorously in the past two or three years.' However, this increased effort attracted only 225 graduates in 1967, or less than one per cent of male employees. Furthermore, the report also pointed out that the banks did not expect to have more than 10 per cent of their 28,000 male employees 'drawn from the Universities for some time.' An estimate that 2 per cent of the male employees of the banks were university graduates was made in 1967 by the Chairman of the Institute; in other words, the university graduates recruited in 1967 represented an increase of 40 per cent in their number (from 560 to 785). With approximately one per cent 7 'Young Bankers Now Move Quickly Into Management,' the Halifax Chronicle-Herald (15 May 1968).

Restrictive Organizational Features of Chartered Banks

105

of their total labour force holding university degrees, the chartered banks differed substantially from the national average of 5.4 per cent of the labour force reported by the Economic Council of Canada for 1965. The ICB program is a step forward, as is the increased emphasis on university graduates. But one has to be realistic in forecasting the time that will elapse before a significant minority of Nova Scotia's branch banks will have ICB-trained university graduates as managers; even if the banks do put well-qualified people in the branches, there is a basic question of whether existing evaluation procedures will keep them effective. A major deficiency in the manager evaluation practices of the banks is that the promotable people within the banks, on the basis of the comments of those holding managerial positions, have no clear understanding of what actually constitutes merit. Consequently, those holding posts below the rank of manager have no clear indication of what they ought to do to become managers; those holding manager positions have no clear indication of what they ought to do to become managers of larger branches; and a general pattern of 'what-not-to-do-so-as-notto-be-dismissed' appears to develop. The general literature on Canadian banking contains limited reference to manager appraisal. It does indicate that profits are a factor in manager appraisal, since each branch is credited with income earned from loans and services to customers, and charged with interest paid to depositors and direct costs of the branch. If deposits are in excess of loans and necessary reserves, the balance is transferred to head office and the branch is credited with earnings from these investments. Alternatively, a branch with loans in excess of deposits 'borrows' funds from head office for an interest fee. Jamieson said that these income and expense accounts, plus a share of the bank's overhead, make it possible to 'ascertain with reasonable certainty whether the branch is operating at a profit or a loss.' However, if the branch manager is neither acutely aware of his profit responsibilities nor provided with data by which he can compare his performance with that of his peers, the profit rating he receives can have little influence on his performance. 8 If branch managers were 'profit conscious,' an intrasystem rate, as Horvitz suggested, could be used by the head office of the bank to 8 The Federal Reserve Bank of Boston's Functional Cost Analysis (1962) study indicates the potentialities in the field of bank accounting, and what might be done in the area of branch manager accountability for income, costs, and profits. See also the Federal Reserve Bank of Boston's Costs in Commercial Banking (1968).

106

Institutional Financing of Small Business in Nova Scotia

control the activities of branch managers: 'By setting a high intrasystem interest rate, the head office makes it more "profitable" for a branch to restrict loans and have interest credited to their account with the head office. In the opposite case, when the head office wishes to expand loans, it will simply set a low intrasystem interest rate. Now the branches will tend to extend loans rather than remit funds to the head office. ' 9 Indirect evidence of managers' lack of understanding of how they are evaluated has already been cited, principally in the form of widely varying opinions and practices on the subjects treated in the two preceding chapters. It is most unlikely that managers would vary so substantially in their views and practices if they had a clear indication of what was expected of them. Direct evidence is provided by their comments on the subject itself. When asked what constituted their most important duty, seventeen managers gave ten different duties (Table 5/2), and only four mentioned profits. 10 The following comments indicate the divergence of views on profits. A manager's job is to get profits, because his loans and deposit increases show up there. If a branch is making satisfactory progress it will show up in profits. And I think that the supervisors pay considerable attention to profits. I don't think there is any pressure on managers for profits. Because of their location and customers, some branches just don't have any loan demand. But generally, the important thing is to get deposits and loans.

In the process of commenting on profits several managers mentioned branch profit-and-loss statements and the transfer of funds between branches and head office. Generally, managers were reluctant to discuss the interest rates on such transfers, but one provided some details on the rates prevailing at the time: Right now we borrow from head office at 2.3 per cent and lend to them at 3.3 per cent. If a manager had enough deposits he could nurse them along, lend to head office at 3.3 per cent and pay 2¾ per cent on savings deposits. The surplus funds from branches may lead supervisors to turn down some requests because the supervisors know all the outlets the bank has for its money, and there may be better risks at 6 per cent somewhere else in Canada. 9 P.M. Horvitz, Concentration and Competition in New England Banking (Boston: Research Report to the Federal Reserve Bank of Boston, no. 2, 1968), p. 104. 10 While appreciating that some of the classifications possibly are overlapping, they were not edited out because it appears to be relevant that managers are so lacking in precision in defining their 'most important duty.'

Restrictive Organizational Features of Chartered Banks

107

TABLE S/2 Branch managers' opinions on their most important duty

Bank Most important duty• Make good loans and get deposits Make a profit c Perform up to own abilities D Be a good representative of bank E Keep loan losses low F Keep loans up, number of losses down o Not to take too many risks H Keep loans and deposits equal I Straighten out the mess here J Show an increase in volume of business K Don't know what it is A B

TOTALS



Total 6 4 3 2

1 1 1 1 1 1 2 23

A

B

C

D

2 1 1 1 1

1 1 2

1

2 2

1

7

1 1

s

1 3

1 1 1 8

Six managers gave two duties which they considered equally important, while eleven gave one important duty. The pairings of duties given by the six were : A•B, A•E, A-0• B•D, B-D, and F•JC.,

Probably the most significant comment of the entire interview program was made by one manager on the subject of loan losses: The single most important measure of a manager is his loan losses. If I came into a branch which had a profit of $2,000 and no losses in the previous year, and I brought profits before losses up to $12,000, but with losses of $5,000, I would get a very poor evaluation, despite the fact that my net profit was up by $5,000. This is the type of evaluation that has always been used and it will be very difficult to change, despite the fact that this is the way other businesses and finance companies operate. The officers and directors of the bank don't say - 'Good, this higher profit means higher dividends.' They say, 'We got an increase in dividends but think how much bigger it would have been if it had not been for those losses.' They don't realize that the increased losses are part and parcel of the increased profits. They can't accept the idea that more volume, which results in greater profits, is bound to result in greater losses.

Another comment on loan losses was that, while trying to 'keep loans up,' a manager should also try to keep losses down, and that the supervisor's concern was with the number rather than the amount of losses. 'If I had one big loss it would probably be viewed more favourably than many small ones.' The comments on the subject of accepting risk by making loans were made in response to questions about what duties were considered most important and least important by managers. The comments give a clear indication of the absence of positive pressures on branch managers. The following are representative comments:

108

Institutional Financing of Small Business in Nova Scotia

I think that a manager can take too many risks as well as too few, but the supervisor would be more likely to criticize the too many. The manager's personality and sense of responsibility to his community determine how much risk he takes. The real pressure to take risks comes from the manager himself. There is no need for us to make risky loans. We have all sorts of places to make loans and can always loan what we have to good risks. The only reasons for a manager to make loans is that he has an ambition to get somewhere. If he did not want to go anywhere he could sit on his hands. If he did a good job of holding savings where they were it would be OK because that would provide funds for branches elsewhere.

Exception was taken to the above views by only two managers. One said that exporting of funds rather than loaning them at some risk would only permit a branch to show a small profit. Another spelled out more dire consequences, saying, 'If a manager exports funds rather than lend them I think that shortly there'd be a new manager in the branch!' Three managers indicated a particularly vague concept of the requisites of a successful manager. To be successful a young banker should try to develop his personality and his ability to meet the public. I don't think he should work particularly at figuring out how to get deposits or how to make more good loans. He should develop his natural abilities and not try to make himself something he isn't. Then he should hope that the bank sees the speciality he has developed and puts him into a branch where he has to be good at meeting the public or lending. To be successful in banking a man should take public speaking, join service clubs, attend his church regularly, dress well and have enough formal education. That 'Fellow's Course' is good too. I am afraid that the young generation of bankers does not have the right attitudes to their work. They don't turn off lights they don't need, and they are reluctant to come down on Saturdays to inspect the premises and make sure that there are no loiterers on the step.

It is evident from the foregoing that the banks generally do not provide

their branch managers with a clear statement of what is expected of them, or of what constitutes superior performance. It is equally clear that the banks do give weight to profits in their evaluation of managers. However, only four of seventeen managers commenting on evaluation said that operating at a profit was their major obligation; three of these four also mentioned another obligation which they ranked as equally important; one manager went so far as to say that profits were not considered; and several managers indicated that they were not informed

Restrictive Organizational Features of Chartered Banks

109

as to the full cost of their branch operation. The absence of specific evaluation criteria, including the absence of constraints to maximize branch profits, results in a minimum of pressure on the branch manager to undertake the onerous and risky task of developing loan business, particularly loan business with a type of activity, such as manufacturing, which is new to him. Another aspect of the personnel problem has to do with older branch managers. Managers' comments on the differences among them indicate that a major personnel administration problem, which the banks undoubtedly bring on themselves by their recruiting, training, and evaluation practices, is in dealing with older managers. The comments of three managers are particularly relevant. I followed one manager who had retired and after looking the situation over, I concluded that he has just been coasting through his last years. For all practical purposes, he wasn't making any loans. Managers with five years to go to retirement take the easy way. Rather than jeopardize their position, they reject quite acceptable loans. At the same time, the young manager is probably too enthusiastic and will accept some that are too risky. At 55 a manager won't stick his neck out, but most young managers are aggressive. And the smaller the community the more conservative the manager. They know they aren't going anywhere and don't want to have things to worry about.

This last comment also offers further evidence of the absence of incentives for branch managers. Three officers of main branches also mentioned the problem of older managers. One said that some managers 'may be dying on the vine,' but that it was not often the case. In any event, it did not constitute a problem in that such a manager would be in a branch for only a few years before he would retire and be replaced by someone more competent. The second officer felt that 'deadwood' was a serious problem as the banks had 'no place to put these people except in the branches.' He also felt that the deadwood problem might continue for some years because of the cutback in recruiting during the depression years which reduced the number of people now available with the necessary background. The third expressed the hope that the banks would initiate programs to overcome 'the lack of manager development.' The major problem faced by the banks in dealing with older staff members is that they have few places other than branches to place them. Their loyalty to staff precludes the alternative of dismissal, and top management probably concludes that the 'safest' place for such individuals is in a small branch. Such men will get some volume of deposits

110

Institutional Financing of Small Business in Nova Scotia

simply because the branch is there, and their lending limits can be set so that there is minimum risk exposure for the bank. These people are astute enough to recognize that they are not going any farther in the bank, so they are disposed to 'nurse' the situation along until they retire. There is no short-run solution to a problem of this kind. It can only be dealt with at the recruiting, training, and evaluation stages over a period of time - by recruiting personnel for management positions, by training them in financial administration, and by indicating clearly what is expected of them. If the banks continue to emphasize recruiting at the high-school levtl, heavy reliance on a haphazard program of on-the-job training, limited employment of interregional transfers, and vagueness in manager appraisal criteria, the smaller communities of the nation will be faced with an unwarranted economic hardship, because they will be required to bear an increasing burden of managers with marginal competence or on the way to retirement. The small businesses of such communities will probably bear a relatively larger burden as these conservative managers use personal loans to fulfil their limited sense of obligation.11 The burden is likely to increase because the growth of cities and the increased complexity of banking and business will require more skilled bank staffs in the larger centres, while antiquated personnel policies and limited opportunity to exercise initiative will discourage competent young people from considering a banking career. The shame of the present situation is that the banks have done so little to encourage and develop the latent talent within their organizations. The ICB program will help, but for many it is too late. A limited supply of qualified personnel will ultimately push lending decisions further away from the location of the borrower's business activity, as centralization is used to compensate for weakness at the branch level. This, in turn, will result in lending decisions being based almost entirely upon past and forecast financial conditions. It has already been indicated that more emphasis on financial condition would be a favourable development, and one which would lead to the most efficient allocation of bank resources. However, several factors complicate the process if decisions are based upon financial condition and are centralized in regional offices: (a) the limited financial skill 11 Horvitz concluded that 'if a relatively untrained and inexperienced person is to serve as branch manager, some way must be found of minimizing the amount of discretion which must be exercised in his job. There is very little discretion involved in making personal loans ... Making the lending process as mechanical as possible means that the branch manager does not have to be capable of determining the quality of a loan application on his own.' See Horvitz, Concentration and Competition, p. 156.

Restrictive Organizational Features of Chartered Banks

111

of the branch manager and the small businessman will result in applications giving limited evidence of the firm's actual needs, condition, and prospects; ( b) notwithstanding removal of the interest ceiling, small business applications would be at a distinct disadvantage in competing for the limited resources of the banks with the more complete and skillfully prepared and presented applications of larger, lower-risk borrowers; and (c) unless all credit applicants completely bypass the branch manager, it is probable that many potential small business applicants would be discouraged from making a formal application by poorly informed branch managers. The inconvenience and consequent restraint on credit available to small business arising out of the need to apply to distant regional offices is obvious. The fact that the borrower may now bypass the branch manager who is not sympathetic to bis case is only relevant to the borrower who is aware of this opportunity; to expect a large proportion of borrowers to be aware of this is to expect them to know how the system functions as well as do the members of the banking fraternity. The personnel policies, particularly the vagueness of evaluation criteria, also indicate why managers can and do vary so substantially on the variety of subjects dealt with in this and the two preceding chapters. LOAN LIMITS

It was evident from the interview data that bank managers and supervisors employed different sets of criteria in dealing with loan applications in excess of managers' loan limits. It was also evident that use of these two relatively independent sets of criteria restrict the credit available to small business. The variation in standards arises out of managers' inability to communicate effectively their assessment of an application relative to their own criteria, and out of their inability to comprehend the means by which supervisors assess an application. From the branch manager interviews and Jamieson's work it is clear that each branch manager has a series of credit limits. There are two limits: 'discretionary limit,' up to which he can make loans without reference to higher authority; a second limit, 'reporting limit,' up to which he can make loans without prior reference to higher authority. Each of these loans, however, must be reported to the regional supervisor's office after it has been made; all loans above the reporting limit must have the approval of the supervisor's office before they are made. Again, the supervisor's office in each region has a discretionary limit and a reporting limit. All loans above their reporting limit go to head office where a special loan committee passes on them. Each manager

112

Institutional Financing of Small Business in Nova Scotia

has a second set of limits which applies to loans secured by collateral, and it appears that the discretionary limit on such loans is the same as the reporting limit on other loans. One manager explained how the two sets of limits could be used jointly. I can lend up to $2,500 on my own. From $2,500 to $7,500 I have to report after I have made the loan if it is unsecured or secured by inventory or accounts receivable, and over $7,500 has to be reported before I can make it. But I can lend up to $7,500 on a fully secured basis without reporting it, and from $7,500 to $15,000 I only have to report the fully secured loans. If a customer came in here and wanted to borrow $22,500 and had $15,000 in Government securities, I could lend him the amount and only report it to the supervisor's office.

Although there is no concrete evidence to support it, 12 the various comments made by managers indicate that virtually no manager can loan over $10,000 without supervisory approval, and that the great majority have reporting limits of $3,000 or less. Evidence cited below indicates that this was not likely to provide for most loans made to manufacturers, and it would probably be insufficient for most term loans which would likely be for relatively larger amounts than are advanced on short-term loans. The amount of the lending limit varies with the experience and competence of the manager, and the age and size of the branch. The actual distribution of loan approvals appears to be 90 per cent by the branch managers, 5 per cent by regional supervisors, and 5 per cent by head offices.13 The fact that 90 per cent of all loans are approved by branch managers appears to leave the majority of business loan decisions to the supervisory and head offices. As of 30 September 1960, 16.9 per cent of all bank loans were agricultural loans, averaging $1,457, and another 69.1 per cent were personal loans averaging $978. These two loan classifications accounted for 86 per cent of all loans, and the low average would indicate that virtually all loans of these types would fall within the managers' discretionary limit. 'Industry, commerce, investment dealers and brokers,' and 'government and public service' account for the remaining 14 per cent. Of the loans in these classifications, many would be 'fully secured' and within branch managers' higher discretionary limits for such loans, leaving most of the nonfully-secured loans to these borrowers to make up the 10 per cent of 12 Most branch managers were reluctant to discuss their lending limits and there is no published material on the subject. 13 See 'Bank Loans,' White Bulletin (January 1962) , p. l; Muir, The Canadian Banking System, p. 11; and A.B. Jamieson, Chartered Banking in Canada, Revised (Toronto: Ryerson Press, 1963), p. 151.

Restrictive Organizational Features of Chartered Banks

113

loan approvals not made by braneh managers. With 'industry and commerce' loans averaging $18,135, it is quite probable that virtually all of these applications must have at least supervisory approval.14 Branch managers indicate that within their own lending limits they seldom have occasion to reject credit applications. The CBA also indicates that branch managers seldom refuse credit requests, saying in a 1955 publication that 'the banks are anxious to say "yes" whenever possible, but they have to exercise due care because at all times they must be prepared to pay deposits on demand.' In all, twenty-eight branch managers commented on some aspect of credit rejections. Fourteen of sixteen managers commenting on the frequency of credit rejections said that there were few outright rejections but many compromises, one that there were 'many' rejections, and one that they were 'common.' Twenty-one managers suggested a total of twenty different reasons for rejections. Again, the diversity of the causes, both inter- and intrabank, and the lack of any clearly predominant cause are noteworthy (see Table 5/3) . In noting that fourteen of sixteen managers felt that rejections were rare, it should be kept in mind that these were managers who did not make term loans, made their loans on a demand basis, relied heavily upon the integrity of the borrower, loaned on historical data, and had alternative investment opportunities. With the types of credit they extend so narrowly circumscribed, a small number of rejections can only indicate that there are few applications for a wide range of types of credit. Only one manager said that credit rejections could be avoided by the borrower under specified conditions: Some borrowers get credit because they keep profitable current and/ or savings accounts - good deposit balances - and use other services of the bank. Some others are accepted because they generate goodwill towards us or prevent us from losing goodwill. We will take on unacceptable risks if we are pretty sure that turning down the loan would mean the loss of another profitable account. The manager who stated that rejections were 'common' said: Rejections of formal applications for credit are common, but there are probably more that are rejected before they get to the stage of a formal application. I do not think borrowers know what is acceptable to banks. If they did there would not be so many informal and formal rejections. 14 Data from 'Bank Loans,' White Bulletin (January 1962), pp. 2-3 . On the same date loans of less than $10,000 accounted for 96.4 per cent of the number of all loans outstanding. See 'Banking Statistics,' White Bulletin (May 1964), p. 3.

114

Institutional Financing of Small Business in Nova Scotia

TABLE 5/3 Branch managers' reasons for rejecting credit requests

Bank

Number of managers commenting on rejections Number offering reasons for rejections Number of reasons offered One Two Three Four Reasons

Poor financial and operating plans Inadequate equity Established borrower showing no progress New borrower without good record Too ambitious for skill and resources Unknown background Questionable management ability Excessive accounts receivable, inventory, and/or drawings Inadequate equity, if new Project not sound Poor working capital position Risk too high Inadequate security, prime rate now 6 per cent Cannot demonstrate ability to pay Inquire as to how much they can get Seeking more than they should get No experience in line of activity

Total

A

B

C

28 21

5 4

7

10

9

1 1

3

1

1

2 1 1 1

1 1 1 1 2

5 5 2

5 4 4 4 3 2 2 2 2 2 2 1 1 1 1 1

1

1

1 1

1

5 1

6

8

4

3

2 1 1

2

3

1 1 2 1 1

1 1

D

1 2 1 1 1 1 1 1

1 1 1

1 1

1

There were three significant comments by managers who said rejections were rare and compromises common: We can work something out either by reducing the amount or by finding some additional security. The major reason for so few rejections is that our people are so conservative. They are not willing to risk their money in something that has too much risk, so most of them come to the bank with something that is acceptable to us, although they may be a little light on their own investment. I think another reason is that some of them, particularly on personal loans, still have the Stephen Leacock attitude towards banks. 111

There are very few rejections because businessmen are sufficiently astute to restrict their applications to what they know are bankable propositions. There are few outright rejections and many compromises because the banks are willing to lend on personal background and possibly because the businessmen have a pretty good idea of what the banks will go along with. 15 Leacock related in a well-known short story the awe with which he entered a

bank to make a deposit, and the haste with which he 'fled' the 'pillared hall.'

Restrictive Organizational Features of Chartered Banks

115

The interesting aspects of managers' views on credit rejections are that they are rare and that they are rare because businessmen do not ask them to do things they cannot do. If most credit applications are acceptable in some form or other - lesser amounts and/ or more security 16 then it can only be assumed that (a) all loan applications which are received by the bank are of relatively low risk, which means, in turn, that credit is not available to many firms because they do not seek it; or ( b) that banks are willing to accept all risks and there is virtually no restriction of credit. The narrow range of types of loans which the banks make has already been indicated, so the most likely explanation is that (a) is true and that this situation prevails because many potential applicants believe the lending criteria of banks are beyond their capacity. If the impression which banks have conveyed is one of a conservative approach to lending, this impression, as much as the things they actually do, can restrict credit and give substance to the banks' contention that they meet the needs of small firms - they meet the needs of which they are aware. There is a marked consensus among managers that they employ different and more liberal credit standards than their supervisors (see Table 5/ 4). It is also clear that there are real differences between the approaches used by supervisors and managers. One manager who had experience in one small town, two cities in succession as accountant, another small town as manager, on credits in a supervisor's office, and was back in another small town indicated the inappropriateness of some of his experience: 'When I came here I had to change my way of thinking. Here personal contact produces biases, pro and con, which despite your best efforts, creep into your credit decisions. You may turn an applicant down and then be at a party with the fellow that same night. The city experience was good in the supervisor's office, but then when I came here I had to recall my days in my last small town.' Then he added his comments on how he, as a supervisor's office staff member, viewed managers : 'In a short time in the supervisor's office you get to know the managers as managers get to know their customers. Some make it sound bad, some make it sound good, some lie and some tell the truth. After I had been there a short time, I found my boss telling me to authorize credits which did not look good to me, and to reject others that looked good. In both cases it was because the supervisor knew the way in which the particular manager reported.' 16 Managers' opinion that compromises were common was not taken as an

indication of 'bargaining' for credit. Without attempting to make the distinction esoteric, the managers did not convey the impression that they saw this as bargaining. It was simply a matter of them asking for more security, or offering a smaller loan on the same security, or some combination of these. Possibly it is best described as 'unilateral bargaining.'

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Institutional Financing of Small Business in Nova Scotia

TABLE 5/4 Branch managers' opinions on supervisor and manager credit standards

Bank Comment

Total

A

Credit standards are the same Credit standards are different

3 28

7

14 14

s s

8 7 7 6 4 2 2

2 1 2 3 2 1 1

Reasons for standards differing

Managers are more liberal Supervisors lend on facts and figures Supervisors disregard the personality and character of the borrower Managers cannot communicate Supervisors have more information• Supervisors have more experience Supervisors are more cautioust Supervisors are less personal Supervisors have a different personality Supervisors will not lend to a new type of activity Supervisors follow the rules more closely Supervisors lend by formula Other comments by managers

There is a major communication problem Have had few or no rejections by supervisors Phone calls are few, initiated by supervisor



t

B

C

D

s

10

1 6

3 2

4 3

2 4

3 2 1

3 3

2

1 4 3 1

1

1

1

1

1

10 8

2 1 2

s

2 1

1

4 2

1

1 3 2

3 2

More information regarding conditions in the line of activity, and throughout the country . Included in ' managers are more liberal,' but an added comment by these four.

In all, thirty-one managers expressed opinions or made comments on the differences between supervisor and manager standards (Table 5 / 4) . Two of the three managers who felt that the standards employed by supervisors and managers were the same attributed this to their supervisors' confidence in them : one of these managers never had a credit rejected, and another could only recall having one credit rejected by his supervisor over the previous ten years. The managers who said that standards were different usually attributed this to their inability to provide the supervisor with the data upon which they based their own recommendations. The breakdown in communication appears to derive from limiting communication to writing. Two significant comments were as follows: The success a manager has with the supervisor depends upon how well he can write. He has to be able to get across his personal impressions of the borrower's character and ability. I think supervisors need to appreciate the importance of the personality and background of the borrower. I think we should be able to use the phone

Restrictive Organizational Features of Chartered Banks

117

more to talk these things over with the supervisor. That way we could get across more about these things. A branch bank manager across the street and I can agree completely on a borrower, and he might get approval from the supervisor when I don't, simply because he is better at bringing out the borrower's personality and background.

On the other hand, the communications problem was minimized by four managers of one bank which apparently had no reservations about use of the phone. One of these managers said: 'When I feel the borrower's character is significant I just pick up the phone and talk it over with the supervisor. I don't think that trying to put these applications all in writing is a very good idea. You can't really describe the personality and character of a man in writing.' Two managers who felt that supervisors loaned primarily on 'facts and figures,' to the exclusion of the borrowers' personality and character, commented: 'Supervisors lend by a sort of formula'; 'Supervisors' rules are too tight. They see everything in black and white with nothing between.' The officers of the main branches were asked to comment on the following statements with regard to the differences between managers' and supervisors' lending criteria. 1 Branch managers are more liberal than supervisors. 2 The reason for ( 1) is that supervisors lend on the financial statements and are not influenced by subjective appraisal of character and capacity. 3 Supervisors do not approve of managers using the telephone to elaborate on the subjective elements of a credit application. Three of the four officers agreed with ( 1), with two adding that this was natural because the function of the supervisor was to control the granting of credit. One officer disagreed: 'All supervisors have been managers so they see the problems of the manager.' However, he added that supervisors attempt to keep the manager from being too impressed with the person and more impressed with the facts. Two of three officers agreed with (2); the third stated that it would be the case with borrowers who were new to the supervisor, but that once the borrower was known to the supervisor he too would recognize the subjective aspects. Two officers also expressed the opinion that emphasis on character was much more prevalent in Nova Scotia than in central Canada and that, because of the lack of emphasis on financial condition, the average firm receiving bank credit in Nova Scotia was a poorer financial risk than its central Canadian counterpart. (Several of the small number of managers with experience outside the region made the same comment.)

118

Institutional Financing of Small Business in Nova Scotia

All four officers agreed with (3) . One added that this would be the case particularly before the supervisor had received any correspondence on the application; a second that the initiative might be taken by the supervisor to advise the manager what changes could be made in the application to make it acceptable. The branch managers' views were that they loaned on the non-financial aspects of the application and that supervisors loaned on the financial data, yet they contended that supervisors seldom rejected their requests. Neither group has any practical alternative to their bases for credit decisions because written requests for supervisor approval impede the communication of the nuance of borrowers' character, and, as evidenced by managers' comments on financial analysis, managers have limited ability to communicate on financial matters. Thus, the borrowers who seek credit over the limits of the branch manager's power of decision do so with the manager's approval only when they have satisfied his non-financial criteria; an applicant who might meet the supervisor's financial criteria may never reach the latter's desk because he has not met the manager's criteria. Thus, managers and supervisors approve credit applications from borrowers who are well established and have a satisfactory financial record. The obvious conclusion is that the small number of credit rejections at both the manager and the supervisory level most probably mean that the lower limits of their respective credit criteria are not being tested; that is, there is an area between what is accepted and what is acceptable which is not being used. Assuming that Nova Scotia businesses constitute a broad, continuous risk spectrum, some firms with acceptable applications are not reaching the desks of branch managers, branch managers are not forwarding some acceptable applications to supervisors, and credit is being unnecessarily restricted. It seems probable that, if branch managers were given more specific encouragement to maximize net profits, they would in turn encourage all applicants to make themselves known. The number of rejections might increase appreciably, at both the manager and supervisor level, but it is equally probable that many additional businesses would be serviced with bank credit, without significant increase in risk to the banks. The fact that managers' requests for supervisory approval are seldom rejected, given that their criteria differ from those used by supervisors, indicates that managers' non-financial criteria may be so selective that they coincidentally screen out all who would not meet supervisors' financial criteria. If this is not the case, then the growing small firm can face a peculiar problem. In its early stages such a firm probably would be borrowing within a manager's reporting limit on non-

Restrictive Organizational Features of Chartered Banks

119

financial criteria; however, as its borrowing needs grow with its business, it moves beyond the reporting limit and has to meet a different set of criteria. The possibility exists that in the latter case it will be refused credit when the only change in operations is a modest increase in size; that is, small firms which have become dependent upon bank credit may find it unavailable or restricted as they grow and this experience could lead to hesitation by some businessmen who would otherwise consider expansion. In the short run, managers' and supervisors' criteria could be made more similar if branch managers were encouraged to describe the nonfinancial aspects of applications by phone. Something approaching unified criteria would have to wait until managers become more competent financial analysts. Testing of credit criteria by both borrowers and branch managers will require more aggressive business and branch management; the latter, in turn, will require more selective recruiting, better training, and profit oriented performance criteria which are clearly understood by branch managers. If these requirements are met, it is reasonable to suppose that lending authority could be decentralized, thereby (a) reducing the communications problem by reducing the amount of communication required, and ( b) facilitating the negotiations between borrowers and managers. Until such time as branch managers are better qualified and more aggressive that at present, decentralization of lending authority offers no advantage to the small business. Note should be taken of a recent practice, introduced by several of the banks, giving more authority to regional offices, undoubtedly to reduce the administrative bottlenecks caused by the previous degree of centralization. Such decentralization has the potential to make bank policy more responsive to regional needs, if there is decentralization of head office decision-making responsibility; however, the so-called decentralization to regional offices might be in fact a centralization of branch management responsibilities. If regional offices have increased responsibility by virtue of assuming some administrative functions previously performed by head offices and responsibility for approving somewhat larger loans, and by assuming some functions previously performed by branch managers, including responsibility for larger loans previously approved by branch managers, then we have both decentralization and centralization. Consequently, decentralization to the regional offices from head offices, if accompanied by centralization to those offices from branches, could result in the banks becoming more responsive to regional needs in general at the same time as they become less responsive to particular (smaller) communities' needs.

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INTERBANK COMPETITION

Interbank competition is relevant to the availability of credit to small business in four particular ways. If there is an absence of interbank competition, (a) there is a minimum of pressure on the banks to initiate new types of customer service and to seek new customers; ( b) there is a minimum of pressure on the banks to develop personnel policies which will produce aggressive branch level management; (c) the centralization of significant lending authority becomes acceptable because of the insignificant consequences of delayed and/or negative decisions; and (d) the removal of the interest ceiling is undesirable because it will result in an opportunity for the banks to levy unreasonable rates on those types of lending where they have a virtual monopoly. It would be presumptuous to contend that the absence of interbank competition can be established conclusively. For current purposes all that can be offered is a sketch of the evidence which indicates that it is probable that there is not intense competition, particularly in seeking lending opportunities among small businesses. This evidence derives from an examination of (a) the capital supply and demand situation in Canada; ( b) the development of Canadian financial institutions; ( c) the concentration of banking; (d) the basic 'sameness' of the banks; (e) bank advertising; (f) low and slow rate of innovation in bank services; (g) Hodgman's customer relationship concept; (h) the tendency of bank customers to confer a monopoly on their bank; and (i) branch managers' comments on the subject. Of some consequence is the fact that another writer also concluded that there is less interbank competition in Canada than in the United States. Donaldson commented: It is ... impossible to make any categoric statements about the extent of competition [between Canadian banks] as compared with the United States. It can only be expressed as a personal opinion that there is less competition in Canada. There is certainly less evidence of innovation to meet changing needs of business and less evidence of the 'hustling' for new accounts. There is no doubt that the individual small business loan means more to the unit bank than it does to the national branch bank. This does not mean, however, that the Canadian bank is not interested in small scale loans nor that the different banks do not compete for these loans - it is rather a matter of degree. 17

Many of the items of evidence noted above do not need lengthy treatment. The Canadian economy has been a substantial importer of capi17 Gordon Donaldson, Financial Management in the New Small Scale Manufacturing Enterprise (doctoral thesis, Harvard Business School, 1955), pp. 22-3.

Restrictive Organizational Features of Chartered Banks

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tal for several decades. Given the excess of demand over the supply of domestic capital, it is most likely that the chartered banks have had demands for credit far in excess of their resources, and could be highly selective in their lending. This situation, in turn, would lead to competition for deposits but make competition for loans superfluous. Three developments in financial institutions are significant in the fact that they are recent. The first of these is the development of noticable competition for deposit accounts, particularly from mortgage loan companies, trust companies, caisses populaires, and credit unions, a matter to which the CBA'sSubmission to and testimony before, the Porter Commission paid particular attention. Second, it is only within the past eight to ten years that there has been significant competition for nonfinancial corporations' idle cash balances, particularly from consumer and industrial finance companies' issues of short-term promissory notes. Third, it is only within this same period of time that there have been any competing suppliers of credit for small business and, as will be noted in chapters 7 and 8, these are developing slowly. Thus, there is only recent evidence of competition for deposits, primarily from nonbanks, and little significant development of alternative lenders. Consequently, Canadian banks seem to have had a minimum of the ambivalent attitude that the ABA attributes to United States banks. 18 While the latter have alternating problems of obtaining deposits and earning assets, the Canadian banks' problems are of recent origin, and only significant in the area of deposits. If bank ownership concentration is indicative, 19 then there is a low level of interbank competition in Canada. The country has eight banks, down from ten 15 years ago, and four of these eight have 80 per cent of all bank assets and 7 5 per cent of all branches. The 'sameness' of the banks is reflected in their historically identical rates on deposits, loans, and services, in the recently established ICB, and in their practice of having the CBA speak for them as a group. It is one thing to have a 'trade association' speak out on common problems 18 Notes from the Commercial Banking Industry, Monograph Prepared for the Commission on Money and Credit (Englewood Cliffs: Prentice-Hall, Inc., 1962), p. 18. 19 A United States study has questioned the adequacy of concentration ratios as a measure of competition. However, the factors which lead to the questioning of such ratios in the United States are largely non-existent in Canada. See 'Measures of Banking Structure and Competition,' Federal Reserve Bulletin (September 1965), pp. 1112-22. Also, see 'Competition in Banking,' Federal Reserve Bank of Chicago, Business Conditions (February 1967) for an excellent review of twenty-one studies on interbank competition and arguments for branch and unit banking. The review concludes that the influence on competition of a variety of factors is still not established.

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of its members, but quite another to have it as virtually the only voice heard from the banks. In an attempt to get some indication of advertising practices and the innovating activities of the chartered banks, in 1962 a letter of inquiry was sent to the public relations offices of each of the four survey banks, and a perusal of advertisements in a Nova Scotia daily newspaper and a weekly national business newspaper was made. Hood commented that 'bank advertising tends to concentrate on the deposit facilities rather than the lending facilities provided.' 20 and this was supported by the perusal of the newspapers. The only loans advertised were the personal loan programs of the chartered banks, with the exception of one bank which advertised that: ' ... When you ask for

a loan at the - - - , you do not ask a favor ... if your proposition is sound and reasonable, there's money at the---.' The advertising copy is still of essentially the same nature, with one bank (a different one now) mentioning business loans; the significant change is in the very substantial increase in advertising of personal loan programs, deposit-savings facilities, and interest rates on savings deposits. The responses to the letters of inquiry indicated that the banks advertise all of their services, but the emphasis was, on an overall modest scale, on deposit accounts and instalment loans to individuals. Two of the four banks indicated that they virtually never advertised business loans, while two others contended that they advertised business loans 'often.' However, one of these latter two added that 'the subject of the advertisements is general, with type of security not specified.' The other bank in this group of two indicated that it advertised all of its business loans 'often,' by means of in-bank displays, metropolitan and national newspapers, and magazines. Despite these contentions the fact remains that the author was unsuccessful in finding such advertisements at that time, and they were still relatively inconspicuous seven years later. Table 5/5 indicates the new services which the banks declared that they initiated in the 1934-62 period. Excluded from the table are those loan programs initiated by federal legislation - Farm, Home and Fisheries Improvement Loans, and SBL Act loans. In all, thirteen new services have been added by the banks collectively between 1934 and 1962; six have been added by all four banks. Six of the new services are related to deposits, and seven to loan accounts. Of the loan accounts, four are in the high-yield personal loan area, while the other three provide assistance in paying university fees. 20 William C. Hood, Financing of Economic Activity in Canada (Ottawa: Queen's Printer, 1958), p. 389.

