The University of Chicago Press

Working-Capital Financing in a War Economy
Author(s): Marshall D. Ketchum

Source: The Journal of Business of the University of Chicago, Vol. 15, No. 4 (Oct., 1942), pp.
306-342
Published by: The University of Chicago Press
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WORKING-CAPITAL FINANCING IN A
WAR ECONOMY
MARSHALL D. KETCHUM'
T HE conversionof industryto a warbasisbeganwith the

collapseof Francein June, I940. Although the pace of the
transition was slow at first, political factors, such as the
realization of the inevitability of our active participation in the
war and the actual declaration of a state of war, increased the
tempo of the change. It is estimated that in August, I942, about
50 per cent of industrialproduction,as measuredby the index of
the FederalReserve System, was directly related to the war effort
as against goods for civilian consumption. The percentageof in-
dustry the products of which are allocated to the armed forces
will no doubt increasestill further in succeedingmonths.
This conversion of industry has been accompanied by note-
worthy changes in the methods of financing business enterprise.
The treasurersof corporationsreceiving war orders find them-
selves under the necessity of acquiringadditional capital of two
types. In the first place, there is the need for an increasedsupply
of workingcapital to financethe purchaseof large physical quan-
tities of raw materials and the processingof these materials into
finished goods. Circulating-capitalrequirementsresulting from
increasedrates of operating capacity and a larger productionof
physical units are augmented by rising prices for raw materials,
labor, and supplies. Also, as new facilities are brought into use,
it is necessaryto provide workingcapital to financethe output of
such newly constructedplants. Second, there has arisen in many
industries the need for capital for new plant facilities because of
I The author is associate professor of economics in the college of commerce,
University of Kentucky. The writer wishes to acknowledge the assistance of Frank

M. Murchison and Craig 0. Black, the manager and assistant-manager, respectively,
of the Chicago office of the Reconstruction Finance Corporation, and of Harry R.
Kimbark, manager of the Chicago Office of the Bureau of Finance of the War Pro-
duction Board, in securing access to information used in this article. Opinions ex-
pressed should be attributed only to the author.
306

WORKING-CAPITAL FINANCING IN A WAR ECONOMY 307
the inability of the existing plant to satisfy the greatly increased

demand for goods. These two types of capital have been derived
during the war emergency largely from different sources and
throughthe use of differenttechniques. It is the objective of this
paper to trace some of the changes which have occurredin the
financing of the working-capitalrequirementsof business firms
and to appraisethe significanceof these changesto businessenter-
prises,to the commercialbankingsystem, and to the relationships
between private and governmentfinance.
In solving the problem of working capital major reliance has
been placed throughout the period under review upon the com-
mercialbanks, the traditionalagency for the financingof the tem-
poraryoperating-capitalrequirementsof businessfirms. It is gen-
erally recognizedthat during the decade of the I920's, especially
duringthe latter years of the period, business firmslooked to the
securitiesmarketsas sourcesof workingcapital, and new security
issues, especially of common stocks, displaced short-term bank
loans as the primary source of capital for operating purposes.
During the decadeof the I930's there was little demandfor work-
ing capital eitherfrom the securitiesmarketsor frombanks. Now,
during the war emergencyof the early 1940's, the banks are re-
gaining the importance in the financing of business enterprise
whichthey lost in the I920'S.
This reversalmay be accountedfor by changesboth within the
commercialbanking structureand within the securitiesmarkets.
On the one hand, the commercialbanks found themselvesin June
of I940 with large excess reservesand with decreasedincomefrom
investment accounts. The need for liquidity had decreasedas a
result of the Federal Deposit Insurance Corporationand legis-
lation enlarging the scope of collaterability of assets with the
Federal Reserve banks. Some of the bank-examinationagencies
were trying to encourage an expansion in loans. Because of the
use to which the funds were to be put, patriotism influencedthe
banks' lending policies. It is true that all these conditionsexcept
2 An article analyzing changes in methods of financing the construction of
new
plant and equipment will appear in a subsequent issue of the Journal of Business of
the University of Chicago.

308 THE JOURNAL OF BUSINESS
the last had existed for some years previous to June, I940, but
duringthis priorperiod little demand for bank loans had been in
evidence. The expansion in loans occurringafter the middle of
I940 supports the thesis that the major cause of the failure of
bank loans to expandbefore that time was the lack of demandfor
businesscredit ratherthan an unwillingnessof bankersto provide
such credit.
With respect to the situation in the capital market, business
firms have found themselves unable to rely on the sale of secu-
TABLE 1
TOTAL LOANS AND INVESTMENTS, TOTAL LOANS, AND COMMERCIAL, IN-
DUSTRIAL, AND AGRICULTURAL LOANS OF WEEKLY REPORTING
MEMBER-BANKS ON SELECTED DATES
(Amounts Outstanding, in Millions of Dollars)
Percentage
Percentage Commercial, Commercial,
Total Total Total Loans Industrial, Industrial,
Date Loans and oa to Total and Agri- and Agri-
Investments Loans and cultural cultural
Investments Loans Loans to
Total Loans
JuneI940 ..... 23,59I 8,444 35.8 4,383 5I .9

March, 1942.. 30,94I I I, 408 36.9 6,976 6i .2
July, I942. . . . . 32,998 I IO 74I 32.6 6,454 6o. i
rities for new capital. This statement is applicableboth to capital

for currentfinancingand to capital for new plant. While the pure
rate of interest has remained low, high premiums for risk have
made it unprofitablefor corporationsto offersecurityissues. Cor-
porationshave not found it desirableto increasetheir bonded in-
debtednessfor purposesas ephemeralas war financing,while ac-
quisitionof capital throughthe sale of equitieshas been precluded
by the general feeling of uncertainty and by high corporatein-
come and excess profits taxes and high capital gains taxes against
individuals.
Table i gives data which serve to show the extent to which the
commercial and industrial loans of banks have expanded since
June, I940.
From June, I940, to March, I942-the high point to date of the

expansion-loans by reporting member-banksto commerce,in-

dustry, and agricultureincreased from $4,383 million to $6,976
million, or by 59.2 per cent. Loans in other categoriesincreased
only slightly during the period, so that loans for commercial,in-
dustrial,and agriculturalpurposesincreasedfrom 5I.9 per cent to
6i.2 per cent of total loans. It is estimated that within this group
about 5 per cent of the total representsloans to agriculture. Total
loans increasedby 35.5 per cent to March, I942, but, since total
investments increased nearly as rapidly, the percentageof total
loans to total loans and investments increasedonly slightly from
35.8 per cent to 36.9 per cent. The increase in investments was
largely in the holdingsof United States governmentsecuritiesby
banks. However, during the early months of the defense effort,
the extent of deficit financing by the federal government was
smallerthan at present, and there was less need for the purchase
of governmentbonds by the banks then than later.
Since March, I942, loans to commerceand industry and total
loans have been declining, while total loans and investments are
still increasing. From March to July nearly all the decrease in
total loans was in the commercial and industrial classification.
The continued expansion in total loans and investments is to be
accounted for by the increasedabsorptionof governmentbonds
by the banks.
Figures are available to show in fairly precise terms the extent
to which the expansionof loans to commerce and industry has
taken the form of loans to firms engaged in the war effort as
against firms producing civilian goods. In I94i a survey was
made by the Board of Governorsof loans and commitmentsof
weekly reporting member-banksas of April 30, I94I. This sur-
vey was made for the purpose of supplying informationto what
was at that time the Defense Contract Service of the Officeof
ProductionManagementand to the Board of Governorsas to the
participationof banks in the defense effort. It was found that de-
fense loans amountedto about 40 per cent of the total increasein
commercialloans of the reportingmember-banksbetweenAugust
2I, I940, and April 30, I94I. However, the report showed that
defenseloans accountedfor only about 8 per cent of total commer-
cial loans outstandingon the latter date. The reportexpressedthe

3IO THE JOURNAL OF BUSINESS
opinion that at the time of its publication (June, I94I) defense

loans had increasedto I 2 per cent of the total.3 These percentages
may be comparedwith the results of a more recent survey made
by the Board of Governorsof commercialand industrialloans of
the 5,362 Reserve System member-banks(8i per cent of all mem-
ber-banks), made between April i6 and May I5, I942. It was
found that, of new loans and renewals,3I.9 per cent were entirely
for direct war purposesand 3.7 per cent were partly for war pur-
poses, making a total of 35.6 per 'cent. With respectto new loans,
TABLE 2
DEFENSE LOANS AND COMMITMENTS OF WEEKLY REPORTING
MEMBER-BANKS AS OF APRIL 30, I94I, BY PURPOSE OF LOAN
COMMITMENTS
FOR TOTALLOANSAND
LOANS FUTURELOANS COMMITMENTS
PURPOSE
Amount Amount Amount
Number (in Number (in Number (in
Millions) Millions) Millions)
For plant facili-

ties .1 233 I38 85 7 264 2,090 402
For defense sup-
plies .........2,282 287 I,3I5 310 3,597 597
For both..I I2 35 8i 59 I93 94
Total . , 627 460 2,253 633 5,88o I1093
43.6 per cent were partly or entirely for war purposes,while 24.0
per cent of renewalswere partly or wholly for direct financingof
war activities.4
Not all loans obtained by firms with defense orders have been
for working-capitalpurposes. In the survey made by the Board
of Governors of loans and commitments by weekly reporting
member-banksas of April 30, I94I, the situation with respect to
the distributionof such loans and commitmentsfor plant facilities
and for defense suppliesor operating capital is shown in Table 2.
3See V. M. Longstreet,"BankLendingfor Defense,"FederalReserveBulletin,
September,I94I, pp. 866-73.
4 "Surveyof CommercialLoans at MemberBanks," FederalReserveBulletin,
August, I942, p. 770.

