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Tuesday, February 14, 2012

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Home > Bank Resources > Bank Resources Publications > SRC Insights > 2010 > First Quarter

SRC Insights: First Quarter 2010

Supervision Spotlight on Small Business Lending Conditions

by Michael E. Collins, Executive Vice President

The effect of the financial crisis and economic recession on small businesses remains a prominent concern for 2010. Small firms have traditionally played an important role in spurring new job growth and stimulating broader economic recovery, and community and regional banks continue to serve as the primary financial intermediary for their credit needs. The focus on credit availability for small businesses has heightened in recent months, and this issue has been addressed in several policy responses intended to rejuvenate lending activity. As a recent GAO report indicated, "due to turmoil in U.S. credit markets, many lenders have been reluctant to offer conventional loans-that is, loans not guaranteed by the federal government-to small businesses to finance their operations and capital needs."¹

The Importance of Small Businesses

Small businesses play an important role in the economy. More than 99 percent of all U.S. employers are classified as "small businesses," and, as a group, small businesses employ about half of all private sector workers. Research indicates that small firms, defined as those with 1 to 499 employees, create about 64 percent of new jobs. During the 2001 recession, the very small businesses, those with 19 or fewer employees, lost fewer jobs and recovered faster than their larger counterparts.² In contrast, during the current recession, there has been more job loss on a percentage basis at smaller firms than at larger firms. This could indicate that small businesses have been hit particularly hard during this broad-based credit crunch.

Credit Conditions

The National Federation of Independent Business's monthly survey of small business economic trends reveals that obtaining loans is still a challenge for prospective borrowers, as a net 15 percent reported loans harder to get than in their last attempt. The report suggests that "many potentially good borrowers are simply on the sidelines, waiting for a good reason to make capital outlays and order inventory and take out the usual loans used to support these activities."³

Analysis of ratios derived from the Federal Reserve's flow of funds data indicates that small businesses have accumulated greater debt relative to net worth than large businesses. It is also known that small businesses have been relying more on credit cards to fund operations, in part because traditional lending sources contracted, and house price declines curtailed the funds available under home equity lines of credit.

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Influences on Credit Availability

History shows that the economic cycle exerts influence on lending in the banking industry. Credit cycles and contractions and expansions in the availability of credit have been an inherent part of banking, largely due to the ways banks compete for borrowers. During good times, both borrowers and lenders are confident, and perhaps sometimes overconfident, about investment projects and the borrower's ability to repay. Credit tends to flow freely during these periods, with affordable rates and relaxed terms. As lender and borrower sentiment shifts, often preceding the actual recession, credit availability contracts, and loan growth slows. In fact, during the most recent recession, the speed with and extent to which total loan growth turned sharply negative was unprecedented.

Several factors influence the availability of credit and outstanding loans. On the supply side, we are seeing self-corrective actions to strengthen underwriting and reduce exposures. There is a greater tendency toward conservatism and tightening of credit standards as banks experience higher levels of nonperforming loans, increased provisions for loan losses, and declining collateral values. The Federal Reserve's January 2010 senior loan officer survey indicated that "commercial banks generally ceased tightening standards on many loan types in the fourth quarter of last year but have yet to unwind the considerable tightening that has occurred over the past two years."⁴

Compounding the reduced supply, borrowers generally demand less credit, as expansion plans are put on hold, business activity slows, and cash flows tighten. Third District bankers contacted for the Beige Book have indicated that "lending activity has been soft in nearly all major consumer and business credit categories, mainly due to slack demand."⁵ Looking ahead, they see loan growth starting around mid-year as the economy recovers and loan demand picks up.

The Role of Community and Regional Banks

It is apparent that community and regional banks continue to be an important source of strength for the financial system and serve as the primary lender to small businesses. Their emphasis on personal service and relationship banking is highly sought after by small businesses. In Congressional testimony, Jon D. Greenlee, associate director, Division of Banking Supervision and Regulation at the Board of Governors, noted that "small businesses rely on banks for 90 percent of their financing needs, compared to large businesses, which use banks for only 30 percent of their financing."⁶

A review of data from the FDIC call reports as of June 2009 shows that banks with less than $10 billion in assets make a greater proportion of their business loans to small businesses than do larger banks. Over half of business loans made by banks with assets of less than $1 billion are small business loans, while about one-third of business loans made by mid-size banks with assets between $1 and $10 billion are small business loans.