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TABLE 5/5

New services added by four chartered banks 1934-62 Year added by bank Service

C

Demand accounts with prepaid cheques 1957 1953 Christmas club 1954 Drive-in tellers• Walk-up tellers• No After-hour depositories• n.a. Automatic savings plan with life No insurancet 1936 Personal loans with life insurance 1954 Automobile loans 1954 Pleasure boat loans Home appliance loans 1954 n.a. Students' loans of one year or less Students' loans due after graduation 1964 Education (parent borrower) loans 1962

M

R

s

No No 1950 1957 1954

1955 No 1963 No 1949

1957 No No No 1955

No 1959 n.a. n.a. n.a. n.a. n.a. 1962

No 1962 n.a. a.a. n.a. 1961 1961 n.a.

1954 1958 1958 1958 1958 No No n.a.

C, Canadian Imperial Bank of Commerce; M, Bank of Montreal; R, Royal Bank of Canada; S, Bank of Nova Scotia. • Selected branches only. t One other bank offers an automatic savings plan, but without the life insurance feature. No, indicates the service is not offered. n.a., indicates that the service bas been added since 1934, but the bank did not specify the date.

KEY:

In the context of the services that have been added over a span of thirty years, the comment of the ABA is interesting: 'It should be evident that the commercial banking system is ... an industry which, under the spur of competition is constantly devising new ways of serving its customers.'21 The innovating characteristics of chartered banks have not indicated a sharp spur, although post-Bank Act innovations in deposit accounts are encouraging. An absence of competitive zeal in the area of small business lending is particularly likely if one accepts Hodgman's 'customer relationship' concept.22 Of the three means by which a borrower might provide a bank with revenue - a deposit balance which will support earning assets, a loan, and other bank services - the small business is typically a net borrower (see Table 1/5), and is in a position to provide only loan revenue. Further, the presence of the interest ceiling precluded an interest rate on the small business loan which would compensate the bank for the revenue it did not have an opportunity to earn on a significant deposit balance and provision of other bank services. Thus, con21 Notes from the Commercial Banking Industry, p. 18. 22 Donald R. Hodgman, Commercial Bank Loan and Investment Policy (Champaign: Bureau of Economic and Business Research, University of Illinois, 1963), particularly chapters x and XI.

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ditions restricted the profitability of the customer relationship with the small business, and made his 'account' relatively unattractive. 23 In an unindustrialized area comprised, for the most part, of small towns, it is quite possible that a majority of bank customers minimize the incentive for interbank competition by providing banks with a monopoly. According to a Federal Reserve Bulletin article: Everything we have seen leads us to believe that a large share of customers of banks - particularly personal customers - are so tied to an individual bank office by reason of convenience, habit, and the like as to convey an important degree of monopoly to their banker. We would like to focus attention on those bank customers (perhaps a minority) who respond to variations in the cost, type, and quality of services among banks ... This 'marginal group' of customers is important ... because its actions may induce changes in the forms and avenues of rivalry among banks. 24

Since the majority of small businesses could rightfully be added to the 'personal customers' of a bank, and since these customers are unlikely to be particularly responsive - in part because they do not know of anything better - the conferred monopoly minimizes any pressure for aggressive competition and makes its potential rewards, in terms of the number of new customers and the revenue potential of such customers, modest. Alternatively, if the banks had a long-run profit orientation, they could regard their monopoly type relationship as a substantial incentive for supporting the viable small business: bank support of the small firm through its growth stage could ultimately produce a very profitable and loyal customer as the small firm prospered. It is to be expected that the banks deny any suggestion that they are not competitive. The Macmillan Commission of 1934 concluded that there was 'a degree' of competition 'even between branches of the same bank ... Only in the field of interest rates have we found evidence of 23 An article in the Federal Reserve Bulletin ('Research into Banking Structure and Competition,' November 1964, p. 1395), contends that Hodgman's concept 'probably becomes progressively less applicable as one moves to the less prestigious customers who are the "bread and butter" of the banking business.' It offers nothing in support of this contention. It would appear that such customers could be the 'bread and butter' for a United States bank which was not restricted by an interest ceiling and could compensate for a relatively unprofitable loan relationship by charging higher interest rates. The removal of the interest ceiling, by itself, does not generate the large demand deposits, which 'on average ... are the most profitable component of bank operations and easily cover the cost of additional services provided large business customers.' See 'Large Firms and Their Banks,' New England Business Review (December 1968). 24 'Research Into Banking Structure and Competition,' pp. 1396-7. A later study, 'Large Firms and Their Banks,' reported that 'once a choice is made, a banking connection is seldom broken: the frequency appears to be on the order of 1 % per year for large concerns.'

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common policy.' Hood reported 'keen competition' among the banks, but said that 'it takes the form more of competition in service for loans and deposit accounts rather than price competition.' The CBA attributes the high ratio of banks to population in Canada to competition, and says that the 'compelling force' behind the search for new branch locations 'is competition for deposits, loans, revenue and a desire to fill the banking needs of the Canadian people.'25 There was nothing in the CBA Submission to the Porter Commission to suggest that banks compete with one another in small business lending, 26 nor is there any such evidence in branch managers' comments. The only type of competition, as such, which managers commented upon was competition for savings deposits. They also made comments on the differences between banks and on the activities of other lenders, but they did not appear to view either as competitors. In fact, only eight managers commented on competition for savings deposits, all of them saying that they felt it to some extent. Three managers identified trust companies, three identified mortgage companies, and one identified credit unions as the competing institutions. It has been suggested frequently that borrowers might be well advised, upon being rejected by one bank, to take their credit application (in most Nova Scotia settings literally) 'across the street.' An effort was made to determine whether and why this was likely to be successful. Thirty managers commented on the differences between banks, twenty-three of whom felt that there were differences while seven felt that there were none. However, of the twenty-three who thought that there were differences, fifteen said that the only differences arose out of the differences between managers; that is, that the differences were only at the branch level and were related to the manager rather than the bank he represented. Two representative comments were as follows: Nine out of ten requests transferred across the street get what they want, but I think it would be the same if the borrower went to another branch of the same bank. The only difference is in managers; in their personalities, temperament, mood of the day and prejudices, and this makes one manager accept what another rejects.

Banks generally make the same kinds of loans, but some managers can see something attractive, or a way of getting added protection, that another manager won't see and they'll make the loan. 25 'Heavy Silence From Banks,' the Financial Post ( 19 January 1963) . 26 See Submission to the Royal Commission on Banking and Finance, the Canadian Banker, Supplement (Spring 1963 ), pp. 81-3, for a description of competitive practices.

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Six other managers thought that the managers accounted for most of the difference, but gave at least one other reason as well, including bank policy, age of the branch and age of the manager. Only two managers did not attribute any part of the differences to managers, both saying that differences existed only at the branch level and that they arose out of differences in the time the particular branch had been in the community. Branch managers also commented on interbank competition as such, with five managers saying that competition had no bearing on their activities and six saying it had. One of the former group said that if a loan was not acceptable he would not make it, regardless of the circumstances. Another manager, also quite unmoved by pressure, said: 'It doesn't matter if you lose an account or goodwill with the borrower's friends. If you don't feel you can make the loan, you don't.' Four of the five managers who felt that competition had an influence on their decisions referred to its effect on eliminating overdrafts. One of these said that overdrafts would not be ended until all of the banks acted at once - 'You let them continue rather than risk losing a customer.' One of this group of five also stated that a customer who did a significant amount of business with the bank could 'pressure the bank into making a loan' to the customer or his friends. Several managers were asked how banks competed for new customers. Two comments on the subject were as follows: I compete for new business by keeping my staff on their toes to solicit new accounts and by canvassing potential business depositors. I'd talk to another bank's customers, but mostly I'd make sure that when established firms open a branch here, I got their account. But you don't go out showing customers where they could benefit from more credit. You compete for business with your services. You try to give better and more attractive service to your customers than the others do. You try to meet your customers, and try to describe your services to any new firms opening up. It's sort of an established rule between banks that you don't go to another bank's customers and suggest you could do more for them. But if one of my customers tells me about a friend having a problem, I'll suggest that be send him in.

Eighteen managers commented on other lenders, with fourteen who mentioned the amount of activity of other lenders equally divided between those who thought others were active and those who thought they were not. The eighteen managers made reference to a total of fourteen different lenders (Table 5/6); and four of six managers who mentioned referring applicants to others said they did so, while the other two did not. Three of the four managers who criticized other

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TABLE 5/6 Non-bank lenders mentioned by branch managers Lender Industrial Development Bank Mortgage companies Industrial Estates Limited Individuals Other lenders, unspecified Unspecified mortgage lenders Industrial Acceptance Corporation Oil companies Equipment finance companies Unspecified long-term working capital Factors Eastern Canada Savings & Loan Trust companies

Number of managers 12 4 3 3 2 1 1

1

1

1

1

1 1

lenders directed their criticism against IDB, because of its allegedly 'excessive security requirements' in each case. The major characteristics of managers' comments on other lenders were vagueness and questionable accuracy; of the entire group of eighteen managers, only one indicated an accurate knowledge of the situation. One manager in Halifax 'thought' that there was an IDB office in the city - there had been for five years. Another manager 'thought' there were sources of long-term working capital credit, but did not know what they were. Referrals, in actual practice, appear to be of little value. One manager said that he would suggest to an applicant with real estate to offer as security that 'he borrow on a mortgage,' but he did not know where the applicant might do so successfully. Another manager would send applicants with low working capital ratios to IDB, but he had never sent any. A manager who would not refer borrowers said: 'I never refer a borrower to another source. I make the loan or say nothing.' There is little to encourage a suggestion that small businessmen seek out their branch managers when they need financial advice, suggestions, or evaluation of alternative sources of credit. The branch bank managers were conscious of only one type of competition - that provided by non-banks in the savings account field. Managers' comments on other banks were virtually devoid of any mention of competition, except for the immediate problem of overdrafts. And any success in going 'across the street' can be attributed to the varying criteria of managers, rather than to significant differences in banks' lending criteria or concern with obtaining new accounts.

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Institutional Financing of Small Business in Nova Scotia

Granting that most other lenders are not directly competitive with the banks because of the formers' emphasis on mortgage lending, it appears that any competent businessman should be aware of 'near substitutes' for his 'product.' The lack of concern for competition from other banks can only be explained in terms of what the branch managers must hear on the subject from their head offices and experience in their work, that is, little or nothing. Just prior to and since the implementation of the 1967 Bank Act, the principal aim of which, according to the then finance minister, was 'to achieve a more competitive atmosphere in banking,' there have been several interesting statements on competition in Canadian banking. Mr John H. Coleman, speaking in his capacity as president of the Canadian Bankers' Association, expressed a view in June 1968 which is typical of those who are associated with the chartered banks. He said that to think that the Bank Act of 1967 'spurred the banks into competition is a serious misreading of the situation. The Act released the chartered banks to do the things they have been wanting to do for some time. Legislation did not create the energy for change. The rapidity of recent change testifies to the pressure that had been built up.' The definition of 'some time' is but one of three contentious points here; evidence cited in this and earlier chapters suggests that major concern for being 'released' did not significantly antedate the 1960s. Secondly, the changes are, as already indicated, largely in the areas of personal deposit and loan accounts and of modest discernible benefit to small business. Finally, increased 'hard sell' advertising to the general public should not be automatically equated with competitiveness. Also, there is a question of the type and nature of hindrances the banks thought existed. An article in the Globe and Mail (5 February 1969) reported that 'a number of executives of the larger chartered banks feel that the key to taking the maximum advantage of the profitmaking opportunities opened by the 1967 Bank Act is innovation.' To suggest, as many comments have, that revisions had to be made in the 1954 Bank Act before innovations were possible is indicative of, at best, peculiar assumptions concerning the coverage of the Act. Certainly the removal of the Bank Act interest ceiling makes many previously unattractive activities profitable, but unimaginative management should not be confused with constrained management. One student of Canadian banking has probably accurately forecast the intermediate and longer-term consequences of the revisions. Will the structure of Canadian banking be more competitive a decade hence? No one can say for sure at present. On the balance, it seems probable that there may be some increase in competition in banking as a whole.

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129

To a considerable degree this probability seems to depend on the attitude of the banks to inter-bank competition. With only five major banks in operation it is conceivable that after the profit opportunities opened up by the new legislation have been exploited, the willingness to compete actively with each other may diminish. 27 The evidence in support of a conclusion that there is a lack of aggressive interbank competition for loans is circumstantial: the traditional environment in which the banks have operated is not one which would necessitate strong competitive measures, and the manner in which the banks have operated indicates far more concern with attracting deposits than with attracting commercial borrowers. The absence of aggressive competition between banks for loans results in a tendency to do only those things which have been done in the past for the same type of people, resulting, in turn, in restricted availability of credit for all applicants who have a 'different' problem or who are new to the bank. Interbank competition at the branch level is the critical matter insofar as small business credit is concerned. Competition at that level appears to be tied to removal of the interest ceiling. The banks, relieved of the interest ceiling, will be able to allocate credit on a price basis, and be provided with an opportunity to finance industry in the slowergrowing, higher-risk areas such as Nova Scotia. However, to do this with a reasonable measure of safety they need skilled managers. The skills required if such credit is to be available to viable small businesses, old or new, are distinctly different from those which managers now have. Such skills can be provided by doing more recruiting further along in the educational system, by increasing the rate of interregional transfers, by utilizing off-the-job training and management development programs, and by clearly indicating to their staffs the criteria by which they are evaluated. If skills are developed, individual managers can be entrusted with higher lending limits and this would result in better recognition of any peculiar local conditions bearing on credit applications. Superior skills would also permit decentralization of responsibility for competitive activity, which in turn would permit individual branches to be more responsive to local conditions. 27 Grant L. Reuber, 'Revisions in Canada's Banking Legislation,' the Business Quarterly (Spring 1968) , pp. 42-3 .

6 Interviews with Senior Regional Officers of Three Chartered Banks

After the branch managers and the officers of the main branches had been interviewed during the summer of 1961, the data gathered were examined and a list of tentative conclusions and recommendations was prepared. These were presented to one member of the senior regional management of each of three of the four survey banks in the summer of 1962. (No senior officer was available at the fourth bank.) These officers were asked to give their reactions to the material presented. TENTATIVE CONCLUSIONS

1 Institutional credit is currently available for most foreseeable business purposes and terms, with the exception of refinancing, and most businessmen are satisfied with the credit available to them. All three officers agreed with the first conclusion. Officer A added that there was full coverage of needs when all possible funds suppliers were considered. Officers B and C suggested that businessmen should be satisfied since they both were convinced that businessmen generally received more bank credit in Nova Scotia than was the case elsewhere, B adding that businessmen might well be receiving more credit than they were actually entitled to. (The pattern of bank personnel with experience outside the region expressing the view that the banks more actively supported firms in the region has been noted already.) 2 Businessmen are generally poorly informed of the lending services and criteria of financial institutions. This situation affects application-

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131

rejection ratios and lending criteria of lenders and artificially restricts the availability of credit. The point here was that the businessman's ignorance restricts credit applications to those who think they have 'bankable' requests, thus inflating the success to application ratios of the banks; and that lenders develop criteria which reflect the credit applications they see rather than all credit needs. This conclusion met with a widely mixed reception. Officer B felt that businessmen were quite well informed on what the banks would do for them, and that the small number of rejections was evidence that they knew the acceptable criteria quite precisely. He thought that, if there were more applications, there would be a proportionately larger number of rejections. This officer also thought the businessmen were constantly testing the lower limit of bank lending criteria, and that he, consequently, had to spend a great deal of his time examining credit applications which were marginal and generally unacceptable to the bank. He was also of the opinion that the existence of regional supervisory offices reflected banks' recognition of diflerences in borrower characteristics and lending operations by region. The most striking aspect of this particular officer's comments was his view that there were no credit needs with which borrowers did not approach the banks. Officer A agreed that potential borrowers might overestimate banks' credit criteria frequently, and felt that there was no other likely explanation of the small number of credit rejections mentioned by managers. (However, he was not happy with the suggestion that managers reject applications solely to protect borrowers from themselves. He thought that it would be very difficult for managers to do this without disclosing information of a confidential nature; e.g., that firms in the line of activity under consideration were not doing well in the area.) Officer C thought borrowers knew which types of credit banks would provide, but that they were not well informed on what banks expected of borrowers. He remarked that he had never thought of the possibility that there were few credit rejections because borrowers overestimated banks' credit standards, or of the possibility that, consequently, banks did not see a representative sample of small business credit needs. He did feel that this could be the case, and that banks could be underestimating the credit needs of small firms. 3 Small business in general, and new firms and manufacturers in

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Institutional Financing of Small Business in Nova Scotia

particular, cannot expect experienced or constructive financial counsel from the lenders currently operating in Nova Scotia. Officer A conceded that businessmen get little constructive counsel or guidance. He felt that it was not a part of the banks' responsibility to refer rejected applicants to alternative sources of credit, and that the banks did not want to do this because of the possible loss of goodwill from referring an applicant to a source which cost more than the applicant anticipated, or a source which would not meet the borrower's needs as he ( the borrower) wanted them met. Officer B disagreed completely with this conclusion. He said that when the borrower was willing, and where the amount was not 'trifling,' he could come to the supervisor's office. In the supervisor's department, he thought, the borrower could receive all the experienced financial counsel he would require. However, he pointed out that this would first require the approval of the manager concerned; thus, no opportunity is provided for credit applicants who cannot obtain a manager's recommendation. This officer was also quite convinced that it was not a function of the banks to provide advice for businessmen. 'Banks shouldn't meddle in the affairs of the business or tell the businessman how to run his business.' He pointed out that the banks keep a particularly close watch on firms that have become stagnant, because this is viewed as the prelude to difficulties with outstanding loans; however, the banks did this to protect their loans rather than because of any concern for the welfare of the business per se. His reasons for not wanting to give advice to the businessman, despite the fact that he recognized that competent counsel could lead to success for the business and more business for the bank, were that the banks should not be in the business of giving advice, that the borrower probably needed equity capital which the bank could not provide, and that the banks had no shortage of alternative outlets for their funds. Officer C agreed that there was a lack of experience and competent financial counsel. It was at this point that he said that it was clear to him that his bank's major problem in the area was the lack of competent branch managers. He attributed the managers' lack of ambition and the absence of any responsiveness to incentives to the age of the managers and their recognition that they were not going any further in the bank. He also felt that a major reason for the managers' lack of aggressiveness was that many of them had obtained much of their initial experience in the 1930s, and that the difficulties of that period had carried over to the present to make them conservative lenders.

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4 Five major factors influencing institutional lending to small firms are: (a) lack of competition; (b) lack of skill and experience among lending officers; (c) personalized lending criteria; (d) weakness of incentives for market area development; ( e) the existence of more favourable investment outlets outside the market area and in other types of credit. All three officers disagreed with the conclusion that there is a lack of competition. Officer A felt that there was substantial competition among the banks. He visualized it as taking the form of providing services appropriate to the customer so that he would not consider shifting to another bank. 'Anyone who says that there is no competition between banks doesn't know what he is talking about.' He would not acknowledge the possibility that customers could be attracted from one bank to another which would provide a larger loan on the same security offered to the first bank. In effect, he saw competitive effort as attempting to provide quick service, providing credit under relatively informal conditions, and making it easy to arrange for credit. Officer B said that competition between banks took the form of extending more credit on the same security, or the same amount on less security, than you thought a competitor would extend. He said that managers know that their customers frequently can turn to another bank and have their credit needs met, and that they have to anticipate what other banks will do and match their action in order to keep their customers. He did not think that 'better service' was the only form of competition, unless that included granting more credit on the same security. He also said that managers were advised to seek out the promoters of any new developments in their areas, but explained that they were then to pass the information on to the head office which would follow up by approaching the head office of the national concern involved in the development. He did not indicate any emphasis given to local promoters involved in new developments. In general, he was of the opinion that competition was intense and he did not qualify this view. Officer C stated that competition is 'really too keen.' However, he conceded that incompetence at the branch level might very well result in managers not seeking new business and not being responsive to incentives to make a branch grow. Lack of skill, in his opinion, substantially limits the ways in which managers attempt to compete. He also said that the relevant consideration was what the individual manager would do for a borrower - not what the bank may be willing to do;

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Institutional Financing of Small Business in Nova Scotia

thus, when the would-be borrower is rejected or discouraged by the branch manager, the borrower is likely to abandon the proposal. In general, it appears that the banks think that there is significant competition among them, and it also appears that there is real competition among the larger branches in the cities and among the banks at top management levels. However, the type and amount of competition at the small branch level does not necessarily match what occurs at the largest branches, or what top management of the banks would like to think occurs at the smaller branches. As has been pointed out already, managers can neither explain what they mean by competition, nor offer examples of it. If there is competition at the small branch level, it takes the form of better service, with little emphasis given to credit extensions. All three officers agreed that there was a lack of skill and experience among lending officers. Officer A attributed this to the rapid growth of the banks and the demand for branch managers and head office personnel in central Canada: 'We don't have enough qualified people for the jobs that are open.' He added: 'We are not going to put a qualified person in a position here when there is more demand for his skills elsewhere. Some of those we transfer to central Canada come back to this region, but most of them stay there where the need is greatest.' He also referred to the problem of personnel without significant qualifications but with significant seniority. 'What are we going to do with them? We need managers in these places and they are the only ones available.' Officer A thought that another reason for the lack of skilled personnel was that their initial training had been the responsibility of accountants and managers under whom they worked; he did not feel that this sort of training prepared them for credit work. Finally, he thought that many of the current managers had joined the banks in the early 1930s and that the conditions at that time accounted for their conservative attitudes. He saw no way of overcoming this. He was aware also of major problems in communications between supervisory officers and branch managers, saying that much of the information reaching branch managers was either not read or read but not understood. He said that the lack of broad experience resulted in many managers having wide areas of potential activity where they would not venture because they had a natural fear of the unknown. It was Officer B's opinion that the major problem was lack of experience rather than lack of skill, and that the rapid growth of the banks had forced them to use young men as branch managers. Such men would make mistakes, but the branch would not stagnate under

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them because they had 'upward mobility.' He thought that young managers should have frequent telephone communication with their supervisor's office because this provided a means of obtaining experienced counsel. He said that written communications with managers could cause problems because some of the managers are naturally more conservative than others. When they were told to 'cut back' on lending activities they frequently overdid it. He thought that all communications with managers should reflect the supervisor's knowledge of the personality of the individual manager. Officer C also felt that there was a lack of skill and experience, and added: 'But what do you do when you discover, after the appointment of a manager, that he dies on the vine?' The remark is interesting in that it reflects the absence of effective definitive criteria for manager selection, and in that it does not consider the alternatives of dismissal or demotion. Officer A agreed that managers develop their own lending criteria, that these could be more demanding and less flexible than those of the bank, and that they could 'get away' with employing such criteria. He thought that managers were 'far less competent in lending than in the other aspects of their work.' Officer B concurred that managers develop their own lending criteria, but said that his office investigated the development of each branch, and that managers were told when the development was not satisfactory. Officer C said: 'I have always felt that the problem I have with branch managers resulted from their lack of experience and skill. It never occurred to me that they had any lending criteria at all. It is quite possible that the reason for so few supervisor rejections of managers' requests is that the managers have higher standards than we expect them to use. I think that the job of improving my staff will be considerably easier if they have credit criteria of their own rather than, as I suspected, none at all.' Officer A felt that it was difficult to develop incentives for development of branches: 'Most managers do not operate their branches as business organizations. I don't think it is possible to have managers seek out profitable business in their own areas until they operate their branches as private businesses which must make a profit. Only a few managers are genuinely concerned about the profits of their branches.' Officer B thought that a manager's main responsibility was to his employers and his depositors, and that it was not really part of his job to develop his area. 'And you should notice how generous they are with their time to service clubs. What more would you have him do?' When it was suggested that managers might advise their businessmen cus-

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Institutional Financing of Small Business in Nova Scotia

tomers that they should try to develop their businesses, this officer said that this was not part of the function of a bank and that it was not likely that the businessman would accept such instructions in any case. Officer C saw the existence of incentives in the form of opportunities for promotion and higher salaries. However, he conceded that these were not relevant for the manager who was fifty years old and had concluded for himself that he was at the end of his promotional line. He pointed to one of his managers who was still quite aggressive at fiftythree. However, this manager was in one of the bank's largest branches in the province, and the officer admitted that if he was not aggressive he would be in one of the smaller communities. Officer A said that all investment outlets are examined on their merit, without reference to where they are located. If the project has merit, then the bank provides the financing. He did not comment directly on exporting funds from the region, but his point does indicate a substantial disadvantage for those regions with below average growth rates. Officer B offered essentially the same points as A, while Officer C argued that funds are allocated on the merits of the credit application without reference to locality or the funds position of the particular region. He did agree that there may now be relatively less of the banks' total assets invested in the Atlantic region and that capital may be moving out of the region. He attributed these possibilities to more outlets in other parts of the country which were expanding more rapidly. (He also expressed the opinion that managers did not make personal loans because they produced a higher rate of return, but because they felt more comfortable with them.) It is evident that the banks' top management is primarily concerned with increases in deposits and loans, and that they have vague criteria for determining the amount of growth a branch should have in each of these. The evidence indicates that profit does not carry heavy weight in the evaluation of most managers. 5 The lending practices and procedures of financial institutions do little, if anything, to encourage the development of the provincial economy, and quite probably inhibit the expansion and development of secondary industry in Nova Scotia. Officer A disagreed very strongly with this conclusion. He said that the problem with industry in Nova Scotia was that the people had no confidence in their own province and would not invest their money in it. 'Why should the banks set up a capital investment fund for the development of this area when the residents themselves won't invest their own capital in the area?' He also contended that, if banks did not do more

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for business in this region than they did in other regions, there would be real financing problems for small firms. Officer B would agree with the above conclusion only if it meant that the banks would not provide risk capital. Officer C also disagreed and pointed out again that banks did more for firms in Nova Scotia than they did in other regions. However, he agreed that, to the extent that the branch managers were weak, it was possible that banks were doing less than they could do. He also suggested that for a bank to prosper and grow the area in which it was located had to prosper and grow. To achieve this the banks had to seek out growth opportunities in their areas. But then he observed that for the manager who does not respond to incentives there is not much hope of developing business in the area. As noted above, there was little ( except the interest ceiling and the prohibition or mortgage security) inherent in the banking structure to restrict the availability of credit. However, in practice, the activities of branch managers can significantly inhibit the development of new firms and firms engaged in activities that are not familiar to them. 6 With somewhat modified legal requirements, substantially altered administrative procedures, and education, institutional credit facilities in Nova Scotia would be adequate for the initiation and development of small manufacturing firms. Officer A agreed that the interest ceiling should be removed but did not feel that the banks should be in term lending. (His argument against the latter was mainly that the banks did not have sufficient resources to meet both the short-term and long-term credit requirements of businesses.) In general, he felt that no more than minor changes were in order. Officer B expressed virtually the same opinions as A. He was in favour of removal of the interest ceiling but not in favour of term lending by banks, and he thought that only minor modifications were necessary. However, he did agree that, if term loans were offered, the interest ceiling would have to be removed. Officer C favoured removal of the interest ceiling but said that he had never made up his mind on the desirability of mortgage security. He did think that it would probably be more satisfactory if banks could take any security they wanted and lend at any interest rate they considered appropriate. TENTATIVE RECOMMENDATIONS

1 All institutional lenders should be free to extend credit to business for all purposes and terms on any security, at interest rates set by the

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Institutional Financing of Small Business in Nova Scotia

market, with institutional differentiation based upon the risk acceptable to each. Officers A and C agreed with this recommendation. A said that the banks currently turned away risks which would be acceptable at rates above 6 per cent. Officer C felt that the recommendation was a good one, but Officer B was not particularly enthusiastic, although he did not disagree with the suggestion. 2 Government loan programs for business should provide credit only to risks which are unacceptable to private lenders. Such programs should charge interest at market rates, be administered by a single department of one level of government, and should assist private institutional lenders by providing both partial and deferred participation in lending activity initiated by the latter. Officer A would not make any comments on government loan programs, except to point out that the 5.5 per cent rate on SBL Act lending had not deterred the banks in any way. Officer B agreed with this recommendation, but again he was not particularly enthusiastic. He thought that government should be a lender of last resort, and that it should charge higher interest rates on its loan programs. Officer C only commented that government should be a last resort lender, and that market rates of interest should be used. 3 Chartered banks should examine their training, placement and performance appraisal systems if they are interested in the development of the communities in which they operate branches. Specifically, onthe-job training should be more diversified by region and size of branch, and it should be supplemented by formal residence-type programs; 'deadwood' should not be appointed to the branch manager level, regardless of the history or economic structure of the community; and performance criteria should place more emphasis on profit maximization rather than on loan loss minimization. Officer A said that training programs had been part of bank operations for several years, but he indicated that these programs had been revised only recently to give attention to credit work. Heretofore such programs had been concerned with the non-credit aspects of bank operations. (His comments with regard to the 'deadwood' problem have been noted above under the fourth conclusion.) He also agreed at this point

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that it was quite possible that managers did not know what supervisors expected of them, and that managers might not know precisely what the supervisor's office would accept by way of credit requests. He attributed these two conditions to poor communication ability on the part of the managers, with minor responsibility assigned to the poor quality of the personnel involved at the branch level. Officer B was displeased with the implied criticism of the banks in the above recommendation, and contended that any deficiencies in staff had to be attributed to the problem of obtaining more qualified people. He did dwell on the subject of manager evaluation at some length. At the time of annual inspection the manager is told of the inspectors' appraisal of the quality of his staff, loans, and premises, and of the trend of his deposits. A manager's rating is based on his performance relative to that of other branches in the region; the most that is expected of any manager is that he do as well as branches in similar situations elsewhere in the region. (Thus, if the quality of branch management in towns of, for example, 4,000 to 8,000 population is poor, there is no built-in means of improving it.) He also said that, while profit is used in determining whether a manager is to receive a salary increase, it is a minor factor relative to deposits, loans, and loan losses. He commented to the effect that loan losses were of concern when they became 'regular' since this would indicate that the manager was not learning from past errors. He also said that managers should run their branches as if they were a business enterprise which had to show a profit, but when it was suggested that a branch might show a significant increase in net profit while showing larger loan losses he replied, 'We never look at it that way.' Officer C conceded that the banks have done virtually nothing in the field of effective training programs, and said that such programs are sorely needed, particularly in the Atlantic provinces. He thought that a major problem in developing such programs was finding the time. 'We just can't spare the people to go away to take training or the people to conduct the training programs.' Officer C thought that profits were important to managers and he said that they were important in the evaluation of managers. He also disagreed with the suggestion that loan loss minimization was emphasized and profit maximization ignored. He added that managers were not overly concerned about keeping their loan losses at zero. However, he concluded these objections by observing that he was talking about how he wanted bank management and branch managers to think and act, and that they did not necessarily think that way in practice.

140

Institutional Financing of Small Business in Nova Scotia

4 Financial institutions, particularly the chartered banks, should be required to publish monthly statistics on the dollar amount of loans and deposits, cross-classified by size, type, number, and province. Officer A felt that such data have to be kept confidential for competitive reasons, and that publication would not serve any useful purpose. Officer B commented, 'You don't want the banks to do much, do you!' Officer C made no comment whatsoever on this recommendation; it appeared that the idea was new to him and that he had never heard it discussed.

5 Small business managers should be better educated with respect to: (a) the alternative sources of credit available to them, the subject elements in credit appraisals, and their opportunities to bargain for credit; ( b) the preparation and analysis of past, present, and projected financial data; ( c) market opportunities in the region. Officer A agreed that small businessmen might not be aware of the types of credit available, or of the subjectivity of some credit analyses. He thought that many loan proposals were poorly prepared and that the responsibility for putting them in order frequently fell to the supervisor, as neither the businessman nor the branch manager was capable of performing the task. The possibility of the loss of an account, he said, would not lead the bank to do something which it felt was not in its best interests. 'We are not going to be forced into foolish loans by threats.' However, he did feel that where the loan proposal was 'sound' the bank would attempt to expedite approval so that the customer would not consider taking his business elsewhere. Officer B commented only on the suggestion that small businessmen bargain between banks for funds. He seemed genuinely alarmed about this suggestion. It was pointed out to him that many of the lending criteria were created by the managers, that much of the 'credit' analysis was subjective, and that the credit offered might well be less at one bank than at another. He replied that 'sometimes we make mistakes and another bank will go us one up. But if one of my customers went across the street he need not bother to come back to me.' He was also critical of businessmen who transfer their business from one bank to another. He thought that businessmen should be as loyal to their bank as they expected their bank to be to them. However, he indicated that he would welcome any borrower who approached his bank with a 'sound' credit proposal which had already been rejected by another bank; that is, he would receive any borrower from another bank, but

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did not want his borrowers to turn to other banks. The most striking aspect of the response to the recommendation was the real annoyance it generated from this particular officer. (He terminated the interview very shortly thereafter, making the comment noted above with regard to publication of statistical data by the banks.) Officer C had no reservations about businessmen shopping for credit. 'We are all over twenty-one, so we should face the fact that it is done and that it is effective.' He also thought that small businessmen probably knew little of what types of credit were available or how it was extended, and he admitted the strong possibility that branch managers knew little of alternative sources' methods of operation. He was critical of the quality of the proposals which most businessmen presented to the banks, saying that they were of a low quality 'most of the time.' His criticism of chartered accountants was notably sharp in references to the ineptitude of many of them, and to the ill-will they earned for their clients by being late in providing material which the bank requested of the borrower-client. The most outstanding feature of the officer interviews was the admission by two of them that there were major problems at the branch manager level, and that there could be a wide discrepancy between what they want their managers to do and what they actually do. This, in turn, points to the absence of an effective reward-punishment system for branch managers as well as confirming the thesis that without significant changes in present procedures for manager selection, training, and evaluation the chartered banks will not make any significant contribution to the development of the province.