WORKING-CAPITAL FINANCING IN A WAR ECONOMY 3II
It is seen that 6i.2 per cent of the numberof defense loans and
commitments and 54.6 per cent of the amount were for working-
capital purposes,while 35.5 per cent of the number and 36.8 per
cent of the amount were for plant facilities. Loans and commit-
ments to the extent of 3.3 per cent of the numberand 8.6 per cent
of the amount were made for both purposes. The percentagesfor
working-capitalpurposeswould be larger if there were included
in this category loans made for such purposesto buildingcontrac-
tors for the erectionof defensehousingprojects,cantonments,and
military bases. The average loan and commitment for the con-
struction of plant facilities was $I92,344, while the average work-
ing-capitalloan and commitmentwas $i65,972.
In the light of these figuresthe commercialbank is indicated as
an important sourceof capital for the constructionof plant facil-
ities as well as of working capital. Nevertheless, well over one-
half of all defense loans have been for working-capitalpurposes.
It is to be expected that current production loans would bulk
large in importance,since this is the type of credit which banks
have traditionallygranted. Bank loans for plant expansionare a
newer development.
Loans to financecurrentproductionhave been made primarily
to well-established industries having extensive plant facilities,
such as those producingmachinery,textiles, iron and steel prod-
ucts, ordnance and ammunition, and, until more recently, auto-
mobile vehicles and equipment. Accordingto the Board of Gov-
ernors survey, loans to these industries were large as compared
with commitments,indicating that firms in these industrieswere
able to reach a high level of productionsoon after the beginningof
the defense effort. To some extent also these industrieshave used
their own funds to finance additional plant expansion and have
thus relied on bank credit only for workingcapital.
The Board of Governorssurvey showedthat defense loans and
commitmentsas of April 30, 194I, amountedto about io per cent
of the eleven billion dollars of defense contracts awarded up to
that time. However, a part of these eleven billions of defense
contracts had already been completed and no longer required
financing. Thus banks were in early I941 playing a largerrole in

3I2 THE JOURNALOF BUSINESS
the financingof defense contracts than is indicated by this io per

cent figure. On the other hand, it is probablethat in the past year
the importanceof banks in the financingof war contracts has de-
creased because of the increasing proportion of such contracts
whichinvolve the constructionof new plant and the significanceof
other financingmethods, such as the use of governmentfunds by
the Defense Plant Corporation,in financingnew construction.
The data in the survey provide additional evidence of the in-
creasingimportanceof the term and long-termloan in commercial-
bankingpractice. Of the loans studied, 78 per cent had a maturity
of less than one year, 6 per cent were made with a maturity of one
to three years, and i6 per cent did not come due until a date more
than three years from the time the loan was made. Long-term
loans were found to be granted for working capital as well as for
plant facilities. Of $460 million of loans on which informationwas
available, $74 million involved terms calling for repaymenton an
instalment basis. In addition, 57 per cent of these instalment
loans provided that final payments would fall due after three
years from date of the loan. In the case of such loans there is gen-
erally established at the time the loan is made a schedule of re-
payments timed in accordancewith the schedule of income re-
ceipts of the borrower. An arrangementof this sort is to be pre-
ferred, both by the bank and by the borrower,to a loan which is
nominally on a short-termbasis but which is made on the under-
standing that periodic renewalswill be granted.
The expansionof commercial-bankloans to March, I942, may
be explained partially in terms of the internal condition of the
banking system and the receptivity of bank lending officersto ap-
plications for working-capitalloans. In addition, however, it was
logical that business firms should think of their banking connec-
tions when defense orders began to pour in. Although business
firms in general entered the depressionof the I930's with large
cash reserves, by I940 these had been depleted by operating
losses. Inventorieshad been reducedafter the depressionof I938,
and there was much machineryand equipmentin need of rehabili-
tation. Thus demandsfor workingcapital increasedrapidly, with
internal sources insufficientto take care of requirements. Many

WORKING-CAPITAL FINANCING IN A WAR ECONOMY 3I3
business enterprises had lines of credit available at their\banks

which had not been fully utilized for many years. Moreover,most
of the ordersfor war materialsplaced in the first few months after
June, I940, went to the large firms. The governmentalcontract-
ing agenciesfound it easier to deal with the large enterprises,and
these large businessunits were not eager to or found it difficultto
contract out the work to smaller corporations. Large firms were
in the habit of financing their working-capital requirements
through banks. Firms of large size were also in many cases those
which could most easily pass the banks' credit examinations.
Many of the working-capitalloans in the first few months of the
defense effort were for increasingthe productionof civilian goods
rather than war materials, and the banks were accustomed to
making loans to finance the production of goods for peacetime
consumption. In view of these circumstancesit is not surprising
that the commercialbanks constituted the first outside sourceof
working-capitalfunds as the defense effort got under way.
The decline in commercialloans since March, I942, is probably
a result of a decline in nondefenseloans, the paying-off of some
old defense loans, and the shift of firms producingwar materials
to other sources. Banks have extended credit to many firmsup to
the limit permissible,in spite of some "shading"of credit stand-
ards. Subcontractinghas increased,and there are peculiarprob-
lems in subcontractingwhich until recently had made it difficult
for firmsholdingcontractsfrom prime contractorsto use banks as
sourcesof credit. Many firms have been makinguse of sourcesof
working capital formerly not available, such as advance pay-
ments.
The principal credit instrument evidencing indebtedness to a
bank still remainsthe unsecuredpromissorynote. However, the
financing of defense and war orders has brought about the in-
creaseduse of a numberof other financingtechniqueswhich were
known and used to some extent before June, 1940. Before con-
sidering those financingmethods which have evolved only since
the conversionof industry to the war effort began, it is well to
mention brieflysome of the older devices which have assumedin-
creased importance. Among these are the following:

i. Trust-receiptfinancing.-The use of trust receipts has been

facilitated in recent years by the adoption of legislation favoring
their use and particularlyby the passingof the UniformTrust Re-
ceipts Act in thirteen states, among which are such important
commercial and industrial states as New York, Pennsylvania,
Illinois, New Jersey, Massachusetts, California,Connecticut,and
Indiana. This device has been found particularlywell adapted to
the financingof subcontracts. There still arisesthe difficulty,how-
ever, of identificationof the trusteed goods while they are passing
through a series of manufacturingprocesses. In such cases the
product against which the trust receipt has been issued is likely
to become "scrambled"with other materials and to thus become
unidentifiable.
2. Public and field warehousefinancing.-Field warehousing
especially has assumedgreater importancebecause of its conven-
ience and because public warehouseshave become to an increas-
ing extent full of stored materials. The collateral value of the
warehousereceipt is superiorto that of the trust receipt, since, in
the case of the formerinstrument,the bankerhas possessionof the
merchandise. The negotiationof the trust receipt, however, facil-
itates the releaseof part of the stored product as it is requiredfor
processingor-for sale and delivery. Its use is thus complementary
to the warehousereceipt.
3. The chattelmortgageon machineryand equipment.-In some
cases this device has been used by banks to secure a claim ahead
of other creditorson materialsto be acquiredwith the proceedsof
a bank loan.
4. Accounts-receivable financing.-The assignment of accounts
receivableas a sourceof working capital has been limited by the
need for such capital beforethe productshave been deliveredand
the accounts receivableare on the books.
5. Thedomesticletterof credit.-In some cases commercialrela-
tionships between firmsformerlyunacquaintedwith one another,
brought together by war orders, have been furtheredby the use
of this device.
6. Participationin and syndicatingof loans too largefor one
bankto handle.-To an increasingextent banks in an areahave co-

