Untangling the complex story of small business credit availability

A few things seemed fairly clear. For one, small business lending remained near record low levels throughout 2010. According to the December issue of the Atlanta Fed's monthly Small Business Trends report, the volume of small business loans outstanding in the Southeast fell in each successive quarter of 2010. Late in the year, the level was less than it was six years earlier. To be sure, credit contraction was hardly isolated to the Southeast: in 2009, total credit market borrowing in the United States fell by $634 billion, only the second such decline since World War II, before it picked up slightly in 2010, according to Atlanta Fed research.

It appeared that not many small firms actually sought credit. Less than a third of small businesses in a National Federation of Independent Business survey reported borrowing on a regular basis during the third quarter, "not surprising given the persistent emphasis on cost cutting and the curtailment in capital expenditures," according to Small Business Trends. "Borrowing that does occur tends to be for the purpose of smoothing cash flow rather than for funding expansion or hiring."

Small construction and real estate companies, in particular, had difficulty securing credit. On average, more of those businesses than small firms in other industries sought credit, according to an Atlanta Fed survey conducted in late 2010.

On the flip side, small business sentiment might be improving. The number of discouraged borrowers—that is, the percentage of small companies that did not borrow only because they expected denial or unfavorable terms—declined in the second half of 2010. Furthermore, just 17 percent of small firms applying for credit said they received none of the financing they requested.

Most of the Atlanta Fed survey information came from established small companies. But capital to start businesses—notably, personal wealth—also continued to dwindle during 2010. As commercial banks traditionally do not offer high-risk seed financing, entrepreneurs commonly turn to friends and family, credit cards, and their own wallets. Research presented at an Atlanta Fed conference noted that plummeting home values across the United States have not only eroded individual wealth, but also limited access to home equity lines of credit, sapping a key source of startup funding. American homeowners' equity in real estate at the end of the third quarter of 2010 totaled $6.4 trillion, 52 percent lower than at the end of 2005, according to the Federal Reserve's Flow of Funds Accounts of the United States. Meanwhile, American households' combined net worth was $54.9 trillion at September 30, 2010, down more than $10 trillion from the peak in 2007.

With traditional seed capital sources blocked, when entrepreneurs turned to commercial banks, the results were not always good. Small firms that historically relied on personal credit, including credit cards and home equity lines, were "much more likely (than other companies) to receive no financing" during the third quarter of 2010, according to the Atlanta Fed's Small Business Survey.

All things considered, it appeared both sides of the small business credit debate were right, Bowling pointed out. Credit supply decreased, as many banks instituted more restrictive lending criteria and shrank their loan portfolios. Small companies also demanded less credit. Fewer qualified to borrow under stricter lending policies, and creditworthy firms were generally not keen to assume debt in an uncertain economy, or they chose not to borrow because they didn't like the terms banks offered.

These are important concerns. Bank financing is vital to small companies because they typically cannot access the corporate credit markets open to large firms via vehicles such as corporate bonds and commercial paper.

When small businesses borrow, what do they do with the money? Atlanta Fed survey respondents on average said credit availability most affected whether they diversify operations by, for example, introducing new products or expanding into new geographic markets. In a late 2010 survey, 108 firms—about a third of firms responding—indicated that credit substantially influences whether they hire or rehire employees.

Money isn't the only issue facing small businesses

Important as it is, financing is but one issue facing small businesses. Unlike larger corporations, most small firms do not enjoy a financial cushion to withstand a temporary downturn in business, nor the option to turn to global markets if growth opportunities at home are limited. Moreover, startup companies, an important class of small businesses, are less likely to form when financing is scarce. That matters not just to individual small businesspeople, but also to the U.S. economy at large.

That's because start-up businesses are job creators. Over the past 20 years, start-up companies less than two years old generated about one of four gross new jobs, Fed Chairman Ben Bernanke said in a July 2010 speech. Though these companies are small employers overall—they employ less than 10 percent of the nation's workforce—based on their size, they are responsible for a disproportionate share of new jobs.

"If small and, importantly, young firms are a significant jobs engine and they are not growing, then it means a slower recovery," said Atlanta Fed senior economist Paula Tkac.

Not surprisingly, start-up activity appeared to stall during the recession. In developed countries generally, the formation of incorporated companies showed zero growth in 2008 and declined 10 percent in 2009, according to research presented at an Atlanta Fed conference. Other research from the conference indicated a significant rise in the number of "entrepreneurs of necessity" at the same time. These entrepreneurs of necessity are people who start working for themselves in an informal, unincorporated capacity and generally do not hire employees. Metropolitan areas with high unemployment saw more of these entrepreneurs than did other areas, according to a research paper presented at the conference.

How do we square those perhaps contradictory findings? It is not entirely clear what they ultimately mean for the recovery of the regional and national economies, Atlanta Fed research economist John Robertson observed in the Atlanta Fed's macroblog. For example, researchers do not know how quickly or how often new one-person businesses start hiring other people, nor how fast those enterprises tend to grow. It is an area that warrants additional study, Robertson noted.

Bank financing is vital to small companies because they typically cannot access the corporate credit markets open to large firms.