FRBSF Economic
Letter
2006-36; December 15, 2006
The Geographic Scope of Small Business Lending: Evidence
from the San Francisco Market
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Historically, small businesses have tended to turn
to local lenders for credit. In recent years, however,
technological advances in processing information and
assessing credit risk have raised the potential for
loosening the geographic ties between small business
borrowers and lenders. This Economic Letter discusses
factors affecting the geographic scope of markets for
small business credit and uses data available for the
San Francisco Bay Area to examine the extent to which
small businesses rely on local lenders, how this reliance
has changed over time, and the implications of any
changes for the Federal Reserve's bank merger policy.
The geographic scope of small business credit
Banking theory provides a rationale for the link
between small business lending and local banks. Small
businesses
typically do not have detailed public financial statements.
Therefore, lenders look for other information to determine
a borrower's creditworthiness and to monitor existing
loans. Historically, much of that information was most
efficiently gathered locally, and it might include
knowledge of the local economy and community, knowledge
of the borrower's industry (since some industries are
concentrated locally or regionally), knowledge of the
borrower's particular firm, and knowledge of the "character" and
skills of the small business owner or owners. Brevoort
and Hannan (2004) find direct empirical evidence that
lender and borrower location do matter in small business
lending, even within local areas. Using data for local
banks and local businesses, these authors find that
banks lend more to nearby borrowers than to distant
borrowers, other factors held equal.
Among local banks, small banks may be particularly
well-suited to small business lending. For example,
Berger, Klapper, and Udell (2001) argue that small
banks have a comparative advantage over large banks
in making "relationship" loans, that is,
loans that use "soft" information. Soft information
is more qualitative and subjective than "hard" information
and may be relatively difficult to communicate. Among
the types of local information already mentioned, information
regarding the character of the business owner, a key
element in many small business lending decisions, seems
particularly open to interpretation. In theory, both
large local banks and small local banks can obtain
character information rather easily, for example, through
repeated contacts between the loan officer and the
borrower in either informal social settings or face-to-face
business meetings. However, loan officers at small
banks may be able to use that information more easily
than those at large banks, because they are likely
to be able to convey their impressions through fewer
layers of management. Indeed, in 2005, small (less
than $1 billion in assets) local banks in the San Francisco
Bay Area (the San Francisco-Oakland-Fremont Metropolitan
Statistical Area) are estimated to have held 6.6% of
their Bay Area assets in Bay Area small business loans,
versus only 0.6% for large banks with offices in the
Bay Area.
At the same time, there are reasons to expect that
technological advances in data-gathering and risk-assessment
are working to reduce the importance of geographical
proximity between lenders and their small business
customers. One example is the prevalence of credit
scoring, in which computer-generated models use a
limited number of factors, including an applicant's
loan repayment
history, to determine the probability that a borrower
will default on a loan. Lenders have long used these
models to assess individuals' creditworthiness, and
they now also use them to qualify some small businesses
for loans. Scoring models in essence automate the
credit underwriting process and can limit the added
value
of more qualitative information that might be gleaned
through so-called relationship lending by a local
lender. If so, this would tend to broaden the geographic
scope
of the market for credit at least for some small
business borrowers, thus making non-local lenders more
effective
competitors in small business lending markets.
Evidence from the Bay Area
To examine the extent to which small businesses turn
to local lenders and how that tendency has changed
in recent years, I examine small business lending data
for the San Francisco Bay Area. Part of the data comes from reports that large
banks and all banks in large bank holding companies are required to file with
their regulators under the Community Reinvestment Act (CRA). In using these
data,
small business loans are defined as term loans and lines of credit no greater
than $1 million made to businesses with gross annual revenues no greater than
$1 million. During the period under study, 1998 to 2005, banks' CRA reporting
requirements changed, and I was able to obtain information that allowed me
to correct for the change in reporting in the Bay Area.
Such information was not
available for other areas. I estimate the small business lending of Bay Area
banks that did not report on the CRA with data from the Reports of Condition
and Income and from the Summary of Deposits.
Two criteria are used to group the banks: (1) whether
the entity is a "credit
card bank" or just a "bank," and (2) whether the entity is local
(its own or an affiliates' offices in the Bay Area) or "out-of-market" (non-local).
Credit card banks are defined as commercial banks with the bulk of their business
loans in the form of business credit cards or those with personal credit card
lending as a main activity (at least half of assets in consumer loans and at
least 90% of consumer loans in credit card loans). The category "bank" includes
other commercial banks, savings banks, savings and loans, and industrial loan
banks. (Note that other potentially important sources of small business credit,
such as finance companies, venture funds, "angel" investors, customers,
suppliers, friends, family, and personal credit cards, including those held
by small business owners, are excluded from the analysis.)
Credit card banks are considered separately for two
reasons. First, innovations in underwriting, particularly
the use of credit scoring, have played a major
role at credit card banks. Second, in analyzing the competitive effects of
bank mergers on small business lending in local banking
markets, the Federal Reserve
distinguishes between credit card banks and other depository institutions.
