While there seems to be general agreement among bankers, small business owners, and policymakers that small business lending has declined substantially since before the financial crisis, there seems to be disagreement as to the culprit. Banks profit by making loans,  not refusing them and most “qualified borrowing entities” have numerous banks bidding for their business. This author states that it is because the Federal Reserve has encouraged banks to cut back on small business lending as part of an effort to get them to make better loans —  the banks made credit too easy for small business owners to get in the early 2000s.   The general view is that banks do want to and will fund deals that make sense with satisfactory underwriting of credit, financials and management.  With US bank regulators focused on the liquidity and capital position of the banking industry to protect from loss exposure and another meltdown, there is no doubt that the restrictions have lead to less small and mid-sized businesses fitting into that bankable box. This has driven these companies to seek capital from alternative commercial financing sources.

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Source: The American, May 2 2012, Scott Shane

Banks profit by making loans, not refusing them. So why are banks making fewer loans to small business these days?

On March 29, at a lecture at George Washington University, Federal Reserve Chairman Ben Bernanke innocuously remarked that lately “small businesses have … found it difficult to get credit.” Too bad that none of the students at the lecture thought to ask him why. A case can be made that the Fed is partially responsible.

Bankers, small business owners, and policymakers all agree that small business lending has declined substantially since before the financial crisis and Great Recession. Business loans under $1 million fell 13 percent between June 2007 and June 2011, and the amount lent has declined 19 percent when measured in inflation-adjusted terms, Federal Deposit Insurance Corporation (FDIC) statistics reveal.

But banks profit by making loans, not refusing them. So why are banks making fewer loans to small business these days? The decline is, in part, a response to the Federal Reserve’s incentives for banks to increase their lending standards.

[sws_pullquote_right]When bank lending standards increase, fewer companies qualify for loans, cutting small business lending. [/sws_pullquote_right] When bank lending standards increase, fewer companies qualify for loans, cutting small business lending. Small businesses that would have received loans in 2006, when lending standards were less stringent, were unable to get them in 2011, when standards had been ratcheted up. As Kansas City banker Katherine Hunter explained in a recent Federal Reserve Bank of Kansas City publication, “There are businesses that got loans five years ago that would not have today, under more traditional lending practices.”

The banks increased their lending standards because the Fed told them to stop making the kinds of risky mortgage loans that led to the financial crisis. Unfortunately, small business funding was collateral damage in the effort to get rid of bad lending practices in the home mortgage business.

Efforts to fix bad mortgage practices hit small business lending because many small business owners use home equity to finance their operations. As I have explained in an earlier column, 28 percent of small businesses tapped equity in their homes to finance their businesses at the peak of the housing boom, according to Barlow Research, a Minneapolis-based market research firm. During the housing boom, households in which someone owned a small business were more likely than other households to take out home equity lines of credit and to borrow more money on those credit lines, Federal Reserve Bank research finds. With many small business owners making use of home loans to finance their companies, the Fed’s efforts to get banks to improve their home lending standards has meant less small business borrowing.

Moreover, when banks increase their lending standards, those increases often occur across the board. Therefore, in addition to raising standards for mortgage debt, the banks tightened them on small businesses borrowing in the aftermath of the financial crisis, the Federal Reserve’s Survey of Senior Loan Officers shows.

[sws_pullquote_right]Unfortunately, small business lending was collateral damage in the effort to get rid of bad lending practices in the home mortgage business. [/sws_pullquote_right] Of course, the current situation does not mean that the Fed should push the banks to loosen their small business lending standards. We do not want to return to an era of bad mortgage lending practices. And the banks made credit too easy for small business owners to get in the early 2000s. Both directly and through ballooning housing prices, their loose lending led too many marginal businesses to get started, encouraged small business owners to paper over their business problems by borrowing money instead of addressing the causes of cash flow difficulties, and resulted in over-borrowing by many companies.

The Fed might decide that the banks need to maintain today’s higher lending standards, even if that means less small business lending than we used to have. But it should be more honest about what’s going on. Instead of implying that “small businesses have … found it difficult to get credit” because of some mysterious outside force, the Fed chairman should say that the Federal Reserve has encouraged banks to cut back on small business lending as part of an effort to get them to make better loans. Such straight talk would be consistent with the Fed’s new strategy of greater transparency about what it is doing.