This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
The first of these three classes is the banker's favorite, at least in the United States. This is due to the fact that stocks and bonds are usually salable, so that in case of default on the part of the borrower, the banker should have little difficulty in disposing of the collateral and repaying most or all of his advances. This statement is not to be taken as applying indiscriminately, to be sure, to all stocks and bonds; for the securities of some local or little known companies, even though the companies may be carrying on a successful business, are about as unmarketable property as can be mentioned. At the other extreme are the active securities of the great corporations which are being daily bought and sold in large quantities on the New York and other stock exchanges; these are the securities that serve as collateral for the enormous amounts of call loans kept outstanding by the banks of the New York financial district. Between the two extremes there are many sound securities which the banker regards as at least fairly marketable, and which he is willing to take as collateral. Some of these securities are owned by commercial and manufacturing corporations which may properly use them as a basis for bank credit. There is, however, a limitation to be noted here. It is not regarded as sound practice for a corporation to post as collateral the stock of a subsidiary company. In the first place, the stock probably has no active market and the bank will accept it only reluctantly and when it is mixed with some salable collateral, and, in the second place, the corporation should not be compelled to take any chances - even remote chances - of losing control of an essential piece of property. The securities of subsidiary companies may serve properly as collateral for long-term bond issues, but not as collateral for bank loans.
Merchandise serves as collateral when a company posts warehouse receipts, bills of lading, or specific liens upon specific pieces of its personal property as collateral. The first-named case is the one that is most common. Millions of dollars of holdings of cotton, wheat, and other grains are carried in this way every year following the harvesting of the crops.
Once in a while manufacturing corporations may have collateral of this nature, as when a steel manufacturing company holds pig iron, but this is unusual. Bills of lading indorsed to the order of the bank commonly serve as collateral for drafts discounted by the seller of merchandise. Millions of dollars worth of grain, live stock, and other goods in transit are in this way utilized as backing for loans made by the banks, and accepted as collateral up to a fair proportion of their face value for direct bank loans. This is particularly true in the export trade where the banker does not feel sure enough of the standing of the drawer of the draft or of the salability of the merchandise to risk discounting the whole draft, but is willing to make advances up to, say, 50, 60, 80% or more of its face value. This is true also when the merchandise consists of goods that are perishable or that do not have a ready market. A draft covering a shipment of fruit, for instance, might not be readily discounted, but several of these drafts would be regarded as good collateral for an advance of say 50 to 75% against their face value. Liens on specific pieces of personal property are not common, but may at times be perfectly good banking collateral.
Accounts receivable fall into a different class. The evidence of indebtedness of a third party to the borrower is so uncertain and the claims upon specific property are so indirect, that accounts receivable are not customarily accepted as sound collateral for a bank loan. It is considered better for the company to borrow on its general credit rather than to assign its accounts receivable as collateral. Yet this customary rule appears to be based nearly as much upon prejudice as upon careful investigation. As a result of the unwillingness of most banks to accept assignments of accounts receivable as collateral, a considerable number of financing and discount houses have come into prominence during the last few years. These houses make a specialty of advancing money against open accounts. It will be more convenient to discuss their methods and activities at some length a little later when we come to consider working capital. For the present, it is enough to note that during the sudden and severe crises produced in the United States in the fall of 1914 by the outbreak of the European War, the influence of these discount houses was perceptibly increased. They customarily charge an interest of 6%, plus a commission of 1 or 2%. They ordinarily allow interest to the customer on all items as fast as collected, and, inasmuch as they carry no deposits, they do not follow the banking custom of requiring that 20 to 25% of the proceeds of a loan remain on deposit without interest. They usually make advances up to about 80 to 85% of the face value of the receivables that have been assigned. The example of these discount houses has recently been followed, within moderate limitations, by some of the more progressive mercantile banks. The old prejudice against "hocking" accounts appears to be fading away.