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Furthermore, U.S. Department of the Treasury reports show that the 22 largest banks that received TARP Capital Purchase Program (CPP) funds have decreased their small business portfolios. According to the Treasury data, these banks reduced small business loans outstanding by approximately $1 billion in November 2009, the seventh consecutive month of declines.

Third District banks continue to keep small business credit flowing, albeit at a slightly slower pace than in previous years. Anecdotal evidence obtained from bankers suggests that tightened credit and underwriting policies are commonplace. They generally report higher scoring cutoffs, tighter advance rates on collateral, and more conservative cash flow calculations. Bankers are often heard lamenting that demand is down, and creditworthy borrowers are harder to find.

Third District small businesses continue to seek out community and regional banks for financing needs. For the year ended June 2009, the latest period for which these data are available, small and mid-size commercial banks in the District increased their outstanding loans to small businesses by $1.7 billion, while banks with more than $10 billion in assets reported declines in small business loans outstanding of $438 million.

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Pressure on some community banks is inhibiting their ability to lend to small businesses. Dennis Lockhart, the president of the Federal Reserve Bank of Atlanta, noted in a November 2009 speech that "small firms' reliance on banks with heavy commercial real estate (CRE) exposure is substantial. Banks with the highest CRE exposure (CRE loan books that are more than three times their tier 1 capital) account for almost 40 percent of all small business loans."⁷ The economy's emergence from recession may be slowed if a negative feedback loop emerges under which small banks with disproportionately high CRE exposures reign in small business lending, hampering their capability to add employees, making obtaining tenants challenging, and placing further pressure on CRE.

Small Business Administration (SBA) Loans

The SBA lending programs enable participating financial institutions to make loans to small businesses while mitigating some of the risks. SBA lending volumes at both the local and national level declined throughout fiscal years 2008 and 2009, but rose recently due to program incentives associated with stimulus measures.

At the national level, the SBA's main 7(a) program backed 37 percent more loans in the latest quarter compared with the similar period one year ago.

Recently, small businesses have been benefitting from lower fees for SBA loans and increased credit availability. The Philadelphia SBA District Office reported that businesses in the Philadelphia five-county region saved more than $3 million in fees on loans issued in the first fiscal quarter of 2010. A comparison of the first quarter fiscal year of 2009 versus 2010 shows that Pennsylvania, Delaware, and New Jersey all experienced double-digit growth in SBA volumes.

Balanced Response by Regulators

Examiners are urging banks to make prudent decisions and continue lending to creditworthy borrowers. They are also encouraging banks to work constructively with customers who are having difficulty servicing loans.

Research conducted on previous credit crunches shows that while examiners sometimes depart from standards that they set during the previous phases of the cycle, this bias is not widespread or systematic. Research "provides modest support that supervisors got tougher on banks during the credit crunch period of 1989—92. However, all of the measured effects are small, with 1% or less of loans receiving harsher or easier classification, about 3% of banks receiving better or worse CAMEL ratings, and bank lending being changed by 1% or less of assets."⁸ This and other studies suggest fairly small results in terms of economic significance.

The federal bank regulators have taken steps to help promote appropriate bank lending. In November 2008, interagency guidance was issued to encourage banks to meet the needs of creditworthy borrowers. The guidance urged banks to lend in a responsible manner consistent with safety and soundness, by taking a balanced approach in assessing a borrower's ability to repay and making realistic assessments of collateral valuations. Federal Reserve examiners have been directed to be mindful of the pro-cyclical effects of excessive credit tightening and to encourage banks to continue making economically viable loans.

Given the current economic and business climates, the challenge for bank supervisors is to apply examination guidance prudently, without being punitive. Most importantly, regulators must ensure that supervisory practices appropriately constrain risk-taking at financially weak institutions without impeding stronger institutions' extensions of credit to viable small businesses as these firms prepare for the eventual economic recovery.

Policy Response

The Term Asset-Backed Securities Loan Facility, or TALF, facilitates the ability of lenders to originate new small business loans by providing confidence that secondary markets have ready buyers for those loans. The Federal Reserve and the Treasury created the TALF to help market participants meet the credit needs of households and small businesses by supporting the issuance of asset-backed securities (ABS) collateralized by various loan types, including loans guaranteed by the SBA. As the program matured throughout 2009, the volume of securitized small business loans rose sharply.

