2. A Historical Study on the Evolution of Risk Assessment and Credit
2.4. Consumer and Business Credit Information Sharing in the First Half of the
In the early nineteenth century, businesses in the United States could rely on letters of recommendation for information on the creditworthiness of their commercial partners given the small-scale nature of the existing trade credit exchanges. Recommenders could be either local or distant business partners (suppliers) with whom a borrower had performed some transaction in the past, and who therefore possessed sufficient knowledge about the customer’s past payment behaviour. This method based on personal ties, which early nineteenth century American merchants relied upon, was characterized by a long-term business relationship; in other words, the men with which trade was performed were personally very well known to either the creditor or the recommender26. Recommenders could also be, although less frequently, “respectable members of his or her community”, such as lawyers or bankers27 because of their personal knowledge of the customer in question. However, lawyers and bankers, by nature, could only have knowledge of people limited to the locality in which they performed their activities. This information is thus dependent upon the proximity of personal ties. Their influence as providers of credit information can be thus traced to the beginning of the nineteenth century, which started to deteriorate from the 1820s, when the United States commercial activity, and therefore the volume of trade credit, was rapidly increasing.
25 See Olegario (2001) and Sylla (2001).
26 It is worth noting that this kind method of obtaining credit information was also very familiar in the United Kingdom at the beginning of the nineteenth century.
27 Olegario (2001).
As it could be inferred, the geographical scope of trade credit was also expanding, which created the necessity to obtain better credit information on a growing number of potential and existing customers, operating in very distant territories, which in turn made the prevailing system of letters of recommendation inadequate and in many cases, of unreliable content. One solution to this problem was the hiring of agents by the concerned businessmen seeking credit information28; these agents had the task to travel to a particular, or even various places, in order to acquire information on the standing of the businesses of potential and existing business partners. Nevertheless, as this was a very costly way of obtaining information, it was restricted to very large firms only. Some business houses in the United States explored the possibility of relying on travelling salesmen to acquire credit information on distant customers in an effort to develop more formal methods as a solution to their lack of knowledge. However, as reported by Madison (1974), the main problem related to this method of knowledge about distant customers was the fact that these travelling men, too eager to expand their trade through the extension of credit, provided biased reports thus impairing the quality of their reports.
In the United Kingdom, in order to obtain credit information, large mercantile houses also used the method consisting of hiring local agents since the beginning of the nineteenth century. However, their role was not confined to the national sphere; houses such as Baring Brothers and Company, given the prominently international scope of their activities, hired agents to conduct credit investigations on their American business partners, given the magnitude of trade and finance carried out with the United States. Furthermore, given the fact that the City of London had acquired the first position in the world as the most advanced and sophisticated money and financial centre by the end of the Napoleonic wars (Dickson, 1967), mercantile and banking houses saw their business greatly expanded especially with North American associates. Therefore, as in the United Sates, the methods of personal ties and letters of recommendation for acquiring credit information became insufficient to provide an accurate portrait of creditworthiness in a very rapidly changing economic and financial environment with a fast growing number of correspondents whom these houses made business with.
After 1826 the financing of trade and marketing American bonds became one of the most important activities of the merchant bankers, and even if this activity was clearly dominated by Baring Brothers and Company, competition was relatively important and increasing among eight main houses: Wiggin and Company, Wildes and Company, Wilson
28 This practice was common not only in the United States, but also in the United Kingdom.
and Company, W. and J. Brown and Company, Morrison, Cryder and Company, N. M.
Rothschild and Sons, and Baring Brothers and Company. Success in business depended therefore upon the acquisition of reliable credit information about their respective correspondents. It was thus crucial to gain knowledge on the credit quality of correspondents and enterprises, particularly during the boom years of the early 1830’s. It was within this historical context, characterized by a competitive environment and a lack of institutionalized and reliable forms of credit reporting, that the idea of the appointment of an agent with the sole responsibility of providing accurate and unbiased credit information emerged. As one might expect, this system was very high in cost and only the large merchant houses could afford it. In 1829, Baring Brothers and Company in the United Kingdom innovated with the appointment of an agent whose only task was to provide them with accurate reports on their American correspondents.
