ViewPoint: Spotlight: The Dwindling Size of Small Business Lending and the Impact of Bank Failures

Introduction | Spotlight: Banking and Emerging Cybersecurity Risks | Spotlight: A Dodd-Frank Milestone: Enhanced Prudential Standards Adopted | Spotlight: The Dwindling Size of Small Business Lending and the Impact of Bank Failures | State of the District| National Banking Trends

Since the financial crisis, small business lending at banks has dropped significantly for a variety of reasons. On the demand side, the number of owners seeking credit has fallen to historic lows as a result of pessimism over economic conditions. Tighter lending standards and the reduction in the number of banks have had a significant impact on the level of lending. Yet another problem could be the reduction in the number of banks with community ties that provided a large amount of credit to small businesses in the past. Those banks were willing to lend to a small business owner based on the owner's knowledge of the community and a bank's pre-existing relationship with the owner. However, in situations where banks from outside the local market acquired failed banks, it is less likely for that risk to be taken. The concern about small business lending has been so great that policymakers have developed programs aimed at increasing small business lending at banks. While the programs appear to be successful, the reduction of community banks still has had an overall negative impact on lending.

Reduced demand
Growth in small business lending depends on both availability and demand. Most community banks want to lend to small businesses, but over the past few years, there have been fewer new small businesses started and less demand from existing owners. According to survey results from the National Federation of Independent Business, a significant majority of those owners have indicated that they currently don't want additional credit. Two reasons given for not seeking credit are the perception of availability and confidence in business conditions.

According to the Federal Reserve Board's Senior Loan Officer Opinion Survey, underwriting standards for small businesses tightened during the height of the crisis, as bankers pulled back a variety of lending programs and reduced their risk tolerances. However, since 2011, survey results have generally indicated that community banks have been loosening their underwriting standards for commercial and industrial (C&I) loans (see the chart). The lower standards have spurred some growth but have not overcome owners' concerns about economic conditions. Weak sales and the perceived lack of consumer demand are weighing heavily on the decision not to seek new credit. Instead of looking at expansion, small businesses are managing costs tightly in the wake of weak revenue growth.

Demand for Commercial and Industrial Loans

Tighter lending standards
Underwriting standards also play a role in the level of lending. For the past three years, a number of community banks have said that business lending is one of their key growth opportunities. Although community banks would like to increase their loan portfolio, many of those owners are unable to qualify for traditional small business loans in the current market. Following the Great Recession, banks tightened credit requirements and reduced the number of loan products that served small business needs. As a result, credit is generally most available for small business owners with good credit histories and strong financials.

In terms of underwriting, banks prefer higher-quality collateral. According to the Federal Reserve's Survey of Terms of Business Lending, in 2007 roughly 84 percent of the value of loans under $100,000 was secured by collateral. That figure increased to 90 percent in 2013. Small business financials also have generally remained weak, with cash flows and potential collateral unable support a loan.

Most small business owners use their personal assets to help support the business. They typically use a first or second lien home equity loan to secure financing to start or expand a small business. However, in the wake of the real estate crash, underwriting standards for real estate loans tightened. At the same time, as real estate prices have declined, it limited the amount that many small business owners could borrow. Small business credit scores are also lower now than before the Great Recession. So fewer small business owners have the cash flow, credit scores, or collateral needed to obtain a loan in the current environment.

Impact of bank failures
One question about the size of the small business lending that is coming up more frequently is the impact that community bank failures are having the level of lending. On a historical basis, community banks have been much more likely to approve financing for a small business than the larger institutions, the latter taking a more standardized approach to lending. On the flip side, the crisis drove small businesses to seek credit from large banks based on a perception of greater stability. Nationally, banks with assets less than $10 billion approve close to 50 percent of small business loan requests versus the mid-teen range for large banks.

Two government agencies have conducted separate studies over the past year, trying to determine if the community bank closures have negatively affected small business lending. Last summer the Government Accountability Office (GAO) completed a study that assessed the impact of community bank failures on small business lending. The GAO has found that the effects of bank failures could potentially be significant for less populated communities that had been serviced by only one bank or where only a few banks remain. In its own study, the Small Business Association found a positive correlation between bank capital and small business lending and a negative correlation between a bank's size and the amount of small business lending.

