Secondary sources of credit include equipment dealers and suppliers, and credit
cards. Twenty-eight percent of respondents have found equipment dealers and suppliers to be
a very important source of financing, while another 28 percent have found them to be somewhat
important. Fifteen percent have found credit cards to be a very important source of financing
and 25 percent have found them to be somewhat important. (See Table 4.1.)

Less important sources of credit are leasing companies, commercial finance
companies, and credit unions. Nine percent of respondents have found leasing companies to
be very important and 27 percent have found them somewhat important. Only 5 percent have
found commercial finance companies to be very important, while 15 percent have found them
somewhat important. And only 5 percent have found credit unions to be very important, while
8 percent have found them to be somewhat important. (See Table 4.1.)

Table 4.1
Importance of Financing Sources (%)

Owner's personal savings

Small commercial or savings banks with
headquarters in or near community

Equipment dealers or suppliers

Larger commercial or savings banks operating
throughout the state or in several states

Loan secured by owner's home

Owner's family members or friends
|| Leasing companies

Credit cards

Government loan programs or loan programs
operated by local economic development
organizations

| Owner's business colleagues
Other private investors

Venture capital firms or small business
investment companies

Commercial finance companies
Credit unions

Note:
Total Number of Respondents = 205
Source: Mt. Auburn Business Survey

Results from interviews with development finance professionals confirm that the
activity of nonbank credit sources in the region is limited. Those interviewed reported that
they were generally aware of and occasionally encountered lease financing activity, often from
equipment suppliers, although the frequency of lease financing appeared to diminish in more

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Final Report Mt. Auburn Associates, Inc.


manufacturing employment in the region comprised 12.4 percent of total employment, still
below the state average of 15.3 percent and the national average of 12.9 percent. Almost 80
percent of the manufacturing jobs were concentrated in four of the eight counties (Knox,
Laurel, Rockcastle, and Whitley). The tourism industry has also grown in importance, fueled
by the region's state and national parks and other scenic and recreational attractions. In an
effort to accelerate this trend, the region's economic development efforts have focused on
recruitment of small- and mid-sized manufacturing firms (e.g.. plastic components for the
automotive and appliance industries), development of resource-based manufacturing (secondary
wood products, agricultural processing), and tourism development.

In recent years, the region has had some success in attracting new firms and supporting
the expansion of existing firms. Firms in its recently established Empowerment Zone have
created 600 new jobs; other firms have made commitments to create an additional 1,900 jobs.
These are primarily expansions, but some are newly recruited firms. The low rate of new
enterprise formation remains a concern to regional economic development officials. According
to national data, the rate of new enterprise formation is about one-third below the national rate.
Economic developers note that entreprencurially-oriented individuals tend to leave the region
for more hospitable entrepreneurial environments. They also note that individuals who do try
to start businesses in the region often lack the financial resources and management skills to be
successful.

Other economic challenges faced by the region include:
© the scarce supply of land suitable for large-scale industrial development,
particularly as a result of the region's mountainous terrain;

© Jack of tourism infrastructure (e.g., accommodations, developed historical and
recreational sites, tourism development organizations);

© Jow educational and skill levels -- less than one-half of adult residents have
graduated from high school; and

© the potential impact of welfare reform on the region's economy -- local officials
estimate that one-third of the region's population will be affected.

Tue Supp.y or Fivancine: Tue ReGionar Financiar
MARKET
Private Dest AND Equiry MARKETS

Secured Debt Financing

There are 20 commercial banks and savings institutions operating in the region. Despite
the pace of banking industry consolidation nationwide, most of the banks in the region remain
locally-owned community banks. Only one large, non-local bank, Louisville-based National

B-2
Final Report Me. Auburn Associates, Inc.


Table 2.14
Top 10 SBA Lenders

Lender

| Money Store Investment Corporation
AT&T Small Business Lending Corporation

BankAmerica FSB
Banco Popular de PR
Prestige State Bank
Bank of America

Zions First Nati Bank
‘Source: Small Business Administration

The Money Store found its niche in helping small businesses effectively package and
obtain financing through the Small Business Administration. Many banks are now extending
their services to compete with nonbanks in assisting small business in obtaining
government-backed loans (Arndorfer, 1996).

Although banks have reason to be concerned about the growth of nonbank lending to
small] businesses, banks still have clear advantages over nonbank entities. These include:

© branches that provide convenient physical access and a perceived
Jocal/community presence;

© deposits that provide a funding advantage and also help the bank understand the

customer's circumstances; and

© a range of products and services that cement the bank-customer relationship -- for
example, employee benefits and cash management services (Glassman, 1996).

Most analysts agree that the extent to which banks can aggressively market their
strengths will determine their share of the small business lending market. To capitalize on these
advantages, banks are using a host of new and improved small business credit products as well
as improving the quality and convenience of the services they offer. They are also beginning to
target traditionally underserved business owners as a way to find a niche within the small
business market. Wells Fargo, for example, has announced plans to lend more than $10 billion
to women entrepreneurs over the next 10 years.