operatedin makingloans to local enterprises. In other cases large

city correspondentshave been askedto assumepart of a local loan.
The loan-participationfeature has been given an impetus also by
the lendingpoliciesof certain governmentalagencieswhich stand
ready to participatewith local banks in making loans.
In the precedingpages the importanceof commercialbanks in
financingoperating-capitalrequirementshas been indicated, and
brief mention has been made of formerlyknown financing tech-
niques, the significanceof which has been increasing. Attention
will now be devoted to those developmentsin the fieldof working-
capital financing which have occurred only since June, I940.
These developmentswill be divided into four sections, as follows:
A. Financing under the Assignmentof ClaimsAct of I940.
B. Financing through advance and progresspayments made
by contractingagencies.
C. Financing through loans made by the Federal Reserve
banks and the ReconstructionFinance Corporation.
D. Financingthroughguaranteedloans underExecutive Order
9II2.
SectionsA and D are designedprimarilyto facilitate additional
credit extension by the usual credit sources, such as the commer-
cial banks. Sections B and C represent sources of credit which
either competewith the commercialbanks or furnishcreditwhich
the banks cannot or will not supply. Strictly speaking,loansmade
by the Federal Reserve banks and the Reconstruction Finance
Corporationshouldnot be classifiedas a new development. Loans
were made by both agencies to business enterprisesbefore June,
I940. However, changes in the legislation and regulationsunder
which loans are made by these agencies warrant their inclusion
under the heading of new developments.
A. FINANCING UNDER THE ASSIGNMENT OF CLAIMS ACT OF I940
The Assignmentof Claims Act5was passed to encouragecom-
mercial banks and other financinginstitutions to grant credit to
firms with defense orders in amounts larger than might be ex-
5 Act of October9, I940 (54 Stat. I029); Pub. No. 8ii (76th Cong., 3d sess.).
See the Federal ReserveBulletin, October,I940, p. 1045, for a full statementof the
act.

3i6 THE JOURNAL OF BUSINESS
pected in the absenceof the act. The act amendssections3477 and

3737 of the Revised Statutes (Title 3I, sec. 203 and Title 4I, sec.
I 5, respectively,of the UnitedStatesCode),which in effect prohib-
ited the assignmentof receivablesand claims due from the federal
government.6 By the terms of the Assignment of Claims Act, a
manufacturerwith amounts due from the governmentundercon-
tracts of $i,ooo or more may assign the claims to any bank, trust
company, or other financing institution, including any federal
lending agency. The term "other financinginstitution" has been
held to include any institution, the primary activity of which is
to extend credit.
The assignment of sums to be received under contracts may
take place in connection with contracts for the manufactureof
goods from presently existing facilities, sometimescalled supplies
contracts, or in connectionwith contracts for the constructionof
new plant. It is quite likely that the assignment-of-claimsdevice
has had greateruse in the making of loans for the constructionof
emergencyplant facilities than for working-capitalpurposes,since
in the formercase the bank is taking greater risk because of the
time interval between the furnishingof funds by the bank and the
repaymentof the loan. At this point our interest is in the assign-
ment of claimsarisingout of contractsfor currentproductionfrom
existing facilities. The act is designedto render"bankable"loans
which the bank would otherwisebe unable to make. While the act
does not limit the assignmentof claims to war contracts, the par-
ticular value of the act to date has been to facilitate the financing
of such orders.
The act sets forth certain conditionswhich have to be complied
with in order that the assignment shall be valid. It is stipulated
that the assignmentshall not be made to more than one party and
shall not be subject to further assignment,except that an assign-
ment may be made to more than one party as agent or trustee for
two or more parties participatingin the financing. The assignee,
6 Under conditions existing before the passage of the act, assignment of a
claim
under a government contract made it voidable at the option of the government. A
warrant for payment of the amount due after completion of the work might be as-
signed, but this did not enable the contractor to secure working capital to carry
forward operations under the contract.

usually a bank or trust company,is requiredto file written notice

of the assignment and a copy of the instrument of assignment
with certain designatedparties, among whom are the contracting
officerfor the governmentagency for which the goods under the
contract are being producedand the disbursingofficerindicatedin
the contract as the agency from which the manufacturermay ex-
pect to receive payment. After receipt of propernotification by
the assignee of the claims under the contract, the contracting
officerand the disbursingofficerare authorizedto make payments
under the contract direct to the assignee. No assignmentof the
contract itself takes place, and thus there is no shift of responsi-
bility for the performanceof the contract from the contractorto
the assignee. It is only the "moneysdue or to becomedue" which
are assigned.
Further to protect the bank to which the claims are assigned,
the act providesthat, if it is so set forth in the contract,payments
thereundershall not be subject to reduction or setoff for any in-
debtednessof the assignorto the United States arisingindepend-
ently of the contract. By a subsequent ruling of the United
States comptroller-general,7it was held that "indebtedness"as
used in this section of the act includes the assignor'stax liability.
Other rulings issued have clarifiedthe definitionof a "financing
institution" by stating that it includes individuals and partner-
ships engaged in the financing business8and have set forth pro-
cedures necessary in connection with notice by the assignee of
assignment of claims.9 Under another ruling of the comptroller-
generalon December 2, I940,10 it is requiredthat the contractor,
in sending an invoice to the contracting agency, should indicate
thereon that he recognizes the assignment and the right of the
assigneeto receive payment from the government. It is desirable
to requirethis notification from the assignorto insure that pay-
ments are properly made under the assignment and to protect
the government against making payments to the assignee when
7 B-I4686, February 4, I94I.
8 B-I44I5, January 28, I94I.
9 B-I3852, December io, I940, and B-I4686, February 4, I94I. 'IOB-I3700.

3I8 THE JOURNAL OF BUSINESS
theremight be some dispute unknownto the governmentbetween

the contractor and the assignee.
In addition to the documents embodying the assignment of
claimsundera governmentcontract,"a collateral-loanagreement
is negotiated between the contractorand the bank, incorporating
with respect to the loan provisionswhich are designedto be mu-
tually advantageousto the two parties. When a manufacturerre-
ceives a suppliescontract from a contractingagency, the financial
officerof the contractingfirm and the lending officerof the bank
arrangea schedule of working-capitalneeds showing by months
cash expenses, cash income, the effect of these two items on
monthly net working-capitalrequirementsfrom outside sources,
and the cumulative monthly effect on net working capital.12On
the basis of this schedule the collateral-loanagreementprovides
for periodicadvancesby the bank to the borrowersuch as will be
sufficientto take care of working-capitalneeds as the work under
the contract progresses. The spacingof advancesreducesthe risk
to the bank and has the advantageof requiringthe payment of in-
terest by the borroweronly on such sums as are actually needed.
The note or notes,evidencingthe contractor'sindebtednessto the
bank, usually on a demand basis, include referenceto the assign-
ment of payments under the contract.
The loan agreementusually contains provisionsprotecting the
bank, in so far as possible, against cancellationof contractsby the
supplies contractor. Provisions are sometimes found authorizing
the bank to prosecute,in the name of the contractor,appealsfrom
the findingsof the contracting officers-if the contractorhimself
fails to make such appealsand if the contractitself has provisions
for appeals of this nature-and provisions under which the con-
tractor agreesto keep all personalproperty insuredand to assign
the insurancepolicies to the bank. The contractormay agree to
II See Bank Management Commission, American Bankers Association, National
Defense Loans ("Special Bull. 82" [December, I940]), pp. 32-35, for illustrations of
forms for assignment of claims under supplies contracts and of a form for notice of
assignment.
"2 See L. L. Bollinger, Financing Defense Orders (New York: McGraw-Hill Book
Co., I940), Appen. VI, p. I58, for an example of such a schedule.

supply the bank with copies of all communicationsreceived from

the government, to give the bank the right to inspect the con-
tractor'sbooks, and to advise the bank of any action taken which
might affect the bank'sposition underthe contract. A clausemay
be includedwherebythe presently unmortgagedassets of the con-
tractor are to remain available for payment of the loan as col-
lateral security.13
The assignment-of-claimsdevice under a supplies contract re-
quires the exercise of diligence on the part of the banker. The
problem which faces the bank is whether a loan which would
otherwisenot be made is renderedbankableby the assignmentof
the claim under the government contract. The contract itself
must be studied carefully. It must be ascertainedthat there is in
the contract no prohibitionof assignmentof claims arisingthere-
under and that there is included a clause providing that the gov-
ernment may not set off sums payable under the contract. Per-
haps the most important question of all is the ability of the con-
tractor to performthe contract. The governmentdisbursingoffi-
cer will, of course, make no payments to the bank, as assignee,
unless the manufacturerproducesand delivers goods meeting the
specificationsset forth in the contract as to quantity, quality, and
time of delivery. The major problem, then, is whether the con-
tractor can performunder the contract, in so far as deliveryof ac-
ceptable units of the article is concernedand without referenceto
cost. In this connectionbanks have found it desirableto consider
carefully the inspection and verification provisions of contracts.
Banks have lookedwith favor upon final inspectionof the product
in the contractor'splant rather than after delivery at some dis-
tant point. By this method the production of an unacceptable
productwould be stoppedmuch soonerthan if final acceptanceby
the governmentdid not take place until after inspectionat the de-
livery point. Inspectionat the plant is impossible,however,in the
case of some supplies and equipment which must be tested else-
where, as, for example, at an arsenalor proving ground.
13 See Prentice-Hall, National Defense Service, par. 26,258, for a typical collateral-
loan agreement form.

