If you are a small business owner that has recently tried to get a business loan, then you are going to want to read this!
Over the last 10 years or so, big banks have shied away from lending money to small businesses in comparison to other sectors, such as individuals or households.
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I have invited guest contributor Daniel Ng here today to share his insight on money lending and market systems and the resulting decline of big banks lending to small businesses.
Big banks control credit and lending
The systems followed in local credit and money lending market has created a significant impact on the credit and labor market as well. This has had a dynamic impact on the money lending process and now big banks are declining to lend money to small businesses as a result. According to studies, there is a sharp fall noticed in lending money to small businesses by the four largest in the US since 2008 as compared to offering loans in other sectors, households, and individuals. This remained depressed till 2014. As a result, it had a serious impact and consequences on the credit supply and created a shockwave.
There was a particular focus on the subsequent vigorous adjustment process by following a difference-indifferent approach. This approach compares the regions in which these banks had a higher initial market share to the regions where it was significantly low.
It showed that the aggregate flow of small business credit fell sharply as well as there was a remarkably high increase in the rate of interest from 2006 to 2010.
The comparison chart also showed that:
- There was a considerable contraction in the economic activity in the affected region
- It resulted in fewer expansions in businesses employment
- It raised the rate of unemployment
- It also resulted in a noticeable fall in the wages.
Moreover, the comparison showed that the effects on employment were more concentrated in those industries that are specifically and most reliant on external finance such as the manufacturing industries.
Adjustments made to take the hit
A lot of alternative ways were explored to make necessary adjustments to take on the hit and face this shock from 2010 to 2014. This has resulted in the slow recovery of the flow of small business credit primarily because of smaller banks, non-banking finance companies and online lenders such as liberty lending US filled in the void left by the top banks.
The rate of interest of the loans remained elevated suggesting that the credit conditions in these areas are still tighter. Moreover, the effects on the wages persisted even though the unemployment rate slowly returned to normal by 2014. This further suggested that more expensive credit offered to the small businesses may have forced them to become less capital intensive.
This captures the concern expressed by many observers during this slow recovery process from the financial crisis and Great Recession. They felt that this was the primary cause of the probable existence of a small business credit gap resulting in the shrinking fund in the small firms.
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The studies made
A lot of studies were conducted to know the reasons and effects of such a credit gap. It was found that this gap, in fact, opened up in the post-crisis period. It was also found that:
- The economic implications of this gap were severe
- At the point of departure, it plotted the Community Reinvestment Act (CRA) to secure small business loan originations from the banks and
- On the basis of empirical strategy, it showed that small business lending declined at all banks starting in 2008.
However, a closer look at the CRA data showed that the four largest banks owned by Bank of America, Citigroup, JPMorgan Chase, and WellsFargo cut lending rates back significantly as compared to the rest of the banking sector. The data showed that in 2010, the annual flow of originations from these top four banks stood shockingly at just 41% of the 2006 figure. On the other hand, the comparable figure of all other banks was as high as 66%.
Moreover, it showed that the originations at the top four banks remained depressed even after 2010 and was hovering at approximately 50% of the pre-crisis level till 2014. By contrast, the lending rate of all other banks slowly recovered and reached the 80% mark of its pre-crisis level by 2014.
This led to an argument that this differential decline of the top four banks in small business lending resulted in a subsequent differential contraction in credit supply. The most natural alternative in such a situation is to bring in a differential shift in credit demand.
Few suggested that the result was perhaps due to the fact that these top four banks were located disproportionately in those areas that were hit hardest by the Great Recession. The CRA data was once again compared to see the small business loan growth of these top banks in these given places and compared with that of the other banks operating in the same area. This ideally swept away any local variation in the loan demand thereby eliminating the chances of any difference in opinion.
The reason for such a decline
The differences were slightly higher in absolute magnitude as compared with the raw across-bank differences. There was actually no balance between the supply-side and the demand-side of the differential decline in small business lending by the top four banks.
This lead to a difficult question as to why these banks cut their supply of small business loans more than the other banks. Though there is no definitive answer to this question, experts offer a few hypotheses. They found that the loan supply shift and decline evolved in two distinct phases.
First, these banks pulled backed aggressively from lending to small businesses in 2008 during the middle of the financial crisis.
- It was seen that at this time these banks were experiencing high charge-off rates on their small business loan portfolios.
- This reinforced their historic underperformance in this segment that was viewed by the banks to be peripheral to their general business strategies.
- Apart from that, during this time the banks also had to experience and contend with large losses in credit across a range of other products.
- This threatened their solvency leading to an unprecedented wholesale of funding pressures.
To face these challenges the large banks chose to pull back from their non-core small business lending operations. This allowed them to focus more on the tasks of managing the effects of the crisis.
As for the second phase from 2010 to 2014 these were slow to return to small business lending when the crisis had subsided.
Daniel Ng is a freelance writer who has been writing for various blogs. He has previously covered an extensive range of topics in her posts, including business debt consolidation, Finance, E-commerce, and start-ups.