2.3.5 INNOVATIONS IN SMALL Business PRODUCTS AND SERVICES

Both banks and nonbanks report feeling increasingly pressured by intense competition
to offer a wider variety of products and improved services. Even nonbanks, which have
attracted many small business customers through aggressive marketing, products lines, and

26
Final Report Mt. Auburn Associates, Inc.


TAaBLe or ContreENTS

Chapter One: Introduction .......
1.1 Purpose of the Study .........
1.2 A Note on Capital Market Analysis .
1.3 Organization of the Report

ewe

Chapter Two: Overview of Rural Financial Markets and the Availability of Small
Business Capital and Credit .

2.) Introduction .2c.0cc nineteen
2.2 Trends in Rural Financial Markets ...
2.3 Trends in Small Business Lending .

24 Conclusions ......... sieve vnaNaR amadannee

Baauna

Chapter Three: fa yats of Demand for Financing Among Business in the Appalachian
egion ..

3.1 Introduction ...
3.2 Broad Measures of Demand for Ca;
3.3 The Importance of Financing to Business Competitiveness
3.4 The Nature of Capital and Credit Demand .......- weisaness
3.5 Recent and Projected Trends in Demand for Financing .

3.6 Variations in Demand for Financing .
3.7 Summary of Findings ...

RSSRFEBB

Chapter Four: The Supply of Business Financing From Private Sector Sources in the
Appalachian Region ...
4.1 Introduction

4.2 Banks and Other Sources of Credit ..
4.3 Risk Financing Sources
4.4 Recent Trends in Business Financing ..

e24ages

4.5 Summary of Findings ........... saneee

Chapter Five: Private Sector Financing Gaps in the Appalachian Region and the Role of
Development Finance Institutions ......... Savew ses we bastesecebevessuseses 86

5.1 Introduction ..... deeeseceeeees teseceraver pieeses:
5.2 Gaps in Availability of Private Sector Financing .
5.3 The Role of Development Finance Institutions in Addressing Capital and Credit Gaps
5.4 Summary of Findings

Chapter Six: Key Findings and Recommendations ...........+++eeeeseeeeeeeeeee srwesee 105,
6.1 Summary of Key Findings .

6.2 Strategy Recommendations

Finat Report M4. Auburn Associates, Inc.


Table A.2-
Profile of Survey Respondents
Gross Sales for Most Recent Fiscal Year

Number of | Percentage of
| Respondents | Respondents
Less than $50,000 19 92
$50,000 to $250,000 39 18.9
$250,001 to $1 million 46 22.3
| $ 1,000,001 to $5 million 36 175
} $5,000,001 to $25 million 17 83
|| More than $25 million 16 78

Don't know or N/A 33 16

Total 206 100

Source: Mt. Auburn Business Survey

Profile of Survey Respondents
Industry Sector

Number of Percentage of
Respondents Respondents
Retail 58 28.3
Wholesale 21 10.2
Manufacturing 17.6
Services 41
Construction 9.3
Transportation/ Utilities 34
Other 3.9
Don't know or N/A 0

Note: Total number of respondents = 205.

Total adds up to more than 100% as some respondents may have checked
more than one category.

Source: Mt. Auburn Business Survey

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Final Report Me. Auburn Associates, Inc.


Map 4.6

Total Commercial Banks and Savings Institution
Offices Per 10,000 Population, June 1996

[___] Below 85% of U.S. Average
[A] 85% to 115% of U.S. Average
= Above 115% of U.S. Average

Source: Federal Deposit insurance Corporation;
Office of Thrift Supervision,
U.S. Department of the Treasury

Final Report 69 Mt. Auburn Associates, Inc.


Development finance professionals confirm that the most important sources of risk
capital are the owner's personal assets, family, friends, and retained business earnings.

Far less important sources of risk capital are other formal and informal investors.
Informal private investors have been found to be very important by 9 percent of respondents
and somewhat important by 15 percent. Venture capital firms and small business investment
companies (SBICs) have been found to be very important by only 6 percent of respondents and
somewhat important by 9 percent. (See Table 4.1.)

Firms in urban and rural parts of the region attribute different levels of importance
to these types of investors, but the differences are not as clear cut as might be expected.
Survey respondents located in metro areas were more likely then non-metro respondents to
consider venture capital firms and SBICs as very important (7.5 percent to 4.4 percent), but less
likely to consider them somewhat important (5 percent versus 14 percent), These differences
were statistically significant. A similar pattern held for other private investors, but the
differences were not statistically significant. (See Table 4.2.)

Larger firms tend to attribute a higher degree of importance to informal private
investors than smaller firms. Almost 31 percent of larger respondents to the business survey
considered informal private investors as very important or somewhat important sources of
financing versus 17 percent of smaller respondents. However, there was no difference in the
importance attributed to venture capital firms and SBICs. (See Table 4.3.)

The level of personal financial resources within the Appalachian region is very low,
limiting the supply of informal investment capital. A large majority of counties within the
region have per capita income levels substantially below the national average, and almost none
have levels substantially above the national average. (See Map 4.3.) The scarcity of personal
financial resources is particularly extreme in the region's more rural areas. About 94 percent of
the region's non-metro counties have per capita income levels that are substantially below the
national average. In contrast, almost 30 percent of metro counties have per capita income levels
that are at or near the national average. (See Table 4.5.)