320 THE JOURNALOF BUSINESS
Related to the problemof physical ability to performthe con-

tract, but of lesserimportance,is the questionof whetherthe con-
tractor can and will producethe goods without loss. Has the sup-
plies manufacturercomputed his costs correctly? Are his com-
putations based on a sufficientfamiliaritywith the product to in-
sure accuracy? Many producersof civilian goods have been re-
quiredin recent months to discontinueproductionof their regular
line becauseof materialsprioritiesand have attempted to convert
their plants to enable them to accept war orders. The problemof
cost computation on an order for 500,000 units is difficult enough
for a manufacturerwho has for many years been producingthis
articlebut who has been accustomedto figuringcosts on a ioo,ooo
unit order. For a manufacturerwho has just convertedhis plant
to the production of this commodity, the difficulties are multi-
plied.
The government contracting agencies are interested primarily
in the price at which the contractoragreesto supply the material.
This is coming to be less true, however, as the negotiated con-
tract takes the place of the awardingof contracts on a bid basis.
The contracting agency is interested in knowing that the goods
will be delivered, but in the past the agency has partially pro-
tected itself against this risk by the requirementof a performance
bond froma surety company. Thus the realburdenof determining
the contractor'sability to performis thrownback upon the surety
company and the lendingbank. A combinationof inability on the
part of the contractorto computehis own costs accuratelyand in-
ability of contractingagencies, surety companies,and banks, un-
der new and rapidly changing conditions, to decide whether the
contractor'scomputations are accurate has meant that the risks
to the bank have not been obviated by the assignmentof claims
procedure. The risk is mitigated somewhatwhere the contract is
on a cost-plus-a-fixed-feebasis or wherethere are "escalator"pro-
visions in the contract. In the latter case provisionis made for an
increase in the price paid by the contracting agency if there has
been an increasein the costs of the contractorresulting from in-
creasesin the cost of materialsor in the cost of labor.
The questionof cost computationis of less importancethan the

WORKING-CAPITAL FINANCING IN A WAR ECONOMY 32I
problem of production in the physical sense, because the con-

tractor, if he can meet the terms of the contract, will probablydo
so even though he finds before all units have been delivered that
he is taking a loss on the contract. For a number of reasons he
hesitates to cancel or default on the contract. Particularly, he
hopes that by meeting the terms of this contract he will be en-
abled to secureother contracts in the future on which he may be
able to make a profit. He recognizesthat, if he defaults on this
contract, his bank will not finance him in later contracts, on the
basis of assignmentof claims or in any other fashion. Patriotism
also probablyplays a part in preventing cancellation. The bank,
nevertheless,does assume the risk that the contractormay cancel
when he discoversthat he has contractedto furnishan articleover
a long period on an unprofitablebasis. However, most supplies
contracts call for periodicdeliveriesof the product,and payments
by the government to the bank may keep within a reasonable
figurethe net indebtednessof the borrowerunder the loan agree-
ment.
Out of this situation there are arising significant changes in
bank credit standards. In making loans under normal peacetime
conditions, the ability to produce in the physical sense can be
more or less taken for granted. Costs must be studied to deter-
mine the likelihoodof a profit, but fully as important as costs in
determiningprofits is the matter of selling prices. The marketing
problem-how much can be sold and at what price-is one of the
unknown variables. In passing upon applications for loans to
companies in war industries, the significanceof the marketing
aspect is greatly diminished. The sale of the goods, if they can be
produced, can be assumed. Of much greater importanceis "can
the goods be produced,and at what cost?" Here we have another
indication of the declineof the marketingfunction and increased
stress upon engineeringand the production function in business
life under war conditions.
Because of the difficultiesfacing the bank in determiningthe
contractor's ability to perform, with the consequent possibility
that no sums will be due from the governmentunderthe contract,
this methodof financingworking-capitalrequirementsof corpora-

tions producingunder war orders has not been entirely satisfac-

tory. Many banks are reluctant to take the risk that the contrac-
tor may fail to deliverunderthe contract. It is known that the as-
signment of claims has been fairly widely used. The Board of
Governorssurvey referredto heretofore showed that of defense
loans and commitmentsmade between August 2I, I940, and April
30, I94I, 35.5 per cent of the dollar volume of plant-facilities
loans and 6.7 per cent of the dollar volume of working-capital
loans made use of the assignment-of-claimsdevice. Approximate-
ly I5.7 per cent of all loans were made on an assignment basis,
with the remaindergranted without assignment on the basis of
alreadyestablishedcustomerrelationships. As might be expected,
it was found that the higher the ratio of size of the loan to the as-
set size of the borrower,the morefrequentlyloans weremade with
assignmentof claims. For example, with respect to firms having
assets of less than $ioo,OOO,i9 per cent of loans under$io,ooo in-
volved assignmentof claims, while 27 per cent of loans of between
$5o,ooo and $ioo,ooo were made on this basis.
While the proportionof total loans made with assignment of
claims has perhapsincreasedsince the date of this survey because
of better acquaintance of bankers and contractors with assign-
ment-of-claimsprocedureand because of an increasedproportion
of loans involving constructionof plant facilities, it is obvious that
the assignment of claims is not the answer to the problem of in-
creased need for credit under conditions of increased risk to the
banks.
B. FINANCING THROUGH ADVANCE AND PROGRESS PAYMENTS

MADE BY CONTRACTING AGENCIES
To this point we have consideredonly commercialbanks as
sourcesof operatingcapital with the assignmentof claimsserving
in some cases to make bankable loans which could not otherwise
be made under ordinarycredit standards. The contractingagen-
cies of the federalgovernment,such as the army and navy, repre-
sent another sourceof credit for productionpurposes,a sourcein
some respects competitive and in other respects complementary
to the commercialbanks.

Underordinarycircumstancesthe suppliesmanufacturerunder
a contract for the army or navy delivers the merchandise,sends
his invoice, and receives payment within thirty to sixty days. If
payment is not receiveduntil after delivery, the contractormust,
of course, finance the production from other credit sources. Ar-
rangementswereprovidedearly in the history of the defenseeffort
whereby under certain conditions progress or partial payments
might be made by the contracting agency while the work was
progressing,and advance payments might be made before the
work was started or any deliverieshad been made.
In the case of advance payments, the enabling legislation for
navy and coast-guardcontracts is containedin an act of June 28,
I940,I4 and for army contractsin an act of July 2, I940.I5 By these
two acts the secretariesof the war and navy, and the secretaryof
the treasury in the case of coast-guardcontracts, are authorized
to make advance payments to contractorsin amounts not to ex-
ceed 30 per cent of the contract price. After the declarationof
a state of war on December 7, I94I, the President liberalizedthis
provision by issuing Executive OrderNo. 900i, dated December
27, I94I, authorizing the War Department to make advance,
progress,and otherpayments upon contractsof any percentageof
the contract price and to modify existing contracts so that they
might be more in conformitywith the war effort. The secretaries
are empoweredunderthe originalacts to prescribethe termsof the
advances and to requiresecurity which shall be adequate for the
protectionof the government. It was originallythe intention that
advancepayments shouldbe made only if the item being contract-
ed for was one whichit was difficultfor the governmentto procure
or if the manufacturerfound that his financialrequirementswere
likely to exceedhis ability to acquirecapital from normalsources.
The contractormay make the request for an advance payment
either at the time of negotiation or after the contract is in effect.
Many advance payments have been made after the contract has
been in effect for some time, particularlywhere the contracting
agency has asked for a speeding-upof the rate of deliveries. In
case of termination of the contract, advance payments must be
14 Pub. No. 67I, sec. i. Is Pub. No. 703, sec. I (C

returnedto the governmentwithin a specifiedperiod,often fifteen

days.
The security for the advance payment and the manner of re-
payment aremattersof negotiationbetweenthe manufacturerand
the contractingofficer. The securitymay consist of a bond with a
surety company,a personalguaranty, a mortgageon the plant, or
a chattel mortgage. Repayment is usually provided for serially
out of monthly payments for goods deliveredunder the contract.
Originallyno interest was requiredon advancepayments. This
made them appear at first sight to be advantageousas compared
with bank loans as sourcesof capital. However, in many cases the
additional fee on the surety bond requiredby the advance pay-
ment has been such as to remove this cost differentialin favor of
the advance payment. Interest at an annualrate of 21 per cent is
now charged on unliquidated balances in advance-payment ac-
counts, with some exceptions, such as in the case of advances to
suppliersof critical machine tools.
Partial or progresspayments are made on large contractswhere
delivery cannot take place until the lapse of a considerableperiod
from the date of signingthe contract. Such payments undernavy
contracts have been authorizedsince i91 I, when, in an act of Au-
gust 22 of that year, the secretaryof the navy was authorizedto
make partial payments duringthe progressof the work underex-
isting contracts,such payments not to be in excess of the work al-
ready done.,6 In such cases the contractingagency was to have a
lien on the work performed,which lien was to be paramount to
all others. A numberof variations are possible in contracts pro-
viding for progresspayments. Payment may be made at a cer-
tain point in the constructionof a piece of equipment or for all
work completedat the end of each fifteen-dayperiod,or a certain
percentageof the contract price may be paid upon provisionalac-
ceptance of the article, with the remainderto be paid upon final
acceptance. It is generallyprovided that part of the payment for
work which has been completed,perhaps 5 or io per cent, shall be
retainedby the governmentuntil final completionand acceptance
of all work coveredby the contract. In some cases advance pay-
i6 U.S.C., Title 34, sec. 582.
37 Stat. 32;