As shall be discussed, in the beginning of the nineteenth century, the acquisition of information on credit worthiness was a very problematic issue, as one of the most valuable sources of information we know today – payment histories – were not available in the case of individuals. Also, in the first half of the nineteenth century credit information sharing devices were reduced to mutual protection societies, where only members had access to information on obligors that did not pay their debts on a regular basis. Financial statements were also very hard to obtain, and, when available, these were unreliable in content because they were rarely audited and there existed no formal accounting principles to respect.
Moreover, given the highly competitive environment where the large merchant bankers evolved, making a direct request to individuals for information on their own current credit standing or financial information, was notably problematic because potential or existent obligors could well be offended and go to a direct competitor of the merchant house in question who could provide credit without the need of additional financial information.
Hidy (1939) provides one of the most useful sources with regard to the practical aspects of the acquisition of credit information by the large merchant houses in the first half of the nineteenth century. As he explains, unable to obtain information in the form of hard data, obligees were compelled to use qualitative information as their primary input to assess creditworthiness, and the most easily obtainable proxy was businessmen’s character.
In the specific case of Baring Brothers and Company, systematic knowledge of the status of correspondents was judged in accordance with the following principles: “… a correspondent to be reliable must be an accurate judge of the currents of business, must be intensely interested in and devoted to his business operations, must have a capital adequate
to his transactions, must be prudent, and above all must be thoroughly honest. Although a large capital was an attractive attribute of a correspondent, the personal integrity of the leading partner or director of the firm was of greater importance. Prudence and integrity were, indeed, the main indices of reliability and trustworthiness.29” This description is of considerable importance at the time when Baring Brothers and Company signed a contract with Thomas Wren Ward, a retired merchant of Boston (in order to control their business through personal information with American correspondents), because it provides us with the specific aspects that were taken into consideration when evaluating business opportunities in the United Sates.
Ward’s collaboration with Baring Brothers and Company lasted from 1829 to 1853, period in which he rated “several thousands” of businessmen of all ranks and types, and performed the assessments of existing and potential correspondents regardless of their interest in applying for credit with the London house. Being fully aware of the difficulties described above for acquiring information, Wren Ward gathered knowledge (through private conversations with former correspondents and former business partners) of potential clients, and then translated this knowledge into a personal judgement of the individual applicant. Most importantly, his work led to one of the first types of credit rating systems in the modern sense of this concept, as it can be considered the predecessor of the one used by the credit rating agencies today. According to Hidy, the evaluations provided by Wren Ward to Baring Brothers and Company included: “the location of the firm, its capital, its particular preoccupation (dry goods importing, iron importing, import and export commission business, cotton exporting, and so on), its character –whether trustworthy and honourable or unreliable, the amount of credit that it was safe to give to it, the conditions under which the credit should be given, and any special items that might have a bearing upon the business activities of the house.30” Ward then created a system consisting of a list of companies to which he assigned a number individually expressing the standing of their respective credit conditions, and in 1834, January 1836, and January 1837 he sent to the London house copies of a list of past, active, and potential clients. Thus creating a credit rating system based on a grouping of companies according to their level of risk, Ward’s description recalls the ones used by today’s credit rating agencies, and can be found in Hidy’s (1939) cited work:
29 Hidy (1939), p.82.
30 Hidy (1939), p. 85
“No. 1 Contains the Foreign Houses without regard to character or standing but alphabetically arranged; No.2 may be considered as Houses not only entirely safe for what they may do, but likely to continue so under any possible circumstances.
