How Banks' Reluctance To Make Small-Business Loans Is a Major Driver of Sluggish Recovery

How to start and grow companies.
Jan. 9 2012 6:59 PM

Small Companies, Big Credit Problems

How banks’ reluctance to make small-business loans is a major driver of sluggish recovery, and what to do about it.

Small business.
Small businesses suffered more than large businesses during the credit crunch of the recession

Hemera/Thinkstock.

Nobody will be surprised to learn that the past few years have been tough for small business. They’ve been tough for everyone, after all. But interesting research finalized in December from economists Burcu Duygan-Bump, Alexey Levkov, and Judit Montoriol-Garriga published by the Federal Reserve Bank of Boston indicates that the interplay of small business and the banking crisis may have played a special role in the recession. In particular, a tightening of credit standards during the high point of the fiscal crunch seems to have disproportionately impacted small firms and is continuing to hold them back during the recession.

Politicians gushing over small businesses is such a cliché that it’s easy to tune out talk of the importance of small firms. According to the Census Bureau, as of 2008-09 about one-half of all jobs were with firms with fewer than 500 employees, and one-half of those were with firms with fewer than 100 workers. Fully 10 percent of workers were employed by tiny business with fewer than 10 employees. And small-scale operations are unusual in several respects. Most notably, they don’t have access to the conventional financial-market tools of a big company. For aggressively growing startups, that means gaining the financing they need from the special world of venture capital. But for the hum-drum small businesses that make up such a large share of American economic life—the kind of firms that are trying to get by and earn a profit, but don’t necessarily aspire to world domination—that means relying on bank loans for funding needs.

By exploiting what they describe as a “triple difference-in-differences methodology which exploits variation across time, firm size, and external financing needs,” the researchers were able to highlight the importance of this bank-funding channel to the recession.

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In particular, they find that during the recession, workers were more likely to lose their jobs if they worked in a sector characterized by a high level of external finance. For a recession associated with a banking crisis, that’s not so surprising. But they also find that in those sectors, the odds of unemployment are increased if you worked for a smaller firm. This linkage between firm size and unemployment doesn’t exist in sectors with low external-financing needs. This helps us identify the special challenge faced by small business during the recession as focused on the supply of credit. Small firms did, of course, face the challenge of customers curtailing spending as aggregate demand dried up. But the specific problem that distinguished small businesses from large ones was focused in sectors with large financing needs.

Bolstering the focus on the credit channel is analysis of the previous two recessions. The economic downturn in 2001 was not accompanied by any particular problems in the banking sector, whereas the recession of 1990-91 was entangled with the savings-and-loan crisis.

The paper finds that the early-’90s recession had a similar pattern to our own, with disproportionate job losses occurring at small firms in industries with high external-financing needs. By contrast, the pattern didn’t exist following the dot-com stock bust where the results “show almost identical changes in unemployment among small and large firms in industries with high and low external financial dependence.” In the slides accompanying a talk last week focused on these themes, Boston Federal Reserve President Eric Rosengren noted that firms with fewer than 20 employees have continued steadily shedding jobs throughout the past seven quarters of economic growth. This is most likely related to credit problems. Even during good times, companies are constantly going out of business and laying people off. The economy prospers because those failures and layoffs are balanced out by new startups and new hires. But between the third quarter of 2010 and the third quarter of 2011 (we don’t have Q4 data yet), banks steadily reduced their small-business loan portfolios and the rate at which new business establishments were launched remained way below the long-term average.

In response to this problem, Rosengren argued that policymakers “can and should continue to look at ways to better target fiscal and monetary policy” to address the small-business funding gap without elaborating on what that might look like.

Probably the best idea would be to revisit the disappointing 2010 Small Business Jobs Act, which wound down last fall having spent just $4 billion out of the intended $30 billion. The program failed largely for two reasons. One is that the terms under which the money was made available to banks was arguably too onerous. The other is simply that for most of the life of the program, the economic outlook was so weak that there was little demand for loans. Today’s economy, though still in need of support, is stronger, so there may be more interest. And having already conducted the program once, both bankers and Treasury Department officials should be more familiar with how to run the process smoothly.

Another big boost could be provided by using the federal government’s authority over Fannie Mae and Freddie Mac to orchestrate large-scale refinancing of underwater mortgages. This idea has lately been in the public eye in the form of conservative critics suggesting that the Obama administration is poised to do it, but there’s little evidence it’s being seriously considered. It should be. Home-equity financing is an important source of startup capital for businesses, and this is particularly crucial for the long-term unemployed who’ll have enormous difficulty getting hired amidst a sluggish recovery.

On a more fundamental level, however, the search for targeted solutions may be misguided. The small-business credit crunch wasn’t the result of a targeted attack on small-business lending, it was a specific consequence of a generalized financial problem. Today, despite low short-term interest rates, money remains tight relative to the excess capacity in the economy. Banks have parked unprecedented amounts of excess reserves with the Federal Reserve system rather than lending them out. Any number of tools, including targeting a higher inflation rate, setting a level target for nominal gross domestic product, or simply setting a negative interest rate on those excess reserves should boost lending across the board. Generalized credit expansion would help small businesses on the demand side as well as the supply side by putting more borrowing power into the hands of consumers. Most importantly, while small businesses wouldn’t be the specific target of such broad measures, they would benefit disproportionately, just as they disproportionately suffered from the credit crunch. Easy money is no guarantee against business failure, but it does mean that successful businesses will be able to expand, and people with ideas will find it easier to get in the game. That’s what went missing during the crisis, and it’s something we’ll need to get back for the economy to fully recover.

Matthew Yglesias is the executive editor of Vox and author of The Rent Is Too Damn High.

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