ments and progresspayments have been providedfor in the same

contract. Where this is done the advance payment will be amor-
tized by reductionsin the progresspayments as the work under
the contract is carriedforward.
One of the principaldrawbacksto the use of the advance pay-
ment is the complexityof the provisionsrequiredby the contract-
ing agencieswith respect to the use of the funds advanced.I7The
sums so advancedmust be deposited by the contractorin a bank
account separateand distinct from his other accounts. Payments
out of the account can be made only for work performedon the
contract under which the advance occurs, and, all payments so
made must be approved by the contracting officer. The con-
tractor must provide facilities for inspection and audit of the ac-
count. Materialspurchasedfrom the accountmust be segregated,
and the governmenthas a lien on these purchasesto the extent of
the payment until such time as the contractorhas liquidated the
advance payments. In many cases contracting agencies have
made intensive examinationsof the contractorin the form of bal-
ance-sheet audits before authorizingadvance payments.
A numberof changes in procedurehave been introducedfrom
time to time to facilitate the granting of credit through the mak-
ing of advance and progresspayments. Authority to make such
payments has been decentralizedby authorizinglocal contracting
officersin the field to provide in contracts for advance payments
up-to 50 per cent of the contract price where the amount of the
contract is less than $5,ooo,ooo. Requests for advance payments
in excess Of 50 per cent and on contracts for more than $5,000,000
must still be approvedby the officeof the undersecretaryof war.
Ordinarilyno more than 50 per cent of the contract price is ad-
vanced, of which 20 per cent is allocated to subcontractorsunder
the contract and is kept in reserve by the War Department for
advances to such subcontractors. Minor deviations from stand-
ard-contract clauses are authorized to be made by contracting
officers without approval by the undersecretaryof war. Varia-
I See Bollinger, op. cit., chap. iv, for a further discussion of the complexity of
contractual terms and the lack of uniformity in contract terms among government
departments.

tions are found in the types and amountof securityrequired. The

greater the financialstrength of the contractorthe greater is the
likelihood that the contracting officials will reduce the require-
ments. In some cases the lien on materialshas been omitted where
the financial position of the contractor has been exceptionally
sound.
It is obvious from the foregoingthat a considerableamount of
discretioncan be exercisedby local contractingofficersin connec-
tion with the requirementsfor advance and progresspayments.
While successfulprosecutionof the war effort would seem to call
for simplificationof the requirements,many contracting officers
have hesitated to exercise the discretion which they possess to
facilitate financingby this method. It is not unnatural that this
should be the case, since large losses might easily subject them to
censureby their chiefs, with the possibility of a congressionalin-
vestigation always present. Strict enforcementof the regulations
and adherenceto standard-contractclauses have multiplied the
difficulties of manufacturers, already harassed by production
problems,and have renderedit even more difficultthan underor-
dinary circumstancesfor businessmenand governmentofficialsto
carry on their relationshipsin an amicable manner. The proce-
dures are new and frequently changing,and numerousmisunder-
standingsarise between contractorsand contractingofficialsas to
what may and may not be done. In contrast, manufacturersfind
it relatively pleasant to deal with their bankers, in spite of many
new problems in this field also. Even when advance payments
were made without interest, many businessmenpreferredto bor-
row from their banks. Now that 2A per cent interest is chargedon
unexpendedbalances,it is likely that this conditionwill be found
still more frequently.
C. FINANCING THROUGH LOANS MADE BY THE FEDERAL

RESERVE BANKS AND THE RECONSTRUCTION
FINANCE CORPORATION
It has been pointed out that the FederalReservebanks and the

Reconstruction Finance Corporation do not represent credit
sources which have come into existence in response to the war-

induced need for credit. Rather, they are included as special

sourcesof credit for the financingof war contracts because of the
adaptations to the war effort which have taken place in their or-
ganizationand credit policies and practices.
The FederalReservebanks.-The Federal Reserve System has
continued,as beforethe war, to take the attitude that its primary
functionis to facilitate the financingof the war by makingit possi-
ble for the commercialbanks to satisfy the credit demandsof busi-
ness firms through loans and to satisfy the credit demand of the
government,in so far as is necessary, by the purchaseof govern-
ment bonds. Thanks to increased acquisitions of gold by the
banking system during the decade of the I930's and consequent
large commercial-bankexcess reserves, the problemof providing
a sufficientreservoirof credit through the commercialbanks has
thus far not been a seriousone. Rediscount rates have been kept
low, but there has been no need for borrowingfrom the Federal
Reserve banks. For many years after I934 the Federal Reserve
banks neitherbought nor sold governmentsecuritiesin significant
quantities, the portfolio of the twelve banks combinedremaining
at roughly$2,500 million. The reserveposition of the FederalRe-
serve banks is such, however,that they could institute an exten-
sive programof open-marketpurchases at any time it might be
deemed necessary to increase commercial-bankreserves. Such a
program has, in fact, been inaugurated;holdings of government
securitiesby the FederalReserve banks on August i9, I942, were
$3,448 million, an increaseof $803 million as comparedwith the
end of June, I942. Excess commercial-bankreserves within the
system as a whole, however, are still substantial, and it is prob-
able that these purchasesweremade only to relieve a tight reserve
condition in the New York commercialbanks. Commercial-bank
required-reserveratios for Reserve city and "country"banks are
as high as is permitted by law, but there is little doubt that the
Board of Governorswould reduce these requiredratios if neces-
sary to preservethe banks' ability to participate in the financing
of the war. Such a conclusion follows from the amendment to
the Federal Reserve Act, approved July 7, I942, permitting the
Board of Governorsto lower reserve requirementsfor member-

banks in central Reserve cities without changing the require-

ments for banks in Reserve cities. Reserve requirements for
banks in central Reserve cities were reduced from 26 per cent to
24 per cent on August i8, I942, and to 22 per cent on September
I4, I942. Again this action results from a lowering of excess re-
serves in the New York banks and the desire that these banks
shall not be required to liquidate government securities if the
decline in excess reserves continues.
The Federal Reserve banks were authorized to make direct
loans to business firms by an amendmentto the Federal Reserve
Act approved on June I9, 1934 (48 Stat. 635). Section I3(a) of
the act now provides that, in exceptionalcircumstancesand when
it appearsthat established industrial and commercialenterprises
are unable to obtain necessaryfinancialassistanceon a reasonable
basis from the usual sources, the Federal Reserve banks are au-
thorized to make loans to, or purchaseobligations of, such busi-
ness enterprisesand to make commitmentsfor the making of such
loans and the purchaseof such obligations. The Federal Reserve
banks are further empoweredin section I3(b) to discount for or
purchasefrom any bank or other financinginstitution obligations
enteredinto by the financinginstitution for the purposeof furnish-
ing working capital to established industrial and commercialen-
terprises,to make loans and advances to financinginstitutions on
the security of such obligations, and to make commitmentswith
respect to such discounts, purchases,loans, and advances. In no
case are the obligations acquiredand commitmentsmade by the
Federal Reserve banks to have a maturity in excess of ten years.
The provisions of the legislation have been carriedout under
Federal Reserve Regulation S. This regulationwas revised most
recently on April 30, I942, to give effect to certain changesneces-
sitated by Executive Order9II2 for the governmentguarantyof
bank loans, describedin a succeedingsection.
Direct loans to industry by the Federal Reserve banks have
never been large, and they have not expanded significantlysince
June, I940. Industrial advances by the Federal Reserve banks
outstanding on August 26, I942, amounted to $I4,833,000, as

