Executive Summary

Section 2227 of the Economic Growth and Regulatory Paperwork Reduction Act of 1996 requires that, every five years, the Board of Governors of the Federal Reserve System submit a report to the Congress detailing the extent of small business lending by all creditors. The act specifies that the study should identify factors that give policymakers insight into the small business credit market, including the demand for credit by small businesses, the availability of credit, the range of credit options available, the types of credit products used, the credit needs of small businesses, the risks of lending to small businesses, and any other factors that the Board deems appropriate.¹

Between 2007 and 2012, the years covered by this report, financial markets experienced extraordinary stresses. Conditions in financial markets began deteriorating in 2007 and worsened dramatically in the fall of 2008. As the financial crisis intensified, the U.S. economy entered a recession. The financial crisis and the recession negatively affected credit flows to businesses for several reasons, including tight lending conditions that restricted the supply of credit by financial institutions, reduced investment opportunities that depressed the demand for funds by businesses, and the deterioration of the financial health of potential borrowers. Since the recession ended in the second quarter of 2009, overall lending conditions and credit flows have improved for businesses, but improvement has been slower for small businesses.

The concerns of the Congress and other policymaking bodies about small business financing largely stem from the perception that small firms have more difficulty gaining access to credit sources than do large businesses or other types of borrowers. The source of this difficulty may be that lending to small businesses is generally considered riskier and more costly than lending to larger firms. Compared with larger firms, small businesses are much more sensitive to swings in the economy and have a much higher failure rate. In addition, lenders historically have had difficulty determining the creditworthiness of applicants for some small business loans. The heterogeneity across small firms, together with widely varying uses of borrowed funds, has impeded the development of general standards for assessing applications for small business loans and has made evaluating such loans relatively expensive. Lending to small businesses is further complicated by the "informational opacity" of many such firms. Little, if any, public information exists about the performance of most small businesses because they rarely have publicly traded equity or debt securities. Many small businesses also lack detailed balance sheets and other financial information often used by lenders in making underwriting decisions.

Up-to-date and comprehensive information about the universe of small businesses is sparse, and most evidence about financing needs and sources is derived from surveys. In response to the financial crisis and ensuing economic turmoil, the National Federation of Independent Business (NFIB) sponsored surveys in 2009, 2010, and 2011 to gauge the credit access of small firms during this period.² The surveys show that, among small businesses, larger firms were more likely than smaller firms to use traditional sources of credit such as lines of credit and business term loans, and declines in usage between 2009 and 2011 were strongest for the smallest firms. However, whether this pattern reflects a greater need for credit at larger firms or whether lenders are simply more willing to extend credit to larger firms is unclear. The relationship between firm age and credit use is similar to the relationship between size and use, with declines in usage between 2009 and 2011 being most apparent for the youngest firms.

In addition to traditional sources of credit, many small businesses rely on alternative means of financing, including credit cards and trade credit. These widely used alternative forms of credit may be important both in financing small businesses and, as substitute products, in influencing the demand for traditional credit by small firms. According to the NFIB surveys, just under 60 percent of small firms used a credit line or business loan in each year, but nearly 90 percent used a credit card or trade credit. Although the vast majority of small firms used credit cards or trade credit, a large percentage of these firms paid their outstanding balances on time, suggesting that much of the use of these products was for convenience rather than for longer-term financing of expenses.

In some cases, small businesses may have wanted to use more credit than was reflected in the survey, but were unable to obtain it. According to the NFIB surveys, one-half of small businesses applied for some type of credit in 2009, and just over one-half of these applicants were successful in obtaining all or most of the credit for which they applied.³ The application rate in 2010 was similar to that in 2009, but the approval rate increased, with nearly two-thirds of firms obtaining all or most of the credit for which they applied. In 2011, the fraction of firms applying for credit increased more than 8 percentage points over 2010, but success rates declined to a level similar to that observed in 2009.

Besides the firms that were denied credit, some firms that may have wanted additional credit may not have applied for it because they anticipated that their applications would be denied. The NFIB surveys asked respondents whether they had forgone applying for needed credit because of the expectation of denial. The data indicate that there may have been a large number of "discouraged borrowers" over this period; in 2009, more than one-third of the sample reported having forgone applying for credit for this reason. While this fraction declined a bit over time, it remained at about 30 percent in 2011, a level that seems elevated relative to earlier periods.