Development finance professionals report very little activity among formal risk
capital sources. Some venture capital firms were reported to very occasionally venture out
from their urban centers. Few respondents, however, could identify sources of formal risk
capital outside of the nearest big city. They also noted that businesses are often reluctant to use
venture capital because it typically requires them to give up a sizable piece of the business as a
condition of financing.

Our experience trying to interview SBICs indicates that these nominally
development-oriented organizations operate largely outside the rural parts of the
Appalachian region. Several SBICs located in or near the region were not willing to be
interviewed. Those that did indicated that they were not very active outside urban centers, and
did not partner with, and in fact were unaware of, development finance institutions in their
areas. As one SBIC manager noted, "We are looking for people capable of creating wealth.
These people don't want to be in depressed areas where development finance programs operate."

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Final Report MM. Auburn Associates, Inc.


(Pulver and Hustedde, 1988). Overall, there is little information about the availability of
venture capital in rural areas nor much comparative literature between traditional lenders and
venture capital investors, but anecdotal evidence suggests that venture capital firms do not play
a strong role in rural capital and credit markets (ERS, 1997).

2.3 Trenps In Smau. Business LENDING

2.3.1 Overview

The availability of credit to small businesses has gone from near drought in the early
1990s to a borrower's market during the last several years. Banks went from a "credit crunch"
so tight that foreign banks were able to significantly expand their lending to U.S. small
businesses to a lending binge made possible by industry-wide deterioration of lending
standards, and, more recently, to a somewhat less aggressive push for small business lending
with slightly more rigorous lending standards.

Much of this trend can be attributed to the strength of the economy in recent years and
the subsequent strong position of banking institutions. That is, the rates of return on equity
and on assets are high, delinquency rates for business loans have remained extremely low, and
bank profits are strong leaving banks in a good position to make capital available to small
businesses. Another important factor is federal regulatory reforms, which have significantly
loosened restrictions on geographic market entry and lending products for banks and other
depository institutions. In addition, product innovations and new technologies have increased
the ability of nonbank financial institutions to offer a wider range of products to consumer and
small business markets.

The financial services industry in the United States has undergone enormous structural
change during the last two decades. The growth of nonbank lenders, for example, has signaled a
considerable decline of traditional banks as the primary repositories for savings and as capital
lenders and has forced many banks to redefine roles, products, and services in a variety of their
lending markets. Concomitantly, the significant growth in capital market transactions largely
based on the packaging, repackaging, and hedging of financial instruments has dramatically
altered the content and character of capital markets in the United States (Arista and Schlesinger,
1996). Moreover, the failure of the savings and loan industry after industry-wide banking
deregulation generated multiple repercussions and restructuring not only for banks and their
customers but in the regulation of banks.

Notwithstanding these sweeping changes, commercial banks still dominate the market
for small business lending. Commercial banks loaned more money to small business than any
other time in the history of commercial banking, with $172 billion in bank credit to small
businesses in 1996. Even so, nonbanks have been expanding into the small business market and
nonbank small business lending also reached record proportions, with more than $96 billion
allocated by finance companies in 1996. Government lending programs to small businesses also
invested heavily in the small business market in 1996, SBA guaranteed loans totaled more than

16
Final Report Mt. Auburn Associates, Inc.


There is a range of viewpoints on how effectively development finance programs address
these gaps and what additional steps should be taken:

© State financing programs are generally not seen as useful to small firms,
non-manutfacturing firms, startup firms, and firms needing working capital. Some
local development finance professionals also complain that the state has made little
effort to foster tourism enterprises, an increasingly important component of the
region's economy.

© Some development finance professionals believe that the shortage of good technical
assistance is a more serious problem than the shortage of development finance
resources. While this is particularly true for startups, they note that even most
established firms still do not have business plans. Still, most appear to believe that,
with increased technical assistance capacity, the region could absorb more development
finance resources than are currently available.

© While KHIC is viewed as a highly competent organization that is addressing part of
the risk capital gap through its Development Venture Fund, some observers
believe there is still a gap for risk capital financings in amounts smaller than deals
in which KHIC typically participates.

© There is mixed opinion about the need for additional microenterprise financing.
Some development finance professionals believe microenterprise development is
overemphasized and does not hold the potential to significantly affect the region's
problems of poverty and unemployment. Even among those who are more supportive
of microenterprise development, the concern is more about increasing entrepreneurial
training and technical assistance than the availability of financing.

© The various development finance and technical assistance organization are seen as
having made progress in coordinating their activities. However, small business
assistance professionals indicate that small businesses and new entrepreneurs still have
difficulty identifying resources and determining where to go for assistance.

Some firms remain reluctant to use development finance programs because of fear
of red tape and taking on additional debt.