7 Availability of Credit from Public Non-Bank Financial Institutions

Three potentially significant sources of debt financing for small business in Nova Scotia are provided by two levels of government. The federal government established the Industrial Development Bank (IDB) in 1944, and the Province of Nova Scotia established the Industrial Loan Fund (ILF) in 1951 and Industrial Estates Limited (IEL) in 1957. This chapter will deal with these three public sources of financing for small business, in what the author considers their order of importance, describing the purposes behind their initiation, their growth patterns, and the current problems facing both the institutions and the small business credit applicants to each institution. INDUSTRIAL DEVELOPMENT BANK

The preamble to the act of parliament founding IDB in 1944 sets forth the purpose of the Bank as follows: ' ... to promote the economic welfare of Canada by increasing the effectiveness of monetary action ... by supplementing the activities of other lenders and by providing capital assistance to industry with particular consideration to the financing problems of small enterprises.' The Bank is operated as a wholly owned subsidiary of the Bank of Canada, with both IDB and the Bank of Canada having the same board of directors, executive committee, and principal officer. However, unlike the Bank of Canada, IDB is organized on a regional basis. Prior to 1966, IDB consisted of a head office, and regional and branch offices, with the manager of each regional office also acting as supervisor for a region encompassing one or more branches. The super-

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visor, in turn, was responsible to head office. A 1966 reorganization resulted in the creation of four distinct regions (Atlantic, Quebec, Central, Western), each with its own resident 'Assistant General Manager.' The supervisors were relieved of their branch management responsibilities and assumed supervisory responsibilities for all branches in their region. All branch managers are now responsible for the activities of their particular branches only. The 1966 Annual Report of IDB stated that these changes were aimed at 'improving the quality and speed of service and maintaining closer contact with regional developments.'1 It appears that the 1966 reorganization was also aimed at decentralizing lending and administrative authority, particularly the former. The president of IDB said in IDB's 1967 Annual Report that 80 per cent of the number of loans in 1966 were approved at local branches or regional offices while for 1967 the figure was 90 per cent. 2 At about the time of the Porter Commission hearings, regional officials of IDB in Halifax said that they would be able to approve virtually all loan applications received if there was a modest upward adjustment in their lending limits. It would now appear that IDB is attempting to follow this suggestion. One change which could result from reorganization would have undesirable consequences. In 1962 an IDB official pointed out to the writer that all files were reviewed by Head Office after a decision had been reached on the application at the branch level. This review seldom resulted in significant comments on loans which were approved, but frequently produced comments suggesting ways in which it might have been possible to approve loan applications which had been rejected by the branch. Such a review would tend to place a minimum of negative constraints on branch and regional management, and would encourage them to meet all reasonable requests. Alternatively, of course, if lending I A sample kit prepared by IDB in the mid-1950s, dealing with a hypothetical loan application, indicated a period of seventeen weeks between initial contact and acceptance of a loan of $60,000. There is some indication, including the comment of the 1966 Annual Report, that this period has been reduced slightly, but there is also evidence that it is still a subject of concern to applicants. IDB officers now think that loans are processed quite rapidly, arguing that at least one half of all loan applications result in disbursements in one month or less; also, they consider that most delays result because applicants have not prepared a firm proposal and/or are slow in having necessary legal work, such as title searches, completed. 2 It was impossible to eliminate confusion resulting from a statement in IDB's presentation to the Porter Commission which reported that 72 per cent of loans were approved at the branch level, another 14 per cent at the regional level, with the balance (14 per cent) approved at Head Office. If all of these data are accurate, there was a falloff in regional or lower level approvals between 1962 and 1966 from 86 to 80 per cent.

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Institutional Financing of Small Business in Nova Scotia

authority is decentralized and if, as one IDB official put it, 'The desire to lend is pervasive in IDB,' then the 'bullish' influence can exist at the branch level. Each of the twenty-eight offices operated by IDB at the end of 1967 (an office was opened in Halifax in June 1956) is under the direction of a manager who is responsible for the administration of branch staff and lending activity at the branch level. In addition, each branch of IDB is usually staffed by two to three credit officers, a technical officer (graduate engineer), a lawyer, and stenographers. A credit officer and the technical officer visit the premises of applicants, and then prepare a complete lending proposal which they submit to the manager, together with their recommendations. Their proposal sets forth the amount of the proposed loan and all covenants which they consider necessary. The completed offer from IDB is incorporated in a letter to the applicant. The net result of three sets of amendments to the IDB Act (in 1952, 1956, and 1961) has been that virtually every type of enterprise may borrow from the Bank. As a consequence, there has been a substantial change in the 'mix' of Canadian firms served by IDB: manufacturers accounted for 91 per cent of 1955 loan approvals, 39 per cent of the 2,085 loans approved in 1962, and 32 per cent of the 2,168 loans approved in 1967; approximately 68 per cent of 1967 loan approvals were for firms not eligible in 1944. Virtually any firm in Canada can meet the basic IDB lending criteria, because there is no restriction on the size of loans ( except that loans in excess of $200,000 cannot exceed $75 million in aggregate), their term, or the security which may be taken. The basic lending criteria are described as follows.3 (a) Future earnings of the business are expected to be sufficent to repay IDB and to provide for other needs of the business. (b)Appropriate security is available to IDB . (c) The amount invested or to be invested in the business by persons other than IDB, 'and the character of that investment, are such as to accord the Bank reasonable protection.' (d)The required financing is not available from other sources on reasonable terms and conditions. (e)The firm must plan to operate in Canada. The Bank's Submission to the Porter Commission refers to 'future earnings prospects' as a 'prime factor in determining the extent to which 3 Industrial Development Bank, A Source of Financing for Canadian Business,

undated, pp. 2-3.

Credit from Public Non-Bank Institutions

14S

the Banlc can help provide financing.' It added that 'by emphasizing and inquiring into the earnings potential of the business, the IDB is often able to go further in providing financing. ' 4 This emphasis on future prospects would provide a high degree of flexibility in lending arrangements, and is in marked contrast to that of the chartered banks which pay minimal attention to such things, emphasizing historical financial condition instead. The 'appropriate security' in no way restricts IDB lending because it may take any type; typically its basic security is a real and/or chattel mortgage lien. IDB does not view second mortgages as appropriate security and has preferred to extend funds to pay off existing liens so that they could have both a first mortgage lien and a floating charge. However, the author was told that if the borrower had established a significant equity in a property with an existing mortgage lien, IDB would take a second, or even a third, mortgage. IDB officers feel that the ratio of a loan to the pledged security tends to decrease as loan size increases, and that the loan to the small firm would tend to be large relative to the pledged security. Whether deliberate policy or accident, the existence of high loan to security ratios when loans are extended to small firms would provide clear evidence of IDB's willingness to loan to such firms on earnings prospects. The criteria for determining 'reasonable protection' have never been stated or implied by IDB, except that the Bank requires that loans by shareholders be subordinated to IDB loans. The 'reasonable terms and conditions' criterion had been the most controversial aspect of IDB activity and was given relatively lengthy treatment in its Submission to the Porter Commission. The Bank takes several steps to satisfy itself that the application meets this criterion, of which the most significant is that of requiring the applicant to provide a signed statement indicating that he cannot obtain the funds elsewhere on reasonable terms and conditions. However, the Bank will pay out existing liens if the other lender's terms, in combination with those of IDB, are too burdensome and the other lender refuses to renegotiate its terms. (Table 7 /1 gives an indication of the importance of refinancing in IDB activity.) The Submission noted that the terms of alternative financing may be viewed as unreasonable if the term is too short for the firm's cash generating capacity, the security requirements preclude provision for all credit needs, or because of the difference between its lending rate and that of the alternative source. It is this last criterion which has caused 4 Submission by the Industrial Development Bank to the Royal Commission on Banking and Finance (3 October 1962), p. B 10.

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Institutional Financing of Small Business in Nova Scotia

TABLE 7/1 Purposes served by Industrial Development Bank loans, years ending 30 September

Per cent of Total• Purpose

1963

1964

1965

1966

1967

Investment in land and buildings Investment in machinery and equipment Increase in working capital Refinancing of mortgages, liens, etc. Financing of changes in ownership All other

41 29 15 8 5 2 100

39 29 15 10 5 1 100

39 32 10 5 3

46 31 10 7 2 2

46 32 9 8 3 1

100

100

100

TOTAL

13

Industrial Development Bank, Annual Report, various years. Data are published, with respect to percentage of total, with the total investment to be made by the borrower equal to 100 per cent; thus, in 1967 borrowers invested a total of S167 million in projects which me financed to the extent of $113 million: the $113 million was used as the denominator in calculating the various items here. Totals do not add to 100 because of rounding.

SOUllCE :



particular controversy, as described below. IDB does not set forth any criteria by which it measures reasonable lending rates, but it appears very likely that it has regarded anything over 10 per cent as excessive. While the president of IDB told the Halifax Board of Trade in February 1966 that IDB is 'always willing to participate in the initial financing of soundly conceived new businesses,' an IDB officer told the author that it was most unlikely that IDB would loan money to some completely new activity involving new management. He felt that initial financing should not be by means of loan capital since the borrowers generally would not have any significant security to offer. On the same point, Donaldson thought that in its early years IDB 'adopted the general policy that loans would only be made after convincing evidence of ability to repay had been produced. Normally this meant some record of profitable performance and ruled out the completely new business.' 5 The IDB loans outstanding at the end of the five fiscal years 1963-7 reflect the purposes served by IDB lending (Table 7 /1). There are no data by which one can determine whether this loan distribution was typical of IDB over its early history, but the Bank has implied that loans for working capital, refinancing, and changes of ownership were very infrequent and provided only under unusual conditions. 6 Loans for working capital are made to restore it to previous levels when it has been depleted by fixed asset investment - a sort of delayed fixed asset loan; and as a part of a 'package,' including fixed asset ex5 Gordon Donaldson, Financial Management in the New Small Scale Manufacturing Enterprise (doctoral thesis, Harvard Business School, 1955), p. 176. 6 See D>B, A Source of Financing, pp. 4-5.

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pansion financed by the Bank, where the working capital needs 'can be met only partly by an increased operating credit from the borrower's chartered bank.' 7 The interview data indicated that both of these types of working capital loans are made on a term basis and on types of security not generally taken by chartered banks. Loans for refinancing are made when existing loans from other sources, in combination with a proposed IDB loan, would be too burdensome because of the short payout of the former, and when IDB wants a first mortgage lien and a floating charge on the firm's assets. Loans to finance change of ownership are made where the proposed management offers a possibility of 'significant improvement in the efficiency of management,' and to assist Canadians purchasing Canadian firms likely to fall into non-resident control. 8 Correspondence with one IDB officer indicated another type of IDB assistance which might be particularly relevant to unindustrialized areas such as Nova Scotia. IDB is willing and able to loan money to development groups for the acquisition of buildings and equipment to be leased to business firms, when the tenant is known in advance, and when IDB is satisfied with the conditions of the lease. It appeared that IDB's principal concern is with avoiding speculative building, although it is also concerned with the financial strength of the proposed lessee. This officer indicated that IDB would be willing to provide in excess of 50 per cent of the financing required. In addition to lending on a term basis for a variety of purposes, IDB is also permitted to provide equity capital, underwriting of security issues, and guarantees of loans. However, none of these have been significant in IDB activities to date. The Bank indicated, in their Submission to the Porter Commission, they found most borrowers reluctant to restrict their freedom or to share potential earnings by issuing equity capital. They also observed that the vast majority of borrowers (75 per cent borrow no more than $50,000) have a narrow equity base and that any significant investment by IDB would materially alter the pattern of control. In all, the Bank had approved only thirty equity investments, twenty-three of which were disbursed through 1962, and equity investments of $273,000 were outstanding (to five firms) at the end of 1962. By the end of the 1967 fiscal year a total of forty-five equity investments had been approved, thirty-nine had been disbursed, and $1.1 million was outstanding to thirteen firms. 9 One IDB officer pointed out in the course of an interview with the 1 Submission by the Industrial Development Bank, p. 8 Ibid., pp. B 8, 9. 9 Letter from IDB, 4 July 1968.

B

7.

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Institutional Financing of Small Business in Nova Scotia

author that the Bank was not particularly interested in acquiring an equity interest as a means of obtaining board representation and providing for 'after-care' - a consideration given considerable importance by many so-called venture capital firms. He also thought that the equity investment which would be acceptable to the businessman-borrower would be so small that it would not materially influence the financial status of the firm, and that such a sum could be raised from private sources. Through 1962 the Bank had found 'only one case suitable for utilizing' their power to underwrite a security issue, a situation unchanged at the end of 1967, and 'few occasions' to utilize their power to guarantee loans. In all, forty-one guarantees had been issued, through 1962, with a further eleven, bringing the total to fifty-two by the end of 1967. These guarantees were typically for chartered bank loans to IDB customers where the latter's financial status made the bank reluctant to continue its operating credit without a guarantee, a procedure it believes preferable to replacing the chartered bank as a supplier of operating credit. There is no limit on the term IDB may grant on loans it makes. The Bank indicates that most loans are for terms of seven to ten years, and that its experience has shown that most loans can be repaid quite readily within that range. However, terms of up to fifteen years are provided, and the average terms for selected years are shown in Table 7 /2. It is very likely that the longer average terms do not have special application to manufacturers, but reflect the increasing weight of non-manufacturing firms which typically would have relatively smaller cash flows. IDB applicants are usually expected to provide the Bank with audited financing statements for the previous five years, and pro forma financial TABLE 7/2 Industrial Development Bank: average term of new loans (selected years)

Year

Term in months

1950 1955 1960 1962 1964 1965 1966 1967

65 77 69 81 85 87 87 88

Submission by The Industrial Development Bank to The Royal Commission on Banking and Finance (3 October I 962), Table I 3; letter from Industrial Development Bank, 4 July 1968.

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statements. However, one IDB officer pointed out to the author that the Bank does not expect small firms to have detailed forecasts, but does assist in the preparation of them. He also pointed out that the clarification of legal matters normally required considerable time in the processing of loan applications. The Banlc obtains, in addition to financial statements, a credit agency report on the applicant and a letter of appraisal from the applicant's chartered bank. In the process of investigating financial condition, the Bank does not attempt to restrict the scope of its investigation to match the size of its loan. To the contrary, it may spend more time investigating a small loan than a large one, and thinks that 'one of the useful functions [it] can play is in providing guidance on ways in which the prospective borrower can arrive at a sound and suitable mix of financing for his business.' 10 IDB provides a detailed loan contract in which it spells out the covenants of the loan. It points out in a descriptive booklet that these covenants, which usually require the periodic presentation of financial statements and restrict capital expenditures, are intended to 'keep the Bank advised on developments within the business ... and to provide protection against developments which might jeopardize the financial condition of the business.' The opinion of one IDB officer was that the practice of using loan covenants was consistent with lending on, basically, the general security of the borrower, in that the covenants dealt with potential problems of the firm as an entity rather than on a piecemeal (individual asset) basis. Another IDB officer pointed to a rather obvious and natural reason for the typical borrower's resistance to written covenants which he had experienced. Since most borrowers have previously dealt almost exclusively with the chartered banks, they are accustomed to relatively informal arrangements which are likely to produce reservations about formal requirements. This officer said that most borrowers resist the covenants initially, but he added: 'You ask any one who has lived with covenants for a year or more. He'll tell you he's delighted with them because he knows they keep him from hurting himself and they give him an indication of what is expected of him.' He also thought that the informal type of bank lending was much more prevalent in the Atlantic region than elsewhere in the country, and for that reason IDB operations in the region had to di.ffer from the national scene in that they were required to overcome more borrower resistance to covenants than was common in other regions. The interest rate on IDB loans has varied from a low of 5 to a high 10 Remarks of Louis Rasminsky, governor of the Bank of Canada, before a meeting of the Halifax Board of Trade, 7 February 1966.

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Institutional Financing of Small Business in Nova Scotia

TABLE 7/3 Lending rates of Industrial Development Bank and other lenders

Date•

Chartered banks' prime rate(%)

maximum rate(%)

November 1944 February 1951 April 1952 September 1956 November 1957 March 1959 October 1959 September 1960 September 1962 February 1966

4½ 4½ 4½ 5¼ 5¾ 5½ 5¾ 5¾ 6 5¾

4½ 4½ 4½ 5½ 6 6 6 6¾ 6¾ 6¾

NHA

Conventional mortgage rate(%)

IDB

5 5¾ 6

5 5½ 6

7 7 7½ 7¼ 7½

6 6½ 7 6½ 7 7½

6¼ 6¾

rate(%)



Submission of the Industrial Development Bank to the Royal Commission on Banking and Finance, p. cl; Industrial Development Bank, Annual Report, various years. • Dates are those on which IDB changed its lending rates.

SOURCES :

of 7½ per cent, and compares with other lenders' rates on the dates on which it was changed, as shown in Table 7 /3.11 Loans secured by a second mortgage and loans involving relatively large amounts and above normal risk carry a rate of ½ per cent above the posted rates. In addition to interest charges, IDB borrowers can be called upon to pay a 'commitment fee' for short delays in taking down an approved loan, a 'standby fee' for more extended delays, and a 'prepayment indemnity.' The volume of IDB loans outstanding has expanded continuously since 1945, and only in 1963 and 1967 have the number of loans approved failed to increase over the previous year. The initial upward trend in average loan size turned down from 1956 to 1963, but turned back up again in 1964 (Table 7 / 4) . The expansion of IDB activity after 1956 was initially accompanied by an increase in the proportion of loan approvals being granted to new borrowers, as contrasted to previous borrowers ( new borrowers accounted for 66 per cent of the number of loan approvals in 1956 and for 83 per cent in 1962), but the proportion of loans approved for new borrowers has slipped off rather steadily since 1962 to 72 per cent in 1967. While 1965 and 1966 produced a reversal of the pattern of average size loans to new borrowers being larger than those to existing borrowers, the change was 11 The 1967 Annual Report noted that rates of higher than 7½ per cent were 'applied to larger loans.' In January 1968 the lowest IDB rate was increased to 8 per cent and applied to loans of up to $75,000; loans of $75,000$150,000 were at 8½ per cent, loans of $150,000-$300,000 at 9 per cent, and loans over $300,000 had 'a minimum rate of 9 per cent.' This rate structure shows clear evidence of IDB's attempts to force larger borrowers to be diligent in seeking out alternative sources.

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151

shortlived as average loans to existing borrowers in 1967 were again larger (by 4 per cent) than those to new borrowers. Expanded IDB activity was also accompanied, from 1956 through 1964, by an increasing proportion in the number of loans approved not exceeding $25,000 (such loans accounted for 38 per cent of the number of loans approved in 1956, 51 per cent of approvals in 1962, and 55 per cent of approvals in 1964), but after 1964 the pattern changed, with such loans accounting for 52, 45, and 45 per cent in the years 1965-7, respectively. While indicative of the importance in IDB lending activity of what are probably small firms, these loans have never exceeded 20 per cent of the amount of all approvals. (They were 13.8 per cent of the amount approved in 1967.) IDB has been criticized by officers of other lending institutions for not protecting small business or underdeveloped regions by acting as a counter-cyclical factor during periods of tight money. The data (see Table 7 / 4) do not clearly support this contention. Fiscal 19 57, which encompassed most of the 1956-7 tight money period, showed a modest increase in the number of loan approvals, but a significant decrease in the amount approved and in the average size of loans. Thus, it could be argued that this reflects IDB servicing of the smaller firms most likely to be affected by credit restrictions in the banking system. Fiscal 1960, which covered the 1959-60 tight money period, shows a substantial increase in both the number and the amount of loan approvals without a significant change in the average size of loan approved. However, the 1959 decrease in amount and the modest increase in number of loans approved suggest that IDB reversed itself between the first quarter and the last three quarters of the 1959-60 tight money period. IDB's apparent willingness to act on a national basis in a countercyclical manner during tight money periods, and its significant services to small businesses and new borrowers, might lead one to expect that it would tend to offset national tight money policies which are not warranted by regional conditions; that is, that it would put forth its strongest counter-cyclical efforts in areas where small businesses are characteristic, such as Nova Scotia. Unfortunately, it is not possible to determine whether this is the case. While the amount and number of loans approved for Nova Scotia in IDB's fiscal 1957 was significantly above 1956 (see Table 7/5), fiscal 1957 was the first full year of operation for the Halifax branch of IDB. On the other hand, the falloff in the number and amount of loans approved in 1960 does not necessarily reflect restraint by the Bank. From the experience of Nova Scotia's Industrial Loan Fund ( see below), there may have been a significant falloff in inquiries for loans from public agencies generally in 1960, and, as

TABLE 7/4 Industrial Development Bank loans outstanding and approved 1945, 1950, and 1955-62

Loans outstanding

Loans approved

Fiscal year

Number

Amount ($000,000)

Number

Amount ($000)

1945 1950 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967

80 490 692 819 1,021 1,321 1,609 1,966 2,768 4,083 5,104 6,027 6,961 7,868 8,593

1.0 21.8 43 . 9 52 . 0 71. 7 88.6 96.7 103 .0 123.1 164.7 200.3 223.7 254.3 297.2 332.4

103 188 221 349 401 571 599 740 1,365 2,085 1,986 2,083 2,209 2,334 2,168

4,151 7,738 17,462 39,359 30,111 35,941 30,579 38,576 71,236 91,981 79,811 88,148 96,146 122,647 113,132

Average size ($000) 40 41 79 113 75 63 51 52 52 44 40 42 44 53 52

Approvals percent change from previous year Number

Amount

Average size

+58 +15 +42 + 5 +24 +85 +53

+125 - 23 + 19 - 15 + 26 + 85 + 29 - 13 + 10 + 9 + 28 8

+43 -34 -16 -19 + 2 0 -15 - 9 + 5 + 5 +20 - 2

- 5 + 5 + 6 + 6 - 7

-

Submission of the Industrial Development Bank to the Royal Commission on Banking and Finance, Tables 7 and 8; Industrial Development Bank, Annual Report, various years. Percentage changes compiled.

SOURCE:

TABLE 7/5 Industrial Development Bank lending to Nova Scotia firms, years ending 30 September ( dollars in thousands)

Loans approved Percentage change from previous year

Year

Number

Amount($)

Average($)

1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967

4 7 15 28 32 28 49 61 47 62 51 57

252 393 1,060 1,235 1,355 1,075 2,130 2,840 1,881 2,122 2,356 2,386 1,516

63 56 71

45

44

42 38 43 47 40 34 46 42 34

Loans outstanding

Number

Amount

Average

+ 75 +114 + 87 + 14 - 12 + 75 + 24 - 23 + 32 - 18 + 12 - 21

+ 56 +170 + 17

-11 +27 -38

+ + +

10

21 98 33 - 34 + 13 + 11 + 1 - 36

- 5 - 9 +13 + 9

-15

-15 +35 - 9 -19

Industrial Development Bank. Report of the President and Statement of Accounts, various yean. Percentage changes and averages compiled.

90tlllCE:

Number

Amount($)

43 66 82 111 140 163 171 189 204 203

2,452 3,026 3,276 4,751 6,138 7,050 7,663 8,050 8,742 8,240

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Institutional Financing of Small Business in Nova Scotia

suggested in the discussion of the Industrial Loan Fund, it is quite possible that Nova Scotia businessmen assume that tight money makes loan applications to all lenders futile. The overall impression is that IDB was willing to make loans during the tight money period, that the regional officers had authority to make most of the loans which might have been sought, but that the businessmen's preconceptions precluded the-testing of these two hypotheses.12 The regional distribution of numbers and amounts of IDB loans, in comparison with regional population and number of manufacturing establishments ( the only meaningful establishment statistic available), indicate a rather consistent pattern over the 1957-65 period 13 (see Table 7/6). In Nova Scotia the proportions of amount of loans virtually never exceeded the proportions of either population or manufacturing establishments. The proportion of number of loans exceeds the proportion of manufacturing establishment two-thirds of the time in Nova Scotia, while it exceeds the share of population less than onequarter of the time. In the other three Atlantic Provinces the proportion of both number and amount of loans exceeds the proportion of establishments with some regularity, but the sharpest contrast is between Nova Scotia, Quebec, and Ontario, on the one hand and the Prairie Provinces and British Columbia on the other. The most probable explanations of the abnormal proportions for the Prairies and British Columbia are that IDB communicates more effectively with the business community there than elsewhere, that IDB is more aggressive there than elsewhere in seeking and meeting requirements, and/ or that manufacturing establishments are a less significant part of IDB lending activity there than elsewhere. If IDB was to attempt to encourage the growth of the Atlantic region, including support of growth during periods when national policies of 12 It should be noted, by comparing Tables 7 /4 and 7 /5, that while the direction of year-to-year changes in number, amount, and average Joans is the same in Canada and Nova Scotia 22 out of 30 times in the 1958-67 period, the magnitude of the change, when it is in the same direction, is greater for Nova Scotia, 17 of 22 times. Thus, IDB activity in Nova Scotia is far more extreme than in the country as a whole, and the absolute differences in relative change appear to be larger than could be explained in terms of 'leverage' arising out of Nova Scotia's small size. 13 It is impractical to go back to a period before 1957 because of the modest branch coverage IDB provided before that date, and it is impossible to go beyond 1965 because at the time of this writing (June 1968) DBS had only managed to publish data on establishments through 1965. However, in 1966 and 1967 the Prairies and British Columbia both had numbers and amounts of loans in excess of population in both years, while Ontario had amount in excess of population in 1966, and number in excess of population in 1967; in all other cases proportions of population exceeded both numbers and amounts.

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155

monetary restraint were operating, it would be necessary for the region's share of both number and amount of loans to consistently exceed population and manufacturing establishment shares. If the share of the number of loans in itself was above the population and manufacturing establishment shares, the result would be smaller than national average loans to already smaller than national average firms. An imbalance of interregional growth, aimed at bringing up the bottom, would also require more vigorous IDB promotion in areas such as Nova Scotia. While it is dangerous to place too much emphasis on the single item of the decline in Industrial Loan Fund inquiries in 1960, empirical evidence suggests that the major deficiency of the Nova Scotia business community is a lack of aggressiveness and entrepreneurial skills, which would have to be offset by IDB initiative. The hope that it will do so is fostered by the view of the president of IDB. He has said: 'The Bank attaches particular importance to lending to businesses in remote areas or in smaller centres outside the large towns and cities. There are many sound enterprises in such places which are capable of substantial growth, but their location often presents difficulties for ordinary financial institutions.' 14 It appears that IDB has had some difficulty in making businessmen aware of their services, a fact that may be reflected in the imbalance of proportions already noted. IDB has found that its services were not known to many it might serve, or to their advisers. To overcome this, the Bank used newspaper and magazine advertising, as well as a program of promotion involving visits by IDB officers to communities in the general area of its branches. Such programs could be differentiated on a regional basis if IDB adopted a policy of emphasizing slow growth regions. However, a program of regional differentiation would be unlikely to achieve results in Nova Scotia until one major problem was overcome. One IDB officer told the author in 1962 that most referrals to the Halifax branch were made by lawyers and accountants, with relatively few from branch bank managers. He thought that the majority of branch bank managers were ill-informed critics of IDB activities and requirements. The low level of branch bank manager consciousness of IDB has already been noted, and may have been a factor in Nova Scotia's modest share of IDB lending activity. It is evident that if IDB is to make the businessmen in remote and/ or smaller centres aware of its services it will have to try to reach them through their main 'financial world' contacts; that is, the branch bank managers. And IDB will have to take the 14 Speech to the Chamber of Commerce, Quebec City, May 1964, by Louis Rasminsky, president of IDB.

TABLE 7/6 Distribution of population, manufacturing establishments, and Industrial Development Bank loans, by region 1957~5

Per cent of Canada Year

Item

1957

Population Establishments Number of loans Amount of loans Population Establishments Number of loans Amount of loans Population Establishments Number of loans Amount of loans Population Establishments Number of loans Amount of loans Population Establishments Number of loans Amount of Joans Population Establishments Number of loans Amount of loans Population Establishments Number of loans Amount of loans

1958

1959

1960

1961

1962

1963

Nova Scotia

Other Atlantic

Quebec

Ontario

Prairie provinces

British Columbia

4 .2 3. 5 3.8 3.5 4.2 3. 5 4.9 3.4 4.1 3. 6 5.3 4 .4 4.1 3. 5 3.8 2.8

6. 5 5. 6 5. 8 5.0 6. 5 5.2 4.5 4.0 6.4 5.3 6.5 3. 8 6.4 4. 7 6.2 4.4

28 . 7 32.6 24 .4 23.7 28.7 32.4 25 .8 29 . 1 28 . 7 32.2 23 .4 24. 9 28 . 8 32.6 19 .9 24.3

33.9 35 . 8 32.1 30.2 34.1 36.1 29.6 29.1 34.1 36.0 32.2 32.2

17.5 11.2 13.5 12.7 17.4 11.6 19.4 16.3 17.4 11. 7 17.9 18.9

8.9 11.3 19.9 23.0 9.0

17.4

4.0 3.1 3.6 3.0

6.4 3.7 6. 3 5.0 6.4 3. 6 7. 9 4.9

28.8 33.8

34.2 36.5 35 . 7 32.1 34. 2 37. 3 39.4 35 .0 34.2 37 .6 38.9 36.7 34. 1 37.7 34.0 35.0

4.0 3. 1 2. 9 3. 1 4.0 3.1

2.4 2.4

6.4 3.5 6. 7 5.2

18.9

23.7 28 . 9 33.2 20.2 26 .4 28.9 33.2 19.9 28 .2

11.8

19 .0 17. 8 17 .4 11.3 22.0 20.4 17.4 11.6 21.4 18 .9 17.4 11.8

27.3 20 .4

11.1

15.6 17.4 9.0 11.3 14.4 15 . 5 9.0 10.9 14.9 18.3 8.9 10.8 9.4 12. 7 8. 9

10. 8 8.1

9. 3 9.0 10.8 9. 1 8.4

1964

Population Establishments Number of loans Amount of loans

1965

Population Establishments Number of loans Amount of Joans

4.0 2.9 3.0 2.4 3.9 2.8 2.3 2. 5

6.3 3. 5 5.6 4.3 6. 3 3.4 5.2 3.8

28.9 33.0 21.1 28 . 3 28.9 32.9 21.9 26 . 5

34. 2 38 .0 32.5 31.9 34.4 38 . 3 31.0 31.3

17. 3 11.9 26 . 7 20 . 8 17.2 12 .0 26 .0 20.4

9.0 10. 7 11.1 12 .0 9.1 10. 5 13.3 15.3

Summary Number of years in which event occurred (maximum possible= 9)

Proportion of number of loans exceeds proportion of Population Establishments Proportion of amount of loans exceeds proportion of Population Establishments

Nova Scotia

Other Atlantic

Quebec

Ontario

Prairie provinces

British Columbia

2 6

3 8

0 0

3 2

8 9

8 6

1 1

0 5

1 0

3 0

7 9

8 7

Total Authorizations, 1 Nov. 1944 to 30 Sept. 1965• Per cent of Canada

Number Amount

Nova Scotia

Other Atlantic

Quebec

Ontario

Prairies

British Columbia

2. 8 2. 5

6.2 5.0

21.2 28 .4

33 .9 32.0

23 .4 18 .2

12.0 13 . 6

Compiled from Table 12, Submission of the Industrial Development Bank to the Royal Commission on Banking And Finance ; Industrial Development Bank, Annual Report, various years ; and Canada Year Book, various years. A total of I 0,885 loans for $726.S million were made •

SOURCES :



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Institutional Financing of Small Business in Nova Scotia

initiative in educating branch bank managers since the banks themselves have not carried out the task. The rewards to the chartered banks should be obvious - the more success that can be enjoyed by their customers, the more profitable their relationship with the customer will be, so long as the functions of IDB do not overlap those of the chartered banks. Capitalization and operating performance

The IDB lending program has been financed entirely by the Bank of Canada, through the acquisition of share capital and debentures, and through retained earnings. The Bank's authorized capital, originally set at $25 million, was increased to $50 million in 1961. With its bonds and debentures limited to five times paid-in capital and reserves, IDB was utilizing just over eighty per cent (82.6) of its line of credit from the Bank of Canada at the end of 1967. In his appearance before the Porter Commission, the president of IDB said that the interest rate on IDB debentures was then set at 0.6 percentage points above the rate on Government of Canada bonds of similar maturity. Table 7 /7 compares the rates paid by IDB on its debentures with the rate it received on its loans. The president of IDB commented to the Porter Commission that the average cost of all its resources increased from 0.68 in 1956 to 3.27 per cent in the final quarter of 1962. He attributed this to an increase in the Bank's debt ratio, and said that 'interest-free sources of funds (paid-up capital, reserve fund and reserve for losses) had declined to 30 per cent of the total' sources of funds. It is rather astonishing that the governor of the central bank would take the view that there are such things as cost-free funds. Since all IDB funds come from ( or could go back to) the same 'pocket' - the federal treasury - the cost of IDB funds is the rate paid by the government of Canada for funds it advances to IDB; the classification of government funds on IDB's balance sheet is not relevant in determining their cost. In order to approximate the subsidy element in IDB financing, it appears that the best comparison is between the return on total capitalization and the effective rate on debentures outstanding. The latter value would give recognition to the rates being paid on the various advances to IDB over time, while the average interest rate on new debentures (Table 7 /7) would reflect only the rate on a particular increment of funds. Lower levels of net profit from 1961 onward (Table 7 /8) pushed the return on total capitalization below the effective cost of funds provided IDB in the years 1961 through 1967. However, in only one of those seven years ( 1962) was the differential more than the 0.6 per-

Credit from Public Non-Bank Institutions

159

TABLE 7/7 Industrial Development Bank lending and borrowing rates 1955-67 Average interest rate on new loans

Average interest rate on new debentures

Spread 3.66 2.69 1.95 2.21 1.53 1.63 1. 79 1.76 1.90 1.91 2.00 1.52 2.10

Year

(%)

(%)

1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967

6.00 6.04 6. 50 6.00 6.34 6.96 6.50 6.54 7.02 7.07 7.10 7.50 7.98

2.34 3.35 4.55 3.79 4.81 5.33 4. 71 4.78 5.12 5.16 5.10 5.98 5.88

(%)

Submission of the Industrial Development Bank to the Royal Commission on Banking and Finance, p. o2 ; letter of 26 July 1968.

SOURCE:

TABLE 7/8 Industrial Development Bank rate of return on net worth and total capitalization 1945, 1950, 1955-67

Year 1945 1950 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967

Net profit as a per cent of income•

Net profit as a per cent of net wortht

Net profit plus debenture interest as a per cent of total capitalizationt

64 50 52 56 43 39 24 29 21 8 10

1. 98 2.14 3.51 4 .40 4.24 4 . 83 3.64 4 . 54 3.60 1.66 2.43 2.92 2.74 2.32 2.65

1.96 2.14 3.45 3.52 3.43 3.78 3.54 4 . 15 3.74 3.23 3.91 4.25 4.37 4.35 4.00

11

10 8 8

Interest expense as a per cent of debentures outstanding at year end§

3. 22 1.81 2. 60 2.99 3.47 3.89 3. 81 3.89 4 .44 4.69 4.89 4.92 4.37

Submission of the Industrial Development Bank to the Royal Commission on Banking and Finance, pp. o2, HI, Tables I, 2, 3; Industrial Development Bank, Annual Report, various years. • Net profit is all revenue less the sum of all operating expenses, interest on debentures and net bad debts (bad debts written off minus recoveries). It docs not include 'Provision for Losses.' t Net worth includes Capital, Reserve Fund, and Reserve for Losses. Rates compiled. Capitalization includes Capital, Reserve Fund, Reserve for Losses, and Bonds and Debentures. " Rates compiled.

SOURCES :

i

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Institutional Financing of Small Business in Nova Scotia

TABLE 7/9 Industrial Development Bank equivalent lending rates required to produce a five per cent rate on return on new worth ( dollars in thousands)

a

b C

d e

I g h i

Net profit reported, 1967 Rate of return on net worth, 1967 Profit before taxes required to produce a rate of return of 5 per cent on 1967 net worth of $71,092 Profit before taxes required to produce a 5 per cent rate of return on net worth, after taxes of SO per cent Increase in interest income of $22,849 required for (c) Increase in interest income of $22,849 required for (d) Average interest rate on new loans, 1967 Average interest rate required for (c) = 1.073g Average interest rate required for (d) = 1.229g

$1 ,884 2.65% $3,555 $7,110 7.3% 22 .9% 7.98% 8.06% 9.22%

centage points added on; thus, the return on total capitalization generally has continued to be more than the cost of the funds to the government. It is worthwhile at this point to approximate the interest rates which IDB would have to levy in order to produce a somewhat more attractive rate of return on net worth on before and after tax bases ( see Table 7/9) . IDB would have had to levy an average rate of 9.22 per cent (compared with an actual rate of 7.98 per cent) in 1967 to have produced a rate of return on net worth of 5 per cent after taxes of 50 per cent. Thus, IDB's average interest rate was approximately four-fifths of what would have been required if IDB had been a private firm paying taxes of 50 per cent and seeking a rate of return of 5 per cent on net worth; the rate was virtually equal to what would have been required to produce a 5 per cent return on net worth without taxes.15 The data in Table 7 /8 indicate that the significant shift to less economic expansion started in 1961 when the Bank undertook major ex15 The 5 per cent rate is arbitrarily chosen. While the chartered banks' return on net worth (see Table 2/3) averaged 8.6 per cent in the 1957-67 period, it reflects tax considerations which are not discernible, and lower cost funds in the form of checking accounts and 2¾ per cent ( or lower) savings accounts. At the other end of the spectrum, the sales finance companies' rates of return appear excessive; thus, there is no type of financial institution which appears to be directly comparable. The 5 per cent rate has the feature of approximating the cost of IDB new money in the 1959-65 period. The statement that IDB would attempt to cover its costs, 'plus some moderate return on its capital,' offers no indication of a target rate of return (see Submission by the Industrial Development Bank, p. c 1) .

