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The Federal Reserve Bank of San Francisco

FRBSF Weekly Letter

96-02; January 12, 1996

Small Banks, Small Loans, Small Business

  • Small business borrowing
  • Small business lending
  • Why do small banks focus on small loans?
  • What consolidation might bring
  • Conclusion
  • Reference
  • 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.

    Small business borrowing

    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.

    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.

    Why do small banks focus on small loans?

    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.

    What consolidation might bring

    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