SumMMARY

The Cumberland Valley ADD region faces a number of economic development
challenges and still lags well behind national averages in measures of economic well-being. Yet,
the region is also experiencing positive, if uneven, economic trends. The region's private capital
markets have turned in a mixed performance in supporting economic development. The
banking industry, despite a limited deposit base, appears to be reasonably competitive and to
offer a level of service to businesses comparable to other parts of the country. However, like
many poor, rural regions, the region lacks access to other sources of capital, particularly formal
and informal risk capital. At the same time, the region benefits from a number of
well-established, highly-regarded development finance organizations that fill gaps left by the

BT
Final Report Mt. Auburn Associates, Inc.


Sources oF DEVELOPMENT FINANCE
Local and Regional Organizations

North Central Pennsylvania Regional Planning and Development Commission
(NCPRPDC). NCPRPDC is the primary source of development finance resources within the
region. NCPRPDC is a nonprofit organization also organized as a Regional Planning
Commission acting through the Pennsylvania Department of Community Affairs. It is
governed by a 25-member board composed of county and municipal elected officials and local
civic leaders. Its membership is appointed by the region's six county commissioners and the
mayors of each of the region's cities.

NCPRPDC has three revolving loan funds.

© a U.S. Department of Agriculture Intermediary Relending Program (IRP) with
current capitalization of about $2 million;

© an ARC RLF with current capitalization of about $1.6 million; and

© an Economic Development Administration RLF with current capitalization of
almost $1.2 million.

NCPRPDC loans are provided on the following terms:

© Joan amounts in the $10,000 to $100,000 range for fixed assets and in the $10,000
to $50,000 range for working capital;

© maturities range from three to ten years;

© interest rates ranging from 4 percent to four points below prime and fixed at
closing; and

© aminimum of 50 percent of the deal in private financing.

About two-thirds of the loans are to startups and about 60 percent to PM houses. Most
of the loans are for fixed assets because borrowers prefer to use low-interest loans for
longer-term assets.

NCPRPDC has experienced strong demand for its RLF loans and has aggressively lent
out its funds. As of May 31, 1997, it had a total of almost $4.6 million in loans and
commitments outstanding and only $215,000 available to lend. It had a total of about 200 loans
outstanding. NCPRPDC staff report that they receive about 10 applications for every loan
approved.

Many of the banks in the region are eager to participate in financings with NCPRPDC,
and also have representatives on the organization's loan committee. Banks report a number of
reasons for their interest. First, the low-interest rates are attractive to their clients and improve
cash flows. Second, smaller banks sometimes cannot lend the full amount needed by borrowers

C5
Final Report Mt. Auburn Associates, Inc.


that these banks understand that small local businesses comprise their marketplace and
community. On the other hand, other respondents reported that regional banks are more
responsive. Factors noted as contributing to this perception were the efforts of regional banks
competing to gain market share in an evolving marketplace, and their ability to offer greater
sophistication in responding to borrowers’ increasingly sophisticated demands. At the same
time, community banks were sometimes seen as taking themselves out of the competition by
focusing on the consumer and home mortgage market to the exclusion of commercial credits.
An oft repeated qualification to this positive assessment of regional banks was the importance of
decentralized branches and decision-making to provide access and timely decision-making.
Exceptions to the community/regional bank dichotomy are new banks, which uniformly were
seen as being aggressive in small business lending in order to establish a foothold in the
marketplace.

Bank Participation in Development Finance Programs

Bank participation in development finance programs varies. While it differs from
nationwide patterns, it is not clearly either higher or lower than that of banks outside the
region. While data on bank participation is not easily available for all development finance
programs, particularly state and local programs, data from two major SBA programs, the 7(a)
Guarantee program’ and the 504 Certified Development Company program,” can provide some
indication of the relative aggressiveness of banks in the region in the use of development finance
programs. This data provides conflicting results, with participation in the 7(a) program
generally high, but participation in the 504 program generally low.

Bank participation in the SBA 7(a) program tends to be relatively high. As
measured by number of loans outstanding per 1,000 enterprises, most counties in the region
substantially exceed the national average. (See Map 4.8.)

There is one glaring exception to this pattern. In all of the Appalachian region's
Tennessee counties, as well as counties in bordering areas of Kentucky and Virginia, almost
every county is substantially below the U.S. average. This may indicate that banks in that area

are resistant to using the program or that there is a problem in the SBA district office serving
that area. (See Map 4.8.)

In contrast to use of the 7(a) program, use of the 504 program tends to be relatively
Jow. In most counties in the region, use of the 504 program, as measured by number of loans
outstanding per 1,000 enterprises, is substantially below the U.S. average. There are a few
notable exceptions to this, particularly in the state of Alabama, where use of the program
substantially exceeds the U.S. average in most counties. Other patterns of high 504 use occur in
the Appalachian counties of Georgia, around Knoxville, Tennessee, and in smaller clusters in
parts of North Carolina, West Virginia, Pennsylvania, and New York. (See Map 4.9.) These

Under the 7(a) program, the SBA guarantees repayment of up to 90 percent of outstanding principal on secured loans made
to small businesses by private lenders. The maximum guaranty amount is $750,000.
Under the 504 program, statewide and sub-state development finance organizations, certified by SBA to participate in the
program, make loans to small businesses for real estate and equipment in conjunction with private lenders. The certified
development companies finance up to 40 percent of project costs and take a junior collateral position to private lenders.
Loans are at fixed, below-market rates, and the maximum loan amount is $750,000.

