Editor's note: This is the second in a series of articles based on a Harvard Business School working paper by Karen Mills that analyzes the current state of availability of bank capital for small business.
During the 2008 financial crisis, small businesses were hampered in securing bank credit because of a perfect storm of their falling sales and weakened collateral, and growing risk aversion among lenders. Those days are not over. While lingering cyclical factors from the crisis may still be constraining access to bank credit, there are also structural barriers that seem to be preventing banks, both large and small, from ever fully returning to the small business market.
Cyclical Factors Linger From The Recession
In the recent recession small-business sales were hit hard and may still be soft, undermining their demand for loan capital. Income of the typical household headed by a self-employed person declined 19 percent in real terms between 2007 and 2010, according to the Federal Reserve's Survey of Consumer Finances. And a survey by the National Federation of Independent Businesses (NFIB) noted that small businesses reported sales as their number one problem for four straight years during the crisis and subsequent recovery.
In addition, collateral owned by small businesses lost value during the financial crisis, potentially making small business borrowers less creditworthy today—in fact, small business credit scores are lower now than before the Great Recession. The Federal Reserve's 2003 Survey of Small Business Finances indicated that the average PAYDEX score of those surveyed was 53.4. By contrast, the 2011 NFIB Annual Small Business Finance Survey indicated that the average small company surveyed had a PAYDEX score of 44.7. Moreover, the values of both commercial and residential real estate, which represent two-thirds of the assets of small-business owners and are often used as collateral for small-business loans, were decimated during the financial crisis.
On the supply side, banks remain more risk averse in the recovery then they were prior to the recession. Measures of tightening on loan terms, including the Federal Reserve Senior Loan Officer Survey, for small businesses increased at double-digit rates during the recession and recovery, and have eased at just single-digit rates over the past several quarters. Loosening has been much slower and more tentative for small firms than for large firms.
Regarding points of access to capital, community banks have long been crucial to small business lending. But community bank failures have been high and few new ones have started up. Troubled and failed banks reached levels not seen since the Great Depression during the financial crisis of 2008, with the failures consisting mostly of community banks. This environment—where troubled local banks appear unable to meet re-emerging small firm credit needs—would be an ideal market for new banks, but new charters are down to a trickle. In fact, a year recently went by with no new bank charters issued by the Federal Deposit Insurance Corporation (FDIC), the first time that happened in the agency's 80-year history.
Perhaps the most compelling cyclical factor tightening the loan spigot is the concern that increased regulatory requirements may be hurting small-business lending. Banks have been raising their capital reserves to comply with new standards initiated by risk-averse bank examiners and other regulators post-crisis. They are also hoarding deposits, which undermines their ability to underwrite small-business loans.
Federal Reserve economists have recently modeled that increasing regulatory burdens are forcing banks to hire additional full-time employees focused on oversight and enforcement, which can hurt the return on assets of some community banks by as much as 40 basis points. Other studies have found that an elevated level of supervisory stringency during the most recent recession is likely to have a statistically significant impact on total loans and loan capacity for several years—approximately 20 quarters—after the onset of the tighter supervisory standards.
Structural Barriers Continue To Depress Bank Lending
Structural barriers also appear to be impeding bank lending to small businesses, including consolidation within the banking industry, high search costs, and higher transaction costs associated with small business lending.
A decades-long trend toward consolidation of banking assets into fewer institutions is eliminating a key source of capital for small firms. Community banks are being consolidated by big banks, with the number of community banks falling to less than 7,000 today, down from over 14,000 in the mid-1980s, while average bank assets continues to rise. This trend was exacerbated by the financial crisis. The top 106 banks with greater than $10 billion in assets held 80 percent of the nation's $14 trillion in financial assets in 2012, up from 116 firms with 69 percent of $13 trillion in assets in 2007.
Additionally, search costs in small-business lending are high for both borrowers and lenders. It is difficult for qualified borrowers to find willing lenders, and vice versa. Federal Reserve research finds that small-business borrowers can spend almost 25 hours on paperwork for bank loans, and often apply to multiple banks. Successful applicants wait weeks or, in some cases, a month or more for the funds to actually be approved and made available. Some banks are even refusing to lend to businesses within particular industries (for example, restaurants) or below revenue thresholds of $2 million.
Perhaps most important, small-business loans, often defined as business loans below $1 million, are considerably less profitable than large business loans for several reasons, including:
- Small-business lending is riskier than large-business lending. Small businesses are much more sensitive to swings in the economy, have higher failure rates, and fewer assets to collateralize.
- Assessing creditworthiness of small businesses can be difficult due to information asymmetry. Little, if any, public information exists about the performance of most small businesses because they rarely issue publicly traded equity or debt securities. Many small businesses also lack detailed balance sheets, use sparse tax returns, and keep inadequate income statements. Community banks have traditionally placed greater emphasis on relationships with borrowers in their underwriting processes, but these relationships are expensive and have not in the past translated well to automated methods for assessing creditworthiness, which are favored by larger banks.
- Costs of underwriting small-business lending are also high due to heterogeneity of small businesses and the lack of a secondary market. Heterogeneity of small firms, together with widely varying uses of borrowed funds, have impeded development of general standards for assessing applicants for small business loans and have increased costs of evaluating such loans. Moreover, the heterogeneity of small business loans has made it difficult to securitize and sell pools of small business loans in the secondary market.
- Transaction costs to process a $100,000 loan are comparable to a $1 million loan, but with less profit. As a result, banks are less likely to engage in lending at the smallest dollar level. Some banks, particularly larger banks, have significantly reduced or eliminated loans below a certain threshold, typically $100,000 or $250,000, or simply will not lend to small businesses with revenue of less than $2 million, as a way to limit time-consuming applications from small businesses. This is problematic as over half of small businesses surveyed are seeking loans of under $100,000, leaving a critical gap in the small business loan market. Often times, the biggest banks refer small businesses below such revenue thresholds or seeking such low dollar loans to their small business credit card products, which earn higher yields.
As the economy enters the final stages of the cyclical recovery from the recession, it appears unlikely that all the barriers to bank lending to small business will disappear. The structural issues of higher risk, search, and transaction costs appear to be here to stay—unless banks themselves, or more nimble new competitors, use technology to tackle these challenges.
In the next post in our series, Mills will explore efforts by the federal government to incentivize and increase small business lending during the recession and recovery.