The Long Drought in Small Business Lending
By: William Phelan, President and Co-Founder of PayNet Inc.
Most Americans have moved on from the financial shocks that struck our economy almost a decade ago. Millions of new jobs have been created, wages are rising and companies have repaired their balance sheets. Yet one unfortunate legacy of the 2008-10 meltdown remains: the tens of thousands of small businesses that still struggle to obtain a bank loan at reasonable cost, if at all.
A new study* by three Harvard Business School economists provides fresh insights into the pullback in small business lending, and its consequences. The researchers found that the nation’s four largest banks— Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo—not only cut back more sharply than other lenders during the recession, but also showed far less interest in regaining lost ground as the economy picked up again.
According to the Harvard study, the four banks’ advances to small businesses hovered at only half of pre-crisis levels until 2014, even as rivals pushed up their lending to almost 80% of pre-crisis levels. All in all, lending by the big four was 30% lower than other banks included in a Community Reinvestment Act database.
The lending drought has its origins in the big banks’ decision to focus on other, less risky sectors during the financial crisis. Among other drawbacks, small business loans carried higher capital requirements, and were hampered by inefficient automation of underwriting processes. Once the recession was over, the Big Four were constrained by stifling new regulations imposed by the 2010 Dodd-Frank Act and by the Federal Reserve, notably a large uptick in risk weightings for small business loans.
The pros and cons of the banks’ actions will be debated for years to come. What is beyond dispute is their painful consequences. A county-by-county examination by the Harvard researchers shows that in areas where the Big Four pulled back, business expansion slowed and job growth suffered, especially in communities where small businesses played an outsized role. Wages also grew more slowly. All these impacts were felt most strongly in sectors most dependent on outside funding.
The Harvard study acknowledges that other lenders, including an array of “shadow bank” start-ups, have largely filled the gaps left by the Big Four. Nonetheless, the cost of credit remains unusually high in the worst-affected areas and, while jobs have returned, wages continue to lag. “Our findings suggest that a large credit supply shock from a subset of lenders can have surprisingly long-lived effects on real activity”, the study concludes. It adds that “the cumulative effect of these factors could explain some of the reason why this recovery has been so weak compared to others in the post-war period”.
These findings are confirmed by the recent performance of the Thomson Reuters-PayNet small- business lending index. Apart from a brief uptick after last November’s election, lending has been stuck in the doldrums for several years. The index has fallen, year-on-year, for 12 of the past 13 months. With a shortage of credit compounded by economic and political uncertainties, many small business owners remain reluctant to invest in new plant and equipment.
We at PayNet estimate that the small business credit gap costs the U.S. economy $108 billion in “lost” output and over 400,000 jobs a year. Some firms are forced to put operations on hold for two or three months while they wait for a bank to process their credit application.
According to our count, a typical commercial and industrial loan requires 28 separate tasks by the lending bank. It involves three departments— relationship manager, credit analyst, and credit committee—and takes between two and eight weeks to complete. The cost of processing each credit application runs at $4,000 to $6,000. The result? Few banks are able to turn a profit on this business unless the loan size exceeds $500,000, which is far more than most small businesses borrow. The time, paperwork and cost involved are pushing more and more small businesses away from traditional financing sources.
We cannot allow such a key sector of our economy to fight with one hand behind its back. Lenders need to be more accepting of new kinds of financial data and fresh approaches to credit standards. Regulators must open the door to more innovative underwriting techniques and assessment processes.
A good place to start would be to examine what has gone wrong over the past decade. As the Harvard study puts it: “Going forward, it will be useful to better disentangle the causes of this shock. If regulation played an important role….then understanding the specific rules that contributed the most would be helpful from a policy perspective”.
- William Phelan is president and co-founder of PayNet Inc. He chairs the research committee of the Coalition for Responsible Business Finance, and is a member of the Chicago Federal Reserve Bank’s advisory council.
*Brian S. Chen, Samuel G. Hanson and Jeremy C. Stein, The Decline of Big-Bank Lending to Small Business: Dynamic Impacts on Local Credit and Labor Markets, http://www.hbs.edu/faculty/Pages/item.aspx?num=52458