Credit from Public Non-Bank Institutions

161

pansion in staff (from 402 in 1961 to 624 in 1967) to accommodate the expanded number of eligible borrowers anticipated in 1961. It now appears that the expansion in staff, branches, and list of eligible borrowers has increased costs and reduced ratios of net profits to revenue and to net worth. The increased ratios of net profits to capitalization are undoubtedly related to the fact that IDB's spread (between borrowing and lending rates) has held relatively constant. As already noted, the expansion has also pushed the rate of return on total capitalization below the rate of interest paid by IDB, but not to a level which resulted in an actual subsidy by the federal government. It is also possible that IDB's profit margin will be reduced by higher loan losses than has been the case heretofore. Through 1967, ma's total losses were 0.424 per cent ('bad debts written-off, net') of total disbursements of $779.6 million, with the 1962-7 period showing relatively higher losses of 0.442 per cent on disbursements of $494.0 million. This latter ratio may not fully reflect the actual loss experience of lending to new types of borrowers since the period has been rather short for potential significant losses to be realized. Possibly reflecting the expectations of IDB is the fact that the 'reserve for losses' at the end of 1962 was 2.82 times the balance at the end of 1957, while outstanding loans were up 2.3 times over the same period; and from 1962 to 1967 these values increased by 2.42 and 2.02 times, respectively. Also, the reserve account has been increased from 1.25 per cent of loans and investments at the end of 1957 to 1.5 per cent at the end of 1962, 1.79 per cent at the end of 1966, and to 2.25 per cent at the end of 1967. Granting that loss ratios may rise, the fact remains that they have been very modest ( over the 25-year period 1942-66 the chartered banks' loss ratio was 0.161 per cent). This figure leads one to question how much risk is actually involved in lending to so-called 'marginal' firms. Granted that IDB's 23-year average is only slightly under three times that of the banks, the fact remains that the differential interest rate would only have to be approximately one quarter of one per cent higher to cover the differential loss. It appears that a carefully conceived set of lending criteria and procedures, employed by qualified people, can significantly reduce such risk. Further, it would appear that a modest rise in effective rates to recover increased losses, if they become a reality, could be implemented with little difficulty. IDB's view that it can take on more risky proposals as it has gained experience, and that it can 'assist in the sound development of more marginal enterprises'16 are indicative of what it has learned from its first-hand experience in lending to small business in Canada. 16 Speech to the Chamber of Commerce, Quebec City, by Louis Rasminsky.

162

Institutional Financing of Small Business in Nova Scotia

Functions in the financial institution structure

A reasonable perspective of IDB's functions in the financial institution structure at present and in the future can be obtained from an examination of current views on its functions. One IDB officer saw its main function as that of filling a term rather than a risk gap, and doing things other lenders would do only under terms and conditions less acceptable to borrowers. Thus, he did not see IDB as competing with chartered banks which at the time did not engage in term lending or take mortgage security. He saw the provincial ILF as a last resort lender relative to IDB, and thought that, if there was a pattern to IEL activity, it was one of IDB being a last resort lender to it. It was his view that the finance companies were last resort lenders which typically loaned on what he felt were unreasonable terms and conditions, and encouraged excessive equipment purchases. He also thought that there was an inevitable overlap between all public and private lenders, with any one capable of doing what another would do, at least at the margin. An IDB officer, questioned on the controversial subject of reasonable terms and conditions, said that the bank's officers came 'to know what sources provided what financing on what terms and conditions on the local scene.' li they thought that another lender would make the loan under conditions that were reasonable, they would request loan covenants which they were confident would send the borrower to the alternative source. Possible competition between the chartered banks' SBL Act lending authority and IDB lending was not viewed as serious by the IDB officer commenting on competition: He said: 'It will result in the smaller loans being provided by local branch banks which are in a better position to make them and can do so economically. They are also in a better position to formulate lending criteria for such loans than we are. But I do feel sorry for the banks having to make those loans at 5½ per cent interest.' 17 He saw little competition with mortgage loan, trust, and life insurance companies, because they were not at all active in business lending. He attributed their inactivity to the confused state of property titles in the province. Two representatives of the finance company industry were, as might have been expected, particularly critical of IDB in their presentations to and testimony before the Porter Commission. In their Submission, the 17 An IDB officer told the author in 1968 that he had not noticed any influence on IDB activity from either the SBL Act or the revisions of the Bank Act, but he thought that the period had been characterized by such high interest rates and tight money that the banks simply were not getting involved in term lending to small businesses.

Credit from Public Non-Bank Institutions

163

Laurentide Finance Corporation Ltd. alleged that IDB was a source of inequitable competition, and suggested that interest paid on IDB loans not be deductible for income tax purposes but, in effect, be regarded as a distribution of profit. It argued that this would restrict IDB activity to last resort lending, and eliminate those who went to IDB just for cheaper money. The effect of such a change would be to bring IDB's highest lending rate to an effective after-tax rate of about 7.5 per cent. The lowest after-tax rate of interest payable to sales finance companies, when effective rates are from 15 to 16 per cent before tax for loans of less than $100,000 (see chapter 8), would be 9.5 to 14.2 per cent for firms with taxable income of less than $35,000, the group most likely to include the customers of both IDB and the finance companies. If IDB was charging rates as if its own profits were taxable, then presumably the treatment of interest suggested would not apply; nevertheless, an IDB levy of 9.22 per cent (Table 7/9) not allowed as a tax deduction for the borrower would still be less than the after-tax cost of finance company loans at 15-16 per cent. A second sales finance company critical of IDB before the Porter Commission was Industrial Acceptance Corporation Limited (IAc). It questioned the existence of a gap in the financial structure, but said that, if one did exist, the 'state owned agency should be restricted to filling the gap.' It would concede only that there may have been a gap in 1944, but that the subsequent growth of private financial institutions 'substantially closed' it. 18 The advent and growth of various provincial agencies and Roynat (see below and chapter 8) leads one to wonder if there is not a gap beyond IDB; otherwise there would be no need for these organizations, or for the SBL Act. IAC contended, as did Laurentide, that the only advantage borrowers realized in dealing with IDB was the lower rate of interest. They argued that this low rate of interest was made possible by IDB's borrowing at below market costs through the Bank of Canada, the fact that IDB did not have to earn a rate of return on equity in order to attract it, and by its tax-exempt status. If IDB sought a return of 5 per cent after taxes of 50 per cent, it would have had to charge borrowers 9.22 per cent in 1967 (Table 7/9) . The addition of approximately 1.8 percentage points in this rate would have offset IDB's borrowing advantage relative to IAC 19 {see Table 7 /10) . Thus, if IDB were a tax-paying firm earning 5 per cent on its net worth and borrowing at the same rates as IAC, it 18 Brief of Industrial Acceptance Corporation Limited Submitted to the Royal Commission on Banking and Finance, pp. vi, 53. 19 In 1962, the year of IAC's submission to the Porter Commission, the differential rate was 0.8 per cent, with IAC's average borrowing rate at 4.7 per cent compared with IDB's 3.9 per cent. IAC's 1967 experience is undoubtedly related to the particular pressures on sales finance companies at that time.

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Institutional Financing of Small Business in Nova Scotia

TABLE 7/10 Average cost of borrowed funds Industrial Acceptance Corporation Limited and Industrial Development Bank 1965-7 Year 1965 1966 1967

IAC

IDB

(%)

(%)

5. 35 6.01 6.21

4.89 4.92 4. 37

Industrial Acceptance Corporation Limited, Annual Report , 1966 and 1967; Industrial Development Bank, Annual Report, various years, compiled.

SOURCB :

would have had to charge borrowers 11.0 per cent compared to IAC's average rate of 11.4 per cent. 20 The sales finance company contended that the critical aspect was the matter of 'reasonable terms and conditions.' They argued as follows before the Porter Commission: 'Irrespective of the rates being charged by IAC under various plans for providing business credit, it seems to us that agreement on a particular transaction by a customer implies that the terms will enable him to make a reasonable profit on his business venture, after allowance for all costs, including charges by IAC. The full price of our service is clearly controlled by competition in the market, which is still the best way for determining any price.' The most interesting aspect of this argument at the time it was presented was its inference that the borrower is knowledgeable about interest rates, and the juxtaposition of the opinion that something approaching perfect competition exists in the sales finance industry and the facts that: (a) IAC and Laurentide, combined, had total receivables at the end of their 1962 fiscal years equal to 53.1 per cent of all sales finance company credit outstanding at 31 December 1962;21 and (b) IAC's rate of return on net worth in 1962 was 11.63 per cent, while Laurentide's was 12.04 per cent. 22 20 The average rate of interest on receivables for IAC (interest income relative to year-end receivables) in 1965, 1966, and 1967, was 10.2, 1l.i, and 11.4 per cent, respectively; in 1961 and 1962 the average rates were 13.1 and 11.7 per cent, respectively. 21 Annual Report, Industrial Acceptance Corporation Ltd., various years; Laurentide Financial Corporation Ltd., Annual Report, various years; Bank of Canada, Statistical Summary Supplement, various years. This was an increase over the 1960 and 1961 proportions, which were 43.8 and 49.9 per cent, respectively. More recently, these two companies' total receivables as a proportion of all sales finance companies' receivables were 56.4, 52.7, and 48.4 per cent, in 1965, 1966, and 1967, respectively. 22 Annual Report, Industrial Acceptance Corporation Ltd., various years; Laurentide Financial Corporation Ltd., Annual Report, various years. The rates of return on net worth for 1960 and 1961, for IAC, were 13 .03 and 13.69 per cent, respectively; for Laurentide they were 13.64 and 9.77 per cent,

Credit from Public Non-Bank Institutions

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The Porter Commission may have indicated their concern with IAC's criticism of IDB by not bringing up the subject in subsequent questioning of IAC's officers. The Province of Manitoba was critical of IDB for acting as an 'arm of monetary policy' rather than as an agency to counter such policy in areas where there were no inflationary tendencies. The province also charged that there was a 'branch office climate' in IDB offices; tt wanted more decentralization, particularly to provide branches with authority to work out joint programs with local and provincial agencies. However, the province argued that the growth of IDB was evidence of the existence of a gap in the current financial structure. 23 The CMA Submission to the Porter Commission complimented IDB for having 'been very valuable in filling gaps in the financial facilities available to industry.' It thought that it would be preferable to have private lenders and internally generated funds finance further expansion of industry rather than have 'any substantial expansion in government banking.' CMA members complained about several aspects of IDB operations, the most significant of which were excessive security requirements and attention to present status of the applicant rather than to his potential. The members also suggested several changes in IDB policy, including more loans for 'venturesome' purposes, working capital, consolidation of existing debt, and acquisition of businesses currently in difficulties. Conclusion and recommendations

The principal conclusion that can be reached regarding IDB as a source of funds for Nova Scotia's small businesses is that it can be a significant source for a wide variety of purposes: it provides for relative freedom on security, moderate interest rates, loan terms to match the needs of the borrower, and has a commitment to such firms manifest in its efforts respectively. The latter company had an increase of $9.3 million in net worth in 1961 from the sale of stock. More recently, IAC's return on net worth was 11.5, 10.6, and 10.7 per cent, in 1965, 1966, and 1967, respectively; and, before significant reverses in 1966 and 1967, Laurentide had a return on net worth of 7.6 per cent in 1965. 23 Royal Commission on Banking and Finance, Hearings at Winnipeg, Vol. 8A (Toronto: Official Reporters), p. A 461. In his Quebec speech in May 1964 the President of IDB said that there was 'still a gap. Our experience shows that there are, in fact, many opportunities for successful lending to well managed, potentially profitable small businesses which find it difficult or impossible to borrow elsewhere.' In the same speech he pointed out that the gap had narrowed in recent years and attributed this in part to the pioneering efforts of IDB; he repeated these views, virtually verbatim, in a Halifax address in February 1966.

166

Institutional Financing of Small Business in Nova Scotia

to assist borrowers in devising suitable financing programs. As of the end of 1967, IDB had more credit outstanding to more Nova Scotia firms than either the Industrial Loan Fund (ILF) or the Industrial Expansion Fund (IEF); it was not until the major expansion of both ILF and IEF in 1967 that these two sources, in combination, exceeded IDB in loans outstanding - $11.5 million against $8.2 million for IDB. Further, IDB had more credit outstanding than IEL until the latter's major expansion in 1964. In fact, in the twenty-three years ending with 1967, IDB approved 371 loans for $22.1 million in Nova Scotia, whereas all business loan programs (excluding IEL) in Nova Scotia, from their inception in 1944 through 1967, made 230 loans for $22.7 million to industrial firms. Second, it seems obvious that the Nova Scotia businessman ought to be encouraged to be more aggressive in seeking IDB assistance, and that he not assume that any given set of money market conditions necessarily precludes IDB assistance. Third, it is recommended that the Bank study the economic ( and political, if need be) feasibility of implementing a policy of established priorities for the underdeveloped regions of the country, particularly the Atlantic region, with the priorities operating particularly during periods of restricted bank credit. 24 The priorities should not take the form of preferential interest rates, but should be implemented by more extensive and aggressive promotion, and an especial emphasis on highly skilled staff which would travel within the underdeveloped region. Any such promotion must recognize actual levels of initiative among small businessmen, and not rest on theoretical models of how these people 'ought to' behave. Fourth, businessmen in Nova Scotia would probably benefit substantially if IDB would attempt to educate chartered bank managers on the Bank's functions and services. The education program for branch managers should include an encouragement of referrals of applicants the chartered banks cannot or will not assist. Fifth, IDB should make a concerted effort to secure the services of personnel capable of exercising initiative in formulating financial plans for small firms, and in carrying out the type of financial analysis required for term lending. In this endeavour, they should not look to the chartered banks as a potential pool of employees. 24 Although far from definitive on the subject of IDB action during periods of monetary restraint, the following comments by the president of IDB before the Newfoundland Board of Trade in January 1968 are interesting: 'Although the Bank of Canada cannot direct monetary policy as such towards the specific economic problems of any one region, I believe that our subsidiary, the Industrial Development Bank, is in a position to make a modest, though not unimportant, contribution to regional economic growth.'

Credit from Public Non-Bank Institutions

167

Sixth, it probably would be a worthwhile stimulus to competition if were to state publicly that it regards all interest rates in excess of 10 per cent (effective) as 'unreasonable.' In any event, the carping criticism of the sales finance companies ought not to be taken seriously by anyone responsible for IDB policy. Seventh, the federal treasury would probably benefit significantly if IDB promoted loan guarantees more actively. This means of assistance could be availa_ble at little incremental cost to the borrower; further, with the banks permitted to take mortgage security and given freedom on interest rates, loan guarantees would put IDB services within easy reach of businessmen at any location. This last could be achieved only with the education of branch bank managers as suggested above. IDB

INDUSTRIAL ESTATES LIMITED

Industrial Estates Limited (IEL) was incorporated as a Crown Company of the Province of Nova Scotia in September 1957, and legislation concerning its functions was passed in May 1958. 25 It has authorized share capital of $10,000 (of which $8,700 has been issued to the province), and authority to borrow up to $100 million from the Province of Nova Scotia;26 there is no legal limit on the amount it may borrow from other sources. In seeking a workable alternative to an abortive development-type organization proposed in 1956, the government of Nova Scotia secured the service of M.D. Methven. In his 'Report to the Province of Nova Scotia' Methven's principal recommendation was as follows : 'I would create an independent and autonomous body charged to help finance industry as well as to provide industry with Industrial Trading Estates where sufficient population justified such a course and to provide Trading Estate amenities and facilities on single isolated sites where the smallness of the population did not justify the creation of an Estate.' He also recommended that attention be focused on light secondary industry, and he thought that the principal criterion for the provision of assistance should be the ability to provide employment, and that 25 Statutes of Nova Scotia, 1958, chap. 5. 26 This limit has now been raised four times : from an original $12 million to $18 million in March 1963, to $50 million in March 1964, to $60 million in 1965, and to $100 million in 1967. These funds may be obtained from the Special Reserve Account of the province, or out of the revenues of the province. Special resolutions at IEL meetings authorized a $15 million debenture issue in fiscal 1966, a u.s. $15 million secured notes issue in fiscal 1967, and a u .s.$15 million secured notes issue in fiscal 1968, the last to retire the 1967 issue. Special resolutions have also been passed permitting IEL to borrow money from any of four chartered banks.

168

Institutional Financing of Small Business in Nova Scotia

there should not be undue concern with losses unless they outweighed the benefits of the employment being created. However, he strongly urged that 'credit-worthy industry should be able to take care of itself.' The most noteworthy features of the Industrial Estates Limited Act are its generality, brevity, and the absence of statements on objectives, purposes, administrative machinery, or amendment procedures; however, the agreements 27 entered into between the province and IEL ( on 25 September 1957) do describe the objectives, functions, and responsibilities of the organization. 'Schedule A, Memorandum of Association of Industrial Estates Limited,' sets forth the objectives of IEL in detail, but it can be noted in summary that it provides for IEL to build, for sale or lease, buildings for firms when it will 'encourage the promotion, expansion and diversification of industrial activity' in Nova Scotia. It also provides for loans for the purpose of acquiring machinery and equipment. A significant change in general policy occurred in February 1964 when a general meeting of IEL passed a retroactive resolution: 'That the Company may ... with the consent of the Principal Shareholder ... subscribe for, take or otherwise acquire such shares or securities of other companies as the Directors deem fit.' The purpose of this additional authority was to permit IEL clients to benefit from grants from the Canada Area Development Agency. The principal agreement between the province and IEL sets forth the 'general policies' of IEL, of which the following are the most significant. (a) IEL would not assist the establishment of an industry which would endanger an existing industry. (b) Initially, only one 'industrial estate' would be planned for, but provision would be made for assisting 'single, isolated sites.' (c) New facilities would be provided those currently operating in the Province when the new facilities would ultimately result in greater employment, or when the lack of new facilities would prevent the firm from continuing to operate and provide employment. (d) Operating losses would be expected initially, but ultimately rentals would be set at a level which would enable IEL to break-even, 'subject always to the provision that rentals must be such as to be attractive to industry.' (e) No borrower would be ineligible for assistance by reason of ability to raise funds elsewhere. (/) Buildings were to be erected for sale or lease only when IEL was satisfied that 'the financial resources and business prospects of the potential tenant or industry are such as to justify such action.' (g) Buildings could be erected on speculation only when three-quarters of the Directors agreed. 27 'Memorandum of Agreement Between Her Majesty the Queen in the Right of Her Province of Nova Scotia ... and Industrial Estates Limited .. .' 25 September 1957.

Credit from Public Non-Bank Institutions

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'Schedule A' is followed by 'Exhibit B. Articles of Association of Industrial Estates Limited.' The principal points in this 'Exhibit' are that IEL can issue any type of security, so long as all shares are 'held in trust for the Minister of Trade and Industry and any profits must be distributed as dividends to the Minister'; and there is provision for the directors to have entire operating control of IEL. 'Schedule c' of the agreement names the original shareholders, and Schedule o is the 'Finance Agreement.' The principal points in Schedule D, as amended to mid-1968, are the province's commitment to provide IEL with the funds required, by purchase of IEL debentures, that the debentures are to be unsecured and for 20-year term 28 and are to bear interest, at a rate set by the Governor in Council, from 25 September 1962, or the date of issue, 'whichever happens second, or from such date not later than five years after the date of issuance. ' 29 In 1962, the general manager of IEL had a staff of four: a secretarytreasurer, a partially qualified engineer, and two secretaries. By 1967 this had grown to a staff of eleven: a secretary-treasurer who also acts as chief financial officer, a development officer, an assistant secretarytreasurer, a field representative, an industrial research officer, and six secretaries. In addition, there is a board of directors consisting of a president and eleven others, one of whom is appointed by the House of Assembly, and an advisory board, now consisting of five members, which was established in 1961. The members of the advisory board are all former Nova Scotians who, according to the 1962 Annual Report, 'have reached the top in the business and professional world.' The basic functions of the IEL office staff, including the general manager, are the promotion and development of industrial activity in 28 The initial agreement provided that the debentures be of perpetual term, callable at the option of JEL. 29 The interest 'holiday' to 1962 was provided for in the original agreement, and the additional option of five years from dates of issuance subsequent to September 1957 was the result of a 1961 amendment to this particular section of the agreement. At the time the amendment was made the Minister of Trade and Industry told the House that the objective was to offer further inducements to industrial development, by placing IEL in a position where it could charge low rentals to tenants during their starting period. He explained that the holiday option would be used to assist in the location of industry in the distressed areas of the province, and that such an inducement 'will not be used anywhere else.' However, he also pointed out that while the low rentals would be used as an inducement to location in the distressed areas - Springhill, and Cape Breton and Pictou counties - there would be no move to make such locations a condition of the normal assistance provided by IEL. See the Halifax Chronicle-Herald (16 February 1961). The Company's Annual Report, 1961, reported that considerable difficulty was being experienced in getting industry to locate in Springhill, and recommended 'more attractive inducements in the line of starting up or free rental periods.'

170

Institutional Financing of Small Business in Nova Scotia

Nova Scotia. Whether the applicant will ultimately be assisted by direct financing or by facilities for rent, initial negotiations are carried out with members of IEL's office staff. This stage of the negotiations, upon completion, result in a 'proposal' made by the applicant outlining his needs in equipment, buildings, land, and financing. The proposal, which normally includes audited financial statements for up to five years, a market survey, and forecasts of cash flows, income statements, and balance sheets for five years, is prepared by the client in consultation with the IEL office staff. The applicant is free to use legal, financial, and architectural advice of his own choosing, one consequence of which is that whether he receives a loan or premises for rent, the building is designed to his specifications. The proposal, together with credit reports on the company and its principals from banks and Dun and Bradstreet, is passed on to the Board. The Board then reviews the proposal prepared by the applicant, calling upon the office staff for backup information or clarification, and renders a decision to accept or reject the proposal. An IEL officer told the author that 'the Board is truly a working Board. They make the decisions on the basis of the proposal and their experience. If there is disagreement they appoint a committee from the Board which makes a recommendation to the full Board. None of the administrative staff are on that Committee.' If the applicant's proposal is accepted, the office then assumes responsibility for drawing up the necessary contracts, gathering and collating any relevant data still required, and disbursing and collecting funds. While it is the responsibility of the applicant to develop his own proposal for presentation to the IEL Board of Directors, it is encouraging that IEL now has a staff qualified and willing to assist the applicant in the preparation of his proposal. Regardless of the extent to which one might deplore the situation, one of the realities to be faced in developing the small business sector of the Nova Scotia economy appears to be the apathy and ignorance of financial matters on the part of managers of such firms. Unless the lender is prepared to take a considerable amount of the responsibility for assuming the initiative, and to guide the applicant through forecasts and loan applications, it is unlikely that the lender will be a significant factor in the development of small business in Nova Scotia. Types of financial assistance available

In addition to financial assistance for buildings and equipment described below, IEL provides fully serviced land on 'estates,' and will do market and transportation analyses, provide for facilities for future expansion,

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provide plants designed to the specifications of the prospective tenants, and arrange for municipal property tax 'holidays' for its tenants. Authority to purchase clients' securities was originally provided only to Springhill Development Corporation Limited (soc), 30 but was also given to IEL in 1964. In all other respects soc is the same as IEL, except that IEL advances to the former were interest free; that is, IEL absorbed the interest cost. Initially, the basic type of IEL assistance to clients was the provision of plant facilities by indefinite rental, fixed period lease, lease with purchase option, or purchase-leaseback. There is no upper limit on the term of leases, but the legislation and agreements suggest a maximum of ten years. In practice, an IEL officer said that the actual limit is twenty years, and 'most are for that period, although we have some for ten and fifteen years.' The purchase option on IEL buildings provides the tenant with the opportunity to purchase the building at its 'net book value,' which is defined as the initial cost of the building, land, and architects' fees, less any payments over and above the interest and administrative charges. The purchase option may be exercised at any time by the tenant. Beginning in fiscal 1965, IEL emphasized direct loans rather than facilities for lease, in order that the firms so assisted could avail themselves of the grants and tax benefits provided for under the Federal Designated Area legislation. 31 In the 1966 Annual Report, IEL's president noted that when financing is provided by this means, and IEL 'has no ownership in the property, it has been found necessary to let the client build his own property without any restrictions from Industrial Estates regarding tender calls, etcetera, except to make sure that the design of the structure is consistent with good building practices, and that the costs are in the price range of this type of construction in the area.' The term of loans for land and buildings is set at a maximum of twenty years, with IEL loaning up to 100 per cent of the cost of land and buildings on mortgage security. The loans may be prepaid by the borrower without penalty. IEL equipment loans are for a maximum of ten years, secured by a chattel mortgage on the equipment being financed, and are made for 30 soc was established as a wholly owned subsidiary of IEL during fiscal 1959, to provide special assistance to the town which had been hit by major disasters in 1956, 1957, and 1958. To date slightly over $1 million has been invested through soc, and the 'subsidiary' was absorbed by IEL in June 1968. soc's authority to purchase securities was first exercised in 1962. 31 This legislation requires that beneficiaries of Area Development Agency grants own their own buildings and equipment.

172

Institutional Financing of Small Business in Nova Scotia

up to 60 per cent of the cost of the equipment. Initially, IEL leased some equipment to tenants, but at the end of fiscal 1962, $165,000 (the entire amount) of equipment on lease was transferred to the mortgage account. Although not required by the agreements, practice has been to restrict financing of equipment to firms which occupy buildings financed by IEL. In practice, the principal criterion for eligibility for IEL assistance appears to be a firm's ability to generate employment in the province. The preferred recipients are those who can assist in developing, expanding, or diversifying its industrial activity, those who would increase light or secondary industry; and those most likely to benefit Nova Scotia's economy by using its natural resources, complementing existing facilities, and/or improving the province's balance of trade nationally or internationally. Those who might jeopardize the position of existing firms may be excluded, but the criteria are liberal. 32 An IEL officer pointed out that when there are doubts about the principals of the applicant firm, it will seek personal guarantees of payment in addition to the signed lease, and liens on other buildings owned by the applicant. The criteria for choosing those who must provide such additional security are not set out, but one officer suggested that the nature and location of the building, the experience and personal net worth of the principals, and the capitalization of the firm, were the standards used to decide who would be requested to provide it. Other data which have to be supplied by applicants have been described above. No precise data are available on application-rejection ratios, but IEL officers conveyed the impression that most rejections resulted from the applicant requiring financing of a type (for example, working capital) not provided by IEL, or because the applicant had 'no business background.' The point at which IEL 'fits' into the financial institution structure is not clearly delineated, except to note that it will do things other institutions do not do. It does not appear that IEL is a lender of last resort, although it does not refer applicants elsewhere. If the applicant is capable of expanding employment in the province, and is otherwise acceptable, IEL offers lease financing of a building and land, equipment and/ or real estate loans, and/ or agrees to purchase debentures or equity. If the applicant finds the offer acceptable, the 'deal' is on; if not, IEL may compromise, but is unlikely to refer the applicant to alternate sources at any stage, particularly at the outset. (Occasionally, 'in32 An IEL officer told the author that competing firms would be assisted if they offered the possibility of increased exports from the province.

Credit from Public Non-Bank Institutions

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eligible' applicants have been referred to IDB and ILF, but not to chartered banks.) While recent security purchases might appear to have changed the orientation, an IEL officer probably put the organization's position most aptly when he said: 'IEL is primarily in real estate and industrial development rather than the financing business.'

Firms assisted By the end of fiscal 1967, IEL had assisted a total of fifty-five firms (an additional five were assisted by Springhill Development Corporation), of which forty-three were located in five of Nova Scotia's eighteen counties. Detailed data available to the writer concerning firms assisted by IEL through 1962 indicated that in its early years assistance was not likely to be provided for firms managed by businessmen whose experience and financial resources had not 'matured,' whose firms required specialized plants, or who proposed locating outside the main population centre ( s) . Of the twenty-two firms which signed agreements with IEL up to the end of fiscal 1962, three were assisted by soc. Of the remaining nineteen it appears that none were new firms, over one-third ( 8) were in Halifax county, and the remainder, while dispersed (see Table 7 / 11), were established names. At least fourteen of the nineteen were established prior to IEL, since they were listed in the Nova Scotia Directory of Manufacturing, 1958, which was based on 1957 data. Of these, eight replied to a mail questionnaire prepared by the author: TABLE 7/11 Total firms assisted by Industrial Estates Limited ( distribution by county) 1962, 1966, and 1967

County

1967

1966

Cape Breton Colchester Cumberland• Digby Halifax Hants Kings Lunenburg Pictou Queens Yarmouth

5 6 3 1 18 1 4 5 9 1 2

2 6 2 1 16 3 4 7 1 1

2 3 1

Totals

55

43

19

1

1 1 1 8

1

Industrial Estates Limited, Annual Report, various yean. In addition, there were three soc assisted plants in 1962 and five at the end of 1966.

SOURCE:



1962

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Institutional Financing of Small Business in Nova Scotia

the newest of these eight firms was established in 1953, the oldest in 1931; the average age of the eight was 12.6 years; four had over 100 employees, and only one had less than 25 employees at any time during 1959. Thus, this two-fifths sample of the nineteen IEL-assisted firms does not indicate special efforts for new firms, or for firms with employee size common to the province. In addition, two other firms listed in the Directory, but not included in the mail survey, would not qualify as small businesses by any yardstick. Of the five firms not listed in the Directory, two were branch plants of large national firms, one was from Europe, and two were new firms reputed to be under non-Nova Scotia management. Comparable data are not available on the thirty-six agreements signed since 1962, but at least eighteen of the firms involved are known to be branch operations of already established firms . The dominance of Halifax county has tapered off with eighteen of the fifty-five agreements signed with firms located there, after eight of the nineteen agreements signed through 1962 were in Halifax county. Fiscal 1967 appears typical of recent IEL activity: in that year it signed agreements with twelve new clients - six with Nova Scotia firms, three with firms from the United States, and three with one firm each from Austria, Japan, and Ontario - and undertook to finance expansion of four firms that were already IEL clients. Probably the most salutory development of recent IEL history is that in the 1963-7 period nine agreements ( with eight different firms) were signed in Pictou county, and four agreements were signed in Cape Breton county. Locational advantages (plus the possibility of modest political considerations) could account for the increases in Halifax and Colchester counties. As indicated below, IEL has undoubtedly stimulated employment and ultimately will stimulate economic growth in Nova Scotia. However, its record indicates clearly that it is only in the latter stages of its first nine years that it has become a source of any significance for firms and individuals already in the province; throughout its existence it has been of virtually no significance to small new businesses. If it is to assist these small businesses in the future, it will be necessary for it to increase its staff, since it is not currently equipped to assist such firms, and has made minimal use of consultants to complement its staff deficiencies, with outlays for 'Consultants' Fees' hitting a high of $15,300 in 1965, and averaging $10,600 over the six years 1962-7. The fact remains that for the mature small local firm it provides a potential source of funds, a potential which has been enhanced by IEL's recent direct lending, and will assist such firms when they branch into new endeavours. The benefits of stimulated employment, economic

Credit from Public Non-Bank Institutions

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growth, and a potential source of funds to mature small local firms must be compared with the cost of operating IEL.

Financial operation analysis The financial operations of IEL are reported upon annually, but the annual reports issued, with the exception of that for 1967, have been presented in a manner which maximizes confusion, minimizes comparability, gives no indication of the efficiency with which resources are being used, and leads one to question how the auditors could certify the statements as they did. Despite the limitations of the annual reports, they make it clear that IEL has grown considerably since the end of 1959. At the end of 1959 IEL had signed six agreements, invested $600 thousand in projects for rental, loaned no money, and owed the province $891 thousand. By the end of 1967, it had assisted fifty-five firms, invested $21.5 million in projects for rental, had loaned $50.7 million, had purchased $3 million in 'shares of client companies,' and owed the Province $56.9 million (all exclusive of advances to soc). The other major source of funds at the end of 1967 was a secured term note of $15 million u .s. The $50.7 million outstanding on loans at the end of 1967 represented a substantial change in the form of assistance provided by IEL. The year-end investment in projects for rent was 28.6 per cent of total assistance in all forms (rented projects, loans, and share holdings) at the end of 1967, an appreciable decline from the 73, 91, and 86 per cent levels of 1965, 1964, and 1962, respectively, and down slightly from the 35 per cent level of 1966. This change is the product of two different conditions. First, as already indicated, federal Designated Area legislation provides beneficial tax treatment only on owned facilities; thus, IEL provided loans to enable the firms to undertake their 'own' construction. Second, the province, partially through IEL, set out to assist in the construction of a heavy water plant in the 1964 fiscal year. A series of nightmarish events has placed IEL in the position of owning control of this plant (not in production up to the end of April 1969), with a $25,000 equity investment, and advances totalling $28.2 million at the end of fiscal 1967 - 56 per cent of all IEL loans to all clients.33 In order to appraise the operations of IEL it is first necessary to digress to describe the rental charges it levies upon clients. There are three basic components to the rental fee paid by IEL tenants: an interest 33 Direct advances by the province to Deuterium have been estimated at an additional $56.8-$65.3 million.

176

Institutional Financing of Small Business in Nova Scotia

charge, an administrative charge, and the charge for the recovery of the capital cost of the rented facilities. An officer of IEL disclosed in 1962 that the interest levy on tenants generally had been 5.5 per cent, fixed for the term of the lease, but he thought that the rate would be raised to 6 per cent in contracts written after September 1962 ( when the province would begin to levy interest charges, 'at the rate or rates from time to time determined by the Governor in Council' ); in any event, rentals are normally set at two percentage points above the rate of interest the province is charging IEL in the current year, and loans are set at one percentage point above IEL's borrowing rate. The two percentage points added to the prevailing interest rate are for capital recovery (or amortization of principal) and for recovery of administration cost. The interest charge to the client is based on the declining balance of the principal, the administrative charge is fixed at 1 per cent of the project cost, and the balance of the rental payments is applied to the principal. Thus, a tenant of a $100,000 project, initiated when the IEL rate payable to the province was 5½ per cent, would pay rent of $7,500 per year; if the assistance had been in the form of a direct loan for 20 years, with an interest rate of 5½ per cent, plus 1 per cent for administrative costs, annual payments to amortize principal and interest would be $8,357 plus $1,000 for administrative costs, or a total of $9,357. A 7½ per cent rental rate, with the balance of each rented payment ( after interest and administration charges) applied to the principal, would require slightly less than thirty-five years for recovery of the cost of the rented facility. 34 The thirty-five year building write-off appears reasonable, and an interest charge of 5.5 per cent approximately matched borrowing costs for similar maturities for the province through 196535 - 6 per cent would be more appropriate after that date. 34 The situation is analogous to retiring a loan by means of equal annual instalments equivalent to 6.5 per cent of the initial principal, with the interest rate on the loan at 5.5 per cent of the declining balance; one percentage point - 'off the top' - goes to administration. It should be pointed out that, if the rental charge is increased by an amount equal to a desired increase in interest, the actual result would be a reduction in the period required to recover the capital cost (and/ or an increase in actual interest yield). 35 There is limited evidence that the rate actually charged IEL by the province is 5.5 per cent, in that the 1966 interest payment set by the province was 5.53 per cent of the average amount of debentures outstanding during the year, and in 1967 interest payments were 5.27 per cent of the average amount owing the province. The province's eleven bond and debenture issues, with maturities of five years and over, in the 1960-2 period had average interest rates of 5.24 per cent. See Royal Commission on Banking and Finance. A Submission by the Government of Nova Scotia (Halifax 1962), Appendix J.

