FRBSF Weekly Letter
96-02; January 12, 1996
Small business has a special place in American public policy. Small
businesses are said to be important elements of growth and development,
and even are seen as essential threads in the national moral fabric. Whether
or not smaller businesses have larger significance, their financing is
distinctive: many depend on banks for a sizable part of their funding.
Small business lending is one area in which banks appear to dominate other
types of financial firms. Yet surprisingly little is known about the structure
of small business lending by banks.
Anecdotes suggest that small banks in particular are big lenders to
small business. If this is true, developments in the banking industry
that affect small banks also might touch small businesses. For example,
if many smaller banks are swallowed by larger banks in mergers, could
small business credit become scarcer or more expensive? In this Weekly
Letter we use a relatively new source of information on small commercial
loans to look at the evidence linking small banks and small businesses,
and discuss the impact of increased bank merger activity on small business
credit availability.
Bank loans are an important part of small business finance. A 1993 Federal
Reserve survey found that two-thirds of the small businesses with some
outside borrowing received credit from commercial banks, far exceeding
the share for other types of financial firms. The Commerce Department's
June 1995 Quarterly Financial Report for manufacturing firms showed that
bank loans made up 34 percent of the total liabilities of smaller firms
(in the report, those with $25 million or less in assets), compared to
14 percent on average for all firms. Larger firms can use commercial paper
and various other forms of nonbank debt to borrow funds, whereas small
firms usually are unable to tap these other sources of credit.
Federal banking regulators recently began collecting additional information
on small business lending. Since 1993, banks have reported annually on
the number and total value of all small commercial loans, where small
is defined as $1 million or less. In this Letter, we focus on the subset
of these small loans that were categorized as commercial and industrial
(C&I) lending not secured by real estate as of June 1995, a total
of $165 billion in bank loans for the US as a whole. One problem with
these data is that banks are asked about small loans to businesses, not
loans to small businesses. However, logic and the results of other studies
suggest that the bulk of these small loans are to small businesses. Another
problem is that banks also provide small business credit through such
avenues as home equity loans, personal credit cards, and personal lines
of credit, all of which generally are excluded from reported small business
lending. Despite these shortcomings, the new data provide a good, comprehensive
picture of which banks do small business lending.
The data show that small banks do a lot of small business lending, especially
when compared to their overall presence in the industry: Banks with assets
of under $1 billion hold 24 percent of the industry's assets but do almost
half of the small business lending. The pattern is the same for even smaller
banks: the nearly 9,100 banks with less than $300 million in assets do
35 percent of small commercial lending, even though they account for only
15 percent of total U.S. banking assets.
Given these aggregate figures, it is no surprise to find that small
banks also tend to allocate more of their portfolio to small business
lending. Loan-to-asset ratios show that larger banks are more active lenders
than small banks if all sizes of C&I loans are considered: The shaded
bars in Figure 1 show that C&I loans generally make up a larger fraction
of assets as bank size increases. However, the pattern for small C&I
loans as a percentage of assets is strikingly different, as shown by the
solid bars in Figure 1 (this file requires Adobe
Acrobat). The ratio rises for the first three size groups, then steadily
declines. These ratios show that small business loans figure most prominently
in the portfolios of banks in the $50 million to $100 million asset range,
and are a tiny fraction of assets for the largest banks.
One explanation of the tendency for small banks to devote a larger share
of their funds to small business lending is that there are clear limits
to the size of the loans a small bank can make. If loans are too big relative
to the rest of the bank, the bank becomes undiversified and may suffer
sudden, catastrophic losses. Most banks have internal policies setting
limits on the amount they will lend to any single borrower; in general,
regulations require that this limit be no more than 15 percent of the
bank's capital. The average bank with $100 million or less in assets simply
cannot make loans larger than $1 million without running afoul of these
limits. Bigger banks can make large loans and still be diversified. As
a result, small loans may decline as a share of assets because other loans
increase, not because small loans fall.