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The American Recovery and Reinvestment Act of 2009 (Recovery Act) was signed into law on February 17, 2009. In part, it provided tax incentives and financing opportunities to help small businesses create jobs. Importantly, the Recovery Act provided the SBA with specific tools to make it easier and less expensive for small businesses to get loans, gave lenders new incentives to make more small business loans, and included provisions to boost liquidity and help unfreeze the secondary markets.

The America's Recovery Capital (ARC) loan program, a new SBA program formed under the Recovery Act and launched in June 2009, offers participating banks a 100 percent guarantee on loans made to viable but struggling businesses. Given the full guarantee, the SBA's eligibility guidelines are very restrictive. Among the main qualifications, firms must have been in business for at least two years, must have reported positive cash flow in one of the last two years, and must be able to demonstrate severe financial hardship in revenue streams. Finding stressed businesses that meet the borrowing qualifications has proved somewhat problematic. Nonetheless, ARC loans are being originated. By January, 2010, nearly 5,200 ARC loans had been approved, with a total value of $167 million, representing 65 percent of the $255 million of appropriated funds. Interestingly, the volume of ARC loans in Delaware and New Jersey has been relatively low in comparison to other states.

In November 2009, the White House announced a series of initiatives to stimulate small business lending. These include providing lower cost capital to banks to increase small business lending; making lower cost capital available to community development financial institutions; increasing the maximum size of SBA loans; and convening a Treasury-SBA lending conference to work with regulators, lenders, and Congress to ensure that credit is readily available to small businesses.

Recently, the administration proposed legislation that will use $30 billion from TARP repayments to create a new separate program designed to provide capital to small and community banks. The proposal includes a carefully-designed incentive structure that improves the terms of the capital as a small bank expands lending to small business.

Conclusion

Regionally, small business owners are cautiously optimistic. TD Bank asked small business owners across the Northeast, Mid-Atlantic, and Southeast regions how they think 2010 will compare to 2009. "Eighty-seven percent of small business owners felt their business performance will remain the same or improve during 2010. A remarkable 92 percent of small business owners are considering proactive strategies to prepare for an economic upswing, with 36 percent expecting to see their business grow in 2010."⁹

Despite recent signs of economic improvement, considerable challenges remain for small business owners in 2010. An August 2009 survey completed by the City Business Journals revealed that the U.S. economy — and not necessarily credit availability — topped small business owner concerns. Close behind was the rising cost of doing business. Furthermore, only 52 percent of those surveyed had a positive outlook about future business prospects. Clearly, demand for credit may remain soft in the near-term, as nationwide many small business owners remain apprehensive and lack the confidence needed to put plans for expanding or hiring into action.

The tepid optimism about the economy is also reflected in the National Federation of Independent Business's Index of Small Business Optimism. The NFIB Index lost 0.8 points in November 2009, falling to 88.3. It was the sixth quarter that the index was below 90 during this recession. In comparison, the index was below 90 in only one quarter during the 1980—82 recession period, and it quickly surged to a record high level in early 1983.

As we transition from recession to recovery, small businesses will again assume their prominent role in the economy, and banks will continue to be the providers of credit that drive the growth.

• ¹   GAO report, available online.
• ²   Helfand, Jessica; Sadeghi, Akbar; and Talan, David; "Employment Dynamics: Small and Large Firms over the Business Cycle," Monthly Labor Review , March 2007.
• ³   Dunkelberg, William C. and Wade, Holly, Small Business Economic Trends , NFIB, December 2009.
• ⁴   The January 2010 Senior Loan Officer Opinion Survey on Bank Lending Practices.
• ⁵   Summary of Commentary on Current Economic Conditions by Federal Reserve District (Beige Book) , January 2010.
• ⁶   Greenlee, Jon D., Small Business Lending Testimony Before the Subcommittee on Oversight and Investigations, Committee on Financial Services, U.S. House Of Representatives , Southfield, Michigan, November 30, 2009.
• ⁷   Lockhart, Dennis P., "Economic Recovery, Small Business, and the Challenge of Commercial Real Estate ," speech given at Urban Land Institute's Emerging Trends in Real Estate Conference, Atlanta, Georgia, November 10, 2009.
• ⁸   Berger, Allen N.; Kyle, Margaret K.; and Scalise Joseph M.; "Did U.S. Bank Supervisors Get Tougher During the Credit Crunch? Did They Get Easier During the Banking Boom? Did It Matter to Bank Lending?"
• ⁹   "TD Bank Small Business Survey Reveals Optimism Despite Negative Impact of U.S. Recession"