15
Final Repore Mt. Aubuen Alesociates, Inc.

?


SSeS EE

CHaAprTer THREE:

ANALYSIS OF DEMAND For Financing AMONG

BUusmnEsseEs IN THE APPALACHIAN REGION

3.1 INTRODUCTION

As noted earlier, there are no practical analytic methodologies for accurately measuring

the absolute level of demand for business financing, much less for particular types or amounts
of financing. In the absence of such methodologies, indirect indicators of financing demand
must be relied upon. This chapter synthesizes analysis of three indirect sources of data on
financing demand. These sources are:

L

Broad measures of the structure and performance of the Appalachian regional
economy. Data on economic structure includes the relative share of economic
activity comprised by firms of different sectors, sizes, and ownership characteristics.
Data on economic performance includes employment growth, unemployment rates,
and rates of enterprise formation. This data is analyzed at the county level and also
by urban vs. rural status.

Results of a survey of over 200 Appalachian region businesses with five or more
employees. This includes data on the types and amounts of financing sought in the
recent past by businesses and financing needs projected for the near future. This data
is broken down by firm size and by urban vs. rural location.

Results of telephone interviews with development finance professionals, and
face-to-face interviews with development finance professionals, economic
developers, local officials, and bankers in three diverse parts of the Appalachian
region served by regional economic development districts. These interviews
provided informed perceptions of business financing needs in the region.

The analysis and synthesis of data from these sources enable us to develop the following

indirect indicators of financing demand:

the overall demand for financing in counties of the Appalachian region relative to the
rest of the nation, as evidenced by measures of economic performance;

the level of demand for financing by different types of businesses in the region
relative to the rest of the nation, as evidenced by measures of economic structure;

the relative importance of different types and amounts of financing to businesses in
the region;

projected trends in demand for financing based on expectations of future economic
performance and the investment plans of businesses; and

33

Final Report Mt. Auburn Associates, Inc.


financial services, make access to business financing more problematic than in other
parts of the U.S.

© A small but still significant proportion of established Appalachian firms as well
as a larger proportion of startups, high-growth firms, firms in non-traditional
industries, and firms owned by non-traditional entrepreneurs, are seriously
affected by inability to obtain sufficient financing. In addition, firms in the more
economically distressed parts of the region appear to face more severe financing
constraints because of lower levels of financial resources and less competitive

financial markets.

© Businesses in the region do not appear to pay a premium in financing costs.
While providing subsidized financing may be justified by other factors constraining
business development, it is not required to address inefficiencies in financial markets.

© There is somewhat of a mismatch between the unmet financing needs of firms in
the region and the financing tools emphasized by the region's development
finance organizations. While the most difficult types of financing to obtain include
risk financing, working capital financing, and financing of less than $50,000,
development finance sources place a stronger emphasis on providing secured debt
financing, particularly for fixed assets, and on participating in financings of greater
than $50,000 and, more typically, greater than $100,000. Development finance
professionals themselves generally support this finding.

® There is some evidence of inefficiencies in the distribution of development
finance resources. While some ARC-funded revolving loan funds cannot meet the
demand for financing, others have not drawn on all of their available funds. Other
federally-funded programs that make large grant or low-interest loan commitments
that are then drawn down as needed by local development finance organizations are
likely to experience similar inefficiencies.

® There is widespread recognition in the region's development finance community
of the need to expand non-financial business assistance and better coordinate it
with financial assistance.

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Final Report Mt. Auburn Associates, Inc.


Map 3.5

Establishments with 250 or more Employees
as a Percentage of all Establishments, 1994

[___] Below 85% of U.S. Average
[I 85% to 115% of U.S. Average
Es Above 115% of U.S. Average

Source: U.S, Department of Commerce,
County Business Patterns

ti) 50 100 150 200 Miles
 —

Final Report 40

Mt. Auburn Associates, Inc.



Map 4.2

Total Commercial Bank Deposits
Per Capita, June 1996

[___] Below 85% of U.S. Average
[BR 85% to 115% of U.S. Average
ial Above 115% of U.S. Average

0 50 100 150 200 Miles
 _——

Source: Federal Deposit Insurance Corporation

Final Report 65 Mt. Auburn Associates, Inc.


Map 3.2

Average Unemployment Rate,
1993 - 1995

[___] Below 85% of U.S. Average
[EE 85% to 115% of U.S. Average’
(Treat Above 115% of U.S. Average

Source: Bureau of Labor Statistics, te) 50 100 150 200 Miles
U.S. Department of Labor ee

Final Report 36 Mt, Auburn Associates, Inc.


Map 4.5

Total Commercial Banks Per
10,000 Population, June 1996

[___] Below 85% of U.S. Average
[J 85% to 115% of U.S. Average
(ane Above 115% of U.S. Average

nN

0 50 100 150 200 Miles
Source: Federal Deposit insurance Corporation —

Final Report 35 Mt. Auburn Associates, Inc.