comparedwith $i0,988,000 on June 26, I940, and $I3,589,000 on

December 26, I934. Commitments outstanding increased from
$8,762,000 on June 26, I940, to $i6,720,000 on August 26, I942.
Likewiseparticipationsoutstandingincreasedfrom$1i,i82,000 on
June 26, I940, to $25,I95,000 on August 26, I942. The size of
these amounts indicates the relative unimportanceof the Federal
Reserve banks as direct sourcesof capital to business enterprises.
The Federal Reserve banks have endeavored through the de-
fense and war emergencyto expedite the grantingof credit by the
banking system by serving as liaison agency between contractors
in need of funds and the banks. The Federal Reserve banks have
paid special attention to the problemof small businesses,many of
which were in the habit of financing themselves from internal
sources when producinggoods for peacetime markets but which
needed to fall back upon bank credit in the financingof defense
orders. The FederalReservebanks have tried, throughservingas
contact between small and medium-sizedbusiness firms, on the
one hand, and banks, on the other, to spread defense and war or-
ders among a larger number of firms and to encourage subcon-
tracting and thereby to mitigate the social problems involved in
the shutting-downof many small plants and the concentrationof
war productionin the large centers. The activities of the Federal
Reserve banks have had the corollary effect of acquainting con-
tracting agencies with sources of supply and making known to
small business enterprisesthe types of goods needed by the gov-
ernment.
In the early months of the defense programthe National De-
fense Advisory Commissionappointed Donald M. Nelson as di-
rector of small business activities to deal with the problems of
small business establishmentsin relation to the defense program.
The Board of Governorsrequested the Federal Reserve banks to
representthe directorof small business activities in their respec-
tive districts and appointed one of the membersof the Board of
Governorsto act as liaison officerwith the director. It was the
announcedintention that the Federal Reserve banks would serve
as 'conduits of informationbetween the Defense Commissionand

the War and Navy Departments on the one hand, and business
enterprisesand banksin their variousdistrictswhich desireto par-
ticipate in the defense program,on the other."'8 An officerwas
designated in each of the Federal Reserve banks and in some of
the branch banks to act as field representative of the Defense
Commissionand the Board of Governorsand to assist in carrying
out the program.
In June, I94I, the National Defense Advisory Commissionwas
displacedby the Officeof ProductionManagement. In early I94I
there was establishedwithin O.P.M the Defense Contract Serv-
ice, the function of which was to serve as a clearing house of in-
formationbetween contractors,the governmentcontractingagen-
cies, and the banks. Branches of the Defense Contract Service
were set up in each Federal Reserve bank and branchbank. The
branchesor field officesof the Defense Contract Service were or-
ganized into two sections, one having to do with business pro-
cedures,subcontracting,and technical service, and the other con-
cerning itself with fiscal and legal matters. The organizationof
each field office was integrated with the Federal Reserve bank or
branch to which it was attached. The president of the Federal
Reserve bank or branch exercised general supervision over the
fiscal affairsof the field officeand acted in an advisory capacity on
financial matters. The Federal Reserve defense contract officer
was the administrativedirectorof the field office and assisted in
solvingfinancialproblemsin connectionwith contractingand sub-
contracting.
In July, I94I, the Defense Contract Service was enlarged in
scope and set up as an independentbureau of the O.P.M. under
the name Defense ContractBureau.I9On September4, I94I, this
Bureau was convertedinto the Division of Contract Distribution
within O.P.M. When the War Production Board was created in
January, I942, the Division of Contract Distribution was trans-
ferredto the new agency and became the Bureauof ContractDis-
i8 Federal Reserve Bulletin, December, I940, p. I265.
'9 See O.P.M. Release No. PM-976, August i9, I94I, and Regulation No. 9,
July 29, I94I.

tribution of the Production Division of W.P.B.20 The primary

function of the field offices of the Bureau is to serve as point of
contact between actual and potential contractors and subcon-
tractors. Whilethese changesbroughtabout a physicalseparation
of the offices of the government agencies from the offices of the
Federal Reserve banks and branches, the two sets of institutions
neverthelessworkedin close collaboration. That part of the func-
tions of the old Defense Contract Service related to bringingto-
gether the demand for and supply of credit were transferredto
the regionalofficesof the Bureau of Finance of the Division of In-
dustry Operationsof the W.P.B. Here again the Federal Reserve
banks co-operatedwith the Bureau of Finance in attempting to
provide contractorsand subcontractorswith requisitecredit. The
Bureau of Finance, as is true of its predecessorbureausand serv-
ices, did not itself make loans. Its function was one of information
and advice to business enterpriseswith respect to the best meth-
ods for solving their credit problems.21 On September I5, I942,
the Bureau of Finance was abolishedand its functions were taken
over by the SmallerWar Plants Corporation. The evolution of
the various agencies related to financinghas been marked by an
ever increasing attention to the problems of small and medium-
sized firms in their attempts to convert from a civilian to a war
economy.
The ReconstructionFinance Corporation.22-Thebasic lending
20
See W.P.B. Releases No. I4, January 23, I942, and No. I44, February 5, I942.
22
See W.P.B. Release No. 704, March 29, I942.
22
The Reconstruction Finance Corporation was established by the Reconstruc-
tion Finance Corporation Act approved January 22, I932 (47 Stat. 8). This article
and the one which will follow, in a subsequent issue of the Journal of Business, are
not concerned with the activities of the Corporation previous to June, I940. Atten-
tion will be devoted to those activities of the Corporation related to the defense and
war effort and only to those war activities which pertain to the granting of credit
to business firms. No consideration will be given, for example, to financial assistance
rendered by the Corporation to the Export-Import Bank or to loans made to Great
Britain with the deposit of American securities as collateral in connection with the
purchase of goods by Great Britain under Lend-Lease arrangements, although
these activities are directly related to the war effort. Further to delimit the scope of
our interest, this article will consider only the participation by the Corporation in
providing working capital to business firms in contrast to capital for the construc-
tion of new plant facilities.

authorityof the ReconstructionFinance Corporationis prescribed

in section 5 of the Reconstruction Finance CorporationAct as
amended. Authorizationfor loans to businessenterpriseswas pro-
vided byan act of June 19, 1934 (48 Stat. 653), addingsection 5d to
the original act. The clause in effect at present with respect to
predefenseand prewarloans to individualenterprisesresults from
an act of April 13, I938 (52 Stat. I40). In this clausethe Corpora-
tion is authorizedand empoweredto purchasethe securities and
obligationsof and to make loans to any business enterprisewhen
capital or credit, at prevailingrates for the characterof the loan
applied for, is not otherwise available, provided that in the opin-
ion of the board of directorsthe purchasesor loans are of sound
value or so secured as reasonablyto assure retirementor repay-
ment and that the business enterpriseis solvent. Such financial
assistance may be effected directly or in co-operationwith banks
or other lending institutions through agreements to participate
or by the purchaseof participations.
A numberof subsectionsof section 5dhave been addedwhereby
the Corporationis empoweredto assist in variousways in the na-
tional defense and war program. These subsections are now in
effect as follows:
Subsection (I), added by an act of September 26, 1940 (Pub.
No. 792 [76th Cong.]),authorizesthe Corporationto supply funds
to the Export-ImportBank.
Subsection (2), added as at present in effect by an act of June
II, I942 (Pub. No. 603 [77th Cong.]), empowersthe Corporation
to make loans to and purchasethe obligationsof any businessen-
terprise for any purpose deemed advantageous to national de-
fense. Terms, conditions, and maturities of purchasesand loans
are placed within the jurisdictionof the Corporation.The War
and Navy departments are authorized to participate in or to
guarantee any such loans made by the Corporation.
Part of subsection (3) was originallyenacted in an act of June
25, 1940 (Pub. No. 664 [76th Cong.]) and was amendedby an act
of June I0, I94I (Pub. No. io8 [77th Cong.]). These parts of sub-
section (3) authorizedthe R.F.C. to create or organize corpora-

tions with power (a) to acquire strategic and critical materials; (b)
to purchase and build plants and equipment for the manufacture
of facilities necessary to national defense; (c) to lease and sell such
facilities to others to engage in such manufacture; and (d) to en-
gage in such manufacture itself, if the President finds that it is
necessary for a government agency to so engage. The R.F.C. was
empowered to make loans to and purchase the capital stock of
such corporations.
Additional parts of subsection (3) were originally placed in the
Reconstruction Finance Corporation Act by the act of June Io,
I94I. By these additions the R.F.C. was empowered to create and
organize corporations for the purposes of acquiring and disposing
of railroad equipment and commercial aircraft and of acquiring
and disposing of facilities for the training of aviators. The Cor-
poration was further empowered to take such other action as the
President and the federal loan administrator might deem neces-
sary to expedite the national defense program, except that the
amount of funds of the R.F.C. outstanding at any one time for
carryingout "such other action" might not exceed $200,000. In
this connection Congress prohibited the Corporation from taking
any action with respect to certain proposals which had thereto-
fore been considered by the Congress, such as the Great Lakes-
St. Lawrence seaway and other projects.
Subsection (4), added by the act of June Io, I94I, authorized
the Corporation to make loans to foreign governments and their
agents, based on the deposit of American securities, for the pur-
pose of achieving maximum dollar-exchange value in the United
States for the American securities owned by such foreign govern-
ments.
The R.F.C. has participated in the financing of the working-
capital requirements of business enterprises primarily under the
authorization of section 5dof the act as approved on June I9, I934,
and amended on April I3, I938. The financing of new capital
facilities has taken place largely under subsection (3) of section
5d, empowering the R.F.C. to organize corporations for certain
purposes. A number of subsidiary corporations have been or-

