Bankers and Borrowers
When dealing with personal property, it is clearly the right of the individual to decide by whatever criteria he chooses to consider, or even to act on his emotions alone, in deciding whom to lend his personal property. However, banks are often seen as a business whose purpose it is to serve "the public" and as such there is great incentive to meddle in his affairs. It is very difficult and somewhat dangerous to attempt to apply requirements on restrictions on the banker's lending activities.
In general, it is expected that the board of directors and senior management of a bank will develop a set of procedures and policies that will be followed flawlessly by all the managers of all the branches of that bank. But the individual borrower and his circumstances are highly idiosyncratic, and any governance must be flexible enough to give branch managers latitude in considering applicants. Systemic requirements are intended to create systemic safety, but also have the potential to create systemic inefficiencies and even systemic disasters.
Classes of Borrowers
Retail borrowers are private individuals who are not in possession or large sums of money (if they were, they could use their own wealth rather than borrow) and whose ability to repay a loan depends on their future income. In the author's time, such borrowers were viewed with suspicion, as their need of a bank loan means they do not have relationships upon which they can draw to borrow privately (non of their friends has much money), or simply that they are so distrusted (their friends will not loan to them).
Personal loans are generally extended to individuals of solid reputation, who have an established profession and are expected to remain within the community for at least the duration of the loan. Even in those instances, bankers must be wary of the potential loss of income, or even loss of life, that will leave the banker holding a note that will not be repaid.
More often, bankers provide loans to "commercial men" or firms, who have need of capital to fund an operation that will generate sufficient revenue to repay the loan. This may be a business that is being funded, or which has had a sudden and unexpected need for cash that cannot be met by its current cash reserves. There are various reasons a commercial operation may have a temporary cash-flow issue that requires a temporary loan. The commercial borrower generally has business assets to collateralize the loan, as well as proof of the probability of future income that will serve to repay it, which the banker may inspect and investigate to assess and ensure their validity.
The author refers to a third class of borrower: companies created under the Companies Act (EN: these trading and exploration companies are a historical anomaly, so the information is dated and not applicable to the current day.) There's much detail, but essentially it comes down to the charter and license of such a company, which varies.
Methods of Borrowing
The first method of borrowing, common in commercial lending, is the issuance of a bill or promissory note that promises the repayment of a certain sum of money on a future date. The lender receives less than the face value of the bill, discounted for the interest paid for the loan, and must repay the face value in a lump sum on a day the bill is due. The bill is payable at the bank that issued it, though the bank may resell the bill if it needs capital, its responsibility is to collect payment and remit it to the party that owns the right to collect.
The second method of borrowing is the issuance of a loan contract, which provides the borrower the full sum in exchange for a stream of payments at regular intervals which pay interest as it is accrued along with a portion of the principle until all payments are made and the loan has been repaid in full.
The third method is an overdraft upon an account, which is described in vague terms but seems to be analogous to a standing line of credit on which the accountholder may draw (up to a limit) as needed, to pay the interest at an agreed-upon interval along with as much or as little of the principle as is permitted by the contract. The credit account is a convenience to those who need small amounts of money to be loaned frequently without having to create a fresh loan contract for every instance.
Security for Lending
A banker may in some instances lend money on nothing more than the promise of the customer to make repayment, but this tends to be small amounts for short period of time. For substantial and long-term loans, the banker may requires the security of some valuable asset that the banker may seize to cover his losses if the borrower fails to repay the loan.
The most usual form of security is the deposit of stock exchange securities. In this instances, the borrower has the capital he needs, but does not wish to liquidate productive assets, and instead places those assets in the hands of his banker and borrows the money he needs. The banker may require security of only a partial amount of the borrowed sum, and is likely to consider the risk of the securities in accepting them as collateral (a government bond having greater certainty of preserving its value than stock an a company).
Another common form of security is the title deed to real estate, which is signed over to the bank until the loan is repaid. The banker will again consider how much security he will require, and will estimate the value of the property being used to secure the loan. There's various details about the property needing to be insured, the bank's support of agreements with existing tenants, and other peripheral concerns.
Similarly, a loan may be secured by other assets, whether the banker receives the goods immediately to hold until the loan is repaid, or merely receives a document entitling him to ownership of the goods (such as a bill of lading for goods in transit)
For personal lending, a common form of security is the life insurance policy of the borrower, which typically has some "surrender value" that can be collected immediately. The bank becomes the owner (not merely the beneficiary) of the policy for the duration of the loan, and generally takes responsibility for maintaining payment of premiums (the cost of which is passed to the borrower via the interest or discount rate on the loan).
The use of guarantors (cosigners) is also a form of security, as this makes another person responsible for repaying the loan if the borrower does not. Banks may require a guarantor of an unknown borrower or if the venture in which the funds will be invested seems highly risky. A guarantor may stake his reputation alone, or he may provide other forms of security from his own assets. In most instances, the guarantor is held responsible for the full balance of the loan should the borrower default.
Random Bits
Two points of advice to lenders:
- First, the "mistake of optimism" should be avoided. The banker should be suspicious of the claims of a borrower and independently validate when possible (appraising collateral, verifying business operations, etc.). Those who wish to commit fraud are often those who paint the rosiest picture, and provide exaggerated or falsified documentation.
- Once a banker has entered into a contract, he is just as bound by the terms of the agreement as is his debtor. He should hold is debtor to the letter of the agreement and expect to conform to it himself.