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For Whatever Reason, Small Firms Aren’t Borrowing
YOUNGSTOWN, Ohio -- Banks lending to small businesses across the nation “has dropped substantially since the Great Recession,” the Cleveland Federal Reserve Bank reports, which is reflected in the slow recovery since 2009.
Two researchers at the Cleveland Fed, Ann Marie Wiersch and Scott Shane, explored why and noted the paradox of an increase of nearly 100,000 small businesses since the recovery began but a drop of 344,000 loans to such enterprises between 2007 and 2012 vis-à-vis loans made before the onset of the recession.
“Policymakers have become concerned that the decline in small-business lending may be hampering economic recovery,” Wiersch and Shane write in their commentary, “Why Small-Business Lending Isn’t What It Used to Be,” issued Aug. 14. “Small businesses employ roughly half of the private-sector labor force and provide more than 40% of the private sector’s contribution to gross domestic product [the economy]. If small businesses have been unable to access the credit they need, they may be underperforming, slowing economic growth and employment.”
Wiersch and Shane could not identify a leading reason. Instead they propose five causes:
- “The Demand-Side Problem.” Small businesses can’t justify borrowing because they don’t see opportunities for growth that would cause them to borrow or allow them to repay their loans.
- “Small Businesses Are Less Creditworthy than They Used to Be.” Lenders are shying away from lending to small businesses because fewer owners have the cash flow, credit scores or collateral banks want to see. The latest Wells Fargo/Gallup Small-Business Index reports only 48% described their cash flow as “good” last quarter compared to 65% in the second quarter of 2007.
- “Bank lending standards have tightened.” “Lending standards on steroids?” the authors ask. Bankers in the Mahoning and Shenango valleys The Business Journal has talked to suggest standards had been relaxed too much before the Great Recession and have returned to where they should have been all along. “Were standards too loose before [the Great Recession]?” Shane said in a telephone interview. “That’s a matter of opinion” and outside the scope of their commentary. “We’re not commenting on [where] standards should or shouldn’t be,” he said.
- Even before the Great Recession, banks were exiting the small-business market. What has occurred since simply reflects acceleration of that trend.
- Consolidation of the banking industry. “Recent declines in small-business lending also reflect longer-term trends in financial markets,” the authors write. “This realignment has led to a decline in the share of small-business loans in banks’ portfolios,” as banks find it more profitable to lend to larger businesses, credit-card holders and the construction industry, Shane said in the interview.
In addition, larger banks acquiring smaller or community banks has resulted in fewer community banks with commercial lenders more likely to lend to small businesses. “Small-business loans are less profitable,” they explain, “because they are banker-time intensive, are more difficult to automate, have higher costs to underwrite and service and are more difficult to securitize.”
The definition of a small business, Wiersch and Shane said in their interview, is elastic. Each source they consulted had it own definition that had different upper limits: $50 million in annual revenues or $20 million? 500 or fewer employees or 99 or fewer employees?
“It’s clear from the date and anecdotal evidence that banks have sufficient capital and more than enough cash on the sidelines that could be deployed to … small business lending,” the editors of Forefront, a publication of the Cleveland Fed that first reported Wiersch and Shane’s research. “At this moment, policies that aim to strengthen banks’ capacity to lend won’t help solve the problem.”
Hindering banks’ willingness to lend to small businesses, as noted, is the higher expense involved in administering loans extended to this market. Small businesses are far more diverse than larger companies and cannot go through an automated approval process. Regulators are paying far more scrutiny to banks’ portfolios, causing lending officers and credit committees to err on the side of caution.
This is reflected in the level of industrial loans of $1 million or less, “a common proxy for small-business loans,” during the second quarter, the editors of Forefront write. Second-quarter loans stood at 78.4% of where they stood the second quarter of 2007.
While banks severely tightened their lending standards since the onset of the Great Recession, Wiersch said, and relaxed them as the recovery began, the standards have been relaxed more for middle-market and large businesses than for small businesses.
Loan standards remain “stricter than before the Great Recession,” they write, and net tightening was slightly greater for small businesses in 2009 and 2010. Since then, however, the net tightening has remained for small businesses “despite a net loosening for big businesses.”
More lending is secured by collateral today than in 2007, Wiersch and Shane write. Eighty-four percent of loans of $100,000 or less were secured by collateral in 2007 versus 90% today. And 76% of loans of $100,000 to $1 million were secured by collateral six years ago compared to 80% today.
The decline in property values, especially residences, has made it harder for small-business owners to offer their homes as collateral, Wiersch and Shane note. Values in the states hardest hit by the Great Recession have rebounded but not returned to 2007 levels.
A Moody’s survey released in January 2010 showed that commercial real estate values plunged 40% on average between 2007 and 2009. Prices have recovered, the authors note, but remain 27% lower today than 2007.
Footnotes:
- A Fed survey in 2003 showed that 45% of small-business loans were secured by real estate, both commercial and residential.
- Loans guaranteed by the U.S. Small Business Administration, continue to comprise just more than 1% of all loans to small businesses. This was the case before the Great Recession, Shane said, and the number of SBA-guaranteed loans fell 17% last year.
Huntington Bank, which has consistently ranked as the top SBA lender in its Midwest markets and second or third in the United States, is an anomaly, Wiersch suggested. Few banks across the United States work as closely with the SBA as Huntington.
Wiersch, who joined the Cleveland Fed in 1999, is a policy analyst whose research has focused on small businesses and local government finance.
Shane is a visiting scholar at the Cleveland Fed and a professor of entrepreneurial studies at the Weatherhead School of Management at Case Western Reserve University.
EDITOR'S NOTE: This story appears in our September 2013 print edition.
Copyright 2013 The Business Journal, Youngstown, Ohio.
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