When applied to the Bay Area, three groupings of
lenders are applicable: (1) local banks, (2) out-of-market
banks, and (3) national credit card banks. Below,
small business loans from credit card banks will be synonymous with credit
card loans to small businesses, and small business
loans from other banks will be
synonymous with non-credit card loans to small businesses. In practice, of
course, credit card banks make some non-credit card
loans, and other banks make credit
card loans.
 The estimates for the Bay Area show that, in 2005,
local banks held most of the dollar volume of small
business loans (84.6%), while national credit card
banks
held most of the remainder (14%) (Figure 1). The negligible share held by out-of-market
banks is not surprising, given evidence from the 2003 Survey of Small Business
Finances, which indicates that the median distance between small businesses
and their non-credit card depository institution lenders
is only four miles.
The most recent data, then, show that local banks
dominate Bay Area small business lending. Is there
evidence that the geographic scope of the market for
small
business credit is expanding? As Figure 1 shows, the market share of local
banks did decline somewhat between 1998 and 2005—from
91% to 84.6%. The share of out-of-market
banks also shrank.
The lenders gaining share clearly are the credit
card banks. Their cut of the pie more than tripled,
from 4.5% in 1998 to 14% in 2005. Since credit card
banks
have widely adopted credit scoring, their gain in small business lending is
at least consistent with innovation working to loosen
the geographic tie between
small business borrowers and lenders.
Assessing bank mergers
The growth of credit card small business lending
could have implications for the analysis of the effects
of proposed bank mergers on competition in small
business lending. When reviewing bank merger proposals, the Federal Reserve
analyzes the proposal's potential competitive effects
using each bank's deposits in the
local banking market to measure its share of that market. Local branch deposits
proxy for the bank's supply of banking services as a whole, including small
business loans. When this broad analysis indicates
the possibility of significantly large
anticompetitive effects resulting from the proposed merger, the Federal Reserve
often also analyzes the potential competitive effects of the merger on small
business lending in particular, using loans made to small businesses in the
local market to measure market share.
Under current practice, small business loans made
by credit card banks are excluded when calculating
banks' small business lending market shares. Insofar
as the
data for the Bay Area may be representative of trends elsewhere in the country,
credit card banks' recent gains may argue against such exclusion.
However, in judging the relevance of credit card
lending, we need to consider the degree of substitutability
between small business credit card and non-credit
card loans. For example, as with personal credit cards, business credit cards
have relatively low loan limits, so credit card loans tend to be much smaller
than local non-credit card bank loans. For example, in 2005, the average size
of a local (non-credit card) bank small business loan was $55,468, versus only
$8,756 for a credit card bank small business loan. After all, credit scores
can yield only so much information and cannot, for
example, indicate how business
owners respond to uncertainty or how the business fares over economic cycles.
With a much richer set of information, local non-credit card banks can likely
better manage the risk entailed in lending relatively large sums than can credit
card banks. And, since credit card loans are smaller, they tend to be used
for working capital purposes, unlike the capital investment
expenditures for which
local non-credit card small business loans are more likely to be used.
Moreover, in at least some cases, business credit
card contracts prohibit small businesses from holding
multiple credit cards from multiple banks. In such
cases,
small businesses cannot circumvent credit limits on their cards by borrowing
against multiple cards and, therefore, cannot duplicate a larger non-credit
card loan with multiple smaller credit card loans.
In addition, again as with personal
credit card loans, interest rates on credit card loans tend to be much higher
than for non-credit card loans, for similar terms to maturity. Therefore, small
business borrowers' incentives to replace non-credit card loans with credit
card loans may be limited.
Conclusion
Small businesses have tended to rely on local lenders
for credit. The dominant role of local lenders often
is ascribed to information advantages associated
with having a presence in the region in which the business customer operates.
Data for the San Francisco Bay Area, however, show that in recent years national
credit card banks have gained some market share in small business lending.
The gains are consistent with expectations that advances
in information technology,
risk assessment, and risk management should have helped loosen the geographic
ties between small business borrowers and lenders.
Nevertheless, those ties appear to be far from severed.
The most recent data still show that banks with their
own or affiliates' offices in the San Francisco
Bay Area account for about 85% of the lending to small business by traditional
intermediaries. Moreover, out-of-market lenders other than national credit
card banks have lost market share in the Bay Area,
suggesting that distance still
is a deterrent for some lenders. And the relatively small average amount of
credit extended via credit cards raises some question
about the likelihood that credit
card lenders ever will substitute fully for local lenders. Liz Laderman
Economist
References
Berger, Allen, Leora Klapper, and Gregory Udell.
2001. "The Ability of Banks to Lend to Informationally
Opaque Small Businesses." Journal of Banking
and Finance 25(12), pp. 2127-2167.
Brevoort, Kenneth, and Timothy Hannan. 2004. "Commercial
Lending and Distance: Evidence from Community Reinvestment
Act Data." Finance and Economics Discussion
Series 2004-24, Board
of Governors of the Federal Reserve System.
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. Comments?
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