Another possibility is that small banks concentrate on small loans because
they cannot compete for larger loans. To some degree, smaller banks might
tend to be cut out of the market for larger business loans because they
are less able to offer certain other banking services that larger lenders
can provide, such as foreign exchange transactions, acceptance financing,
or interest rate swaps. Many business customers demonstrate a preference
for dealing with a single bank, putting small banks at a disadvantage
in competing for larger borrowers that need these other services.
Smaller banks' heavier focus on small business lending could also be
due to comparative advantage. Small banks might be better able to serve
small businesses because they can more efficiently collect the detailed
local information needed for credit analysis on such loans, or because
they can provide a superior level of customer service. The idiosyncracies
of some small borrowers, such as new businesses or those with unusual
credit histories, might require a flexibility in loan underwriting standards
that larger banks cannot afford to allow within their organizations. Berger
and Udell (1996) have presented evidence that small banks tend to serve
borrowers that are less "generic" than those who borrow from
large banks.
Small banks tend to have higher ratios of small loans to assets, but
a merger wave that consolidates small banks into larger ones need not
reduce small business lending. Motives matter. A larger bank acquiring
a smaller bank might be interested primarily in the deposit base or the
geographic market, and therefore might curtail small business lending.
Alternatively, large banks might be attracted precisely because of the
smaller bank's profitable small business loan portfolio. In that case,
the acquiring bank has a strong incentive to maintain existing borrowing
relationships. Also, liquidity and loan diversification can be managed
more efficiently on a larger scale; freed from the need to manage such
risks locally, an acquirer might be able to use the deposits of a small
bank to support an even higher volume of small business lending.
Big banks certainly are capable of lending to small businesses. Small
C&I loans are split almost equally between banks with less than $1
billion and banks with more than $1 billion in assets, with the larger
banks holding somewhat fewer by number but slightly more by dollar value.
For banks in each size group, Figure 2 (this file requires Adobe
Acrobat) shows the average number of small business loans outstanding
(the solid line and the right-hand scale) and the average value of the
small business loan portfolio (the bars and the left-hand scale). Based
on either measure of loan activity, the typical large bank does much more
small business lending than the typical small bank. In fact, the average
small C&I loan portfolio of $640 million at a bank in the over $50
billion category exceeds the total assets of about 95 percent of US banks
and is hundreds of times larger than the small business loan portfolio
of the typical bank in the smaller size groups. As a hypothetical extreme,
even if all 7,000 banks with assets under $100 million vanished completely,
the 136 banks with assets above $5 billion could potentially make up the
difference by adding small business loans amounting to about 1 percent
of their assets.
Looking to the future, the banking industry probably will continue to
be a mix of large and small banks. As noted above, small banks may be
superior financiers of small businesses in certain ways that large banks
cannot copy. If so, and if the cost of those unique services can be recovered
through appropriate interest rates and fees, then smaller banks will live
on. Small new entrants may arise to fill profitable local niches left
open by mergers. The small banks of the future may even be stronger, if
competitive pressures from industry consolidation focus them more narrowly
on the nongeneric small borrowers where their advantage is greatest.
Recent data show that small business loans tend to be a more significant
part of the product mix for smaller banks, as reflected in higher ratios
of small loans to assets. However, big banks are the top providers of
small business loans. The extent of small business lending by big banks
suggests that they are both interested in and capable of such lending,
and there is no reason to think that consolidation in the banking industry
will change this. Small businesses will still get loans, provided those
loans are profitable for the lenders. Many of those loans will come from
big banks, as they do now, but new and existing small banks will continue
to serve parts of the market that big banks cannot.
Mark Levonian
Research Officer
Jennifer Soller
Senior Research Associate
Berger, Allen, and Gregory Udell (1996). "Universal Banking and
the Future of Small Business Lending." In Financial System Design:
The Case for Universal Banking, A. Saunders and I. Walter, eds. Irwin
Publishing, forthcoming.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco,
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
to
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120
|