ganized, the most important of which, so far as the provision of

new productive facilities is concerned,is the Defense Plant Cor-
poration.
The R.F.C. has publishedsince September,I940, data separat-
ing loans to industrial and commercial business into the two
categoriesof loans to such businesses "for national defense" and
loans "for other purposes." It is thereforepossible to determine
trends in the importanceof these two classes of loans since that
date. At the end of September,I940, total loans to industrialand
commercialbusinesseswere outstanding of $I31,26,000, of which
$2,598,000, or 2.0 per cent, were for national defense. At the end
of July, I942, out of total loans outstanding of $26o,ooo,ooo,
$I70,000,000, or 65.4 per cent, were classifiedas for national de-
fense. The increasein loans for defensepurposeswas greaterthan
the increase in total loans, indicating a liquidation of loans for
other purposes.
Since June, I940, the Corporationhas at various times been
under attack because of alleged failure to perform its functions
adequately in two differentrespects. The first is concernedwith
the allegations by certain members of Congressand some other
governmentalagenciesthat the R.F.C. has unnecessarilydelayed
the constructionof new plant facilities and the expansionof pro-
ductive capacity in certain strategic industries, among them the
aluminum, the magnesium, and the iron and steel industries.
Since this complaintrelates to the provisionof new capital facili-
ties, it will not be consideredfurther at this point.
The second attack upon the Corporationhas been in the form
of a complaint by many commercialbankers that the industrial
lending activities of the Corporationhave had the effect of com-
peting with the banks for commercialloans and of lowering the
general interest-rate structure on loans to business enterprises.
The officialsof the R.F.C. have throughoutits history deniedthat
the Corporationwas in competition with the commercialbanks.
Time and again the claim has been made that the Corporation
would make commitmentsonly with respect to those situations
where the banks were unable or unwilling to make the loan and
thus where no other sourceof credit was open to the prospective

borrower. The establishedpractice previous to June, 1940, seems

to have been to require applicants for loans to furnish evidence
that they had been unable to obtain the requisite credit from
private sources.23
There is evidence to indicate, however, that the Corporation
has been more seriously a competitor of the banks since June,
I940, than before that date. While the Corporationhas contin-
ued to take the attitude that the banks should make all possible
loans for national defense, it has not in all cases requiredthe ap-
plicant to show that he could not secure credit elsewhere. More-
over, the Corporation,by announcingits intention to make cer-
tain types of loans at particular rates of interest, has forced the
banks to take such loans at interest rates lower than the banks
believed that the rates shouldbe in termsof the risks assumedand
lower than the loans would have been made in the absenceof the
readinessof the Corporationto make the loans at the prescribed
rates. The specificationsby the Corporationof the conditions
under which it would participate with commercialbanks in busi-
ness loans and the requirementsfor take-out agreements have
perhaps also had this effect.
The general nature of the problem may be indicated by refer-
ence to the policy of the Corporationwith respect to loans made
by any agency wherethere is a definiteundertakingon the part of
the War Department or Navy Department to reimbursethe bor-
rowerfor sums expendedfor the purposeof expandingplant facil-
ities to fill war contracts. The point which arousedmost contro-
versy was an announcementby the Corporationwith reference
to emergency plant facilities contracts, under which a business
firm builds a new factory under an agreementwith the govern-
ment whereby the latter obligates itself to pay back to the busi-
ness firmthe cost of the factory in sixtyequal monthlyinstalments.
With respect to such contracts,Jesse Jones, federalloan adminis-
23 See J. D. Glover, "The Industrial Loan Policy of the R.F.C.," Harvard Busi-
ness Review, Summer, I939, pp. 465-76; T. R. Goldsmith, "Financing Industrial

Expansion and Working Capital Requirements of the Defense Program," Annalist,
September 26, I940, pp. 397 and 42I; and N. H. Jacoby, "Government Loan Agen-
cies and Commercial Banking,'" American Economic Review Supplement, March
I942, pp. 250-60.

trator, of which agency the R.F.C. formerlywas a part, wrote to

the secretariesof war and of the navy on November i8, I940, as
follows:
I am writing to advise that where,in accordancewith your established
policy, thereis a definiteundertakingon the part of the War or Navy De-
partment,in a mannermutuallyacceptable,for reimbursement overa period
of five years, the R.F.C., either directlyor throughbanks or the Defense
Plant Corporation,will arrangeor adjust such financingat an interestrate
of I2%perannumon paymentsmadewithinthe period.24
The letter went on to say that
for defense financing,for workingcapital and plant equipmentand ex-
pansion,wherethere is no definiteundertakingfor reimbursementby the
Waror Navy Department,the interestrate will be appropriateto the credit
factorsof the individualcase,but not morethan4%.25
It was the I per cent rate on emergency plant facility contracts
which most disappointed the commercial banks. Apparently
many bankers expected that loans made by banks for the con-
struction of new plants would have an interest rate higher than
I I per cent. It was pointed out by the banks that there are funda-
mental differencesbetween the lending of money by the R.F.C.
and by the banks. The formeragency simply lends out money be-
longing to the taxpayers and has no deposits payable on demand.
Many lending officersexpressedthemselves as of the opinion that
a i2 per cent rate would be fair where the company pledged its
entire credit, but that 3 per cent would be a properrate in cases
where the borrowerattempted to limit its liability by the incor-
poration of a special subsidiary borrowing money without the
guarantyof the parent-company. The argumentwas also used by
the banks that if something went wrong in the constructionof a
plant, the R.F.C. would have a much better chance of collecting
from anothergovernmentdepartmentthan would a private lend-
er.26
On November 25, I940, Jesse Jones sent a letter to P. D. Hous-
24 Federal Loan Agency Release No. 6o, November i8, I940.
25 Ibid.
26
See the New York Sun, November i9, I940, p. 27.

ton, president of the American Bankers Association, further ex-

plaining the position of the R.F.C. and stating that "i-0% is a
high rate for a government guaranteed obligation with an aver-
age maturity of 2 years, and if the War and Navy contracts are
not good, banks should not rely upon them as a basis of credit
whatever the interest rate. l27 Mr. Jones also reiteratedin the let-
ter the R.F.C. policy that "the R.F.C. will be glad to participate
with banks in making defense loans, but the R.F.C. will extend
propercredit at appropriaterates to any reputablemanufacturers
who have defense contracts if such credit can not readily be had
from banks."28
The R.F.C. has followed the properpolicy of recognizingthat
in a war economy the functions of credit differ from such functions
in times of peace. Normally, credit should be made available to
those firms which can produce most efficiently those goods for
which an effective demand exists. In time of war, the cost at
which the requiredgoods can be producedis of secondaryimpor-
tance. No firm which can produce a quantity of a strategic com-
modity must be denied credit because under ordinaryconditions
it would be judged that productionwas taking place inefficiently.
Evaluation of the interest policy of the R.F.C. is not so easy.
It can only be said that, to whatever extent interest rates have
been loweredby R.F.C. policies, businessfirmshave been enabled
to produce at lower costs than otherwise would have been the
case, the government has been able to acquire war materials at
lower prices, and the cost of the war has to that extent been
shifted from the taxpayers to the banks' stockholders.
D. FINANCING THROUGH GUARANTEED LOANS UNDER
EXECUTIVE ORDER 9 II 2
On March 26, I942, the President issued Executive OrderNo.
9II2, which provides that the War Department, the Navy De-
partment, and the Maritime Commission may enter into con-
tracts with any Federal Reserve bank, the Reconstruction Fi-
27 Federal Loan Agency Release No. 63, November 25, I940.
28 Ibid.

nance Corporation,or any other financing institution, whereby

the financinginstitution will be guaranteed against loss of prin-
cipal or interest on loans and advances made to any contractoror
subcontractor engaged in war work. The government depart-
ments are also authorizedto enter into contracts to make loans or
advances on their own account to business enterpriseswith war
orders and to participate with the Federal Reserve banks, the
R.F.C., and other financinginstitutions in making such loans.
The Executive Order is important as marking a complete
break from the normalpeacetime standardsof credit practice. It
has graduallycome to be recognizedthat in time of war, when the
granting of credit is subject to unusual risks, it is not possible to
rely entirely upon private financialinstitutions operatedfor profit
as sources of credit. No condemnation of a system of private
credit institutions may be devolved from this statement. Under
normal conditions the commercialbanks and other private insti-
tutions serve to bring about a more effective allocation of credit
resources and a more efficient utilization of productive factors
than could be accomplishedin a collective economy. In time of
war, nevertheless,it is the duty of the managersof private finan-
cial institutions to protect in so far as possible the interests of
their employers-the ownersof the institutions. Where the effect
of these loyalties is to limit the granting of credit in such a way
that the total productionof certain necessarygoods is diminished
and the successfulprosecutionof the war, the foremost social ob-
jective, is hampered, other credit devices or sources must be
brought into use.
Executive Order 91I2 is a recognition of the inadequacy of
steps formerlytaken to liberalize credit standards and to reduce
the risks of private credit intitutions. As we have seen, the prin-
cipal attempt along this line was the enactmentof the Assignment
of Claims Act. At the same time the Orderrecognizes that the
commercialbanks, rather than governmental institutions, have
been and should continue to be the primary sourcesof credit for
working-capitalpurposes. Yet, under the terms of the Order,the
risks involved in the making of loans for war purposes may be
transferredfrom the depositorsand stockholdersof the banks to