QaaooaaqaSSsSsSESESESESSS——————————————— eee
CHAPTER SIx:
Key Finbinés anp RECOMMENDATIONS

6.1 Summary or Key Finpineés

1. The economy of the Appalachian region, while performing well in some respects,
continues to lag the rest of the nation in key measures of economic health,
including unemployment, new enterprise formation, and participation by
non-traditional entrepreneurs. This is particularly true in the more rural parts of
the region. Greater capital availability alone can not address these problems, but can
play an important role as one tool in the economic development "toolbox."

2. The present and evolving structure of the Appalachian economy has important
implications for capital needs. The region remains more heavily dependent on its
manufacturing base than the nation as a whole. Manufacturing firms that have the
potential to remain competitive will need to modernize, boost productivity, and
develop new products and markets. Financial products tailored to the needs of
manufacturers, along with other forms of business assistance, will be required to
address these needs. At the same time, certain industries are playing an expanding
role in the region's economy, such as tourism and other service industries, small
suppliers to large manufacturing facilities (e.g., new automobile assembly plants),
and technology-based industry. ‘Traditional financing sources will have to modify or
develop new financing products to address the particular needs of these industries.

3. While there is no evidence of widespread, systemic gaps in the availability of
private sector business financing in Appalachia, the region has lower levels of
financial resources and offers business fewer financing options. Personal financial
resources, the most important source of risk financing for startup and early-stage
firms, are at a low level in the region. Beyond the entrepreneur's own financial
resources and those of family, friends, and business associates, Appalachian
businesses are heavily dependent on the banking industry for financing. Financing
sources that are active outside the Appalachian region, including non-bank SBA
lenders, commercial finance and leasing companies, SBICs, and venture capital firms,
provide very little financing to Appalachian businesses. his is particularly true in
the more rural and economically distressed parts of the region.

4. Despite this relative scarcity of financial resources, the availability of financing
does not appear to be a strong concern to a large majority of Appalachian
businesses. Insufficient financing appears to have a serious impact on the
investment decisions of about one in five established companies. (It is also unlikely
that all of these investments would be financially justifiable even if financing were
available.) At the same time, Appalachian firms appear quite conservative in their
use of financing, particularly firms in rural areas. Business attitudes about the use of
financing may pose a further constraint to business investment and growth.

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Final Report Mt. Audburn Associates, Inc.


* terms of five to ten years (usually no more than seven years);
© primarily fixed-asset financing; and

© most of the borrowers were in the manufacturing sector, but the tourism-related
businesses are also targeted.

CVADD typically provides financing in participation with banks, often on a
subordinated basis. It also works with borrowers to approach other financing sources and to
structure deals. While CVADD advises prospective borrowers on the development of their
business plans, it does not provide extensive technical assistance. Rather, it refers borrowers to
other technical assistance sources such as the Small Business Development Center.

Kentucky Highlands Investment Corporation (KHIC): (KHIC is a nonprofit
community-based development organization focusing on small business investment and venture
development. It currently has a staff of 15 and almost $30 million in assets. Its business
financing activities include:

© an SBA-funded microloan fund that makes loans of $500 to $25,000 in a 12-county
region. The fund is currently capitalized at $545,000 and made six loans in 1996;

© a revolving loan fund capitalized by the U.S. Department of Agriculture's
Intermediary Relending Program (IRP);

© = real estate financing;
© revolving credit lines; and

© a Development Venture Fund that makes venture capital investments in the $50,000 to
$1.5 million range. As of June 1, 1997, it had 12 investments with an outstanding
value of $2.3 million. The average KHIC investment per deal was $417,000 and the
average total investment per deal was $3.1 million.

In addition to its financing activities, KHIC also provides extensive entrepreneurial
training and technical assistance, It takes a very active management role in companies in its
venture portfolio, much like traditional venture capital firms. It is also willing to hold an
investment much longer than a traditional venture capitalist if necessary to produce economic
benefits for the region.

Eastern Kentucky Corporation: Eastern Kentucky Corporation serves 43 of the 49
Kentucky counties in the ARC region. It is funded by utilities, coal-related companies, and
banks. It has a privately capitalized $1 million revolving loan fund that provides subordinated
financing of $10,000 to $50,000, primarily to small manufacturers. It had 13 outstanding loans
and three loan commitments as of May 31, 1997, two of which were in the CVADD region. The
organization is also involved in industrial recruitment.

Mountain Association for Community Economic Development (MACED). MACED,
a community-based development organization based in Berea, just north of the CVADD region,

B-5
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3.4 Tue Narone or Caprrar anp Crepit DEMAND

The responses from the business survey provide a good overview of the relative
importance of different types and amounts of financing to Appalachian businesses.*

3.4.1 Types oF FINANCING

Asked what types of financing they had sought during the past three years, respondents
answered as follows: (See Table 3.2.)

© the most frequently sought types of financing were revolving lines of credit (36
percent), equipment loans (32 percent), equipment leases (25 percent), and fixed-rate
mortgages (25 percent);

© other frequently sought types were medium-term working capital (18 percent) and
short-term working capital (16 percent); and

© the least frequently sought were export trade financing (2 percent), and equity or
debt with equity features (about 2 percent).