Credit from Public Non-Bank Institutions

177

Thus, one of the first steps in an analysis of IEL's financial operations is to determine whether rental charges have achieved the desired objectives of 7½ per cent; it would appear initially that they have not (see Table 7 / 12). IEL has not collected rentals equal to 7 .5 per cent of average project investments in any year since its inception; however, it has equalled or exceeded 6.5 per cent in three years, and has equalled or exceeded 5.5 per cent in four years. It should be noted that the year 1966 in which IEL collected 7.4 per cent of project investments is the only one in which average project investments are within 5 per cent of the preceding year-end project investments. Therefore, it would appear to be safe to conclude that IEL has not appreciably missed the mark of 7.5 per cent on completed projects from which it was collecting rental. 36 It is difficult to make any definitive statements concerning interest rates charged for loans made by IEL unless at least one assumption is made: that interest income is treated on a cash rather than on an accrual basis; that is, that it is only shown as income when it is actually collected. This appears to be the only reasonable assumption which will reconcile the fact that the aggregate interest income reported over the 1960-5 period was equivalent to 7 .06 per cent of the aggregate of average balances over the six years involved and the fact that interest income in both 1966 and 1967 was 3.2 per cent of average balances. If one adds the accrued interest income reported on the balance sheets for 1966 and 1967 to interest income reported in the income statements in both of those years, the yield on average balances works out to 5.92 and 4.54 per cent, respectively. These figures appear to tie in much more satisfactorily with the 1960-5 experience. 37 All things considered, it appears that IEL loans, at least through fiscal 1966, bore interest at a rate of approximately 7 per cent. (IEL's 1967 Annual Report indicates three specific loans made at rates of 6.5, 7, and 7.5 per cent. However, the 11 March 1968 issue of the Financial Times of Canada, in a feature article on IEL, said that interest on advances for equipment and buildings was 'from 7½ to 8½ per cent.') If the rate is 7 per cent, IEL is achieving its objective with some to spare, on the assumption that the target for loans is the recovery of an interest cost of 5½ per cent plus 1 per cent for administration costs; if the interest cost to IEL is 6 per cent, then it would appear to be achieving its target almost precisely. 36 Under actual conditions, the interest and administrative costs incurred during the construction period should be capitalized as a part of the project cost; otherwise, they would have to be borne by the province. 37 An attempt to explain the drop-off in interest yield by excluding the advances to Deuterium did not provide useful results: it indicated yields of 10.6 per cent for 1966 and 8.7 per cent for 1967.

TABLE 7/12 Industrial Estates Limited investment and debt analysis years ending 31 March (dollars in thousands) 1967

1966

1965

1964

1963

1962

1961

1960

1959

investments at year end

$21,493.9

$19,843.7

$19,101.8

$ 9,791.5

$5,769 . 4

$4,070.2

$2,296.3

$1,665.2

$599.9

investments• Rentals received during year

20,668.8 1,434.5

19,472.8 1,449.3

14,446 .7 744.9

7,780.5 376.2

4,934.8 321.4

3,183.3 177.1

1,980.8 94.7

1,132.6 45.0

300 .0 3.6

Gross recoverable project

Average recoverable project Ratio of rentals to average project investment

Balances due (ex. soc) from

clients re advances at year endt Average balance due re advances• Interest received during year Ratio of interest to average balance Debentures payable to province, at year end Debentures payable to province, less advances to soc, at year end

Average debentures payable (ex. soc)•t Interest paid on debentures Rate of interest to average debentures Total of average project investment plus average

balances due Total of project investment plus balances due (ex.soc) Finns assisted, cumulative

Ratio of total amount of assistance to firms assisted •

t

i

6.9¼

$50,647 . 6

$37,751.6

44,199.6 1,393.0

22,425 . 2 722.4

3.2%

3.2%

4 . 8¼

5.2¼

7.4% $

7,098.7 4,031.2 281.4 7.0%

$

6.5%

5.6%

963 . 7

S 797 . 8

$ 660.2

$ 512. 1

880 . 8 56.1

729.0 50. 7

586.2 50.8

277 . 0 16.2

6.4%

7.0¼

8.7%

$890. 9

3,090.2

2,189.7

890. 5

4,005.0

2,640.0

1,540. 1

478.8

$11,652. I

$7,582 . 1

$5,482 . 1

56,931.6

41,259 . I

25,778.4

10,617.5

6,576.1

49,095.4 2,587.3

33,518.8 1,853.5

18,198.0 305.2

8,596.8 102.0

5,747.9 74.5

1.19%

2,576.2

26.8%

4, 919. 7

$26,287. I

1.68%

41.8 20.9 5.6

$2,429.0

$42,247. I

5.53%

3.2%

$

S 4,646.7

1.2%

$3,542. I

$57,878.9

5.27%

4.0%

4.8%

Totals

1.30%

64,868.4

41,898 . 0

18,477. 9

8,661.3

5,663.8

3,769.5

2,257 . 8

1,153 . 5

300.0

72,141.5 55

57,595.3 43

26,200.5 33

10,755.2 32

6,567.2 25

4,730.4 19

2,808 .4 13

1,707.0 II

599.9 6

1,31 I. 7

1,339.4

794.0

336. 1

262. 7

249 . 0

216.0

155.2

100.0

Averages are computed by adding one half of the year-to-year increase to the balance indicated for the end of the preceding year. Balances due: S 41.8 $ 13.3 $ 166.8 S 152.4 $ 262.4 $ 1,403.6 $ 1,593.5 $ 1,803 . 0 Equipmentmortgages 498.8 476 . 5 240 .0 215 .7 189.7 161.6 128 . 8 Real estate mortgages 16 .9 405 .4 485.6 5,505.4 35,996 . 5 48,715 . 8 Other advances 41.8 512.1 660 .2 797.8 963.7 7,098.7 37,751.6 50,647 . 6 Totals Springhill Development Corporation advances are excluded on the assumption that the province does not charge IEL interest for them.

4,922 . 5

Credit from Public Non-Bank Institutions

179

In summary then we have IEL possibly falling slightly short of its target on rental charges while it is meeting its target on lending activity. (It seems reasonable to levy the 1 per cent administrative charge for advances, despite the probability that the administrative cost of such activity is less than for rental activity, because of the need to provide for losses on loans.) An apparent past weakness in IEL's operating performance is reflected in Table 7 /13, which shows that operating expenses exceed 1 per cent of the sum of average project and loan investments in each year through 1965; since that time a levelling off in operating expenses, despite substantial increases on investments, has brought these expenses well within the target limits. Table 7 /13 was prepared in an attempt to approximate the 'loss' incurred by IEL over each of its first nine years. In examining these data it should be kept in mind that the application of straight-line depreciation does not match IEL's method of recovering capital cost, that is, the process of applying the balance of rental payments, after interest and administrative costs, would result in capital cost recovery increasing each year of the life of the lease. If 'depreciation' was charged in a manner which matched the capital cost recovery pattern used by IEL, the losses in each of the years would be less than indicated in Table 7/13. The only encouraging aspect of the analysis of IEL's total expense data is that the expenses, expressed as a percentage of investments, have been declining steadily. Total revenues over the nine-year period exceed the sum of operating expenses and non-recurring expenses by $5.5 million. However, estimated interest costs of $6.9 million and estimated depreciation costs of $2.5 million leave IEL with a 'deficit' of $3.8 million. In fact, IEL has never reported a deficit as such. Initial operating expenses in excess of revenues, through 1960, were capitalized and are being written off against revenues. 38 In 1966 and 1967, grants of $413,445 and $1,145,200, respectively, were made by the province to cover the excess of costs over revenues of those amounts in those years; thus, in the conventional sense, IEL should now be showing a deficit equal to the amount of the grants, or $1,559 thousand. This deficit, in turn, would have to be reduced by the $964 thousand reserve which has been built up, leaving a net deficit of $595 thousand. The difference between the deficit shown in Table 7 /13 of $3,838 thousand and the deficit which IEL might show is, therefore, $3,243 thousand, accounted for as follows: 38 While in a conventional accounting sense this would probably be regarded as a deficit, IEL's source of funds to support the deficit was an increase in its borrowing from the province.

TABLE 7/13 Industrial Estates Limited revenue and expense estimates years ending 31 March (dollars in thousands)

Revenues Rentals received• Applied to operationst Applied to capital costt

Total rentals Interest receivedt Total revenues Expenses Operating expensest Non-recurring expensest Depreciation at 3.33%+ Interest at 5.5¼ + Total expenses Loss Ratios : Operating expenses to average project investment§ Operating expenses to total of average project investment plus average balances due§ Total expenses to total of average project investment plus average balance due§



1967

1966

$1 ,049 . 0 385 . 5

$1 ,050.1 399 . 2

--1,434.5 1,393 . 0

2,827 . 5

1965

--1,449 . 3 722 . 4 --2,171.7 ---

--263.9 - 688.3 2,700 . 2 --3,652 .4

--2,823 . 6

=

=

--824.9

308.6 23.1 648 .4 1,843.5

--651 . 9

1964

1963

1962

1961

1960

$ 514. 8 230.1

$312.3 63 . 9

$273. 8 47 . 6

$156 . 1 21.0

$ 87.4 7.3

$ 40 .9

281.4 --1,026. 3 ---

-432.3

--

-321.4 50.7 -372.1 --

- 481.1

227.4 24.8 259.1 472.8

170.3 6.5 164.3 316.1

--717.1

984 . 1

--744 .9 261.4

1,000.9 --1,743 . 4

=

-376.2 56. 1

--

-551.8 =

-657 . 2 -285.1 =

-177.1 50.8 16. 2 -227.9 110.9 -- -110. 1

-106. 0 275 . 3 -491.4

-263 . 5 =

-94.7 -

91.8

-66 . 0 145. 2

303 . 0 192.1 =

1959

4.1

-45 . 0 5.6 -50. 6

$ 3. 1 .5

-3.6 -3. 6

--

-

84.3 49.4 37 . 7 84.7

113 . 1

--

256.1

205 . 5

--

Totals

$ 3,487 . 5

1,159. 2

--4,646 . 7 2,576.2

-7,222 -.9

-

1,630 .9 103 . 8 2,460.9 6,865 . 0

-10.0 26 . 3

-149.4

---11,060.6

--

=

-145.8

1.28%

1.58%

1.81%

2.92%

3.45%

3.46%

4 . 63%

7 . 44%

37 . 7%

0.41%

0.74%

1.41%

2 . 63%

3.01%

2 .92%

4 . 07%

7 . 31%

37.7%

5. 63%

6 . 74%

9.44%

11.36%

11.60%

13.42%

13.42%

22 . 20%

22.80%

3,837 . 7

Rental payments are d istributed by IEL to apply to operations, including non-recoverable project investments, and capital costs. It would appear (see text) that these payments are set at a level which will amortize the principal and interest involved in the project and contribute to operating expenses. Thus, effective rental rates are best approximated by applying total rental revenues to the portion of project investments which IEL expects to recover from tenants. t Taken from Industrial Estates Limited, Annual Report, various years. Rentals applied to operations in 1966 were reduced by $6,000 from the reported figure to offset a credit to the account reflecting a recovery of capital cost. Operating expenses for 1967 reflect a credit for $20,700 arising out of a reduction in Provision for Doubtful Accounts . i Estimated, based on straight-line depreciation over 30 years, of year-end average project investment, and an assumed interest cost payable to the Province of Nova Scotia of 5.5 per cent on average debentures payable at year-end. See Table 7/12 for average balances. § See Table 7/12 for average balances used in calculations.

Credit from Public Non-Bank Institutions Estimated depreciation Capital cost recovered

$2,461

Estimated interest Interest paid province

$6,865 4,923

Difference in deficits

1,159

181

$1,302 thousand 1,942 $3,244

Thus, on a full cost basis, it is clear that IEL is an expensive appendage to the province's industrial development activities. The cost should, however, be viewed in the light of several other factors. First, as the proportion of completed and rent-paying tenants increases relative to total project investments, and as the period of tenancy of these tenants increases, interest costs associated with projects will be lower, while rentals will hold constant, and eventually the annual deficits will disappear, profits will appear, and the accumulated deficits will be whittled away. Second, IEL's operating expenses appear to be levelling off, with the 1965-6 increase being smaller, both relatively and absolutely, than had been the case in other recent year-to-year situations ($49,000 of the increase was accounted for by a larger doubtful account provision, which one would like to think of as an infrequent item), and 1967 actually produced a decline in operating expenses and bore out the nonrecurring nature of the provision for loss, the account being reduced by $20,700 in 1967. Third, data released by IEL in March 1968, indicated that IEL's completed and operating projects directly employed a total of 4,456 people at the end of October 1967 - a rather startling contrast to the estimate of 530 new jobs reported to have been created by IEL assisted firms at the end of its fiscal year 1960. Also, in March 1967, the Nova Scotia Minister of Trade and Industry told the legislature that IEL's completed, in process, and pending (i.e., under contract but not yet in the process of construction) activity would result in 9,081 direct and related new jobs, with a total annual payroll of $37 million. Implicit in this forecast was the assumption of direct employment of 4,100 in IEL financed projects. With the accumulated deficit for nine years, on the basis estimated in Table 7/13, representing approximately 11 per cent of the expected increase in annual payrolls, it is not difficult to accept the estimated loss as a prudent expenditure of taxpayers' funds. The social benefits derived from increased employment opportunities cannot be calculated, but $4 million, over nine years, seems a small sum to pay for the improvement in human welfare. It is possible, therefore, to make the following suggestions regarding

182

Institutional Financing of Small Business in Nova Scotia

the financial aspects of IEL : (a) operating expenses should be held to one per cent of the sum of average balances due on project investments and advances, in order to provide a tighter budget control on expenses and to increase the amount which can be credited to principal each year; ( b) rates for rentals should be set at two percentage points above the cost to the province of funds of similar maturity and rates on IEL loans should be set at least one percentage point above the cost of funds; ( c) IEL's annual reports should be published in a manner that makes them understandable to the average member of the legislature, possibly with the income statement presented in a form resembling that shown in Table 7 /13 and losses explained by the Minister responsible in the manner set out in the paragraph above; and finally, (d) it is most undesirable to have the province 'pick-up' IEL's deficits as it did in 1966 and 1967, and much to be preferred that deficits be supported by having the province buy either additional shares or debentures of IEL, since the current practice will, over time, tend to obscure IEL's loss years. It would not be reasonable to conclude a discussion of IEL without at least passing reference to the substantial amount of controversy which has surrounded it. The controversy has occurred at two levels the political and the economic - which have a strong tendency to diverge at regular intervals. Specifically, there are three items up for regular discussion in the House of Assembly. First, there is IEL's investment in Deuterium of Canada Limited. IEL initially planned to invest a total of $12 million in loans and 40 per cent of the capital stock of this firm. However, the federal government insisted that a firm which was to provide heavy water to Atomic Energy of Canada Limited had to be Canadian controlled, so IEL increased its investment to 50.1 per cent of the voting stock, at a cost of $25,001. All estimates of required investment proved to be too low when IEL's United States partners could not raise the additional capital required for an AECL request for enlargement of the heavy water capacity. At this point the u.s. partners departed and the Province of Nova Scotia bought up the 49.9 per cent of control not already held by IEL. Furthermore, all of the plans of IEL's u.s. partners to raise money had fallen through, leaving the entire responsibility for financing Deuterium, at a cost estimated at from $85 to $93.5 million up to the province and IEL combined ( $28.2 million from IEL). The Deuterium situation is complicated by delays in startup of production (its scheduled opening has already been postponed one year), and the fact that the investment will produce direct employment for only 200 persons. Second, there is IEL's investment in Clairtone Sound Corporation

Credit from Public Non-Bank Institutions

183

Limited. This company experienced consistently poor results from operations, increasing both sales and losses over the past three years. IEL has, since the end of 1967, invested a total of $12 million in Clairtone and has voting control of the firm. Both Deuterium and Clairtone generate considerable controversy because both represent golden opportunities for 'Monday morning quarterbacks,' the Opposition party in the House, who have regularly questioned the judgment of IEL in supporting both of these firms, and investing additional money in what appeared to be situations with poor prospects. From the economic side there is a question of how far the province, directly or through IEL, is going to go in terms of 'getting into business for itself,' and the cost-benefit relationships of these two projects in particular. Undoubtedly there are many times when the members of the Board of Directors of IEL wish they had never heard of either of these two firms, and, hopefully they will dispose of them at the earliest opportunity. The fact remains, despite clear post facto evidence of poor judgment, that an activity such as IEL is bound to pick some 'losers.' Their number should hopefully be small, but to insist that there not be any losers is virtually to invite a termination to all capital assistance. The third matter related to IEL concerns the situation in Cape Breton, where the 1967 decision of oosco to close its steel-making operations forced the province to get into the steel business, requiring from $10 to $25 million in immediate investment, and raising the question of whether this should impinge upon the funds available to IEL from the province. Current opinion appears to be that the oosco problem should not and will not influence IEL's position, principally because IEL should be independent of the provincial government. The independence and autonomy of IEL have also raised some controversy. For example, the Atlantic Provinces Economic Council has argued that Halifax-Dartmouth should be a 'growth centre' for the province. The Council feels that its suggestions have not been reflected in IEL activity in that IEL has made only eighteen of fifty-five investments in the Halifax-Dartmouth area, and another nine in the Pictou County area. 39 IEL does appear to give some emphasis to social responsibilities, in the form of employment opportunities throughout the province, at the possible expense of a more efficient policy of concentrating its efforts in a few growth areas. 40 39 Possibly indicative of the cross-purposes of several agencies is the fact that the Nova Scotia Voluntary Planning group, in its 1967 annual report, praised IEL for the fact 'that it continues to succeed in attracting new industry to the Province, in spite of the advent of the federal Area Development Agency.' 40 It is rather interesting to study those who argue for 'growth centres' in

184

Institutional Financing of Small Business in Nova Scotia

Conclusions and recommendations

The principal conclusion that can be made about IEL is that it has the potential of being a significant source of funds for Nova Scotia's small businesses; in practice, it has not achieved this potential for either small or new local businesses, and several changes would have to precede the effective provision of financing to such firms. Recommendations concerning the future of IEL must contemplate the alternative 'shapes' the organization can take. The basic alternatives in terms of type of financing are emphasis on facilities for rent or upon direct advances, or a mix of the two. Under any of these approaches it can elect to emphasize the attraction of firms to the province, the development of new and small firms in the province, or the development of established provincial firms; alternatively, of course, it can choose to emphasize some mix of any two or more of these. Finally, IEL can decide for or against the provision of advisory services to small firms, mentioned as a possibility in its Annual Report, 1960. To date, IEL has not involved itself in advisory services to any significant extent, focusing instead on firms locating in the province and established local firms, and assisting them by providing rental facilities and direct financing. Dealing with each of the decision areas in turn, it would seem, first, that IEL should continue to mix assistance by providing both rented facilities and advances, but that it should consider increasing service to local firms by expanding its equipment financing service (a) to make mortgage financing of equipment available to non-tenants, and ( b) to make equipment available on a lease basis to both tenants and nontenants. In arriving at a desirable mix of rental and advance assistance, care should be taken, particularly with the latter, that ready availability does not turn out to be equivalent to a carte blanche for firms to build in very high overhead costs which would virtually preclude their financial success. Second, the mix of new and established firms to be assisted should move towards the former, a move which IEL can now make because the Nova Scotia, and the Maritime Provinces generally. Their basic thesis appears to be that the province or the region would grow more rapidly and better use would be made of resources if they were allocated to a few already developed areas (e.g. Halifax-Dartmouth) to the virtual exclusion of the remainder of the province. It appears to this writer that it is frequently these same people who complain most loudly about the concentration of activity in central Canada to the exclusion of the Maritimes - truly it does 'depend upon whose ox is being gored.'

Credit from Public Non-Bank Institutions

185

risk portion of its 'portfolio,' with the exception of Deuterium and Clairtone, is not particularly large; that is, there is apparently no reason why, with the passage of time, giving increased attention to higher risk, new ventures (to be established by residents of the province) would unduly increase the risk of the portfolio. This would be particularly so once the Deuterium and Clairtone investments have been disposed of. At the other end of the spectrum, it would probably be desirable for IEL to have a limit on the amount it could invest (by loan or rental project) on behalf of any one firm, and consideration might be given to the following suggestion: no more than 10 per cent of the aggregate of advances and project investments at the previous year end to be committed to any one client at any time, and the sum of the commitments to any three clients not at any time to exceed 25 per cent of the aggregate of advances and project investments at the previous year end. Such a policy would tend to make IEL's portfolio less dependent upon a few large investments, and could encourage 'secondary offerings' of the securities and lease contracts of established clients. In assisting all ventures, IEL should function as a lender of last resort relative to the chartered banks, other private organizations, and IDB, and should restrict assistance to the provision of buildings and equipment for industrial activity which would benefit the province by increasing employment and/or improving the province's balance of trade. 'Lender of last resort' has a particular meaning in this context. Provided, of course, that the applicant meets the other IEL criteria noted above and that it offers a viable proposal, IEL should provide financial assistance when that assistance is critical to the location or expansion occurring in Nova Scotia. Thus, if an applicant could obtain mortgage financing from an insurance company, but would only locate in Nova Scotia if it had IEL financing, IEL then becomes Nova Scotia's last resort - not the applicant's. Third, and most difficult to resolve, is the matter of IEL acting as an adviser to small business. Since the spring of 1967 a small business advisory service has been functioning as a part of the province's Department of Trade and Industry, and, according to one report, has made some significant progress. 41 Two of the functions of this service are to assist the small firm (a) in developing a financing proposal, and ( b) in finding sources of funds. As a part of the Department separated from its lending activities, this service has gained the support of several small firms as 'more impartial.' Insofar as the primary objective of any such small business advisory service should be exclusively the representation of the businessman, 41 'Free Advice Helps Small Businessman,' the Financial Post (22 June 1968) .

186

Institutional Financing of Small Business in Nova Scotia

rather than a joint activity also concerned with the risks in the portfolio of the lender, this service appears to meet the needs more effectively than could a similar effort under the aegis of IEL. However, IEL should be prepared to assist its applicants in developing a financing plan and finding complementary sources, and should also be prepared to provide some form of aftercare for those small firms it does assist. The aftercare should be concerned with helping the applicant avoid pitfalls rather than with finding means of resolving what has developed into a very serious situation. To provide this recommended form of aftercare, as well as more detailed counselling of applicants, IEL would have to increase its staff, particularly with personnel capable of exercising considerable initiative and imagination in financial matters. To the extent that IEL continues to operate as it has heretofore, several items would appear to require particular attention. First, care should be exercised to see that the sum of the benefits from the direct and indirect employment generated by firms matches the cost of financial assistance provided. The danger of benefits not being commensurate with costs becomes greater to the extent that industry in general, and 'attractable' industry in particular, becomes more mechanized. Second, tailor-made facilities in an unindustrialized area lack marketability, and lease financing provides minimum incentive to ride out storms. If IEL is to avoid major difficulties during any prolonged business downturn, it seems imperative that its willingness to provide highly specialized facilities should be tied to relatively shorter than average payouts. Third, the province must recognize that new industrial plants and payrolls, together with tax incentives, will place a significant burden on local governments. The financial position of most local governments is such that they will have to turn to the province for assistance, and the cost of this assistance is a part of the real cost of IEL. Fourth, IEL operating losses will have to be anticipated for several more years, but abandonment of the 'window dressing' common to all IEL reports to date would provide an incentive for the establishment of long-run policies by the organization and the government. INDUSTRIAL LOAN FUND

The Province of Nova Scotia entered the field of industrial lending in 1944, when it voted money as capital appropriation for the construction of plants and the purchase of equipment for small firms. This step was undertaken largely on the recommendations of the Royal Commission on Provincial Development and Rehabilitation, 1944

Credit from Public Non-Bank Institutions

187

(Dawson Commission). 42 The Commission had recommended the establishment of the loan fund, despite the then-current discussion in Parliament preceding the eventual passage of the IDB Act, because it felt that industries that were small by IDB standards would be large and rare in Nova Scotia, and 'the needs of the genuinely small businessman would still remain to be met.'43 The initial lending by the province, in the 1944-8 period, was by direct capital vote of the legislature, under the Assistance of Small Industries Act of 1944, and the Construction of Hotels Act of 1948. These two acts are still in existence, but they are of minor importance and loans are not being made under them. In addition to these two acts, the provincial Department of Trade and Industry administers three other acts, or sections thereof, each of which has a separate 'fund.' These three are: Provincial Finance Act and the Industrial Development Fund of 1950; Industrial Development Act and Industrial Expansion Fund of 1951; and the Industrial Loan Act ( which replaced the Industrial Assistance Act of 1948) and the Industrial Loan Fund, also of 1951. After pointing out that 'the dollar amount of funds loaned to industry in the province is comparatively small' - $11 million in 311 loans to both industrial and tourist accommodation clients over the eighteen years through 1962 (but up to $29 .5 million in 424 loans by the end of 1967) - the province told the Porter Commission that the 'employment effects have been substantial.' The province said that 'total employment at the end of 1960 in firms established with the assistance of a provincial loan' was approximately 1,400, and that existing firms which had received 'expansion loans' had total employment of about 540 at the same date. The total employment in these two types of firms represented 6.6 per cent of the total 1960 manufacturing establishment employment of 29,311. Cairncross indicated that provincial loans to new firms have been particularly significant. He noted that 2,700 were employed in new manufacturing firms and new branch plants established in Nova Scotia between 1946 and 1955, and that 40 per cent of this employment was in plants assisted by the province. Principally on the basis of this evidence, Cairncross concluded that the loan programs were providing a vital service: 'If the loan boards were to withdraw completely in favour of the IDB there would undoubtedly be some deserving projects that failed to find a backer.' He also thought 42 Royal Commission on Provincial Development and Rehabilitation, vol. (Halifax: King's Printer, 1944), p. 35. 43 Quoted in A Submission by the Government of Nova Scotia, p. 12.

I

188

Institutional Financing of Small Business in Nova Scotia

that without them there would be 'no appeal from decisions by a federal lending agency even when important local interests were at stake ... There is some virtue in competition between public agencies.' 44 Loans from the Industrial Development Fund are of minor importance in terms of the number of firms assisted, with its two debtors ( one industrial firm and one hotel) representing only 1.6 per cent of all debtors of all funds at the end of fiscal 1967. However, its $705 thousand in loans outstanding represented 5.2 per cent of all loans outstanding from all funds at the same date. In that no new loans have been made from this fund in the last several years, it is evident that the government has recognized the direct overlap between it and IEL, and has chosen to phase out the former, which was established to 'assist or encourage the establishment of industry in the Province.' The Industrial Expansion Fund ( IEF), which provides financing of fixed assets, as well as loans for working capital purposes and guarantees of loans made by other lenders, would appear to be a significant 'back-up' to other provincial legislation - particularly IEL and the Industrial Loan Fund - because the flexibility of this particular legislation provides a significant opportunity for any broad scale effort to expand a particular industry or industry within a single community. Unlike the Industrial Development Fund, this fund has become much more active in recent years. At the end of March 1962 there were seven industrial loans, for $1,445 thousand, plus $200 thousand invested in shares of Nova Scotia Abattoir Limited, outstanding. By the end of March 1967 there was a total of $7,974 thousand due to the fund as follows: 22 Industrial loans $7,116.4 thousand Shares 200.0 2 bank loans guaranteed for manufacturers 442.5 215.0 1 bond loan guaranteed for a manufacturer TOTAL

$7,973.9

The peculiar aspect of this fund's growth is that of the 39 loans approved for $13 million in the 1963-7 period, no less than twentythree (59 per cent) were approved by the Governor in Council (i.e., the Cabinet of the provincial government). The other sixteen were approved by a board made up of the members of the Industrial Loan Board ( see below). 44 A.K. Cairncross, Economic Development and the Atlantic Provinces (Fredericton: Atlantic Provinces Research Board, February 1961), pp. 28, 30.

Credit from Public Non-Bank Institutions

189

Clearly the Industrial Expansion Fund is being used more intensely over the past five years than was the case previously, particularly as evidenced by the fact that it was responsible for 5 per cent of all debtors to all funds at the end of 1962, and increased this to 18 per cent at the end of 1967; and, while it was responsible for 29 per cent of all funds outstanding at the end of 1962, it had increased this to 59 per cent by the end of 1967. From the point of view of the individual small businessman, the Industrial Loan Fund ( ILF) has offered the most significant source of direct financing from the province and retains the potential to do so. The regulations of the Industrial Loan Act, revised in March 1966, provide that it may loan to or guarantee loans to a variety of types of firms, including new industries and manufacturers of new products, for periods of up to fifteen years. The Industrial Loan Board, provided for under the Act which established the fund, consists of seven members and a chairman. This Board, which is made up primarily of active and retired businessmen, examines the applications received and makes recommendations to the Governor in Council (through the Minister of Trade and Industry) who may accept or reject either an affirmative or negative recommendation from the Board. The regulations under the Act allow consideration of loans, to eligible types of industries, for the purchase and improvement of land; construction and expansion of buildings; purchase of machinery, equipment and furnishings; retirement of existing obligations (when such action will improve the security taken or to be taken by the province) ; and to replenish working capital depleted, within the previous three years, by the acquisition of fixed assets. Loans can be made for up to 75 per cent of the value of new businesses (i.e., applicants' equity and debt to ILF in a 1 : 3 ratio), or 75 per cent of the value of existing assets to be taken as security. The previous regulations restricted the term of the loan to ten years, required that the borrower demonstrate that the funds were not available elsewhere under reasonable terms and conditions, and limited the loan to an amount equal to the applicant's equity. In practice, the types of assistance have been subject to more restriction than the regulations would suggest. Loans cannot be made for the purchase of a building and working capital loans have not been made by the ILF because, one officer said, 'the banks are already looking after those types of needs.' Again, there have been no guarantees of loans because, according to another ILF official the Board felt that only shortterm ('operating') loans from chartered banks would require guaran-

190

Institutional Financing of Small Business in Nova Scotia

tees, and the Board has taken the view that the regulations were intended to discourage loans for working capital purposes and guarantees of such loans. Finally, funds are not provided for refinancing unless ILF is about to provide other additional credit. ILF's security requirements are 'usually' a first mortgage on real estate, a chattel mortgage on equipment, and assignment of comprehensive fire insurance and life insurance, with personal guarantees required 'sometimes.' In addition to these security requirements, the regulations of the Act limit ILF loans to 75 per cent of the equity and loan investment by the owners, as already mentioned. The opening of an IDB office in Halifax in 1956, the establishment of IEL, and the passing of the SBL Act led the provincial government to plan to de-emphasize lending from ILF, 45 because it was established to supplement existing agencies. One Department of Trade and Industry officer remarked in 1962 that ILF industrial lending was 'fading from the picture' with the advent of IDB and IEL, which together covered most functions previously covered by ILF. He also thought that it would soon be inactive in tourist lending since recent revision in the IDB Act permitted it to finance tourist accommodations. This officer hoped that the SBL Act would be amended to include greenhouses, and said that such an amendment would virtually put ILF industrial lending out of business. On the basis of the government's Submission and remarks of the Department officer, one would expect that the number of industrial loan approvals would have fallen off sharply after 1956. In fact, a falloff did not occur until 1960, after the number of industrial loan approvals in each of the three years 1957-9 exceeded or equalled those in each of the three preceding years, and in 1967 there was a substantial reversal, with both number and amount of loan approvals exceeding any of the preceding thirteen years (Table 7 / 14). A decline in the average size of industrial loans (Table 7 / 14) appears to have set in before the decline in number of approvals; in only one of the six years from 1957 through 1962 was the average industrial loan approved larger than in the three years before the arrival of IDB in Halifax. However, a new and much more erratic pattern has set in since 1962, with the average size loan approved in 1966 being significantly higher than in any previous year, while the 1965 average was the second lowest over the fourteen year period 1954-67. Again, while ILF loans outstanding in 1966 were virtually the same as at the end of 1959, indicating that in the intervening period the province was not actively pushing industrial loans by this means, the 1966 revisions ( which took effect 45 A Submission of the Government of Nova Scotia, p. 13.

Credit from Public Non-Bank Institutions

191

TABLE 7/14 Industrial lending Province of Nova Scotia Industrial Loan Fund years ending 31 March (dollars in thousands)

Loans approved Amount

Loans outstanding Average

Amount

Year

($)

Number

($)

($)

Number

1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967

249. 5 685 . 5 377.6 452. 5 750.0 186.0 225 .1 37.0 27 .5 535 .0 114.6 60.8 1,406.7 4,081.2

6 10 8 12 15 10 6 2 3 3 2 4 3 25

41.6 68.6 47.2 37.7 50.0 18 .6 37.5 18.5 9.2 178 .3 57 .3 15.2 468 .9 163 .2

n.a. n.a. n.a. n.a.

n.a. n.a. n.a. n.a. n.a. n.a.

SOURCE :

58 .1 1,018 .5 1,314.2 1,225 .6 1,123.7 1,242.8 1,314.1 1,168 .2 1,028.2 3,500.4

57 57 55

57 51 46

n.a. 51

Department of Trade and Industry, Province of Nova Scotia, Annual Report, various years.

TABLE 7/15 Industrial loan inquiries Province of Nova Scotia Industrial Loan Fund years ending 31 March

Year

Inquiries

1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967

53 61 48 62

SOURCE :

72 71

26 81 49 51 52 23 40 99

Loan applications considered by Board

n.a. n.a. n.a. n.a. n.a. n.a. 15 11 5

4 2 5 5

39

Approvals as a per cent of Inquiries

Loans considered

11 16 17 19 21 14 23 3

n.a. n.a. n.a. n.a. n.a. n.a.

