The promissory note is a promise to pay “drawn on” the signer. The draft or bill of exchange is an order to pay initiated by the person who is to receive the money (The drawer). It is a written instrument originated by the drawer and addressed to a second party, the drawer, the person obligated to the drawer, or his bank, or a third party known as the payee. The drawer and the payee may be the same person or institution. Drafts for commercial transactions may be sight drafts, which the drawer must pay upon presentation, or time drafts, in which the drawer indicates the time of payment.
When a draft arises in connection with a shipment of merchandise, it is known as a trade acceptance. This type of draft is commonly used when a company is selling goods to another company without an established credit rating or with at poor one. The shipper obtains an order bill of lading from the transportation company, attaches a sight draft to it, and mails both to the buyer’s bank. The purchaser must accept and pay the sight draft at the bank. The bank then gives him the order bill, which he uses to take delivery. The transportation company will not release the goods to the buyer unless he has the order bill of lading. Another flexible way of borrowing money is through bank acceptances. This method allows borrowing the amount needed when it is needed. The borrower establishes credit at his bank. The bank states on documents called letters of credit that it will accept drafts against the borrower’s account. When the borrower purchases something he sends a letter of credit to the seller, who presents it to the bank for payment. The borrower repays the bank on the terms agreed to in advance.
Many well-known public corporations raise money by selling unsecured promissory notes on the open market. These notes run from two to six months and are sold in denominations of $2,500 to $10,000, are known as commercial paper, and are sold to commercial paper houses which in turn sell them to investors through other financial institutions. The ability of a company to raise money this way depends strictly on its reputation, although as happened when the Penn Central defaulted on several million dollars’ worth of commercial paper, the troubles of one company may influence the willingness of investors to accept the risks of others.
We have described primarily unsecured credit, when the lender relies solely on his faith in the borrower. When a bank doubts a borrower’s ability to repay it may require the guarantee of a loan by a reliable third party, usually a friend or associate of the borrower whose credit the bank will accept. This co-maker then signs the front of the note. The third party may be an accommodation endorser, in which case he signs the back of the note. In either case, if the borrower does not pay, the third party is liable.
Sometimes companies can raise money only by pledging a part of their assets as security for a loan. Sometimes they can obtain a lower rate of interest by this: method of financing. Commercial banks and finance companies lend on accounts receivable (open book accounts). In such cases people who owe the company are not notified, and business is conducted as usual. Usually an agency will lend up to 75 or 80 per cent of the total of selected accounts.
Factoring companies or factors specialize in making loans on accounts receivable. These companies actually purchase the accounts, notify the creditors, and collect directly from them. Interest plus a fee or commission is charged to the borrower. This type of financing arose in the textile industry but has spread to other fields such as furniture and paper.
Another common method of financing is borrowing by using inventory as security. With bank acceptances, already discussed, the company keeps possession of the inventory. Another method places the inventory in a bonded public warehouse. The owner of goods so stored receives a warehouse receipt, without which the warehouse will not release the goods. The owner endorses the receipt to his bank in return for a loan. To get the goods out of the warehouse, he must pay off his note and get back the receipt to present to the warehouse.
In seeking short-term credit a business is likely to encounter a variety of financial institutions.
One main reason for the success of business in general and for the freely available sources of short-term capital is that the United States has a strong banking system. The Federal Reserve System provides financial services to the banking and monetary community in the United States and is responsible for much of the stability of our monetary system.
For the first 125 years of this country’s history, banking was marked by chaos and controversy. The nineteenth century was continually jolted by monetary crises and panics. During long stretches of time there were no central banks. Even when there were central banks, there were few federal regulations and almost no control by the states. Many banks failed because of inadequate financing, causing substantial losses to depositors and stockholders. Finally, acting out of necessity caused by the monetary panic and crisis of 1907, Congress passed the Federal Reserve Act of 1913. This act created the Federal Reserve System, which is owned by member banks. All operations are paid for out of the profit of the Federal Reserve. In most countries the central bank is owned and operated by the government, but the decision of Congress to make the bank separate seems to have been a wise one, for the Federal. Reserve has been relatively independent of political pressures.
A chart of the structure of the Federal Reserve System appears clearly the system has a Board of Governors, a Federal Open Market Committee, and a Federal Advisory Committee. At present there are 12 Federal Reserve Banks, 24 branch banks, and 5,728 member banks.
The President of the United States appoints the Board of Governors of the Federal Reserve subject to Senate approval. After appointment, however, the board is autonomous and free from any control by the executive branch of government. or Congress. In its independence of other agencies it may be compared to the Supreme Court. Each of the seven governors is limited to one term of fourteen years, and the term of one governor expires every two years. The term is shorter when an appointee replaces a member whose term had not expired.
Each of the twelve Federal Reserve Banks is a corporation organized and operated to serve the public. The member banks which own the Reserve Banks do not have the powers and privileges that normally belong to the stockholders of a public corporation. Profit is not the goal of their operation. The purposes of the system are as follows:
1. To provide basic banking services, such as serving as a clearing house for checks, supervising the operations of member banks, and distributing currency and coins for the government.
2. To maintain a sound credit policy for all member banks and to promote a high level of consumer buying by regulating the total volume of credit, thus attempting to avoid sharp fluctuations in the business cycle.
All national banks must be members of the Federal Reserve System. State banks may be members if they meet the requirements and if they have a volume of business which makes it advantageous for them to be members. Members are required to subscribe to an amount of stock in the Federal Reserve Bank equal to 6 per cent of their own paid-in capital and surplus. Only 3 per cent must be paid in initially; the rest is subject to call. The member bank receives up to 6 per cent cumulative dividends on its stock. Member banks elect the board of directors of each regional bank.
The following are the major advantages of being a member of the Federal Reserve:
1. Currency can be obtained immediately from a Federal Reserve District Bank.
2. Drafts may be drawn on the Federal Reserve Bank.
3. Deposits may be transferred by telegraph between one bank and another through a Federal Reserve Bank.
4. Eligible commercial paper may be discounted and advances obtained from the Federal Reserve Bank.
5. Deposits are insured in each member bank for up to $20,000 for each depositor by the Federal Deposit Insurance Corporation.
6. Federal Reserve Banks may be used to collect checks and clear other negotiable instruments. As mentioned above, one of the functions of the Federal Reserve is operation of a smooth and stable banking system. One important part of this function is the establishment of bank-check clearing procedures. When a check is given by an individual or a company it must eventually be deducted from the account on which it was drawn, and the individual to whom it was drawn must receive payment. When the payer and the payee both have banks in the same local area, the clearance is usually conducted by a local clearing-house association maintained by the local banks. The money represented by the checks among the banks is totaled daily and differences are paid to the appropriate bank. When the banks involved are in the same Federal Reserve District but not in the same local area, the checks are cleared through the Federal Reserve. The procedure is more complicated when the banks are in different Federal Reserve Districts.