Overall, credit use by small business has declined in recent years. This decline is likely due to a combination of several supply and demand factors. First, the demand for credit started to decrease in late 2006, plummeted in 2008, and has only recovered partially since then. Second, credit generally became less available as banks tightened their standards. Finally, small businesses' financial health and their ability to pay their bills in a timely fashion have generally deteriorated over this time, making it more difficult to borrow, even if the firms desired to do so.

Small businesses obtain credit from a wide range of sources, including commercial banks, savings institutions, finance companies, nonfinancial firms, and individuals such as a family member or a friend. According to the 2003 Survey of Small Business Finances, depository institutions, which include commercial banks, savings institutions, and credit unions, supplied credit to more than three-fourths of the businesses that reported having outstanding credit.⁴ Nondepositories, which include both financial and nonfinancial firms, provided credit to about one-third of small businesses in 2003. More-current data suggest the continued importance of commercial banks as providers of credit to small businesses in recent years.

Because banks are the leading source of credit to small business, much attention has been paid to developments in banking that may influence credit availability. The substantial consolidation of the banking industry over the past 25 years is one such development. Mergers and acquisitions have dramatically reduced the number of banks, thereby increasing the importance of large institutions and the concentration of industry assets. These changes to the structure of the industry have raised concerns about possible reductions in the availability of credit to small businesses because large banks tend to be proportionately less committed than smaller banks to small business lending.

The evidence suggests that small banks continue to account for a meaningful share of small business lending activity--measured by holdings of business loans equal to or less than $1 million (small) and equal to or less than $100,000 (microloans).⁵ In 2011, banks with assets of $250 million or less accounted for 66.8 percent of all banking organizations but only 4.0 percent of all banking assets. However, they held 13.7 percent of all small business loans and 13.9 percent of business microloans. In addition, the results of studies that directly analyze the relationship between consolidation activity and the availability of credit to small businesses tend to suggest that although mergers and acquisitions may sever existing bank-firm relationships and may introduce some short-term uncertainty, overall they have not reduced credit availability to small businesses. After a merger, any reduction in small business lending by the newly consolidated bank is generally offset by an increase in small business lending by other banks.

The relevant market for many small business loans remains local. The structure of the local banking market is particularly important because changes in concentration could affect the level of competition for small business lending, which, in turn, could influence the cost of borrowing and the quantity of credit demanded. The data show that despite the significant amount of consolidation in the banking industry, local banking markets do not appear to have become less competitive. Generally, in rural, micropolitan, and metropolitan statistical area markets, the number of banks and offices has remained constant or increased somewhat, whereas the Herfindahl-Hirschman Indexes have either remained constant or decreased somewhat. Modest deconcentration, in conjunction with a small increase in the number of banks, suggests that a reduction in competition from commercial banking organizations is not likely to have been a contributing factor in the decline in the availability of credit in recent years.

Savings institutions, defined as savings banks and savings and loan associations, provide much less credit to small businesses than do commercial banks. As of June 30, 2011, the value of small business loans held by savings institutions was slightly more than one-tenth of the value held by banks. The differences between the lending volumes of the two groups reflect both differences in the number of institutions (1,057 savings institutions versus 5,670 commercial banking organizations) and differences in their business models.

Credit unions, which are not-for-profit financial cooperatives that are owned and controlled by the people who use their services, offer many of the same financial services that banks do. Like savings institutions, credit unions have not historically provided a great deal of credit to small businesses. However, credit unions have become a more important source of small business loans in recent years. Although outstanding small loans to businesses by credit unions remain a small fraction of those by commercial banks, they have increased steadily throughout the recession and post-recession period, while commercial banks' small loans to businesses have declined. Between 2007 and 2011, credit union outstanding loans to business members increased by 54.5 percent, while outstanding small loans to businesses by commercial banks decreased by 11.1 percent.⁶

In recent years, nondepository institutions have become increasingly important sources of financial services to small businesses. The 2009 NFIB survey reported less than 2 percent of businesses using something other than a bank, credit union, or savings and loan as their primary financial institution. This share more than doubled by 2011, when 5.0 percent of firms reported having a nondepository primary financial institution. In addition, firms may receive credit from institutions that are not their primary financial institution, likely making the shares of firms reporting them as a primary financial institution a lower bound for their total usage.