Table 3.2
Experience in Obtaining Financing in the Past Three Years (%)
Turned Down é 2

[Fixed rate commercial mortgage 34 34 8.0 39
[Variable rate commercial mortgage 10 58 7.1 34
[Equipment loan 15 29 616 39

‘quipment lease 10 29 675 44

jediumn-term working capital (1-5 years) 15 63 @4 63
Short-term working capital (under | year) 19 58 723 63
[Revolving line of credit 24 49 $5.3 39
[Asset-based financing 15 19 811 68
[Export trade financing 0s 0s 92.2 54

quity of debt with equity features 10 10 86.3 88
|Note: Total number of respondents = 206
[Source: Mt. Auburn Business Survey

3.4.2 AMOUNTS OF FINANCING

Among those who had sought financing, the amounts of financing varied considerably.
Among the amounts of financing most frequently requested for each type of financing were the
following: (See Table 3.3.)

* It should be noted that the survey included only existing businesses and requested information only about financing
experiences during the previous three years. The results, therefore, do not reflect the financing experiences of most startup
firms and tend to under-emphasize the demand for early-stage equity or equity-like financing among such firms,

46
Final Report Mt. Auburn Associates, Inc.


professionals broadly agree that lack of access to financing prevents or retards potentially viable
startup businesses.

Graph 5.1

Way In Which Plans to Expand, Modernize, or Renovate were
Affected by Inability to get Financing in the Past Three Years (%)

Number of Respondents

Number of Respondents = 37
‘Sowee. Mt Aubum Business Survey

5.2.1 Types AND AMOUNTS OF FINANCING

The highest unmet financing needs among existing firms are for various kinds of
working capital. Among respondents to the business survey, both medium-term and
short-term working capital are needed but have not been obtained by almost 8 percent of
respondents,’ and revolving lines of credit by a little over 7 percent. (See Table 3.2.)
Development finance professionals widely agree that working capital is the hardest type of
credit to obtain. In more conservative banking areas, those interviewed reported that any
financing collateralized by assets other than real estate was also difficult to obtain.

Next to working capital, the greatest unmet financing need is for commercial
mortgages. Both fixed-rate and variable-rate commercial mortgages are reported by almost 7
percent of survey respondents to be needed but not obtained. In addition, a higher percentage
of respondents, over 3 percent, were actually turned down for fixed-rate commercial mortgages
than for any other type of financing. (See Table 3.2.)

The lowest unmet financing needs reported by respondents were for export trade
financing and equity or debt with equity features. Only one percent reported needing but not
having obtained export trade financing, and only 2 percent reported needing but not having

2 Unmet need was calculated for each type of financing by adding the percentage of respondents turned down to
the percentage who needed the financing but had not yet tried to get it.
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Table 2.4: Financial Trends of Rural and U.S. Commercial Banks, 1990-1995

m2

Average assets
Average deposits
Average loans

Composition of Loan Portfolio:

25.2] 305 31
0.7 2a] 226] 198] 235) 138
20.1[ 209 2] 198] 19.1] 20.6] 186) 18.7
26.9) : M1] 156 28
9a] 29) 26| 82) 23[ 84] 21| 82) 2
1a] 99] 19] _10 1o| 18] 97
80.2 06] 75.7) 06 64
34| 38 39] 38] 42) 42] 37] 42)
05] 09] 0: i{__ oo] 12 13[ li] 12
Equity capital/assets 64] 86] 67] 87] 75] 9. 95] 78] 93
Problem loans/equity capital 35.7 27| 76 61] 98] 53
Loan loss provision 07 07] 13] o6| oa] o4| os] 03

Quarterly average holdings of 25 5 48] 21/ 49) 21) 55 2
tax-exerpt/assets

Quarterly average federal funds 48) 54 48] 45) 42) 43) 36) 39) 25
sold, securities purchased/assets
Quarterly average federal funds} 8.4) 14) 7.2) 16} 7.5 2 8} 22) 78) 28
purchased, securities sold/assets
Source: Credit in Rural America, 1997. Rural Economy Division, Economic Research Service, U.S. Department of Agriculture, Agricultural

Economics Report No. 749. Calculated by ERS from the Federal Reserve Board's Report of Condition and Report of Income files, December
131. 1990-199.

One notable difference between rural and urban commercial banks is in loan-to-deposit
ratios. Lower loan-to-deposit ratios among banks based in rural areas indicates that these banks
lend less aggressively than their urban counterparts. Further analysis, however, indicates that
these differences are related to bank size, not bank location. Banks of similar size in both rural
and urban areas have comparable loan-to-deposit ratios. In fact, among banks with assets of
$500 million to $1 billion, rural banks outperform urban banks by about eight percentage
points. (See Table 2.5.) It should also be noted that this data does not provide a complete
picture of commercial bank lending in rural areas because many large banks that are
headquartered in urban areas and thus classified as urban also have a large number of banking
offices in rural areas.

Final Report Mt. Aubsen Assoctates, Inc.