They possess of course different degrees of wealth, but are placed together in this list on account of wealth, character and habits of business taken together; No. 3 Is composed also of those whom I consider as quite safe and many wealthy, and many also of your best correspondents and almost all of the right sort of people, but who from the extent or nature of their business or from circumstances not necessary to enter into, may not be considered as ranking with those whom I suppose are to continue always beyond question; No. 4 Consists of a class many of whom I should consider safe and some even comparatively rich, but who from the smallness of their transactions, or from their having no abiding place and being abroad as Supercargoes would not seem to belong to a class to be trusted much, or at all unless through me, and it also contain many whom from their extension or want of capital might render it unsafe to trust, but contains few or none whose morals so far as we know is exceptionable; No. 5 No trust. This column consists of those who either have no capital or are not of that character to render it desirable to trust them at all; No. 6 Houses having various connections. Some of whom are safe and even wealthy, but dong with others renders it less important to cultivate and more important to look after; No. 7 Houses having other connections. Are those contained in our numbers, but doing business wholly with others; No. 8 Don’t Know. This class contains many whom I have never known and with whom you do not appear to have had any active account or been exposed in any way, and of many others of whom my imperfect knowledge might rather mislead than be useful. They are therefore left to take their chance supposing you will not trust except where you may have certain knowledge of your own; No. 9 Failed; No. 10 Dissolved, and some failed; No. 11 Dead.” (Hidy, 1939, p. 87-88)
If we take the ex post, realised rate of default by category as the base parameter in order to assess the performance of a rating system, we can easily conclude that the system pioneered by Baring Brothers and Company was highly effective. The rate of default for each number assigned is as follows: Ward noted that for all firms grouped in 1835, only six per cent of the firms included in group No. 2 had defaulted in 1843, the percentage of defaulted firms until that same year for category No. 3 was nine; and for group No. 4, sixteen per cent of firms defaulted. Moreover, these categories show the importance
accorded to wealth in general terms, but also to morals and character of the men in charge of the companies assessed.
In the United States, very similarly to Baring Brothers and Company, another international house, the House of Brown, developed their own credit reports using a system comparable to Barings’ in form and efficacy. In effect, thanks in part to the accuracy of these reports, even as late as 1857, when the Panic seriously damaged the businesses and profitability of the merchant houses, the Browns were able to cope with it and suffered very few losses (Perkins, 1973). Similar to the merchant bankers operating in the United Kingdom, American firms faced the same kind of problems with regard to the acquisition of credit information; payment histories were not available and financial information was not reliable in content because of the lack of general accounting standards.
Additionally, in the nineteenth-century United States, there was not a central authority requiring firms to present consolidated annual statements mostly because each state possessed their own legislature, and only in a few of them was such legislature successfully imposed.
Credit information was therefore obtained through agents or reporters (as in the case of the London houses), hired to travel through some parts of the country, where creditors might have potential business partners, in order to gather knowledge on rough financial information (such as the business principal assets and liabilities31), but giving primary importance to the character of businessmen. However, in the case of the United States, the ways through which credit information was acquired were somewhat less formal that in the United Kingdom in the first half of the nineteenth century (at least until the emergence of the American credit reporting agencies in 1841 with the opening of the Mercantile Agency in New York); the principal sources were direct interviews with potential or existing customers when possible, the business and financial press, county and state tax and property records, and, in many cases, even through local gossip.
An example of a report from the 1850’s is reproduced here in order to provide a clear portrait of the information gathered on a particular business:
Jones, Smith, & Brown
Alfred Jones, John Smith, Wm. Brown, Gen’l Dealers.
31 Financial information as understood in modern times, such as measures of cash-flows, profits, costs, etc., was not available.
“J” is about 50 years old, and a merchant at this place for 20 years, during which time he has been doing a good business, and has made money, never failed, is of good character, and a shrewd business man, Is now estimated worth about $25,000, of which $5,000 is in unencumbered real estate. He does a legitimate business, and never ventures into rash speculations. “S” and “B” are each about 35 years old, and smart business men. “S” had been in business and failed, settled honorably, acted as clerk, for “J” for two or three years, and was admitted a partner some two years since, paying in $5,000 in cash, principally a gift from his father, who is well off.
“B” has been a clerk in the house about four years, and a good and popular one, is just admitted a partner, but does not add any capital. They continue to do a good business, are in good credit, and worthy of it32.