Academic journal article Economic Commentary (Cleveland)

Industrial Loan Companies

Academic journal article Economic Commentary (Cleveland)

Industrial Loan Companies

Article excerpt

Industrial loan companies have been a part of the financial landscape for the better part of a century, but until recently, not many people outside of banking circles had heard of them. Much like early-twentieth-century building and loan associations, which filled a void in home loans left by mainstream financial institutions, industrial loan companies (ILCs) arose to fill a void in unsecured consumer lending.

When the first ILC came into existence in 1910, the way it conducted business-from its approach to consumer lending to the way it funded loans-was sufficiently different from traditional banks that it and the institutions that evolved from it were not considered to be banks from a legal standpoint. This legal distinction would keep ILCs exempt from certain types of bank regulation in later decades.

When commercial banks finally warmed up to the business of unsecured consumer lending in the 1920s and began to surpass the ILCs in the market in later decades, it seemed as though the ILC industry would be relegated to a footnote in financial history. The limited nature of the ILC charter placed these institutions at a competitive disadvantage to other consumer lenders in the market.

Yet not only have ILCs survived, they have begun to grow. At the end of 2004, there were 57 ILCs in existence with combined assets of $140 billion-up from $3.8 billion in 1987-and six of these ILCs ranked among the largest 180 financial institutions in the nation, according to a 2005 GAO report. The largest ILC has over $66 billion in assets, making it one of the top-25 commercial banking companies in the United States.

The marked increase in the size of the average ILC, the growth of the industry's combined assets, and the recent well-publicized applications for ILC charters by large commercial firms suggest that these institutions are becoming more than niche players in financial markets. Below, we take a look at some reasons why.

* A Short History of ILCs

ILCs emerged from the Morris Plan banks of the early twentieth century. The name "Morris Plan" comes from a Virginia lawyer, Arthur J. Morris, who in 1910 began providing loans to low-and moderate-income workers who had stable jobs but did not have access to credit from commercial banks.

Banks of the time were reluctant to lend to these workers because it was difficult for them to distinguish between workers who were likely to repay their loans and those who were not. Such a difficulty can lead to an adverse selection problem, where the only people asking for loans are the most risky sorts of borrowers. Riskier borrowers should pay a higher interest rate than less risky ones, but when bankers cannot distinguish between the two, they cannot set an interest rate that both compensates them for the risk they are taking on and is still acceptable to all borrowers, both high-and low-risk.

Adverse selection can lead to credit market failure if banks don't find a way to tell the types of potential borrowers apart. Commercial bankers at the time had found a partial solution to the problem by relying on the ability of workers to post collateral as a loan-screening device. Safe borrowers could post a large amount of collateral because they knew they would repay the loan and never lose the collateral.

In return, the bank could charge them a low interest rate. High-risk borrowers, on the other hand, knew that they might very well lose their collateral, and they agreed to pay a high interest rate so they could post lower collateral.

But most low- and moderate-income workers did not have acceptable collateral, and as a result, they could not secure credit from a bank. Morris's ingenious solution to the adverse selection problem did not require collateral. Instead, he required the signature of two co-signers on a loan, chosen among the family and friends of the borrower. This business model was based on his now-conventional belief that pressure from friends and family would keep borrowers honest and make them repay their loans. …

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