The Sixth District was hit particularly hard by the number of community bank failures. Two states in the district, Florida and Georgia, have had over 150 bank failures since 2008 (see the table). In reviewing the potential impact that bank failures had on small business lending, call report data from banks in the district was analyzed. The call report does not provide a separate line item for loans made strictly for the purpose of funding small businesses, but it has information on small business C&I and commercial real estate (CRE) loans of $1 million or less made to small businesses.

Bank Failures since 2008

In the fourth quarter 2013, banks in the Sixth District with assets less than $10 billion, had $36 billion in C&I and CRE in small business loans outstanding, a decline of 23 percent from June 30, 2007, and a 2 percent increase over the March 31, 2013, trough. By comparison, banks outside the Sixth District with assets less than $10 billion had $231 billion in C&I and CRE small business loans outstanding, a decline of 16 percent from June 30, 2007, and the trend shows these balances keep declining.

The Atlanta market had one of the highest counts of bank failures of any market in the country. At one point it was named the bank failure capital of the world. The change in level of small business lending was even more dramatic. In the fourth quarter 2013, banks in the Atlanta MSA with assets less than $10 billion had $2.9 billion in C&I and commercial real estate (CRE) in small business loans outstanding, a decline of 48 percent from June 30, 2007 (see the table).

Changes in Bank Failure Rates, 2007-13

While the community bank failures do appear to be affecting the level of lending at banks, since the crisis, other lender types have entered the market. These lenders tend to offer loans at rates higher than at banks, but they offer a less expensive alternative to cash advance companies. In addition, larger banks are becoming more aggressive about community bank lending. Wells Fargo recently announced that it has set a goal of lending $100 billion to small business owners over the next five years.

Small business lending fund
In response to concerns about small business lending at community banks, policymakers have been exploring options to encourage credit availability. One early measure that Congress made to improve credit conditions was the Small Business Jobs Act, which was signed into law on September 27, 2010. At the time, the new legislation was providing critical resources to help small businesses continue to drive the economic recovery and create jobs.

Part of the Small Business Jobs Act was the Small Business Lending Fund (SBLF) program through which Treasury Department made investments in community banks and community development loan funds with assets of less than $10 billion in exchange for Tier 1 preferred stocks. The Small Business Jobs Act defines small business lending as certain loans of up to $10 million to businesses with up to $50 million in annual revenues. Those loans include commercial and industrial loans, owner-occupied nonfarm, nonresidential real estate loans, loans to finance agricultural production, and other loans to farmers and loans secured by farmland.

Qualified institutions that have total assets of $1 billion or less could apply for SBLF funding that equals up to 5 percent of their risk-weighted assets. Banks that have assets of more than $1 billion but less than $10 billion may apply for SBLF funding that equals up to 3 percent of their risk-weighted assets. The government's intention was to encourage banks to lend to small businesses by providing them with much-needed capital.

The Treasury Department invested more than $4 billion in 332 institutions through the SBLF program, which include investments of $3.9 billion in 281 community banks. Among the states that make up the Sixth District, 56 institutions are participating in the SBLF program. The terms of the SBLF program were more favorable than those of the government programs issued under Troubled Asset Relief Program umbrella. The SBLF program removed executive compensation restrictions, did not require issuance of warrants, and quarterly dividend rates decline as banks' small business lending increases. However, four and half years after the issuance of SBLF preferred stock, the dividend rate on the capital increases to 9 percent for all banks regardless of a bank's small business lending.

Periodically, the Treasury Department provides updates on the impact the SBLF program has had on the level of small business lending. The vast majority—roughly 95 percent—report that lending has increased. As of December 31, 2013, the Treasury Department reported that small business lending increased by $1.3 million over the prior quarter and had increased by $12.5 billion over the baseline set by the level of lending as of June 30, 2010 (see the chart)

Small Business Lending Index

Looking down the road
A variety of factors have affected the level of small business lending over the past three years. Small business owners either believe they do not meet the qualifications to obtain new credit or do not want additional credit as a result of concerns about the health of the business. Tighter lending standards have reduced the level of lending from the peak years, though those standards have gradually loosened since the end of the crisis. The number of bank failures has left fewer options through which small businesses can obtain credit, but those banks are being slowly replaced by other lenders. Policymakers remain committed to expanding credit availability to small businesses. Ultimately, small business lending is affected by the overall economy, so as it continues to improve, so likely too will the level of lending.