6 4 17 8 25

75 100 80 60 64

6

40 18

60

Department of Trade and Industry, Province of Nova Scotia, Annual Report, various years.

in 1967) indicate that the ILF is 'back in business' on an expanded scale. The pattern of industrial loan inquiries (Table 7/15) received by ILF over the 1954-67 period indicates that potential borrowers could

192

Institutional Financing of Small Business in Nova Scotia

have been influenced by the presence of alternative sources, such as those provided by IDB and the SBL Act, in the 1962-6 period, but the 1967 reversal rather clearly indicates a 'financing gap,' in that changes in regulations substantially increased demand for funds. It is also noteworthy that in each of the last six years the Board has approved a majority of the loan applications considered. One of the most noteworthy aspects of the inquiry data, however, is the significant decline in the number received in the 1960 fiscal year, 46 which roughly approximated the last tight money period of the 1950s. With total industry inquiries at 42 per cent of their 1957 level, it would appear that potential borrowers assumed that tight money resulted in restraint by all institutional lenders and that applications were futile. The abnormal proportions of inquiries which resulted in approved loans suggests that the Board assumed at that time at least that alternative sources were not open to applicants, and/ or that formal applications were from above average risks who were astute enough to recognize ILF as an alternative source and to follow up their inquiry with a formal application. The apparent willingness of the ILF Board to act as a counter-cyclical factor is worthy of note. 47 (Note might also be taken of the relatively high rate of approvals in the 1957 and 1958 fiscal years which correspond with the earlier tight money period.) Past patterns of loan rejections by ILF offer some indication of what type of borrower might be successful now that it appears to have been reactivated as an industrial lender. One ILF officer cited two common reasons for rejections, adding that either of the two was present in virtually every rejected application. The two reasons were (a) failure to meet the minimum equity requirement ( a requirement which is now appreciably easier to meet because of the change from a 50 : 50 to a 7 5 : 25 lending to equity ratio), and ( b) the judgment of the Board that the firm was unlikely to succeed. While he denied any specific concern with protecting the borrower from himself, he did indicate that projects thought to have little probability of success were rejected even when failure would not place the ILF advance in jeopardy. This officer completely rejected the statement found in a federal government publication that the Board 'takes into consideration the desirability of 46 See Table 7 /5, indicating a decline in IDB loan approvals in its fiscal 1960 in Nova Scotia. 47 In its Submission to the Porter Commission the province said that it was the 'impression' of administrative personnel associated with loan funds generally that interest in government loans tended to increase with 'the uptrend in the business cycle.' They attributed this to greater opportunities seen by businessmen, but said that the impression also existed that the apparent pattern disappeared with the 'increase in activity of the Industrial Development Bank.' See A Submission of the Government of Nova Scotia, p. 23.

Credit from Public Non-Bank Institutions

193

taking a lesser or greater risk from the point of view of the overall good of the economy.' 48 He said: 'We approve applications when we think the venture will succeed; otherwise we reject the application.' Although another department officer pointed out that the government was not bound to follow the Board's recommendation, it appears that such a general criterion as 'overall good' is more likely to be applied by the Governor in Council in making loans from the Industrial Expansion Fund. Conclusions and recommendations

Several general conclusions can be reached regarding ILF. First, there are three areas in which ILF might offer a distinct service: (a) as a source of financing for firms which are too small to be attractive to IDB; ( b) as a source of financing for firms which have problems best appreciated by residents of the province, particularly where the firm would offer the possibility of significant benefits to complementary firms, and where loans rather than buildings were required; and (c) as a countercyclical force during periods of credit restraint at the national level when provincial conditions did not require restraint. In acting to meet these needs, ILF would not necessarily be a lender of last resort in terms of risk, but would complement deficiencies in the existing institutional structure while serving a relatively restricted set of needs. Second, the financial burden which ILF creates for the province could be reduced by a program of loan guarantees and loan participation which could be made attractive to financial institutions as well as to the province. After reviewing and approving a loan application the Board might take any one of three courses. First, it could offer to arrange the loan through a chartered bank, with the borrower paying the bank rate of interest plus a charge of 0.5-1 per cent for the guarantee. Second, the Board could arrange a portion of the loan through a chartered bank and provide the balance of the funds from its own resources. The Board could again offer a guarantee of the bank's portion of the loan under the same provisions as noted above, with the rate of interest on its own portion of the loan at least equal to the higher of the prevailing IDB rate or the rate on the guaranteed bank loan. Third, the Board could provide the funds entirely from its own (i.e. provincial) resources. 49 48 Financing Canadian Industries (Ottawa: Queen's Printer, undated), p. 23. 49 These are essentially the same alternatives as those open to the Small Business Administration in the United States. See also Cairncross, Economic Development and the Atlantic Provinces.

194

Institutional Financing of Small Business in Nova Scotia

Third, a board of competent provincial businessmen, appointed for fixed, staggered terms, would provide a degree of independence and make the 'final authority,' which it is alleged to have on loan applications, meaningful, and would force the government to be careful in selecting board members. Such a board might well be required to budget a maximum amount of lending for each fiscal year, primarily as an inducement to establish priorities and to discourage indiscriminate lending. A minimum interest rate, equal to the prevailing IDB rate, and no interest maximum, if tied to a profit-to-loan ratio criterion for the fund, would provide a measure of control. The profit criterion should be established at a level which would reflect the amount of subsidy the government wanted to build into the loan program. Fourth, if ILF is to be a significant back-up to the existing financial structure, the restraints arising out of the emphasis on fixed asset financing and the limitations on refinancing will have to be removed. Also, the lower applicant equity requirements and longer terms, approved by the new regulations, must be implemented. In an appraisal of any provincial government loan programs it must be appreciated that these are the only means of 'product differentiation' available to individual provinces. The plans offered by eight other provinces are described in outline form elsewhere. 60 The majority of them place the emphasis on direct loans to firms, either directly from provincial funds or through various types of loan boards empowered to make loans, for terms of up to twenty years. It is evident that Nova Scotia's IEL does provide a means of product differentiation, a means which was not available under previous Nova Scotia legislation for the assistance of industry. Whereas the previous acts were directed towards the development of industry in the province, IEL has set its sights on the attraction of industry to the area. ILF activity 50 See Financing Canadian Industries, pp. 19-27. British Columbia does not have a program, and the programs of Alberta and Prince Edward Island are of limited consequence to industrial firms. Ontario opened its 'Ontario Development Agency' for business in 1963. The agency was capitalized at $100 million, and its financial assistance consisted entirely of guarantees of loans to firms which could not 'meet the financial requirements of conventional lending institutions.' It assisted in establishing 25 new 'products, processes or techniques' in its first year of operation, and guaranteed a total of $5 million in loans through mid-1966. In June 1966, The Ontario Development Corporation was established. It absorbed the Development Agency's guaranteeing and business advisory functions, and had the additional authority to loan up to a total of $7 million, for terms of up to 20 years on fixed asset security, for businesses wanting to establish in slow-growing areas of Ontario. See 'Provinces Fight to Snare New Industry,' the Financial Times of Canada ( 26 October 1964) ; and 'Ontario Development Corporation Makes an Instant Hit,' ibid. ( 13 June 1966).

Credit from Public Non-Bank Institutions

195

in Nova Scotia suffers from 'low visibility' in the sense that its assistance produced neither clearly identifiable increases in industrial employment nor new structures. IEL, on the other hand, has provided assistance to almost three score firms, and can name names and give employment figures. In the process of allocating the bulk of available funds to IEL, the province was phasing out the less visible ILF. It must be granted that ILF has had significant room for change and improvement in its lending criteria, its use of guarantees, and its administration, and that the chartered banks' SBL Act lending authority and the advent of IDB provided valid reasons for the proposed phasing out. However, with IEL's emphasis on branch plants and larger-than-average local plants, small and new local firms appeared to have lost the services of a source of financing which had considerable potential for serving them. Thus, the restoration of ILF to active status should be most encouraging for small firms; implementation of the suggested changes noted above would assist in making it more attractive to the electorate. CONCLUSIONS AND RECOMMENDATIONS Conclusions and recommendations have already been presented for IDB, IEL, and ILF individually. However, there is clearly considerable evidence given that these three and the Industrial Expansion Fund activities have had a sufficiently long trial period and that they should be looked at collectively. The IDB stands ready to provide financing at moderate cost over reasonably long terms on a variety of security bases to small businesses that do not otherwise have access to other (particularly bank) credit on reasonable terms and conditions. This points clearly to the types of situations where provincial lending agencies, crown company or otherwise, should be active. First, they should provide financial assistance to small firms when the risk and/or size of the application is such that neither the chartered banks nor IDB is willing to provide it under reasonable terms and conditions. The agencies, however, should only provide such assistance when the economy of the province will benefit through any combination of high employment, larger exports, lower imports, greater efficiency in existing and complementary industries, and the development of an 'industrial climate' which would encourage other firms to locate there. Assistance from provincial agencies, acting as a last resort lender vis-a-vis IDB, would undoubtedly have to contain some apparent subsidy element, in that it would not recover an adequate rate of interest to compensate the province for the risk involved in the project. Never-

196

Institutional Financing of Small Business in Nova Scotia

theless, the 'benefit to the Province' criterion would be a means of justifying the differential between the risk rate which might be charged and the actual rate charged. Thus, if the rate required by another agency was 12 per cent, and a provincial fund charged 7½ per cent, it would be thinking in terms of annual benefit to the province equivalent to approximately 4½ per cent of the assistance provided. The second area in which provincial lending agencies should be active is in those situations where the provision of financial assistance at market or lower rates, for up to 100 per cent of the cost of the fixed assets of the project, would be decisive in having expansion, a branch plant or new industry, locate in the province. The above types of situations comprehend the current activities of IEL, ILF, and IEF, combined, but at the moment all of these agencies are performing some of the same functions. These three agencies, combined, have increased their outstanding amounts more than elevenfold between 1962 and 1967, from $7.4 to $83.6 million. However, we have IEL increasingly doing things which IEF was established to do; we have the Industrial Loan Fund Board sitting to review IEF loan applications, but we also have twenty-three of the thirty-nine lending decisions on IEF loans in the 1963-7 period made by the Governor in Council, without benefit of ILF Board review; and we have all three agencies making direct loans to industrial firms. The patchwork structure which has developed may have been both necessary and desirable in an experimental stage, but the situation now appears to demand some rethinking and restructuring. First, it appears desirable that (a) the government not be directly involved in loan applications; ( b) that there not be multiple agencies with overlapping functions; and (c) that financial assistance provided on a lender of last resort basis should be accompanied by financial management advice before and after the application and approval. Thus, the restructuring should take the form of a single crown company, financed by loans from the province, which would provide (a) financial assistance in the form of land, buildings, and equipment for rental; ( b) financial assistance by direct, guaranteed, and participating loans to finance fixed asset acquisitions and to support working capital requirements; and (c) financial management advisory service to applicants and borrowers. This structure could be achieved by terminating ILF and IEF lending activity, and by broadening the role of IEL to permit it to provide direct loans for working capital and financial management advisory service. The Department of Trade and Industry's Small Business Advisory Service should continue to function as both a complete advisory service

Credit from Public Non-Bank Institutions

197

and as an advocate for small businesses applying for financial assistance from any source. The Board of such a revised IEL should consist of representatives of the industrial and financial firms in the province, all appointed by the Minister of Trade and Industry for staggered fixed terms, and the company should report to the legislature through the Minister of Trade and Industry, who would also sit as a member of the Board. The staff of IEL would be increased to add skills not currently found there, particularly in its capacity to advise on financial management of smaller firms. Consideration might also be given, after the loan and lease portfolio of the revised IEL had matured, to public sale of mortgage and collateral trust bonds by the company, thereby reducing the drain on the credit of the province. If the government does not see fit to restructure its existing financial assistance agencies, it should at least make an effort to terminate the approval of loans by the Governor in Council without review by the ILF Board, and it should terminate the overlapping of activities by IEL, ILF, and IEF.

8 Availability of Credit from Private Non-Bank Financial Institutions

Several organizations are, or are reputed to be, engaged in supplying credit to businesses and Nova Scotia firms may utilize their services in varying degrees. Included in such a group of organizations are the following: industrial finance firms; factors ; specialized credit firms directing their efforts towards small firms; credit unions ; and life insurance, trust, and mortgage loan companies. The activities of each of these will be reviewed briefly to close out this study of institutional suppliers of credit to small businesses. INDUSTRIAL ACCEPTANCE

CORPORATION

A representative industrial finance firm in Nova Scotia, and the largest finance company in Canada with 1967 year-end assets of $972.7 million (approximately 35 per cent of the assets of twenty-one finance companies listed by the Financial Post on 1 June 1963), is Industrial Acceptance Corporation Limited (IAC), which operates a total of eight branch offices in the province.1 IAC's principal activity is the financing of consumer and industrial durables, but since 1960 it has provided capital lending, leasing, and lease financing services, 'for all sizes of Canadian business in amounts and for periods which are not usually attractive to the underwriter of securities or to the chartered banks.' IAC capital loans are for medium terms and available for virtually any business purpose to established organizations, with new firms considered 'when the principals are men of reputation. ' 2 The loan size is 1 The second largest independent finance company, Traders Group, Ltd., also operates offices in Nova Scotia, while the third largest, Laurentide Financial Corporation Ltd., does not. 2 Capital Loans for Canadian Business (Montreal : Industrial Acceptance Corporation Limited, 1960) , p. 4.

Credit from Non-Bank Institutions

199

normally for not less than $100,000 or for more than $2 million. Initially, these loans were usually for not less than $25,000, with consideration to smaller loans 'in creditworthy situations,' and no upper limit on loan size.3 Loans are processed at all branch offices, but final credit decisions are made in Montreal. The primary security for capital loans is a first and/ or second mortgage on real estate and/or chattels of the borrower, while personal guarantees from principals or from parent companies 'may also be required.' The borrower is also responsible for insuring the pledged property and may be required to take out life insurance on the lives of the principals of the firm. 4 A considerable amount of detail is required in applications for IAC's capital loans, 5 but, at the practical level, IAC officers do not expect the borrowers' presentations to be particularly detailed or refined, or that any significant number of their clients are capable of a sophisticated comparison of the costs of alternative sources. IAC officers said they had to assist in the preparation of applications because they did not consider that small firms would be able to provide detailed cash flow forecasts; their experience had indicated that neither the small firms' managers nor their accountants could develop reliable forecasts in this area. There are no data available on IAC capital loan covenants, except the security requirements noted above and IAC's comments on the cost of such loans. The cost of capital loans is difficult to determine with any degree of confidence, but the author was advised by letter from IAC in 1968 that the effective rate varies from 10 to 11 ½ per cent and that it 'varies in accordance with the credit risk involved in extending the loan.' 6 The size of the borrower's business by itself does not affect the rate charged, although it would probably affect the risk, and the initial rate is fixed for the term of the loan. The only evidence of how few capital loans were made in Nova Scotia by IAC through 1962 was provided by one officer who did not appear to be aware of the distinction between his company's 'Capital Loan' program as such, and its program of capital assistance for automobile dealers. For the company as a whole, at the end of 1967 'Com3 Business Loans (Montreal: Industrial Acceptance Corporation Limited, 1963), p. 4. 4 Ibid., p. 4. 5 See ibid., pp. 7-8, for detailed listing. 6 See Capital Loans, p. 5, where rates are said to be 6½ per cent on the average balance, plus a service charge of 3 per cent on the original balance; and the Financial Post (12 June 1962) which reported that IAC's lowest rate was 8½ per cent, rising to 12½ per cent, with a weighed average of 9 per cent. If the 3 per cent service charge is added to these rates, they could go as high as 18½ per cent effective.

200

Institutional Financing of Small Business in Nova Scotia

mercial Loans,' which includes all loans made by the Capital Funds Division, of $90.7 million (10.3 per cent of net receivables and 9.3 per cent of total assets) were outstanding. 7 IAc's leasing service is available to both lessees and lessors of new equipment, and the company also offers purchase-lease-back arrangements. This financing is available for any fixed asset, other than real estate, and the amount of the individual lease may range from 'several hundred to many thousands of dollars.' 8 Terms of three to five years may be arranged, depending upon the economic life of the leased asset and the lessee's requirements, and the criteria and analyses for lease financing are essentially the same as those noted above for capital loans. The lessee's costs include the cost of maintenance, sales taxes, property taxes, insurance, with sales taxes and a deposit of 'up to one month's rental for each year of the lease' paid at the outset. As with capital loans, the initial rates prevail for the entire term of the lease. Lease payments, which include service charges and interest of 13 to 15 per cent, 9 are set to recover the capital cost of the item, the administrative costs of the lease, as well as a return on investment. The only occasion on which there is less than full recovery of the capital cost is when the lease term is significantly shorter than the economic life of the equipment. IAC officers indicated that such leases are written only when they are certain that a purchase option will be exercised. They would not explain how they could establish this with certainty, although it is probably based on a 'letter of undertaking' from the client. This device is used, as a separate document, where the client insists on a purchase option but also wants the acquisition treated as a lease, for tax purposes, during its life. One IAC officer told the author that lease financing, with the exception of that provided for the distributors of construction, restaurant, and institutional equipment, who used it as a sales tool, was generally for clients who were unable to make a significant down payment for the purchase of equipment, and thus tended to be for very high risk firms. In addition to their capital loan and leasing programs for business, IAC offers equipment financing as a separate service. This 'Industrial 7 IAC, Annual Report, 1967. This represents approximately a tenfold growth from 1961 when capital loans (identified as such) of $9.9 million (1.9 per cent of net receivables) were outstanding. A Supplement to IAC's 1965 Annual Report indicated that the average balance of 424 'Business term loans' was $269,000. 8 IAC Leasing (Montreal: Industrial Acceptance Corporation Limited, undated), P· 5. 9 Computed from sample rates given in ibid. However, a more recent IAC publication, Capital Asset Leasing, indicates rates in two examples of 7.38 and 9.37 per cent per annum.

Credit from Non-Bank Institutions

201

Plan' is available for the financing of machinery and equipment to 'any company or individual in good standing doing business in Canada.' 10 There are no stated minima or maxima established for amounts which may be financed, but transactions nearly always vary between $2,000 and $25,000, and seldom exceed $200,000. Terms are 'usually ... two to three years,' but 'in certain circumstances' may be extended to five years or more, with the financing provided only at the time the equipment is first acquired. Under the Industrial Plan the down payment is generally 25 per cent of the cost of the acquisition, but IAC officers indicated that the amount can be negotiated downward if the applicant is considering leasing as an alternative. The balance of the acquisition cost is provided on a conditional sales contract, with charges 'based on the equivalent of 7.8% to 8.4% of the amount financed per year'; that is, an effective rate of approximately 15-16 per cent. Thus, the essential differences between equipment financing and capital loans are the minima ($2,000 vs. $100,000), the interest rate (15 vs. 10 per cent) and the security ( conditional sales contract vs. mortgage). IAC's financing of short-term needs was through Industrial-Talcott Limited, a subsidiary in which IAC held 50 per cent of the voting stock. Two basic services were provided by this subsidiary - the provision of working capital by means of loans secured by receivables, inventories, and/or fixed assets, which the company referred to as 'commercial financing,' and factoring of accounts receivable. The basic appeal by this IAC subsidiary was to firms which could not obtain financing by any other means, and the only cost figure it mentioned was one per cent per month. This company thought that its accounts receivable financing would be 'a profitable procedure for progressive companies whose working capital funds cannot otherwise keep pace with the demands of expanding production and sales.' 11 However, Industrial-Talcott is now part of IAC Business Development Funds Limited, and the company no longer solicits business in the factoring and accounts receivable field. Two particular aspects of IAC financing should be kept in mind. First, there is the possible distinction between financing secured by a specific asset, and financing secured by the general security of the borrower. A finance company could provide financing exclusively on specific security and assume that that security could be converted into cash to pay out 10 Capital Equipment Financing (Montreal: Industrial Acceptance Corporation Limited, 1960), p. 2. 11 Industrial-Talcott Ltd., pamphlet, 'Use All "Lines" for a Balanced Job in Business Finance' (undated).

202

Institutional Financing of Small Business in Nova Scotia

the loan, if the client ran into difficulties. Alternatively, a finance company could obtain specific security, but, in fact, base the loan on the general security of the client. To the extent that the former is emphasized, credit would be available to marginal firms as long as they were using it to acquire readily marketable assets, as has been the case with railroads' equipment trust certificates. In this way, the finance company would be a source of funds for firms to which credit would not otherwise be available. The second aspect of IAC financing is that it tends, in practice, to be in relatively inflexible 'packages,' evidenced by IAC officers' contention that 'we offer a deal and if that is not acceptable he will have to go elsewhere - we won't start shaving points.' IAC concluded its comments before the Porter Commission on its capital loans service, leasing and factoring, by noting that such business still represents a small share of our total earning assets. These lines of business appeared interesting to us some time ago but the generally restrictive nature of monetary policy during much of the Fifties was a serious inhibiting factor. Increasing participation by other financial institutions in the consumer credit field also led us to realize that there would be new opportunities for us to branch out in industrial, business and commercial financing. 12

Apparently, sales finance companies had two factors working against them in securing credit from banks in the late 1950s: the general shortage of money during that period, particularly, and the fact that the banks themselves were interested in the consumer credit market being served by the sales finance companies. The total authorized bank credit lines of the ten largest sales finance companies fell from $334 million at the end of 1955 to $233 million at the end of 1961, and from 1953 to 1961 bank loans went from 26.2 to 8.0 per cent of the sales finance companies' total capitalization (bank loans, short-term notes, secured notes, debentures and equity) .13 The reduced availability of bank credit apparently forced IAC to switch from secured short-term and demand notes to secured term notes at this time. 14 As the company became more dependent upon the money market, it apparently felt compelled to build up its investment in marketable securities, from 1.6 to 11.0 per cent of their total assets, between 1956 and 1961, and 5.9 per cent at the end of 1967. As a further step to protect itself, IAC reduced its debt/equity ratio from 7.71 12 Brief of Industrial Acceptance Corporation Limited Submitted to the Royal Commission on Banking and Finance, pp. 49-50. There is no reason to believe that circumstances of the 1960s have changed any of this. 13 'Banks Closing Door of Loan Firms?' the Financial Post (20 October 1962). 14 See IAC Brief to the Porter Commission, Table v-2.

Credit from Non-Bank Institutions

203

at the end of 1950 to 4.45 at the end of 1961, and raised it slightly to 5.43 at the end of 1967. While earnings fell from 16.8 to 14.9 per cent of gross revenues from 1950 to 1961 and to 13.0 per cent in 1967, the higher equity ratio reduced the earnings/shareholders' equity ratio from 19.3 per cent in 1950 to 13.0 per cent in 1961, further reduced, by lower rates of earnings and the lower debt ratio, to 10.7 per cent in 1967. Thus, it is natural that the company would not be particularly anxious, under these circumstances, to give up a profitable field in which it had had considerable experience, and that it would only move gradually into fields already occupied by institutions offering the same type of financing at lower cost. In the mid 1960s, after a period of rather substantial growth in the early part of the decade (IAc's assets increased by 70 per cent in the 1960-5 period, and Laurentide's increased by 220 per cent over the same period), sales finance companies ran into two events which significantly undermined confidence in the industry and its capacity to borrow money. First, there was the Atlantic Acceptance collapse of 1965, and, secondly, there was the 1966 disclosure by Laurentide that a reassessment of its assets indicated the need for a substantial writedown of assets ( as well as a different means of accounting for incomes) resulting in a 1966 loss of $9.6 million compared with a 1965 profit of $3.8 million. These two events, which discouraged investors in the finance companies, plus relatively tight money and the increased movement of banks into the sales finance companies' types of activity, significantly hampered the latters' growth in the mid-I 960s. Efforts towards full financial disclosure, and more conservative accounting methods, with IAC taking a significant lead in the former, have since ameliorated the situation. The most significant aspect of IAC is that it does provide a variety of financing plans available to small firms, apparently without regard to the type of activity or age of the firm, and that these types of financing probably will be promoted actively under normal or easy money market conditions and as the firm increases its experience in commercial lending. However, alternative sources of the same kinds of financing - particularly the chartered ban.ks' SBL Act loans, IDB, IEL, and, more recently, Roynat (see below) - are available at lower cost to the small businessman. Consequently, it appears unrealistic to have small businessmen, who cannot apply for IAC's capital loans, regard IAc-type organizations as anything other than last resort sources of financing, at least until such time as the banks begin to charge significantly higher interest rates.

204

Institutional Financing of Small Business in Nova Scotia

FACTORING AND COMMERCIAL FINANCE FIRMS

It appears that there are at least three firms offering factoring service to Canadian business: Aetna Factoring Corporation Ltd.; Canadian Factors Corporation Ltd.; and Lombart-Heller Factors Ltd. The plans offered by these firms appear to have the same basic features: (a) 80 per cent of the invoice is paid to the seller upon proof of delivery, with the balance, less charges, remitted on the invoice due date; ( b) the interest rate is 7 per cent per annum on the daily balance, plus service charges of ½ to 2½ per cent of the invoice, depending upon volume; and (c) the buyer is advised to pay the factor directly. While one firm's plan requires a minimum of a one-year contract for all of a client's receivables, another firm permits clients to try the arrangement for a 'short time' and discontinue on short notice. 15 The president of one factoring firm advised the author by letter that the minimum annual volume of factored receivables would be $100,000, although he said that the minimum figure was a 'very contentious subject ... At less than $100,000 the rate would be so high, to be profitable for the factor, that it would not be profitable for the client.' At the same time he did not think there would be any problem arising out of the distance between the factor's office (Montreal) and Nova Scotia. On the contrary, he thought that the factor's proximity to the Nova Scotia firms' major potential markets in central Canada would provide a distinct advantage, since the factor would be well situated for appraising customers' credit. However, he said that he was not aware that Nova Scotia manufacturers had 'expressed any great demand for factoring service.' Commercial financing is a source of revolving funds, generally based on the security of receivables and/or inventory. Criteria employed in such financing include management, financial condition, diversification of security offered, and 'the ability ... to earn such profits with the funds borrowed as will generate a cash flow sufficient for the ordinary purposes of the business, and still ensure that advances do not exceed the percentage limit of the revolving credit granted.16 The most likely candidates for such financing would have annual sales volume of at least $400,000, minimum average borrowing needs of $30,000, and would use this source as a 'bridge' to more permanent funds, for a period of 15 Letters to the author from Aetna Factors Corporation Ltd. (5 July 1960), and Canadian Factors Corporation Ltd. (30 June 1961). 16 R.D. Stewart, 'Commercial Financing,' the Canadian Chartered Accountant (May 1962).

Credit from Non-Bank Institutions

205

about three years. Advances on receivables would be up to 85 per cent, with up to 50 per cent advanced against finished goods inventory. H inventory were the principal item of security, it would under usual conditions be placed in a bonded public or field warehouse. Annual rates of 12 to 15 per cent are charged on the daily balance of any advances. One significant advantage offered by this type of financing is that it precludes the redundant borrowing, of varying degrees, which would accompany bank note borrowing, debenture, or stock issues. Another advantage, relative to bank borrowing, would be the greater advance per dollar of receivables; there would be no advantage, relative to bank borrowing, with inventory security. A second advantage, again relative to bank borrowing, would be commercial financing's use of current, rather than historical, receivables - an advantage particularly for firms experiencing rapid rates of growth. While any cost comparison between direct borrowing and so-called commercial financing or factoring is difficult, the higher effective cost of the latter is at least partially offset by the full-line factor providing services which may preclude the need for the entire accounts receivable function. On the basis of comparative interest and service charges, bank borrowing secured by accounts receivable or inventory is superior to both factoring and commercial financing; inventory secured borrowing from a bank and factoring of accounts receivable would be the next most attractive alternative. Clearly, both factoring and commercial financing are high cost sources of funds and their lower limits of volume would restrict to some degree their availability to small firms. However, both could be reasonably expected, given their security and rate requirements, to provide credit to many firms which could not, by reason of their age, rapid growth, or other risk characteristics, obtain bank financing. The general absence of public and field warehousing facilities and of local branch offices, and the high cost, would limit the use of these types of financing to firms with aggressive management and substantial marginal profit opportunities. CHARTERHOUSE CANADA LIMITED

Representative of Canadian 'venture capital' organizations is Charterhouse Canada Ltd. (CCL), a subsidiary of Charterhouse Industrial Development Company Ltd., London, England. CCL was established in 1953 to provide capital for small and medium size companies in Canada. 17 The 'usual pattern of investment' followed by CCL is to make 11 Capital for Industry (Toronto: Charterhouse Canada Ltd., undated), p. 1.

206

Institutional Financing of Small Business in Nova Scotia

part of their investment in redeemable preferred shares, notes, or debentures, and to 'insist' on the right to acquire up to 40 per cent of the common shares. The company does not seek voting control, interfere in the day-to-day management, make mortgage loans, underwrite public security issues, or see its function as one of replacing bank financing. As a minority shareholder, its control generally consists of board representation, salary limits, and restrictions on capital expenditures and long-term debt. In its presentation to the Porter Commission, CCL reported that it had investigated 1,100 applicants between mid-1953 and the end of 1961, and made a total of twenty-four investments totalling $6 million (an average of $250,000 each). Initial loans varied from $30,000 to $250,000, but most of these were followed by additional investments. CCL usually excludes new businesses because they 'seldom have managerial experience in a particular activity.' 18 CCL indicated three factors that result in the rejection of applicants: lack of managerial ability, 'unattractive field of activity,' and managers 'incompatible with outside minority interests.' With net profit on net worth in 1960 of 3.3 per cent, increasing to 3.6 per cent in 1961 (net profit and capital gains combined were 10.6 and 10.0 per cent of net worth in 1960 and 1961, respectively), 19 CCL does not appear to have found particularly attractive 'fields' even in the twenty-four investments it has made. Certainly its rate of return compares quite unfavourably with the 20 per cent return 'success' criterion used in the financing of new research based enterprises.20 After noting its three reasons for rejecting applicants, it pointed out that 'many' rejected applicants 'successfully sought capital elsewhere as other groups have other criteria and other policies.' CCL used this point as its principal weapon against IDB, of which it was most critical, saying that 'it is seldom that a well-managed company with even reasonable prospects cannot obtain the needed funds from private sources.' It listed sixteen organizations as alternative private sources, 21 of which fifteen are new to the author, despite a rather thorough examination of Canadian and United States literature on small business 18 Submission to the Royal Commission on Banking and Finance, The

Charterhouse Group Canada Limited, p. 3. Their booklet, Capital for Industry, indicates that there is no limit on the size of company in which they will invest, but initial investments 'are usually in the range of $100,000 to $300,000.' 19 'Charterhouse Group Net Profit Up 19 Percent,' the Financial Post (31 March 1962). 20 'Where Does the Money Come From?' New England Business Review (January 1964). 21 Submission to the Porter Commission by Charterhouse Group, p. 4.

Credit from Non-Bank Institutions

207

financing over many years. It may not be too presumptious to suggest that few of these organizations are known to the small businesman in Nova Scotia. An officer of CCL advised the author by letter that his company had no reservations about operating in Nova Scotia, but, he wrote, 'in the past few years we have not found a business in the Maritimes which measures up to our necessarily high standards of management ability.' He thought that Maritime businesses lagged behind the rest of the country, although he saw signs of an 'economic revival' and 'in due course I have no doubt Charterhouse will make investments there. In the past the demand in the Maritimes has not been great and the financing gap is probably wider because of the unattractiveness of the area.' Given the lack of contact between Nova Scotia small businesses and centrally located, so-called 'venture capital' organizations, and the criteria of such organizations, it seems most unlikely that they will be a significant source of financing for small business in Nova Scotia. ROYNAT LTD.

The performance of Charterhouse stands in very marked contrast to that of Roynat Ltd., an organization incorporated in January 1962, and opened for business in July 1962. In the twenty-two months to the end of its first complete fiscal year on 30 April 1964, Roynat built up $25.8 million in bond, debenture, loan and preferred share investments in Canadian companies, and reported profits of $178,360, or 1.8 per cent of net worth. By the end of April 1968, financing outstanding to 793 firms had increased to $99.5 million, plus additional commitments of $10.2 million22 (see Table 8/1) . Roynat's $10 million of capital stock is held by three trust companies (Canada, Montreal, and General) and two banks (Royal and Canadienne Nationale), with combined total assets of over $6 billion. The 1,700 branch offices of these five organizations are 'feeders' to nine Roynat branch offices (Halifax, Montreal, Toronto, Winnipeg, Regina, Calgary, and Vancouver; branches were opened in London and Quebec in July 1968). Roynat was formed 'for the purpose of meeting the difficulties which companies of medium and smaller size often experience in arranging their capital requirements.' 23 It is also evident that the group expected some indirect benefits. One of the participating groups told its branch managers by circular letter on 18 July 1962: 'Where companies receive 22 See Roynat Ltd., Annual Report, 1968. 23 Ibid., 1963, p. 6.

TABLE 8/1 Roynat Ltd.: selected financial data 1964-IJ (dollars in thousands)

Outstanding bonds, debentures, secured notes, other loans, common and preferred stock Amount Percentage change since 1964 Commitments to extend financing Clients• Number Percentage change since 1964 Average amount per client• Disbursed during year Amount Percentage change since 1964 Net worth (Capital stock plus earned surplus) Net profit Net profit/Net worth Roynat Ltd., Annual Report, 1968, Includes commitments to extend financing.

SOURCE:



1968

1967

1966

1965

1964

$99,451.2 284% $10,196.0

$91,083.3 252% $10,114.0

$78,298.9 203% $10,659.4

$49,972.1 94% $16,301.0

$25,820. 5

$

793 199.2% 138.0

$24,004.7 7.2% $11,917.1 $

680.6 5.71%

$

701 164.5% 143.0

$

593 123.8% 149.0

$26,338.2 17.6% $11,286.4

$36,827.0 64.4% $10,824.4

$

$

512.0 4.53%

508.8 4. 70%

$

439 65.7% 151 .0

$6,836.0 265 $

123.0

$29,255.9 30.6% $10,365.6

$10,113.0

$

$

302.6 2.91%

$22,394.6

178.4 1.76%

Credit from Non-Bank Institutions

209

Roynat assistance, the long-term effect should be to create new or enlarged demand for normal day-to-day banking facilities. In many cases these companies will require the services of one of the participating trust companies as trustee, registrar, and/or transfer agent in respect of mortgage bonds or other securities to be issued in connection with their financing.' Roynat advertises that all incorporated companies, including new firms but excluding extractive industries, are eligible for their financing. Its basic requirements are that the firm has proven management, earnings capacity to service Roynat's financing and provide for future needs, a product or service with a known or potential demand, and strong growth possibilities. Earnings prospects are also 'an important factor' in determining the amount, rate of interest, and term of Roynat financing. The amount of financing is also related to the owners' equity, and to the term and amount of existing long-term debt. 24 The circular letter noted above made a particularly noteworthy comment on earnings. A record of earning is advantageous, for often it is a good indication of the company's future prospect ... On the other hand, it is not true that a company must have an earnings record to get financing. A company with a poor earnings record could have spent years and hundreds of thousands of dollars in the development of a product. Or a company that had muddled along for years with an unimaginative or lethargic management could now have a new management with demonstrably progressive or original ideas. If such companies can be shown to be ready for growth, the poor earnings in the past can often be overlooked.

The types of projects Roynat advertises it will assist include acquisition, expansion, and renovation of fixed assets; additions to or replenishment of working capital; acquisition of another business; establishment of new companies 'that show good prospects of success'; refinancing; and financing to pay estate and succession taxes. The minimum loan is $25,000. Its assistance can take the form of unsecured notes, mortgage bonds, debentures, preferred and common stock, as well as convertible bonds, debentures, and preferred stock. However, 'acquisition of common shares is normally confined to those cases where a subsequent issue is planned and in no case will control of the voting stock of the company be sought,' and total share investments have not exceeded $600 thousand at any year end to date. The term of the financing is from three to ten years, with repayment schedules designed to the applicant's needs. Rates of interest vary with security, earning capacity, and future pros24 See Capital for Progressive, Expanding and New Canadian Business (Montreal: Roynat Ltd., undated).

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Institutional Financing of Small Business in Nova Scotia

TABLE 8/2 Roynat Ltd.* changes in the prime rate since inception(%) At inception (July 1962) 5 June 1964 9 July 1965 20 Oct. 1965 16 Dec. 1965 15 July 1966 24 April 1967 4 July 1967 25 Sept. 1967 3 June 1968 18 Sept. 1968

8 7¾ 8 8¼ 8½ 8¾ 8¼ 8½ 9 9¾ 9¼

Letter of26 September 1968. Up to December 196S, there was a spread of approximately two percentage points between Roynat's prime rate and maximum rate, and this spread was increased to three percentage points thereafter.