the government,and thus to society, where the risks of such loans

properly belong.
Another advantage in the governmentguaranty of bank loans
should be in the factor of speed. Much will depend upon the effi-
cient administrationof the system for governmentguaranty, but
the time consumedin application for and approvalof a loan will
probablybe much less than formerly. It is difficultto overempha-
size the importanceof this matter, since a condition in which the
lack of financialaccommodationis permitted to hold up necessary
productionin time of national emergency borderson the tragic.
In governmentalpress releases describingthe effect of the Order
it has been pointed out that hereafterloans are not to be made
under peacetime credit rules and that it will now be production
men who will determine whether credit should be granted. It is
significantthat the Orderauthorizesthe guaranty of loans made
to subcontractors,who under former procedureshave often had
difficultyin securingcredit. The Ordershould also facilitate the
granting of loans to small business enterprises,which generally
produceunder subcontracts.
The Federal Reserve banks were designated by the Executive
Orderas fiscal agents of the governmentdepartmentsin carrying
out the provisions of the Order. Pursuant to this authority, the
Board of Governorsissued Regulation V, effective April 6, 1942
(Codeof FederalRegistry,Title I 2, sec. 223.I ff.), which prescribes
in general terms the policies which will govern the Federal Re-
serve banks acting as fiscal agents underthe Order. It is provided
in section 4 of the Regulation that
.... The FederalReservebankswillarrangeguarantiesandloansin accord-
ancewith the provisionsof the ExecutiveOrderandof the instructionsof the
WarDepartment,Navy Departmentor MaritimeCommission,respectively,
whereverit is believedthat they will contributeto the obtainingof maximum
war productionexpeditiously.While the FederalReservebanks will make
reasonableeffortsto afford the War Department,Navy Departmentand
MaritimeCommissionthe best availableprotectionagainst possiblefinan-
cial loss consistentwith this objective,such guarantiesor loans should not
be deniedor substantiallydelayedwhenthey can be providedin accordance
with the instructionsof the War Department,Navy Departmentor Mari-
time Commission.

It is further provided in section 4 that the Federal Reserve

banks will endeavor to arrange financing through commercial
banks, other financialinstitutions, or the Federal Reserve banks
without guaranty or loan or participationby the governmentde-
partments. Where this is not feasible, the assistancerenderedby
the governmentdepartmentsshould take the form of guaranties
of loans made by commercialbanks or other financialinstitutions,
rather than loans or participations therein by the government
agencies themselves.
It is not the intention of Executive Order9II2 and Regulation
V that all loan applications to the banks will be guaranteedby
the governmentdepartmentsbefore approval. Banks will still be
expected to shoulder a part of the risks of financing business
firms with war orders and to request a guaranty only on those
loans which would otherwisenot be bankableeven after a modifi-
cation of ordinary credit standards. There will probably also be
extended a system of part guaranty, such as 8o per cent of the
amountof the loan, with the remainingrisk being assumedby the
bank. A schedule of guaranty fees has been worked out which
operatesin such a way that the bank's net rate of returnon loans
varies inversely with the percentageof the loan that the govern-
ment departmentguarantees.
No detailed statistics on the volume of guaranteedloans and
the proportionof guaranteedto total loans have as yet appeared.
It is known that guaranteedloans which have been made have
ranged in size from as low as $700 to as high as $50,000,000.29 An
additionaladvantageto the banks in the guaranty system may be
that it will enable them to get back some of the lending business
formerly lost when advances on government contracts were in-
stituted. To businessfirms an advantage in borrowingunder the
system of governmentguaranty is that, if a war productioncon-
tract is canceled, in whole or in part, the borroweris given a
waiverof interestand a suspensionof maturity on a proportionate
amount of the loan.
Although the loan-guarantyprovisionsapply to loans for new
29 See Herbert Bratter, "Regulation V Gets Started," Banking, June, I942, p. 24.

plant facilities as well as for working-capitalpurposes,so far most

of the guarantieshave been on loans for the latter purpose. Most
of the capital for the constructionof new plant facilities is now
coming,as has been previouslymentioned,not fromthe banksbut
fromthe governmentitself throughplant constructionand owner-
ship by the Defense Plant Corporation.
There is reproducedbelow a telegramfrom Jesse Jones to Clar-
ence Stanley, presidentof the Union Trust Company,Pittsburgh,
Pennsylvania. This telegram is given here because it presents a
good exampleof working-capitalfinancingundermodernpractice,
involving, as it does, commercial banks making the loan, the
Federal Reserve bank acting as fiscal agent in securingguaranty
of the loan by the War Department, and the R.F.C. standing
ready to take any part of the loan which cannot be placed with
the commercialbanks. The text of the telegram is as follows:
I understand that you are negotiating on behalf of Standard Steel Spring
Company of Coraopolis, Pennsylvania, a fifty million dollar loan to finance
war contracts and that the Federal Reserve bank, as fiscal agent for the War
Department, has agreed to guarantee go% of such loan, having a maturity of
four months, interest at the rate of 3% per annum from which a commitment
fee of six-tenths of I% will be exacted by the guarantor. I am told that your
bank and National Bank of Detroit have each agreed to take two million
five hundred thousand dollars of loan on these terms. I also understand that
you are negotiating presently with other banks to join in this credit. In
order to facilitate arrangement of this financing, the R.F.C. will take all or
any part of such amount not subscribed for by banks upon same terms and
conditions.30
It is impossible to estimate at the present time, of course, how

large losses may accrue to the banks and to the government from
frozen working-capital loans when the war ends and war con-
tracts are canceled. As the war continues, and as a result of the
extensionof the system of guarantiesby governmentdepartments,
it is probablethat the major portion of the loss on loans of this
type will be borne by the governmentrather than by the private
credit institutions. Even though the loss be a large percentageof
total working-capitalloans outstanding at the terminationof the
30 Department of Commerce Release No. 1602, April i6, I942.

war, such a loss will represent but a slight increase in the total
cost of the war. The volume of credit used for working-capital
financingis, after all, a revolvingfund out of which disbursements
are made throughloans to businessfirmsand to which reimburse-
ments come in the formof repaymentof loans. A much more seri-
ous potential financialloss is representedby investment in capital
equipment for the constructionof war materials, much of which
will be relatively useless after the war. In addition, the fact that
an increasingproportionof new plant facilities is being produced
by the government, title remainingwith the government, offers
a seriousproblemwith respect to the future of our system of pri-
vate enterprise.


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Working-Capital Financing in a War Economy

Author(s): Marshall D. Ketchum

This content downloaded from 185.44.77.136 on Sat, 21 Jun 2014 19:55:47 PM

T HE conversionof industryto a warbasisbeganwith the

University of Kentucky. The writer wishes to acknowledge the assistance of Frank

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the inability of the existing plant to satisfy the greatly increased

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JuneI940 ..... 23,59I 8,444 35.8 4,383 5I .9

rities for new capital. This statement is applicableboth to capital

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expansion-loans by reporting member-banksto commerce,in-

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opinion that at the time of its publication (June, I94I) defense

For plant facili-

Total . , 627 460 2,253 633 5,88o I1093

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This content downloaded from 185.44.77.136 on Sat, 21 Jun 2014 19:55:47 PM

the financingof defense contracts than is indicated by this io per

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business enterprises had lines of credit available at their\banks

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i. Trust-receiptfinancing.-The use of trust receipts has been

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operatedin makingloans to local enterprises. In other cases large

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pected in the absenceof the act. The act amendssections3477 and

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usually a bank or trust company,is requiredto file written notice

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theremight be some dispute unknownto the governmentbetween

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supply the bank with copies of all communicationsreceived from

loan agreement form.

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Related to the problemof physical ability to performthe con-

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problem of production in the physical sense, because the con-

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tions producingunder war orders has not been entirely satisfac-

B. FINANCING THROUGH ADVANCE AND PROGRESS PAYMENTS

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returnedto the governmentwithin a specifiedperiod,often fifteen

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ments and progresspayments have been providedfor in the same

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tions are found in the types and amountof securityrequired. The

C. FINANCING THROUGH LOANS MADE BY THE FEDERAL

It has been pointed out that the FederalReservebanks and the

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induced need for credit. Rather, they are included as special

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banks in central Reserve cities without changing the require-

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comparedwith $i0,988,000 on June 26, I940, and $I3,589,000 on

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tribution of the Production Division of W.P.B.20 The primary

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authorityof the ReconstructionFinance Corporationis prescribed

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