Understanding the Small Business ''Credit Crunch'': Perspectives from a Fed Regulator

The financial crisis and recession have challenged many aspects of our economy over the past 18 months, including the fortunes of small businesses. Yet, history tells us that small business activity is essential to creating new jobs in our economy. And the formation and growth of small businesses depends critically on access to credit.

Businesses across the country report that credit conditions remain very difficult. In fact, the data on small loans made by banks show that outstanding loans have dropped from almost $700 billion in the second quarter of 2008 to approximately $660 billion in the first quarter of 2010.

To better understand the factors affecting small business credit conditions, the Federal Reserve held a series of more than 40 meetings across the country with small businesses, financial institutions, small business trade groups, regulators and small business support providers—including several in the Eighth Federal Reserve District. The input from those meetings suggests that there are many factors affecting small business access to credit, and that no one answer will provide the solution. What are the factors contributing to the perceived "credit crunch?"

Key Factor 1: Tightened credit standards and the procyclical effects of credit made available through automated underwriting

Data from the Federal Reserve's Senior Loan Officer Survey suggests that standards on traditional bank loans (often called "relationship-based lending") have tightened overall from where they stood a few years ago. (See chart.) Some bankers suggest that the tightening was long overdue; others suggest that some relaxation may occur as the economy improves. In any event, some borrowers are seeing the impact through additional collateral requirements, a greater focus on cash flow in analyzing creditworthiness, the requirement for more equity in the proposal or a request for personal guarantees. For some borrowers, these conditions cannot be met.

Tightening credit conditions have been seen not only in relationship-based credit; they are also revealed in the cost-efficient credit generated through automated underwriting systems used by some larger banks. These systems have emerged over the past 15 years and rely on models that are driven primarily by credit scores. Some forms of automated credit are unsecured, such as credit card lines. Other forms are supported by collateral, and frequently, by commercial real estate. Credit generated through automated underwriting mechanisms tends to be procyclical, meaning more credit is available during strong economic times, and less credit is available during periods of economic stress. If a borrower's credit score has declined, or the value of the collateral reduced, then the credit line may be reduced. Some banks using these models have introduced "second look" programs. Those denied credit under the automated system may appeal the decision such that they receive second evaluations.

Key Factor 2: Weak loan demand on the part of healthy, established businesses

Credit supply conditions are not the only contributing factor. The demand for credit on the part of healthy, established businesses is also weak. Bankers associated with healthy financial institutions indicate that they have adequate funds, or liquidity, to make loans to creditworthy businesses. However, bankers report that most applicants are seeking to renew existing loans, and there is still little in the way of new money lending for capital investment or business expansion. Businesses cite concern about economic recovery and the direction of government policies.

Key Factor 3: Bank health

While healthy financial institutions generally have adequate funds for lending, those institutions in weaker financial condition face capital constraints, human resource constraints, and concern about regulatory reaction to expanded lending. Presently, 829 of approximately 7,800 financial institutions are on the FDIC's problem bank list. In general, these institutions are experiencing severe asset quality problems. The losses associated with problem assets have impacted capital.1 To maintain regulatory minimum or even higher required ratios, these institutions may attempt to raise new equity capital. Often, though, investors are unwilling or unable to accept the risk of the investment. Thus, the institution's alternative course of action is to shrink assets, either through the sale of assets, sale of branches, or lack of renewal of maturing loans.

These institutions typically face human resource constraints, as well. Substantially more employee time is deployed in working with troubled borrowers, making less time available for marketing and extending new credit. In today's environment, many of these same institutions are actively attempting to reduce concentrations in commercial real estate loans. Such risk reduction efforts can detract from the ability to extend new credit.

Finally, institutions in troubled condition face heightened regulatory review standards. Typically, the financial health of the institution is examined twice each year. Understandably, the institution's board of directors and management become increasingly reluctant to take on additional risk because of the fear of regulatory criticism. To mitigate unfounded concerns, regulators have issued guidance to examiners in the areas of small business lending and commercial real estate loan workouts.

Key Factor 4: Size and limitations of Small Business Administration programs

Some borrowers unable to qualify for bank credit may qualify for credit under programs sponsored by the Small Business Administration (SBA), and in particular, the loan guarantee programs. These programs are designed to help small entrepreneurs start or expand their businesses. Loans are originated through bank and nonbank lenders, and the SBA guarantees a specified portion of the loan. Some lenders also use the 504 Fixed Asset Financing Program, while a few use the SBA's Microloan Program. The latter program is made available through nonprofit, microloan intermediaries.

This second "tier" of credit has been important for small businesses in recent months. SBA lending has been stimulated through special funding allocations, an increase in guarantee authority and fee waivers—all of which have helped lenders make loans that otherwise might not have been funded. Not unexpectedly, as temporary supports are discontinued, the volume of new loans also declines.

Banks see opportunity for streamlined and faster SBA loan processing, an SBA guarantee program for loan refinance that no longer meets bank criteria and packaging assistance for the 7(a) program, similar to what is available for the 504 program. Some banking organizations believe more borrowers would qualify for SBA programs if they had access to technical assistance to aid them in development of such critical documents as business plans and cash-flow analyses.

Key Factor 5: Credit gaps for those not meeting bank or SBA criteria

For small businesses not meeting the traditional criteria of banks or the SBA, other alternatives are limited. Community Development Financial Institutions (CDFIs), which provide credit and financial services to the most distressed communities, provide one possible loan source to fill this gap. Credit unions have also met some of the need. Other specialty lenders, such as venture capital funds, are typically less accessible to the "Main Street" small business because of the relative sophistication required to draw the interest of these funds. In many cases, these very small and often new businesses have turned to personal unsecured resources, such as family and friends, home equity lines of credit and credit card lines. Employment, housing and credit conditions have reduced these already limited sources.

So, where do we go from here?

While many conclusions can be drawn from the information gathered at these 40-plus meetings, I would offer a few personal observations:

1. In general, healthy banks have funds to lend and sufficient capital to support new lending. Creditworthy borrowers unable to obtain credit from their current banks may wish to consider other bank alternatives.
2. If the borrower cannot meet bank credit standards, financing through the Small Business Administration could be considered. Many, but not all, banks are able to facilitate this financing, and sometimes, the borrower will need technical assistance from small business support providers to meet the credit documentation standards. More can be done to encourage banks to engage in small business lending and to form partnerships with small business support groups. Ongoing funding of the SBA and small business support groups will be critical to long-term success.
3. Some borrowers, especially very small businesses, may not qualify for either bank or SBA credit. These borrowers have typically relied on family and friends, credit card lines and home equity lines of credit because of the riskiness of their business operations. Such funding sources have undoubtedly shrunk over the past few years.

This credit gap may be the most difficult to fill, and a public policy decision on stimulus for this sector may be necessary. Sam's Club's program, which is bringing credit to small businesses through the indirect use of an SBA pilot program, is one example of an innovative effort to disperse credit. (See related article.) However, this program is capped, and any major expansion would require additional funding.

Small businesses face constraints on their access to credit. The Fed's outreach sessions have made it clear the issue is complex and multifaceted. Consequently, it will take innovative approaches and must be attacked from many angles. The entrepreneurial spirit, which is indicative of most small businesspersons, is going to be critical for those entities to come up with solutions—whether private or public, for profit or nonprofit, or a consortium of parties working in concert—to provide credit.

Endnotes

1. When a bank experiences severe asset quality problems, regulators may require higher levels of capital to absorb the additional risk on the balance sheet.