FRBSF Economic Letter
1997-02 | January 24, 1997
Western Banking Quarterly is a review of banking developments in the Twelfth Federal Reserve District, and includes FRBSF’s Regional Banking Tables. It is published in the Economic Letter on the fourth Friday of January, April, July, and October.
Over the past year, big banks have made a highly visible push into small business lending. Several large banks have been using new technology to reduce the cost of originating small business loans and speed the approval process. For example, at some banks businesses can apply for loans by mail using simplified forms, and credit analysis has been automated and streamlined through the use of “credit scoring,” a method of evaluating potential borrowers using sophisticated statistical analysis to estimate the probability that they will repay as promised.
The most recently available small loan data show that these changes may be having a sizable impact in the West, as reflected in relative growth rates of small loans at banks of different sizes. This issue of Western Banking discusses the emerging trends in the Twelfth District.
A superficial evaluation of the success of the big banks’ expansion efforts might divide banks into several size groups and calculate whether the small loans of the largest size group (such as the top 20) increased relative to those of smaller banks. Based on data that federal banking agencies collect each June on banks’ small business loans, the 20 largest banks in the District reported 19.8% more in small business loans for June 1996 than did the top 20 a year earlier. (The term “small business loans” here refers to commercial loans with original amounts of $1 million or less, excluding those secured by real estate.) If accurate, a growth rate of nearly 20% would be remarkable, since overall small business loan growth was 5.7% for banks in the District and 6.5% for banks nationwide over the same period.
Unfortunately, calculations like this are misleading. There have been many recent mergers and acquisitions in banking, including a large number of mergers between affiliated banks as holding companies react to changes in interstate banking laws. One artifact of this merger wave has been consolidation of regulatory reporting, with banks that formerly filed separate reports filing only a single, combined report after they merge. These consolidations distort any size-based comparisons by artificially boosting the reported loans of the surviving banks.
To adjust for mergers, the 14 companies that control the 20 largest banks in the District were identified. Changes in consolidated small business loans for the twelve months ended June 1996 at these “Top 14” were adjusted for the effects of mergers by taking the June 1995 reports and combining the numbers for banks that merged during the year. Comparing these adjusted loan figures to the June 1996 totals isolates loan growth that occurred for reasons other than consolidation of regulatory reporting. After these corrections, the data show that small loans at these largest banks actually grew more slowly during the year than at their smaller competitors: Small business loans increased by only 5.2% for the largest banks, compared to 6.2% for other banks in the District. The contrast with the unadjusted figure of 19.8% cited above demonstrates the importance of correcting for mergers.
However, growth in total small business loans may not be the right measure of success of the larger banks’ expansion strategies, since some of the innovations in business lending are not applicable to loans of all sizes. Credit scoring is a notable example: Scoring models, originally developed for consumer lending, use statistical techniques to relate information about a borrower (such as credit history or current financial position) to the probability that he or she will default on a loan or other debt. Lenders have found that business loans below a certain size are analogous to consumer loans, and therefore are candidates for very similar credit scoring; the analogy breaks down as the business loans get larger. Because scoring can reduce the costs of lending, several of the larger banks have focused their efforts on the smallest of the small business loans.
The loan reports break the small business data into three loan-size categories, and within these categories significant differences between large and small banks are evident. The largest banks in the District (as defined above) increased their holdings of business loans with original amounts under $100,000 by an astonishing 26.2% during the year, while other banks increased these smallest of business loans by only 3.1% (Figure 1). The strong growth in the smallest loans at the largest banks is consistent with an emphasis on automated loan application and evaluation. As a result of this growth, the largest banks as a group increased their share of these small commercial loans by about 5 percentage points during the year, to 58% of the District total.
This shift at the largest banks apparently was accompanied by a retreat from loans that are not amenable to the new technology: Large banks actually reduced their holdings of smaller business loans (in the $100,000 to $1 million range) by more than 5%. Their withdrawal seems to have left room for competitors to expand: Smaller banks increased such loans by 7% in the $100,000 to $250,000 category, and 8.4% in the over $250,000 category. However, expansion by smaller banks was barely enough to offset the contraction by the larger banks: Overall growth within these two loan categories was near zero for the District, compared to 5.5% for such loans nationwide.
The push by big banks into small business lending has been more than just cheap talk. The top banks in the District have strongly increased their commercial loans of less than $100,000 and have taken market share from smaller banks. However, they appear to have retreated from small business loans that are slightly larger and therefore not good candidates for new automated lending processes. Smaller banks have moved into this gap left by the big banks, but have not kept small business loan growth at Twelfth District banks from lagging the rest of the country.
Mark E. Levonian
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