S01JRCE:



pects, but are 'primarily based on the rates current in the capital markets at the time.' 25 Roynat's prime rate has varied from 7¾ to 9¾ per cent, while the maximum has been as high as 12¾ per cent (see Table 8/2). The borrower is also liable for fees for prepayment, delayed takedown and cancellation of an approved loan. Roynat's investments are for the most part 'secured by specific and/or floating charges and/or guarantees. ' 26 Roynat utilizes the branch managers of the associated companies, and one participating organization observed in its circular letter to its branch managers that their 'assessment of the company's management and the prospects of the business will be one of the most important factors in determining whether the proposed financing can be entertained by Roynat.' Roynat's Annual Report, 1963, commented on the extent to which the demand for its services exceeded its expectations, and added that this 'confirmed the fact that there is a significant need existing between conventional bank financing and the longer term public issue or mortgage financing available to industrial and commercial ventures in Canada.' The same theme was reiterated in the Annual Report, 1964. One other comment in the Annual Report, 1964, is particularly relevant. After commenting on the extensive experience of Roynat's senior officers, the Report adds: 'They include bankers, chartered accountants, lawyers, engineers, and other university graduates, many of whom hold Masters of Business Administration degrees.' Possibly the rapid growth of Roynat is related in no small measure to the fact that it is not exclusively a banker's bank. 25 Ibid., p. 7. 26 Roynat Ltd., Annual Report, 1967 p. 2.

Credit from Non-Bank Institutions

211

Despite the fact that Roynat is now ( 1968) five years old, conditions in the money market ( over the past three years particularly) make it difficult to reach any firm conclusions on the organization. Certainly the opening of three new offices since the end of 1964 would seem to indicate that it plans expansion. However, since 1965 Roynat's growth has been tapering off (Table 8/1). While volume of funds outstanding increased each year, the rate of increase declined in 1967 and 1968, the rate of increase in the number of clients has decreased each year since 1965, and disbursements in 1967 and 1968 were actually less than in each of the two preceding years. Available data through September 1967 (Roynat Limited Prospectus, Secured Note, Series E), indicate favourable loss experience (0.23 of 1 per cent on disbursement of $128.7 million). On a more specific basis, it is also encouraging that 8.1 per cent of the number and 5.9 per cent of the amount of Roynat's advances and commitments through September 1967 were to firms in the Atlantic Provinces. (In 1965, the most recent data available, 6.2 per cent of all Canadian manufacturing establishments were in the Atlantic Provinces.) Finally, it should be noted that in seven full years of operation (to the end of 1967) SBL Act loans outstanding were only $75.6 million (lower than at the two preceding year ends) compared with $97.9 million for Roynat after five full years. Clearly, Roynat will have to increase its 5.7 per cent rate of return on net worth and/or provide recognized and significant tangible and intangible benefits to its shareholders if it is to be a significant investment outlet for the participating financial institutions. Nevertheless, the principal reason for including Roynat in this study is that it seems to offer support for three major points already made: (a) there has been a substantial gap in the availability of institutional term financing for small business in Canada; ( b) lending of this type can be carried out profitably at reasonable interest rates; and (c) qualified staff, whose principal purpose is the identification and serving of small business credit needs, and who are market oriented, are necessary to bring the development of such a market to profitable fruition. Three questions concerning Roynat's long-run contribution to small business financing exist at this point. First, the average size loan ( approximately $140,000-$150,000) would indicate that Roynat is catering to the upper end of the small firm range, and therefore may not be a readily available source to the smaller firm. However, the fact that the average loan for firms in the Atlantic Provinces as of 30 September 1967 was $10 I. 8 thousand, compared with an overall average of $141.0 thousand, indicates Roynat's willingness to recognize the peculiarities of regions. Second, the role of the branch bank manager in Roynat can

212

Institutional Financing of Small Business in Nova Scotia

be critical. If he is neither more aggressive nor more willing to offer suggestions, it is likely that Roynat activity will be concentrated in those centres in which its own branches are located. Third, the priority assigned to Roynat in times of tight money by the participating institutions might not be particularly high, reducing it to a 'fair-weather' support for small firms. CREDIT UNIONS

Credit Unions are established under provincial law 'to enable groups of people with a common bond of association to pool their savings.'27 Since 50 per cent of credit unions in Canada were essentially community organizations in 1965, 28 and with a trend towards this type of organization, it seems reasonable, initially at least, to regard them as potential sources of funds for small enterprises owned within the community. One Canadian publication suggests that businessmen who are members of credit unions 'may be able to borrow from [them] for business purposes.'29 The possibility of utilizing this source of funds could have been enhanced by the rather spectacular growth of credit unions in recent years. At the end of 1965, the 178 reporting credit unions in Nova Scotia had 84,718 members, total assets of $29.7 million, and loans granted to members of $25.3 million, representing a five-year growth of 40 per cent in membership, 90 per cent in assets, and 132 per cent in loans. 30 While the Canada Year Book reported that in 1962 Atlantic Province credit unions were 'predominantly rural,' 31 an officer of the Nova Scotia Credit Union League ( NSCUL) told the author at that time that 'the label is not accurate for Nova Scotia.' He reported that half of Nova Scotia's credit unions were urban, and that they had 80 per cent of the assets and 72 per cent of the members. He added that three urban credit unions had assets of over $1 million each, and collectively accounted for over 20 per cent of all credit union assets in Nova Scotia at the end of 1961. By the end of 1967, the situation had changed only moderately with respect to urban-rural distribution: urban credit unions accounted for 82 per cent of assets and 76 per cent of members. However, concentration had increased markedly: eight urban credit unions 21 Canada Year Book, 1963-4, p. 1060. 28 See Credit Union Yearbook, 1967. 29 Financing Your Business, Small Business Management Aid No. 1 (Winnipeg: Province of Manitoba, Department of Industry and Commerce, undated),

p. 23.

30 See Credit Union Yearbook, various years. 31 Canada Year Book, 1963-4, p. 1060.

Credit from Non-Bank Institutions

213

had assets of more than $1 million, and they accounted for 48 per cent of all credit union assets in Nova Scotia at the end of 1967. Given that the eight large credit unions hold 48 per cent of all credit union assets in Nova Scotia, the average for the remaining 170 credit unions falls from an overall average of approximately $225,000 in assets (versus $582,445 in 1965 for Canada) to $120,000. Thus, with an average pool of loanable funds which appears to be about 80 per cent of total assets,82 all but eight Nova Scotia credit unions have average loanable funds of approximately $96,000. Consequently, it seems unrealistic to regard credit unions in general as a source of financing for anything other than the smallest business firms, the owner-manager of which is a member of a residential classification credit union. The central credit union, which accepts deposits from and makes loans to local credit unions, does not, in theory, restrict the individual credit union to its own immediate resources. However, the majority of credit unions are staffed exclusively by part-time personnel, and all credit unions appear to have ample attractive loan outlets to co-operative organizations, personal and real estate loans to members, and loans to or deposits with the central credit union. All factors considered, credit unions should not be regarded as a present source of financing for small business in Nova Scotia. Furthermore, it is not likely that they will grow enough in the foreseeable future to become a significant source. The only situation wherein it is possible that credit unions could become a significant factor ( and even then only the larger and the central units would be involved) would be if there was a substantial falloff in the demand for the housing loans which the large units have been making, during a period which was otherwise expansionary. With rates of 8 per cent (and as high as 12 per cent permitted), it is possible that then the large credit unions would provide for private businesses' financial needs. LIFE INSURANCE, TRUST AND MORTGAGE LOAN COMPANIES

Two factors led to giving some consideration to life insurance, trust and mortgage loan companies; however, their past, current, and foreseeable involvement in financing small business, and small manufacturers in particular, appears to be too modest to warrant extensive treatment here. 33 The two factors which led to consideration are: (a) the size and 32 See Credit Union Yearbook, various years, for balance sheet data. 33 Detailed treatment of relevant legislation, investments, rates of growth, and general operating policies and problems is provided in the following:

214

Institutional Financing of Small Business in Nova Scotia•

growth rates of these companies and the fact that they can finance small business; and ( b) the provision for special programs for small business financing by two insurance companies. At the end of 1962, life insurance, trust and mortgage loan companies had total assets of $12.4 billion, of which $2.5 billion (20 per cent) was in Canadian corporate, institutional, and other non-government bonds ($2.2 billion), and Canadian preferred and common stocks ($0.3 billion). The total assets of these three types of institutions had increased by $3.8 billion ( 44 per cent) over the four-year period from the end of 1958, with the major rate of growth in mortgage loan (up 78 per cent) and trust (up 96 per cent) companies. The principal growth accounts for all three were mortgage loans and sales agreements which increased by a total of $2.1 billion, or 55 per cent of the total growth. Aggregate growth in corporate and other bond accounts was modest ( $204 million, up by 15 per cent), while the proportionate growth in aggregate accounts for preferred and common stock ($83 million, up 33 per cent) was somewhat nearer the overall rate of growth. 34 The substantial increases in mortgage loans and sales agreements, which generally provide relatively attractive yields, reflect the particular efforts of the mortgage loan and trust companies to invest their rapidly increasing deposits - up by $1.04 billion or 80 per cent over the period - at rates adequate to cover the relatively high yields they were offering depositors. 35 Small firms might have some difficulty in qualifying for bond or stock sales to these three types of companies because of legally established William C. Hood, Financing of Economic Activity in Canada (Ottawa: Queen's Printer, 1958), pp. 311-19, 331-67, 381-3; The Canadian Life Insurance Officers Association, Submission to the Royal Commission on Banking and Finance (Toronto, 1962); and Submission of the Trust Companies Association of Canada to the Royal Commission on Banking and Finance (undated). 34 For asset data see Bank of Canada, Statistical Summary, various issues; and Bank of Canada, Statistical Summary Supplement, various issues. The growth pattern has continued over the five-year period 1962-7. Total assets of all three types of financial institutions increased by $7.6 billion (60 per cent), with mortgage loan and trust companies, with increases of 112 and 127 per cent, respectively, again leading the growth. Mortgage loans and sales agreements were again the principal growth accounts, accounting for 59 per cent of the increase in assets. Growth in holdings of corporate and other bonds again trailed (up 24 per cent) the overall rate of growth, while increases in stock holdings (81 per cent) exceeded asset growth, but constituted only 2.9 per cent of aggregate assets. 35 For liability data see ibid. Growth rates in deposits of these two institutions also persisted, increasing by $3.2 billion (114 per cent) over the 1962-7 period.

Credit from Non-Bank Institutions

215

earning and/or interest charges earned minima, but they do not have any inherent ineligibility for mortgage loans, policy loans to managers as individuals, or so-called 'basket clause' investments. Nevertheless, the evidence is that small firms, in general, and small manufacturers and new firms in particular, have not been significant recipients of financial assistance from any of these three types of financial institution. On the basis of interviews with officers of trust and insurance companies, it appears that they are not interested in lending to manufacturing firms . Probably this is explained in part by one officer's comment that he regarded any manufacturing building as a 'special purpose building,' and by comments by officers of one life and two trust companies that the financial and business record of a mortgage borrower was quite secondary to the potential marketability of the mortgaged property. In addition to not being interested in industrial lending in the future, all three of the life insurance company officers interviewed reported that they had never done any industrial lending; one life insurance company officer and one trust company officer commented that they were not aware of there ever having been a request from such a borrower to their firms; and two trust company officers also reported that their companies had not made any industrial loans in Nova Scotia. The literature reflects the moderate interest of these three institutions. Donaldson noted that mortgage companies were unwilling to 'assume the risks inherent in these [new small-scale manufacturing] businesses,' and none of his sample group of firms was successful in obtaining financing from such companies. 36 Loan officers of two trust companies and one life insurance company told the author they would not consider lending to any new firm, one qualifying this by adding 'unless the principals had a substantial stake in the company.' Hood concluded that life insurance companies are 'not ... frequent' investors in 'bonds of small corporations,' and that while mortgage loan and trust companies might contribute indirectly to the financing of small business via residential mortgage loans, 'their contributions in this way to the finance of small business must in total be very small. ' 37 The outlook for financial assistance for small firms of any age or type, from any of these companies is not promising, and there was no evidence of any concern for or interest in small business financing in any of their submissions to the Porter Commission. Rather, it appears most likely that they will continue to be major suppliers of residential 36 Gordon Donaldson, Financial Management in the New Small Scale Manufacturing Enterprise (doctoral thesis, Harvard Business School, 1955), p. 217. 37 Hood, Financing of Economic Activity in Canada, p. 236.

216

Institutional Financing of Small Business in Nova Scotia

mortgage credit, and that they may gradually move into high-grade equity securities. If the opportunity exists, some of the firms may move into a Roynat-type of organization; in the interim they should not be given serious consideration as a source of funds by small manufacturers or new businesses in any type of activity in Nova Scotia. It would be quite unrealistic to expect much of these institutions when four of the six officers interviewed categorized their own firms as 'conservative.' The second reason for considering these particular companies applies only to life insurance companies, but does nothing to alter the previous conclusions. Two major United States life insurance companies offer special loan programs for small businesses, described in some detail in Financing Small Business, 38 and mentioned, without comment, by Hood. 39 Metropolitan Life Insurance Company announced a small business loan plan on 7 February 1950, 'for the purpose of (a) determining if there was in fact an unsatisfied demand for sound small business credit; and ( b) helping to supply such credit if needed.' The plan was offered through commercial banks, which were expected to assume responsibility for 10 per cent of any loan. Six thousand banks were invited to participate by offering such credit in amounts up to $250,000 per loan on from three- to ten-year terms. An officer of the Metropolitan Life Insurance Company in Halifax told the author that (a) he had never heard of the small business loan plan, and ( b) his company did not do any direct lending in Canada, assigning that function to a Canadian trust company. Subsequently, an officer of the trust company concerned explained that under the arrangement the trust company offered to sell its mortgages to Metropolitan. He too had never heard of Metropolitan's small business loan plan. Prudential Insurance Company of America also has a loan program for 'small and medium size business throughout the United States and Canada' which it initiated in January 1956. In addition to a 'desire' to provide financial assistance to small and medium size businesses, Prudential hoped to achieve 'the widest possible distribution of company funds by aggressively seeking direct placement opportunities in all parts of both countries.' The program does not preclude new firms, there is no minimum amount, and the minimum term is ten years. Loans can be unsecured or on the basis of a mortgage. Prudential encountered several problems in attempting to build up its loan portfolio under the plan, but the company thought that as its 38 Financing Small Business (Washington: Federal Reserve Ban1c, 1958), pp. 522-4. 39 Hood, Financing of Economic Activity, p. 237.

Credit from Non-Bank Institutions

217

'desire to serve such businesses becomes more widely known, our objective to serve small and moderate size corporations will come closer to achievement. We believe that we are gradually getting our message across.' As evidence of progress, Prudential indicated that fifty-five applications, 75 per cent for less than $1 million, were 'under consideration' in March 1958, compared with a total of fifty ( of which four were in Canada) approved during 1957. A Prudential officer in Halifax told the author that (a) he had never heard of the loan program; (b) his company did not do any lending east of Quebec City; and ( c) that the minimum size loan considered was $300,000. It appears that the small firm, and particularly small manufacturing firms, new firms of any type, and small firms of any type located anywhere outside the Halifax urban area, should not regard life insurance, trust or mortgage companies as potential sources of funds; some of these firms may utilize such companies as indirect sources of financing by borrowing on residential mortgages. CONCLUSIONS

Of the several types of credit suppliers dealt with above, only two emerge as likely sources of funds for the new small manufacturing firm; these two are Roynat and the 'finance companies,' as typified by IAC. Factors might also be considered, largely because of their relatively large advances against accounts receivable in comparison with the banks. 'Venture capital' organizations, to the extent that CCL is representative, appear too cautious (somewhat of a paradox) in their practices to be considered seriously. Commercial finance companies' loans on inventory offer virtually no coverage or proportionate advances advantages relative to banks, and are high cost sources. Credit unions, life insurance, trust and mortgage loan companies simply do not appear to be 'in the market' for small company investment opportunities. The major reservation with regard to the finance companies would be that they currently only offer those things which the chartered banks, me, the SBL Act, and Roynat can provide at a lower cost. The short history of Roynat, as already noted, makes any conclusions concerning it very tenuous; however, Roynat may well be the most significant development in the field of small business financing that has ever occurred in Canada.

9 General Conclusions and Recommendations

The major research questions of this study were set forth in chapter 1. The general conclusions and recommendations are related to those questions. CONCLUSIONS

The financial institutions currently operating in Nova Scotia are able to provide credit for most foreseeable small business purposes and terms, with the exception of refinancing, and most small businessmen are satisfied with the credit available to them. Thus, there is no 'institutional gap' facing small businesses or small manufacturers in Nova Scotia at the present time. However, the great bulk of the credit provided in dollar amount is for seasonal working capital purposes, with smaller amounts extended for fixed assets on an intermediate term, and virtually none for either purpose for terms in excess of five years. It is estimated that approximately 20 per cent, or 7 5 to 100, of the manufacturing firms in Nova Scotia have unsatisfied credit needs. The unsatisfied needs are most likely in the term credit (in excess of one year) area, and the majority of firms with unsatisfied needs are probably those considering an expansion which would alter some aspects of their operation to a significant degree. The lending criteria used by lending officers in making loans of the types which their organizations are permitted to make vary significantly on an intra- and interinstitution basis. With minor exceptions, the criteria used are such as to restrict the availability of credit for new firms, small manufacturing firms, and small firms planning significant expansion of their operations. The most noteworthy restrictive criteria

General Conclusions and Recommendations

219

are applied by the branch managers of the chartered banks. The criteria used by branch managers vary markedly on an interbranch basis, as well as on an intrabank basis. The restrictive influence arises out of a general tendency to emphasize character to the exclusion of capital, to ignore the underlying liquidity and marketability of current asset security, and to provide credit on the historical rather than the projected financial condition of the applicant. The application of criteria in this manner limits the credit available for new firms in all types of activity, firms with liquid security, and firms with growth prospects. The branch bank managers' lack of experience in lending to small manufacturing firms restricts the credit available to such firms by failing to provide managers with appropriate criteria for such lending activity. The evidence also indicates that branch bank managers may (and do) develop their own lending criteria, and that these criteria can be used, provided they are more conservative than those of the bank employing the manager. Managers tend to develop conservative lending criteria because they are not well informed on the lending criteria of their superiors, and because they are not qualified to do sophisticated financial analysis. The competition between financial institutions in lending to small business is so miniscule as to be irrelevant to the subject of small business financing. Prior to the 1967 Bank Act, the legal framework and organizational structure of financial institutions restricted the availability of credit in general, and particularly restricted the provision of term credit to new firms and small manufacturing firms. The major legal restraints arose out of the Bank Act's prohibition on mortgage security and its ceiling on interest rates. Policy decisions with regard to lending operations also restrict the availability of term credit from Industrial Estates Limited, the Industrial Loan Fund, and the life insurance, trust and mortgage loan companies. The organizational structure and operating procedures and practices of the chartered banks tend to restrict the credit available to new firms and small manufacturing firms by providing branch managers with lending limits, skills, and incentives which are inadequate to encourage initiative. By and large the literature on financial institutions' lending criteria is replete with hyperbole. The availability of credit is more restricted than the literature would indicate, there is evidence of specific contradiction between statements in the literature and the 'real world,' and the criteria are so vaguely stated as to be meaningless for the small businessman. The most noteworthy aspect of financial institution literature in Canada is its scarcity, a problem partially overcome with the material

220

Institutional Financing of Small Business in Nova Scotia

arising out of the activities of the Royal Commission on Banking and Finance. The next most noteworthy feature of the literature concerns that describing the activities of the chartered banks. The great bulk of the written information concerning their activities has emanated from the banks themselves, and has the marked characteristic of describing what the banks may do as if it were what they actually do, and of treating what applies to the minority of branches in the largest centres as though it applied to all branches. The literature in general is such as to suggest that, while it is useful to the small businessman in determining potential sources of credit, it is not useful in appraising actual sources or in weighing alternatives. There is also an appalling lack of data on the financial characteristics of financial institutions, particularly with respect to the provincial distribution of investments and deposit liabilities of the chartered banks. In addition there is very limited data on the financial characteristics of businesses by type, province, and size. These deficiencies substantially hamper any regional analyses of business and financial institutions. The evidence of poor communication between lenders and borrowers is of two types : businessmen do not appear to test the lower limits of lenders' criteria, a fact indicated by low rates of credit rejections; and businessmen apply to particular lenders for types of credit which the latter do not provide. Two probable consequences of businessmen's ignorance and misapprehension regarding lender's activities are that the businessmen do not 'shop' for credit, and that they may not seek it at all. Despite these difficulties, the limitations on the availability of credit to small businesses are such that they could be overcome within the existing institutional structure. RECOMMENDATIONS

To overcome the restrictions on the availability of credit to small businesses, and to new and small manufacturers in particular, in Nova Scotia, the following steps are recommended. 1 The chartered banks should subject their personnel policies to extensive review. This review should be aimed at revising the present recruiting system, de-emphasizing on-the-job training and devising new training methods, broadening the background of staff members by exposing them to more varied regions and clientele, defining manager performance criteria, and improving incentives for branch managers. Until such reviews are carried out and changes initiated, the

General Conclusions and Recommendations

2

3

4

5

221

risks inherent in new lending activity will be inflated, or ( more likely) new lending activity will not become a reality in the majority of communities. The small businessman will be denied experienced and constructive counsel which these 'first line' institutions could provide. IDB should utilize its loan guarantee authority more extensively, and should consider the feasibility of acting more directly in the development of the retarded regions of the country. The more extensive use of their loan guarantee authority would reduce the burden on the Federal Treasury and could stimulate more conservative lenders to experiment in new lending activities. Direct action in the development of retarded regions would require more promotion and initiative in the provision of IDB services, as well as a policy of acting to offset unwarranted credit restraints, in such regions. IEL should alter its present course: it should consider the provision of credit for equipment acquisitions, secured by chattel mortgages, for non-tenants as well as tenants, and it should consider the possibility of expanding its staff to provide financial counselling service for small manufacturers in Nova Scotia. Fortunately, ILF appears to have been reactivated, with its regulations interpreted more liberally, to serve those firms for whose aid it was initially intended. Any financial institution sincerely interested in providing credit facilities for small manufacturers in Nova Scotia should do so with the underlying assumptions that the managers of these firms are not well versed in financial management, and that they are, on the average, not aggressive; that is, those providing the facilities will have to exercise considerable initiative if the province is to achieve development of small secondary industry. The responsible government agencies should make a concerted effort to develop statistical data which will facilitate regional analyses of business finance and financial institutions. Particularly, the Taxation Statistics series on financial structure by province should be added to currently published data, and similar data should be published for non-corporate businesses. Loan and deposit data, by province, for all types of financial institutions, but particularly the chartered banks, life insurance, trust and mortgage loan companies, should also be published. Further research might profitably be directed at the demand side of small business financing in Canada. Such research should be aimed at determining (a) the overall proportion of small firms which have unmet credit needs, and the nature of those needs; ( b) the small businessman's actual knowledge of financial sources; and (c) the level of small businessmen's financial management skills. Further

222

Institutional Financing of Small Business in Nova Scotia

research on the supply side might profitably be directed at appraising the skills of branch bank managers in other provinces, particularly in those provinces which have a low rate of industrial activity. PORTER COMMISSION RECOMMENDATIONS

A lengthy review of the findings, conclusions, and recommendations of the Royal Commission on Banking and Finance is not relevant here.1 In essence, the Report of the Commission holds that the unmet credit needs of small business are modest, and that they can be overcome by modest rather than drastic changes within the financial structure. 2 The Report concurs with this study on the need for removing both the prohibition on mortgage security and the interest rate ceiling; on the undesirability of subsidy-like rates of interest for selected groups or areas; on the need for financial assistance and advice in the extension of credit to small business; on the modest small business financing activity of venture capital, factoring and commercial finance companies and credit unions; and on the paucity of data concerning business finance and financial institution activities. The Report concludes that trust and life insurance companies 'are active suppliers of mortgage funds to smaller enterprises, but usually confine their operations to loans on factories and premises, some of which are of course leased rather than owned by small business.3 The Report gives more favourable treatment to sales (industrial) finance companies than this study does, somewhat less favourable treatment to IDB, and argues for higher rates on SBL Act loans. It argues that sales finance companies have been significant suppliers of relatively small loans to business and, although it does not identify the size or type of activity of the recipients, it is reasonable to assume that the recipients include a substantial number of small manufacturers. This does not alter the fact that they are high cost sources, and relatively unattractive vis-a-vis Roynat, SBL Act loans, and IDB. IDB is criticized for low interest rates which may inhibit the development of private financing facilities. Two general aspects of the Report merit comment. First, as has 1 For summaries, analyses, and evaluations of the Report see: The Canadian Banker (Summer 1964) , which contains six articles dealing with the Report; and The Report of the Canadian Royal Commission on Banking and Finance; A Review,' Federal Reserve Bank of New York, Monthly Review (August 1964), pp. 151-6. 2 Report of the Royal Commission on Banking and Finance (Ottawa: Queen's Printer, 1964), p. 45. 3 Ibid., p. 225.

General Conclusions and Recommendations

223

already been noted with regard to other literature on business finance and financial institution activity in Canada, the Report deals with national performance. Thus, a more careful study of activities on a regional basis would undoubtedly have resulted in many qualifications of the findings and conclusions. Second, the Report has the interesting feature, particularly in its chapter 7, of identifying a wide variety of activities in which the chartered banks have evidenced a considerable lack of what could be called 'competitive zeal.' Yet it never goes beyond observing at several points4 that the banks are, in effect, less effective innovators and experimenters than many of their competitors. The Report does take note of the banks' reluctance to compete on a price basis ( attributed in part to the 6 per cent ceiling), and their longstanding habit of reaching agreements on common courses of action, rates of interest and charges for services. With regard to the prohibition on mortgage security and the interest ceiling on loans, the Report concludes that The prohibition on conventional mortgage lending by chartered banks and the interest rate ceiling are the most serious barriers to free market forces in the present chartered banking legislation .... There is no reason why the investment of a reasonable share of a bank's funds in mortgages should endanger its position and the safety of depositors' funds ... The 6% interest rate ceiling introduces undesirable rigidity into the financial system and hampers and distorts the working of markets ... we recommend its removal regardless of other changes in the legislation. The limitations on the maximum lending rates and on the taking of mortgage security by the banks have effectively precluded them from making the charges and taking the collateral necessary to make certain types of loans to smaller enterprises.5

Thus, there are no significant differences between the related conclusions and recommendations of the Report and this study. However, we have attempted to go much farther on the actual operation of the branch banking system, and place considerably more emphasis on the need for greater skills at the branch level. BANK ACT REVISIONS

The revision of the Bank Act was postponed from its scheduled revision date ( 1 July 1964) to allow the government time to study the Porter 4 Ibid., see pp. 108, 121, 122, 124, 128, 146, and 261. Business Week reported that 'the bulk of the commission's report deals with making Canadian banking more competitive .. .' See 'Pep Pills for Canadian Banks,' Business Week (2 May 1964) . 5 Ibid., p. 364, 45.

224

Institutional Financing of Small Business in Nova Scotia

Commission Report. The revision was initially offered to Parliament for first reading in May 1965, and scheduled for committee hearings in the fall of 1965. This proposed bill disregarded the recommended removal of the interest ceiling, compromised on removal of the mortgage security prohibition, and contained a section that would require the two banks concerned to hold no more than 10 per cent each of Roynat's capital stock. The reasons for refusing to remove the ceiling are vague, but related in part to the view that removal would raise rates to borrowers. This occurred despite frequent statements by responsible bank officers that, on the average, interest rates in the country would probably fall with removal of the ceiling.6 The Financial Times of Canada, which said in a 1964 editorial (15 June) following publication of the Report that 'the ceiling is now a mere monument to outworn political shibboleths,' wrote in 1965 that 'the Government's reasons for clinging to the 6% ceiling ... are now emerging- and they are all political.' 7 The provisions with regard to mortgage security would have permitted the banks to invest up to one per cent of their Canadian deposit liabilities in mortgage secured loans in the first year the new Act was in effect, and a further one per cent in each succeeding year up to a total of 10 per cent. These. loans could be for three years or more, up to 75 per cent of the value of the property, and would be made at going rates of interest, that is, the ceiling would not apply to such loans. While certainly not following the spirit of free and open competition relying upon the price system, which was advocated by the Porter Commission, the initial revision proposals held some small possibility for improving the term loan situation facing small business. The number of firms which could effectively use such credit is probably small, so that if the authority was directed towards small business lending it could meet a large part of the demand. On the other hand, the banks could use their mortgage lending authority in residential rather than in business mortgage lending, and there was and is modest probability that branches in smaller communities would actively seek business mortgage loan opportunities. The requirement that the two banks involved in Roynat reduce them6 See 'Royal Bank's Big Boss and the Comer Grocer,' the Financial Post

(27 February 1965); W.E. McLaughlin, 'The Porter Report and Bank Act Revision,' an address to the Annual Meeting of the shareholders of the Royal Bank of Canada, 14 January 1965; and 'Give Us a Chance to Compete and Cut Borrowing Costs,' the Financial Post (9 September 1964). 7 'The 6% Boys Unopposed in Liberal Caucus,' the Financial Times of Canada (17 May 1965).

General Conclusions and Recommendations

22S

selves to minority shareholders was without both explanation and apparent justification, and in many respects it seemed that the monumental work of the Porter Commission has been ignored by the government. Fortunately for all concerned, the initial proposals died on dissolution of Parliament, and a new Minister of Finance introduced another set of proposals in mid-1966, which became law when the new Bank Act went into effect in May 1967. In their relevant aspects, the proposals, and the Act, provided for removal of the interest ceiling and allowed mortgage loans, subject to a 3 per cent limit the first year, but with the same maximum of 10 per cent; the new Act provided essentially the same treatment to the other matters of relevance here, and previous to its passage it was agreed in Committee that the banks concerned would not have to reduce their holdings of Roynat stock. Thus, there are no longer any significant legal restraints to the banks becoming actively engaged in providing term credit to small firms; one can only hope that their personnel policies and practices will be updated to match the new legal freedom, and that their bullish attitude of the early days of the new Act will come to real fruition for the small firm.

Appendix A MAIL QUESTIONNAIRE RESPONDENTS

208 79 70

Questionnaires mailed Replies received Replies tabulated Replies tabulated - percentage of questionnaires mailed

33

Replies not tabulated Out of business Returned by P.O. department Co-operative enterprise

4 4 1

Age of firms and tenure of present management

Established Year

No.

Prior to 1940

27

1940-44 1945-9 1950-4 1955-9

No answer TOTAL

%

Present management No.

1

39 7 17 20 16 1

19 20 1

4 19 27 29 1

70

100

70

100

5

12 14 11

14 3

%

13

20

Appendix A Number of people involved in management

Firms Number

One Two

No.

14

% 20 35

Three

25 13

5 13

19 7 19

TOTAL

70

100

Four Five or more

Type of ownership

Firms Type

No.

7

%

Proprietorship Partnership Limited company Subsidiary

55 5

79 7

TOTAL

70

100

3

10 4

Controlling shareholders - minimum number of people holding more than fifty percent of the voting stock

Firms Shareholders

No.

One to three Four to nine No answer

41 4

75

10•

18

TOTAL

55

100

•Nine were not asked

% 7

227

228

Institutional Financing of Small Business in Nova Scotia Products

Firms Number of product lines

No.

One product line only More than one product line

54 16

23

TOTAL

70

100

Ultimate consumers only Industrial consumers only Both ultimate and industrial

29 10 31

42 14

TOTAL

70

100

% 77

Products sold to

44

Employment

High

Low

Firms

Firms

Number

No.

%

No.

1-5 6--10 11-25 26--40 41-60 61-75 76--100

23 4 21 9

18

13

Over 100

16 3 15 6 9 2 7 12

3 10 17

5 17 5 12 2 6 5

TOTAL

70

100

70

% 26 7 24

7 17 3 9 7

100

Spread between high and low employment classifications

Firms

%

Spread

No.

Same classification One classification Two or more classifications

45 14 11

64

TOTAL

70

100

20 16

Appendix A Sources offi1111ncing Number of firms using

Source

No.

%

Chartered bank Equipment finance company Industrial Development Bank Industrial Estates Limited Industrial Loan Fund Insurance company - mortgage loan - policy loan Mortgage company Personal finance company Sale of bonds Sale of common stock Sale of preferred stock Personal loan Parent company No borrowing No answer

61 4 12 6 8

48 .0 3.0 9.0 5.0 6.0

1 1 1 1 2

11

6 4 2 6 1

0.8 0.8 0.8 0.8 2.0 8.0 5.0 3.0 2.0 5.0 0.8

127

100.0

TOTAL

Firms

Number of sources used by firms

No.

Bank only One (non-bank) source Two sources Three sources Four sources Five sources Six sources No borrowing No answer

30 2 15 9 5

1 1 6 1

3 21 13 7 1 1 9 1

TOTAL

70

100

% 44

229

230

Institutional Financing of Small Business in Nova Scotia Refusals

Firms Number of refusals

No.

No refusals One refusal Two refusals Four refusals No answer

57 10 1 1 1

83 14 1 1 1

TOTAL

70

100

%

Firms Refusals by

Industrial Estates Limited Industrial Loan Fund Industrial Development Bank Insurance company - mortgage loan Equipment finance company 'People with money' TOTAL

No.

3

%

5 5

20 31 31

16

100

1 1 1

6 6 6

Terms of bank borrowing

Firms Term

No.

Demand Three months or less Four to six months Seven to twelve months More than twelve months Overdraft Demand and over one year No borrowing No answer

35 2 2 3 4 3

TOTAL

% 58 3 3 5

7 5

5

9

6

10

70

100

10

Appendix A Security provided

Frequency Types of security provided

No.

Accounts receivable Inventory Collateral Life insurance Personal endorsement on limited company note

22 24 9 7

30 32 12 9

13

17

TOTAL

75

100

Number of types of security provided

Firms No.

14 15 3 3 2

%

% 22 23

One Two Three Four Five No security No borrowing No answer

19•

30

TOTAL

70

100

8 6

5 5

3 12

*Eleven were not asked

Influence of outside financing on profitability

Firms No.