Support for small business development has been a priority of policymakers for several decades, and federal, state, and local agencies have sponsored programs that assist in channeling capital to small business. Several long-standing government initiatives exist to help support credit access for small businesses, particularly small businesses owned by historically underserved groups such as women and minorities. Two such initiatives of particular importance are the Community Reinvestment Act (CRA) and various loan programs sponsored by the Small Business Administration (SBA). The CRA was enacted in 1977 to encourage federally insured depository institutions to help meet the credit needs of their local communities, particularly low- and moderate-income neighborhoods, consistent with safe and sound operations. The SBA provides financing to young and growing small firms through several channels such as the 7(a) Loan Program and SBA 504 Certified Development Companies. Among the policy objectives of the SBA loan programs are the goals of promoting entrepreneurship opportunities for women and minorities.

Additional support for small businesses has come in the form of new legislation. The American Recovery and Reinvestment Act of 2009 and the Small Business Jobs Act of 2010 both provided resources to small businesses through increasing credit availability, providing capital to small business lenders, and putting in place tax cuts for small businesses. The most recent piece of small business legislation is the Jumpstart Our Business Startups Act. Signed into law in early April of 2012, this bill is intended to make it easier for start-ups and small businesses to raise funds, especially through crowdfunding online. This legislation is a departure from the two earlier bills, as it is focused on access to finance through less conventional channels.

Securitization is the process of packaging individual loans and other debt instruments, converting the package into a security, and enhancing the credit status or rating to further the security's sale to third-party investors. The securitization of small business loans has the potential to substantially influence the availability of credit to small businesses, but the obstacles to securitizing small business loans are large. Securitization generally has thrived in markets in which the costs of acquiring and communicating information to investors about loans and borrowers are low. Most small business loans cannot readily be grouped into large pools that credit agencies and investors can easily analyze: Loan terms and conditions are not homogeneous, underwriting standards vary across originators, and information on historical loss rates is typically limited. The information problems associated with small business loans can be overcome, or offset to a degree, by some form of credit enhancement, as in the case of the SBA's 7(a) loans. However, the more loss protection needed to sell the securities, the smaller are both the net proceeds from the sale of the securities and the incentive for lenders to securitize their loans. Small business loans are an asset for which the high transaction costs of providing credit enhancements have made many potential securitizations unprofitable.

Despite these obstacles, between 2002 and 2007, securitization of small business loans increased at a moderate pace each fiscal year. Then, in late 2008, the securitization markets nearly collapsed. As the secondary markets froze and regulators attempted to restore financial stability, several actions were undertaken, with important implications for small business loan secondary markets. While the secondary markets for SBA 7(a) loans and 504 debentures have largely returned to pre-crisis functionality, securities not backed by an SBA guarantee continue to struggle.

There is always a high degree of churning in the small business population, with firms going in and out of business. However, during the recent period, the rate of new business formation has declined. What has caused the lack of activity is not clear. There has been much speculation that the decrease in home prices--and consequently home equity--has constrained potential entrepreneurs' ability to finance new businesses. However, existing business owners consistently report that lack of demand and economic uncertainty are the largest problems facing their business in recent periods, not access to capital.⁷ The lack of demand, increased uncertainty, or both could have caused fewer business ideas to have a positive expected value and thus fewer businesses to be formed. Nonetheless, it does seem likely that the home price declines had some effect on the number of firms established over the recent period.

Overall, between 2007 and 2012, credit conditions for small businesses underwent substantial change. Favorable supply conditions prevailed until 2008, when such conditions tightened and demand fell. As the recession ended, supply conditions improved but demand remained weak. By 2012, credit flows to larger businesses had essentially returned to their pre-recession levels, while credit flows to small businesses, though improved, remained well below those levels.

References

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