%

No influence Assisted Restrained No answer

37 12 13

12 52 17 19

TOTAL

70

100

8

231

Appendix B STATEMENTS USED AS BASIS FOR INTER VIEWS WITH FOUR NOVA SCOTIA CHARTERED BANK 'MAIN BRANCH' OFFICERS

Main Branch of _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ __ Name _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ __ Date _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ __ 1 Banks lend for three identifiable terms: a Short-term, specifically under one year b Revolving, demand notes, seldom cleaned up c Term, specified orally at 3-6 years, payments monthly to annually 2Banks do not concern themselves with the purpose of the loan so long as the term and security are acceptable 3 There are four forms of lending: a Authorized overdraft b Unauthorized overdraft c Authorized credit supported by demand notes d Loans supported by demand or time notes 4Lending generally takes the form of a demand note 5Written covenants are virtually non-existent 6The data provided by a borrower, and on file by the bank consist of: a Statement of personal worth b Balance sheets and income statements for three years 7 Data kept on file, either prepared by or secured from third parties, consist of: a Reports on credit standing with suppliers b Source and application of funds statement Sa Acceptable security are personal endorsements, guarantors, life insurance, csv of life insurance, bonds, and stocks, accounts receivable, inventory, contracts, and leases b The security value varies, but the following are approximate: personal endorsement - depends on personal worth, but basic to any credit;

Appendix B

233

guarantor - depends entirely on personal worth, name alone worth nothing; life insurance - a 'throw in' csv of life insurance - 100 per cent bonds - government, 100 per cent; other, at about 60 per cent of market stocks - 60 per cent of market receivables, inventory - 50 per cent of book value contracts, leases - 100 per cent c Banks prefer personal guarantees to lodging of securities d Accounts receivable, inventory, contracts, leases are nothing more than moral security 9a Character is appraised by past record of paying bills b Capacity is appraised by profit and growth of the firm l0New businesses with inexperienced management borrow on security, while established businesses ( and new busineses under experienced managers) borrow on character and capacity 11 a Regardless of capacity, character, or capital of the principals, credit applications are rejected when the product is new to the area b New management and new product enterprises cannot secure bank credit; new firms which have neither of these can 12 General lending rules of thumb: a No loan of more than 50 per cent of working capital b No loan of more than 50 per cent of net worth c Working capital ratio should be at least 1 : 1 d No loans when business is showing year-to-year fall-off e When in doubt, don't 13 a The absence of significant secondary industry makes experience in this lending area rare, and consequently credit is more difficult to obtain b The absence also makes the spread between asset book values and market values greater in secondary industry firms than in other types of firms in the province 14a There are no differences between banks, but there are significant differences between managers which result in credit being rejected by one branch which would be quite acceptable to another branch of the same bank, or another bank's branch b In general, older managers and smaller branch managers are more conservative, while young managers and larger branch managers are more liberal 15 a Branch managers are more liberal than supervisors b The reasons for (a) are that supervisors lend on the financial statements and are not influenced by subjective appraisal of character and capacity c Supervisors frown upon managers using the 'phone to elaborate on the subjective elements of an application d Changes in supervisors frequently lead to perceptible changes in kinds of loans securing approval

234

Institutional Financing of Small Business in Nova Scotia

Supervisors rather rapidly categorize managers as to their credit appraisal skills 16a Managers have three lending limit figures: - Amount free to make on own and not report - amount free to make, but must report - amount over which prior approval is required - latter two are higher for fully secured loans b The highs and lows of the above would depend upon the size of the branch, ability and experience of the manager, and would have the following range: - free, no report - $2,000 to $5,000 -free, report, secured - $10,000 to $25,000 - free, report, unsecured - $4,000 to $10,000 17 Removal of the interest ceiling of 6 per cent on business loans would a Enable banks to be more competitive in seeking savings b Permit use of rate to reflect differences in security c Result in no new lending because managers are supposed to minimize losses on loans rather than to maximize profits 18 a SBL Act has not been successful to date and most branches have not made any loans b The reasons for the lack of activity are: - $250,000 revenue cut off is too low - Banks are reluctant to lock-in at 5.5 per cent - Banks are already covering the acceptable risks (under the Act) with term lending 19Virtually all branches have deposits in excess of their loans, and each bank has its branches aim at this position. e

Appendix C STATEMENTS USED AS BASIS FOR INTERVIEWS WITH CHARTERED BANK SENIOR REGIONAL MANAGEMENT PERSONNEL

Major findings 1 Institutional credit is presently available for most foreseeable business purposes and terms, with the exception of refinancing, and most businessmen are satisfied with the credit available to them. 2 Businessmen are generally poorly informed on the lending services and criteria of financial institutions. This situation affects applicationrejection ratios and lending criteria of lenders, and artificially restricts the availability of credit. 3 Small business in general, and new firms and manufacturers in particular, cannot expect experienced or constructive financial counsel from the lenders presently operating in Nova Scotia. 4 Five major factors influencing institutional lending to small firms are: a Lack of competition; b Lack of skill and experience among lending officers; c Personalized lending criteria; d Weakness of incentives for market area development; e The existence of more favourable investment outlets outside the market area and in other types of credit. 5 The lending practices and procedures of financial institutions do little, if anything, to encourage development of the provincial economy, and quite probably inhibit the expansion and development of secondary industry in Nova Scotia. 6 With somewhat modified legal requirements, substantially altered administrative procedures, and education, institutional credit facilities in Nova Scotia would be adequate for the initiation and development of small manufacturing firms. Major recommendations 1 All institutional lenders should be free to extend credit to business for all purposes and terms on any security, at interest rates set by the market, with institutional differentiation based upon the risk acceptable to each institution.

236

Institutional Financing of Small Business in Nova Scotia

2 Government loan programs for business should provide credit only to risks unacceptable to private lenders. Such programs should charge interest at market rates, be administered by a single department of one level of government, and should assist private institutional lenders by providing both partial and deferred participation in lending activity initiated by the latter. 3 Chartered banks should examine their training, placement and performance appraisal systems if they are interested in the development of the communities in which they operate branches. Specifically, on-the-job training should be more diversified by region and size of branch, and it should be supplemented by formal residence-type programs; 'deadwood' should not be appointed to the branch manager level, regardless of the history or economic structure of the community; performance criteria should place emphasis on profit maximization rather than loan loss minimization; banks should also consider the possibility of using local advisory boards. 4 Financial institutions, particularly the chartered banks, should be required to publish monthly statistics on the dollar volume of loans and deposits, cross-classified by size, type, number, and province. 5 Small business managers should be better educated with respect to: a The alternative sources of credit available to them, the subjective elements in credit appraisal, and the opportunities to bargain for credit; b The preparation and analysis of past, present, and projected financial data; c Market opportunities in the region.

Bibliography

Books and Pamphlets American Bankers Association. Notes from the Commercial Banking Industry, Monograph, Prepared for the Commission on Money and Credit (Englewood Cliffs: Prentice Hall, Inc., 1962) Bank Act, 1954 (Ottawa: Queen's Printer, 1954) Beckhart, B.H. Business Loans of American Commercial Banks (New York: Ronald Press, 1959) Brief of Industrial Acceptance Corporation Limited Submitted to the Royal Commission on Banking and Finance Brief to the Royal Commission on Banking and Finance. The Investment Dealers' Association of Canada, vols. I and II, 1962 Business Loans (Montreal: Industrial Acceptance Corporation Limited, 1963) Capital Equipment Financing: A Fact Book (Montreal: Industrial Acceptance Corporation Limited, 1960) Capital Loans for Canadian Business (Montreal: Industrial Acceptance Corporation Limited, 1960) Capital for Industry (Toronto: Charterhouse Canada Ltd., undated) Capital for Progressive, Expanding and New Canadian Business (Montreal: Roynat, Ltd., undated) Cairncross, A.K. Economic Development and the Atlantic Provinces (Fredericton: Atlantic Provinces Research Board, 1961) Chartered Banking in Canada (Montreal: Canadian Bankers' Association, 1955) Chartered Banking in Canada (Montreal: Canadian Bankers' Association, 1958) Donaldson, Gordon. Financial Management of the New Small Scale Manufacturing Enterprise (Boston: unpublished doctoral dissertation presented to the Graduate School of Business Administration, Harvard University, 1955) Edmonds, J.K. Grow or Perish: How to Raise and Use Money to Make Your Business Grow (Toronto: Maclean-Hunter Publishing Company Limited, 1960)

238

Institutional Financing of Small Business in Nova Scotia

Evidence of the Governor Before the Royal Commission on Banking and Finance (Ottawa: Bank of Canada, 1964) Financing Canadian Industries (Ottawa: Queen's Printer, undated) Financing Small Business (Washington: Federal Reserve Bank, 1958) Financing Small Business. Economic Series No. 70 (New York: National Association of Manufacturers, 1956) Financing Your Business, Small Business Management Aid No. I (Winnipeg: Province of Manitoba, Department of Industry and Commerce, undated) Hodgman, Donald R. Commercial Bank Loan and Investment Policy (Champaign: Bureau of Economic and Business Research, University of Illinois, 1963) Hood, Wm. C. Financing of Economic Activity in Canada (Ottawa: Queen's Printer, 1958) Horvitz, Paul M. Concentration and Competition in New England Banking (Boston: Federal Reserve Bank of Boston, 1958) /AC Leasing: A Service to Canadian Business (Montreal: Industrial Acceptance Corporation Limited, undated) Industrial Development Bank Act, 1944-45 (Ottawa: King's Printer, 1945) Jamieson, A.B. Chartered Banking in Canada (Toronto: Ryerson Press, 1953) Jen, F.C. The Determinants of the Degree of Insufficiency of Bank Credit to Small Business (Madison: unpublished doctoral dissertation presented to the University of Wisconsin, 1963) Kaplan, A.D.H. Small Business: Its Place and Problems (New York: McGraw-Hill Book Company, Inc., 1948) Laurentide Financial Corporation Ltd. A Submission to the Royal Commission on Banking and Finance, 1962 Lounsbury, F.E. Financing Industrial Development in the Atlantic Provinces (Fredericton: Atlantic Provinces Research Board, 1960) - Secondary Manufacturing in the Atlantic Provinces (Fredericton: Atlantic Provinces Research Board, 1961) Mcivor, R. Craig. Canadian Monetary, Banking and Fiscal Development (Toronto: Macmillan Company of Canada, Ltd., 1958) Methven, M.D. Report to the Government of Nova Scotia (unpublished, Halifax, 1957) Muir, James. The Canadian Banking System (Montreal: The Royal Bank of Canada, 1956) Report of the Royal Commission on Banking and Currency in Canada (Ottawa: King's Printer, 1933) Report of the Royal Commission on Banking and Finance (Ottawa: Queen's Printer, 1964) Report of the Royal Commission on Provincial Development and Rehabilitation, vols. I and 11 ( Halifax: King's Printer, 1944) Royal Commission on Banking and Currency, Final Hearings at Ottawa (Ottawa: King's Printer, 1933) Royal Commission on Banking and Finance. The Canadian Bankers' Association. Hearings Held at Ottawa, vols. 61 and 62 (Toronto: Nethercut and Young, 1963)

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- President, Canadian Imperial Bank of Commerce; President, Bank of Montreal; President, The Royal Bank of Canada. Hearings held at Ottawa, vol 63 (Toronto: Nethercut and Young, 1963) - Hearings Held at Winnipeg, vol. SA (Toronto: Nethercut and Young, 1962) - Submissions by: Canadian Small and Independent Business Federation; Michael M. Koerner; The Charterhouse Group Canada Ltd. Hearings held at Toronto, vol. 13A (Toronto: Nethercut and Young, 1962) - A Submission by the Government of Nova Scotia (Halifax, 1962) Small Business Manual, 3rd ed. (Ottawa: Department of Trade and Commerce, 1959) A Source of Financing for Canadian Business (Ottawa: Industrial Development Bank, undated) Submissions by the Bank of Canada to the Royal Commission on Banking and Finance (Ottawa: Bank of Canada, 1962) Submission to the Royal Commission on Banking and Finance. The Canadian Life Insurance Officers Association (Toronto, 1962) Submission of the Canadian Manufacturers' Association to the Royal Commission on Banking and Finance, 1962 Submission to the Royal Commission on Banking and Finance by G. Arnold Hart, President, Bank of Montreal, 1963 Submission by the Industrial Development Bank to the Royal Commission on Banking and Finance (Ottawwa: Bank of Canada, 1962) Submission to the Royal Commission on Banking and Finance. W.E. McLaughlin, Chairman and President, The Royal Bank of Canada, 1962 Submission of the Trust Companies Association of Canada to the Royal Commission on Banking and Finance Survey of Credit and Capital Requirements Among Small and Medium Size Business Establishments, Third Federal Reserve District (Philadelphia: Department of Research and Statistics, Federal Reserve Bank of Philadelphia, 1938) Walker, Sir Edmund. Banking in Canada (Reprint of a speech given before the Institute of Bankers, London, June 1911) - The Canadian Banking System and the National Banking System of the United States: A Comparison with Reference to the Banking Requirements of Canada (Toronto: Canadian Bank of Commerce, 1890) Periodicals and Addresses

'The Banking System of Canada.' Lecture to the Third Year of the Law School, Toronto, by A.A. Lash, February 1907 'Changes in Banking Structure,' Federal Reserve Bulletin, September 1963 'Commercial Banks as Suppliers of Capital Funds to Business,' Federal Reserve Bank of New York, Monthly Review, December 1963 Currie, W.M. 'Views on the Report of the Royal Commission,' Canadian Banker, Summer 1964 'District Operating Ratios in 1963,' Federal Reserve Bank of Chicago, Business Conditions, April 1964

240

Institutional Financing of Small Business in Nova Scotia

Donham, Paul. 'Whither Small Business?' Harvard Business Review, March-April 1957 Donham, Paul and Fitzgerald, Clifford. 'Small Business Financing,' Harvard Business Review, July-August 1959 DuVall, K.K. 'A Practical Approach to Small Business Assistance,' Burroughs Clearing House, March 1959 'The Effect of Tight Money on Small Business Financing,' Management Research Summary, 1963 Howard, C.S. 'Report of Proceedings of the Thirteenth International Banking Summer School,' Canadian Banker, Spring 1961 'Innovator at the Till,' Business Week, 6 June 1964 'Instalment Loans - How Profitable?' New England Business Review, February 1962 Macdonald, K.H. 'A Case for Leasing,' Address before the Canadian Credit Men's Association, Montreal, November 1961 MacDonald, W.H. 'Small Business Loans,' Canadian Banker, Autumn 1962 Mitchell, Alison. 'The Royal Commission's View of Banking and NearBanking,' Canadian Banker, Summer 1964 Neufeld, E.P. 'The Report of the Royal Commission on Banking and Finance- A General Review,' Canadian Banker, Summer 1964 'A New Era in Canadian Banking,' Canadian Business, April 1961 Painter, I.A. 'Small Business Lending,' Burroughs Clearing House, September 1959 Rasminsky, Louis. Address to the Chamber of Commerce, Quebec City, May 1964 'Research Into Banking Structure and Competition,' Federal Reserve Bulletin, November 1964 Schott, F.H. 'The Report of the Canadian Royal Commission on Banking and Finance: A Review,' Federal Reserve Bank of New York, Monthly Review, August 1964 Slater, D.W. 'General Economic Policy in the Report of the Royal Commission on Banking and Finance - Some Reflections,' Canadian Banker, Summer 1964 'Small Business Financing: Corporate Manufacturers,' Federal Reserve Bulletin, January 1961 Stewart, R.D. 'Commercial Financing,' Canadian Chartered Accountant, May 1962 Stillman, R.D. 'The New Look in Venture Capital,' Harvard Business School Bulletin, September-October 1963 'Submission of the Canadian Bankers' Association to the Royal Commission on Banking and Finance,' Canadian Banker, Supplement, Spring 1963 'Submission of the Canadian Bankers' Association to the Royal Commission on Banking and Finance, Summary and Conclusions,' Canadian Banker, Spring 1963 'Time Deposit Operating Results, 1962,' New England Business Review, June 1963 Toten, J.E. 'Banking - Royal Commission Style,' Canadian Banker, Summer 1964 Wilkie, D.R. 'Notes on Banking in Canada,' Address delivered before the British American College, April 1889

Index

Accounts receivable as loan security, 81, 84, 85, 86, 98, 112 Advertising of chartered banks, 122, 128 Aetna Factoring Corporation Ltd., 204 American Bankers' Association, 121 Atlantic Acceptance Corporation, 203 Atlantic Provinces Economic Council, 183 Atomic Energy of Canada Ltd., 182 Availability of credit: conclusions regarding, 219; and Porter Commission recommendations, 222; recommendations regarding, 220; see also Small business Bank Act, 28, 31, 32, 34, 49, 162n; and

interest rates, 30, 34, 63, 224, 225; and mortgage security, 50; and Porter Commission, 223; and powers of banks, 33, 34 Bank Act revisions, 223-5; integration of study with, v; of 1924, 30; of 1954,37n, 77;of 1967,45, 128,219 Banking: see Chartered banks; Bank of Canada Bank of Canada: and chartered banks, 27; Governor of, 50; history of, 26; and IDB, 27, 142, 158; and Porter Commission, 27, 50, 64; purpose of, 26 Bank of Canada Act, 26

Bank of Montreal, 37; financial structure of, 40, 41; services offered by, 123; staff transfers of, 102 Bank of Nova Scotia, 37; financial structure of, 40, 41; services offered by, 123; staff transfers of, 102 Bank of the United States, 28 Banks: see Chartered banks; names of specific chartered banks; Bank of Canada Banque Canadienne Nationale, 207 Branch bank managers: attitudes of, see specific areas; communication with supervisors, 117-19, 134; and compensating balances, 75, 76; conservatism of, 87; and credit criteria, 82; and credit rejections, 113, 114, 115, 116; differences amongst, 125; duties of, 106-9; education and training of, 11, 99-105, 115, 129; evaluation of, 105-10, 139; evaluation of financial condition, 87-91; evaluation of security, 80-7; financial analysis methods, 88-91, 94, 98; and IDB, 155, 158, 166; interest rates, attitudes towards, 66-9; interviews with, 11, 232-4; knowledge of competitors, 8, 126, 127; and loan limits, 111-19; and loan security, 54-6; and monetary policy, 45; new small business, attitudes towards,

242

Index

80, 82-7; older managers, 109-10; and overdraft lending, 73-5; on protecting borrowers, 96, 97; and purposes of loans, 56, 51; recommendations regarding, 220; recruitment of, 134, 135; reporting to supervisors, 111, 112, 115; restrictive practices of, 80-98; risk, attitudes towards, 107; and Roynat, 211, 212; and short-term loans, 50, 51; skills of, 87, 88, 95-7, 103, 110, 111, 116, 117, 119, 132, 134, 135, 137, 139; and small business, 81; and Small Business Loans Act, 60-3; and small manufacturers, 93-5, 98; success criteria of, 107, 108; and supervisor relations, 116, 117, 134; and term loans, 50-5, 51, 58, 72; see also Chartered banks: personnel policies; Research: methodology: interviews Branch banks: see Chartered banks; Branch bank managers Business Development Funds Ltd., 201 Caimcross, A.K., 12n, 22, 44-5, 187, 188n, 193n Canada Area Development Agency, 168 Canada Trust, 207 Canadian Bankers' Association, 29, 32, 48n; on bank competition, 125; as chartered banks' spokesman, 121, 122; on credit criteria, 82; and Porter Commission, 49, 76, 99, 100, 121, 125 Canadian banking system: see Bank of Canada; Chartered banks; see also names of specific chartered banks Canadian Factors Corporation Ltd., 204 Canadian Imperial Bank of Commerce, 37; financial structure of, 40, 41; services offered by, 123; staff transfers of, 102; training program, 101 Canadian Manufacturers' Association, 22-3,50,64, 76,165 Character as loan security, 80-7, 97, 117, 118

Chartered banks - and Bank of Canada, 26, 27 - branch banking, advantages of, 29, 30 - charters of, 31, 32 - conservatism of, 115, 132, 134 - criticism of, 30, 31, 45 - and the economy, growth of, 28-30, 34, 65, 66, 136 - and factors, 205 - failures, 30 - and finance companies, 202, 205 - financial performance of, 38-40, 42,43,70, 160 - financial structure of, 34-40, 42, 43, 69, 70, 112 - functions of, 28, 115, 122, 123 - and government loans, 138 - history of, 28-31, 34-7, 45 - and IDB, 145,148,162 - and interbank competition, 50, 64, 72, 120-9, 133; effects of, 120, 121, 125; evidence regarding, 120-4, 129; future of, 129; at organizational levels, 134; reasons for lack of, 128, 129; varieties of, 125-7, 134, 140, 141 - and interest rates, 30, 63-5, 71 - and life insurance, trust and mortgage loan companies, 216 - liquidity, concern with, 48, 49, 53, 54 - loan limits, 111-19 - loan portfolios of, 37, 38, 44, 45, 48, 70, 77-9; approval of loans, 112; 'bankability' criterion, 115, 131; self-selection, 115,118,131 - and Macmillan Commission, 63, 64 - and monetary policy, 44-5 - non-bank competition, 77-8, 121, 126 - in Nova Scotia, 36, 37, 44, 65; development of, 136, 137; and term lending, 71 - number and size of, 26, 28, 30, 34, 35,121 - objectives of, 105-9 - and oil industry, 32, 33 - and open markets, 137, 138 - personnel policies, 99-111, 120,

Index 129, 135, 136, 138, 139, 141; evaluation methods, 105-8; and loan practices, 98; and older managers, 109, 110; recommendations regarding, 220; recruiting and training, 99-105, 109, 110; staff planning, 104; transfers of staff, 100-3 - and Porter Commission, 60 - powers of, 33, 34 - and regional differences, 28, 29, 31 - restrictions on, 33 - recommendations regarding, 137-41, 220 - risk aversion of, 72 - and Roynat, 207,209, 210 - in sample population, 7-10 - senior regional officers, views of, 130-41; on availability of counseling. 132; on availability of credit, 130, 13 l; on branch bank managers, 134-6; on interbank competition, 133, 134 - similarities amongst, 125, 126 - and small business, growth of, 45, 71, 118, 119, 124 - and Small Business Loans Act, 59, 60 - and small communities, 110 - structure of, 28, 29, 110, 111, 119 - term of loans, 49 - United Kingdom comparison, 36n - United States comparison, 29, 36n, 41-3, 46, 48, 120, 121, 124 - see also Branch bank managers; Restrictive practices of banks Charterhouse Canada Limited, 205-7, 217 Clairtone Sound Corporation, 182, 183, 185 Coleman, J.H., 70, 128 Commercial Finance Companies: see Finance companies Competition: conclusions regarding, 219; see also Chartered banks: interbank competition; Chartered banks: non-bank competition Compensating balances, 75-6, 79 Consumer credit: see Personal lending Credit limits: and bank criteria, 115-19; and credit rejection, 113-

243

16; existence of, 111, 112, 114; size of, 112, 113 Credit unions, 10, 212, 213, 217 Dawson Commission, 186, 187 Demand loans, 76-7 Deuterium of Canada Ltd., 175n, 182, 183,185 Discretionary limit: see Credit limits Donaldson, G., 17n, 81, 83n, 120, 146, 215 Donham, P., 23n Dominion Steel Company, 183 Equity: as credit criteria, 83, 86; as loan security, 86 Evaluation methods: see Chartered banks: personnel policy Evaluation of financial condition, 98; use of financial statements, 88-91, 95; see also specific institutions Factors, 204-5, 217 Fellows Course in Banking, 100 Finance companies, 204-5, 217; and chartered banks, 202; financial performance of, 160; and IDB, 164; and Porter Commission, 162, 222; in sample, 10 Financial analysis: see Evaluation of financial condition Financial institutions: financial performance of, 160; function of, 2; opportunities for, 3; see also specific institutions First National City Bank of New York, 78 Foreign investment and IDB, 147 General Trust Co. Ltd., 207 Goodwill, 84, 85, 126 Government as lender, 138; see also Public financial institutions Government financial institutions: see Public financial institutions Hamilton, A., 28 Hodgman, D.R., 75n, 123n, 124n Home Bank, 30 Hood, W.C., 29, 122, 125, 215, 216

244

Index

Horvitz, P.M., 29n, 71, 105, 106, 110n Howard, C.S., 48n Industrial Acceptance Corporation Ltd. (IAC), 198-203, 217; and Business Development Funds Ltd., 201; capital loans, 198-201; and chartered banks, 202, 203; and competition, 202, 203; factoring, 201; and finance companies, 202; financial structure of, 200, 202, 203; functions of, 198, 200; and IDB, 164; and Industrial-Talcott Ltd., 201; and interest rates, 199, 201; last resort lender, 203; and leasing, 200; loan criteria, 199; loan security, 199, 201, 202; machinery and equipment financing, 200, 201; and monetary policy, 202; in Nova Scotia, 198, 199; and Porter Commission, 163, 202; reporting methods, 203; size of, 198; structure of, 199; terms of, 200, 201; working capital financing, 201 Industrial Development Bank (IDB), 21, 28, 142-167, 222; and Bank of Canada, 27, 142, 158, 163; and chartered banks, 145, 148, 149, 162, 166; and Charterhouse Canada Ltd., 206; and competition, 162-4; criticism of, 162-5, 167; and equity investment, 147, 148; and finance companies, 164; and other financial institutions, 160; financial performance of, 158-61; financial statements, use of, 148, 149; financial structure of, 158; and foreign investment, 147; functions of, 142, 146-8, 162, 163; history of, 142; and IAC, 164; and JEL, 162; and n.F, 162, 190, 192; and interest rates, 145, 146, 149, 150, 158-60, 163, 164, 167; and loan approvals, 143, 144; and loan covenants, 162; loan criteria, 144-8; loan portfolio of, 146, 147; and loan security, 127, 145; and Manitoba, 165; and monetary policy, 151, 154, 166; and new small business, 146, 150; in Nova Scotia, 144, 151, 153, 154,

155, 156, 157, 165, 166; and Porter Com.mission, 144, 145, 147, 158; recommendations regarding, 165-7, 221; and regional differences, 149, 151, 154, 155, 156, 157, 166; size and volume of loans, 150-3; staff of, 144; structure of, 142, 143, 144, 165; and tax considerations, 160, 163; terms of loans, 148 Industrial Estates Limited (IEL), 167, 194, 195, 219; and Clairtone Sound Corporation, 182, 183, 185; and Deuterium of Canada Ltd., 182, 183, 185; and DOSCO, 183; firms assisted by, 173, 174; financial performance of, 175-83; financial structure of, 167, 168, 178; functions of, 172, 173, 186; history of, 142, 167, 168; and IDB, 162; and IEF, 196; and ILF, 188, 190, 196; interest rates of, 17 6, 177; and lease arrangements, 171; as lender of last resort, 185; loan criteria, 172; loans, types of, 170-2; performance of, 174, 180, 181, 183; purpose of, 167-70; recommendations regarding, 184-6, 195, 197, 221; in sample population, 7; staff of, 169, 170, 186; structure of, 169, 170 Industrial Expansion Fund (IEF), 166, 188, 196 Industrial Loan Fund (ILF), 166, 186-95, 219, 221; and chartered banks, 193; financial performance of, 188-91; functions of, 193; history of, 142, 186, 187, 190; and IDB, 162, 190, 192; and JEL, 188, 190; and IEF, 188, 196; and interest rates, 194; loan eligibility criteria, 189, 190, 192; and monetary policy, 192; performance of, 187, 188; recommendations regarding, 193, 194; and SBL Act, 190, 192; structure of, 189 Industrial-Talcott Ltd., 201 Information, imperfections in, 118, 131, 220 Institute of Canadian Bankers, 104, 110

Index Integrity: see Character Interest ceilings: see Interest rates Interest rates - and Bank Act, 34, 224, 225 - ceilings on, 50, 63-71; arguments for and against, 64, 67-9, 120, 129; consequences of removal of, 6971; impact on small business, 72 - and chartered banks, 30, 34 - and compensating balances, 76 - competition regarding, 124 - and credit unions, 213 - and factors, 204 - and finance companies, 204 - flexibility of, 63, 64 - and IAC, 199, 201 - and JDB, 145, 146, 149, 150, 158, 159, 160, 163, 164, 167 - and IEL, 176, 177 - for intrabank transactions, 105, 106 - and monetary policy, 64 - and personal lending, 77, 78 - and Porter Commission on, 223 - and public financial institutions, 196 - and regional development, 65, 66 - and risk, 67, 68, 69, 106, 137, 138, 150 - Roynat, 209, 210 - under Small Business Loans Act, 62, 63, 72 - and savings deposits, 65, 68 - and term of loans, 49 - and volume of loan activity, 67-69 - see also specific institutions Inventory as loan security, 81, 84, 86, 94, 95, 96, 98, 112 Investment Dealers Association, 50 James, Dr F.C., 34 Jamieson, A .B., v, 28, 29, 32, 34, 48n, 53, 112n; on banking education, 100; on credit criteria, 82; on credit to new business, 80; on financial analysis methods, 88; on loan criteria, 93; on protecting borrowers, 96 Jen, F.C., 96n Koerner, M., 22, 24

245

Lash, A.A., 29, 31 , 48n, 100n Laurentide Finance Corp. Ltd., 65n, 77, 163, 164, 198n, 203 Lending criteria, conclusions regarding, 218, 219; see also specific institutions Life insurance as loan security, 81 Life insurance, trust and mortgage loan companies, 213-17, 219; and chartered banks, 216; financial structure of, 214; functions of, 21417; as lenders, 216, 217; loan portfolios of, 214; in Nova Scotia, 215; and Porter Commission, 215; in sample, 10 Loan covenants: use by chartered banks, 91-3; use by JDB, 149 Loan limits: see Chartered banks: loan limits; Credit limits Loan portfolios: see specific institutions Loan security: and chartered banks, 55, 56; size and security trade-off, 115; see also specific forms of loan security Lombart-Heller Factors Ltd., 204 Lounsbury, F.E., 29n Loyalty: see Chartered banks: interbank competition MacDonald, W.H., 59n Mcivor, R.C., 26n, 30, 32, 63 McLaughlin, W.E., 224n Macmillan Commission, 26, 30, 34, 63, 124 Manitoba: on aid to small business, 81; and chartered banks, 31; on credit criteria, 82; and JDB, 165; and Porter Commission, 22, 64, 165 Managerial competence as credit criteria, 82, 83 Manufacturing companies: adequacy of financing, 24; financial performance of, 19; financial structure of, 18-20; see also Small business Methven, M.D., 167, 168 Metropolitan Life Insurance Company, 216 Monetary policy and loan activity, 44, 45, 64, 75n

246

Index

Montreal Trust, 207 Mortgage Loan Companies: see Life insurance, trust and mortgage loan companies Mortgage security: and chartered banks' restrictions, 50; credit restraints on usage of, 47-58, 72; for IDB loans, 145; and mL, 171; on personal loans, 78; and Porter Commission, 223; and Small Business Loans Act, 58-63 Muir, J., 29, 34, 100n, 112n National Association of Manufacturers, 23 New small business: credit available to, 80-2, 84-7, 97; see also specific financial institutions Non-bank financial institutions as chartered bank competitors, 127; see also specific institutions Nova Scotia: chartered banks in, 36, 37, 65, 136, 137; coal mining in, 12n; compared to Canadian averages, 12-14, 20, 24; development of manufacturing in, 14, 15; economic characteristics of, 11-14; ILF, 151, 154; and managerial skills, 155; manufacturing in, 12-14, 24; and Porter Commission, 176, 187, 192n Nova Scotia Credit Union League, 212 Overdraft lending, 73-6, 79, 126 Painter, J.A., 79n Personal endorsement: as loan security, 85, 86 Personal lending, 77-9 Personnel policies: see Chartered banks : personnel policies Porter Commission, 22, 31n, 220; on adequacy of small business financing, 21; and Bank of Canada, 27, 50, 64; and Canadian Bankers' Association, 49, 60, 64, 76, 99, 100, 121, 125; and Canadian Manufacturers' Association, 22, 23, 50, 64, 76, 165; and Charterhouse Canada Ltd., 206; compared to this

study, 222-3; and finance companies, 162; and functions of financial institutions, 2; and IAC, 163, 202; and IDB, 144, 145, 147, 158; integration of study with, v, 5; and Investment Dealers Association, 50; and Laurentide Financial Corporation, Ltd., 77; and life insurance, trust and mortgage loan companies, 215; and Manitoba, 22, 64, 165; and Nova Scotia, 176, 187, 192n; objectives of, 4, 5; and Prince Edward Island, 65; recommendations, 222-3 Prince Edward Island: and Porter Commission, 65 Private non-bank financial institutions, 198-217; see also specific financial institutions Prudential Insurance Company of America, 216, 217 Public financial institutions: compared, 10, 195-7; see also specific financial institutions Queen's University, 100 Questionnaire: see Research: methodology Rasminsky, L., 149n, 155n, 161 Recruiting and training: see Chartered banks: personnel policies Reporting limit: see Credit limits Research - findings of, 20 - methodology: inference limitations, 10, 11, 44, 45; interviews, 6, 7, 9-11, 50, 56, 68, 232-4; questionnaire, 5-7; sample used, 5, 6, 9, 10; senior regional officers' interviews, 235-6 - objectives of, 3, 4, 5, 7, 8, 10 - response: employment distribution, 228; financing methods distribution, 229-31; firm distribution, 226; management distribution, 226-7; ownership distribution, 227; product distribution, 227, 228; rate, 226 - suggested further, 221,222 Restrictive organizational features of chartered banks: see Chartered

Index

banks: personnel policies: Chartered banks: loan limits; Chartered banks: interbank competition Restrictive practices of banks: in development of loan covenants, 91-3; in evaluation of financial conditions, 87-91; in evaluation of security, 80-7; lack of experience with manufacturers, 93-6; to protect borrowers from themselves, 96-7, 131; see also specific practices of specific institutions Reuber, G.L., 129n Roynat Ltd., 163, 207-12, 217, 222, 224, 225; and branch bank managers, 211, 212; and chartered banks, 207, 209, 21 O; financial performance of, 207, 211; financial structure of, 207, 208; functions of, 207, 209-11; interest rates, 209, 210; loan eligibility criteria, 209; loan security, 209; and monetary policy, 212; ownership of, 207; performance of, 211; and regional differences, 211; staff of, 210; structure of, 207; term of, 209, 210

Royal Bank of Canada, 37, 70; financial structure of, 40, 41; and Roynat, 207; services offered by, 123; staff transfers of, 102 Royal Commission on Banking and Currency: see Macmillan Commission Royal Commission on Banking and Finance: see Porter Commission Royal Commission on Provincial Development and Rehabilitation: see Dawson Commission Security: issuance of as alternative to bank credit, 65; see also particular forms of loan security Senior regional officers: see Chartered banks: senior regional officers, views of Short-term loans: see specific institutions Small business - adequacy of financing, 20-5

247

- availability of credit, 64, 111; competition with other users, 78; credit criteria, 118, 119; and interbank competition, 129; and interest ceilings, 70, 71, 129; legal restraints on, 71, 72; to manufacturers, 93, 96; and monetary policy, 65; regional differences, 117; type of credit sought, 115; United States comparison, 97; see also particular restrictions on - as chartered banks' customers, 123, 124 - and compensating balances, 76, 79 - counsel available to, 103, 111, 127, 131, 132, 149, 170, 185,186,221 - and distance from markets, 95 - financial performance of, 17, 23 - financial planning of, 74, 75, 77, 79 - financial structure of, 16-19, 21-3 - and JDB, 166 - instalment lending, 78-9 - knowledge of credit sources, 140, 141 - knowledge of financing, 24 - manufacturers and non-manufacturers compared, 94 - and monetary policy, 44-6 - and mortgage security, 47-58; see also Mortgage security - and overdraft lending, 73-5, 79 - problems of, 3, 20, 21 - in sample population, 5-1 - and short-term loans, 51, 52 - size and number of, 15, 16 - size criteria, 61 - and term loans, 51, 52 - United States comparisons, 17, 22, 23,24 Small Business Administration, 24n, 68 Small Business Loans Act, 21, 58-63, 162n, 163, 211; adequacy and success of, 62, 63; and chartered banks, 60-3; and n.P, 190, 192; interest rates under, 58-9, 62-3, 72; and size criteria, 61, 62; size, number, and distribution of Joans under, 59, 60; scope and purpose of, 58-60

248

Index

Small manufacturers: see Manufacturing companies; Small business Springhill, Nova Scotia, 169n Springhill Development Corporation Ltd., 171, 173 Stewart, R.D., 204n Term loans: chartered banks' attitudes towards, 49-58; conclusions regarding, 218; and IDB, 162, 163; maturity date of, 53, 56, 57 Traders Group Ltd., 198n Transfers of funds between banks, 105, 106 Transfers of staff: see Chartered banks: personnel policies: transfers of staff Trust and life insurance companies: Porter Commission on, 222; see also

Life insurance, trust and mortgage loan companies Unit banks, 29 United States banks: see Chartered banks: United States comparison United States Department of Commerce, 23 United States Federal Reserve Bank, 15, 17n, 21, 23, 24n, 43 Universities: as educators of financial personnel, 104, 105 Venture capital, 217 Venture capital organizations: see Charterhouse Canada Ltd. Walker, B.E., 29n Walker, Sir Edmund, 48n