The purpose of this study is to:

help ARC and other economic development policymakers in the Appalachian region
to better understand how conditions in the Appalachian economy and the functioning
of the region's capital markets interact to affect the availability of capital and credit
for the region's businesses and;

identify ways that the Appalachian Regional Commission can more effectively
address unmet business credit and capital needs in the region. This includes helping
ARC to assess the capacity of its RLF Program to address the region's business
financing needs and to provide practical guidance in the refinement of the program or
the development of additional tools to more effectively address such needs.

The approach to the study has involved the following:

identifying and measuring the demand for financing among important business
segments of the ARC regional economy, with a focus on small- and medium-sized
enterprises;

identifying major current business financing sources active in the ARC region and
measuring the adequacy of the supply of important types of financing to the region's
businesses;

assessing the effectiveness and efficiency of current institutional structures for
delivering business credit to the region's businesses; and

identifying current gaps, weaknesses, and/or resource shortages in the current
business finance system, and recommending programmatic and institutional changes
for ARC to undertake or support in order to address business financing issues.

The study has included the following research:

. analysis of county economtic and banking market data;

a survey of over 200 businesses throughout the region with five or more employees;
interviews with 22 development finance professionals;
an inventory of almost 400 state, regional, and local development finance programs;

an assessment of recent financing activity by ARC RLF;

6. case studies of business financing needs and gaps in three representative multi-county

Final Report

areas served by ARC RLFs; and

. a literature review of business finance conditions and trends affecting small

businesses and businesses in rural areas.

Mt. Auburn Associates, Inc.


Map 3.7

Service Establishments as a Percentage
of All Establishments, 1994

Below 85% of U.S. Average
85% to 115% of U.S. Average
[tected Above 115% of U.S. Average

Source: U.S. Department of Commerce, o 50 100 150 200 Miles
County Business Patterns a

Final Report 43 Mt. Auburn Associates, Inc.


Table 4.7
Comparison of Commercial Bank Performance in the ARC
Region, by Urban or Rural Headquarters Location (12/31/96)

Metro County Non-Metro County
$929,258 $137,814
Net Interest Margin 3.51% 4.17%
Return on Assets 1.27% 13%
Equity Capital/ Asset Ratio 8.11% 9.99%
Loan/Deposit Ratio 94.07% 76.83%
Loan Loss Provision 0.19% 0.36%
Problem Loans/Equity Capital 6.45% 5.59%

Source: Rural Economy Division, Economie Research Service, U.S, Department of Agriculture.
Caleulated by ERS from the Federal Reserve Board's Report of Condition and Report of Income files,
December 31, 1996.

Rural-based banks tend to lend less aggressively than urban banks, but this appears
more related to differences in bank size than location. The lower average loan-to-deposit ratio
is consistent with differences in bank asset size, as discussed in Chapter Two. (See Table 4.7.)

With respect to bank size, small banks headquartered in or near a business' home
community are considered more important by business survey respondents than larger
statewide or multi-state banking organizations. As noted earlier, 62 percent of respondents to
the suryey have found small banks to be a very important or somewhat important source of
financing, compared to only 49 percent for larger banks. Borrowers in non-metro counties have
found small locally-owned banks to be particularly important. Seventy percent of non-metro
respondents have found small banks to be very or somewhat important, while only 49 percent
attribute the same level of importance to large banks. (See Table 4.1.)

Larger statewide and regional banks tend to be considered more important by
businesses in metro areas than those in non-metro areas. About the same proportion of
metro respondents have found large and small banks to be very or somewhat important in
meeting their financing needs (52 percent for large banks versus 56 percent for small banks).
(See Table 4.2.)

Correspondingly, larger statewide and regional banks are more likely to be
considered important sources of financing by larger than by smaller firms. Fifty-eight
percent of larger firms consider these banks very or somewhat important sources of financing
versus 42 percent of smaller firms. And a roughly equal proportion of larger firms consider the
large banks and local banks as important sources of financing, while smaller firms favor local
banks by a large margin. At the same time, an approximately equal proportion of smaller and
larger firms consider local banks as important sources of financing. (See Table 4.3)

In part reflecting the dichotomy between urban and rural banking markets, and
smaller and larger firms, development finance professionals have differing views on what
types of banks are most responsive to small business credit needs. Some indicated that
smaller, local banks are more responsive. Typical rationales underlying this perception were

74
Foul Report Mt. Auburn Associates, Ine.


As in the rest of the U.S., the major trend affecting financial markets in the
Appalachian region is the consolidation occurring within the banking industry. While this
phenomenon has occurred at a slightly slower pace in the region than in the nation as a whole,
particularly in urban parts of the region, many previously independent local banks have been
purchased by larger statewide and regional banking organizations. (See Table 4.11.)

Table 4.11
Change in Number of Commercial Banks, 1990-1996
(by Bank Headquarters Location)

12/31/90] 12/31/96 | Percent Change

Appalachian Region 999 805 -19.42
12,257 9,413 -23.2

Appalachian Region 371 287 -22.64
5,788 4,117 -28.87

Appalachian Region 628 518 17.52
US. 6,469 Lae -18.13

‘Source: | Rural Economy Division, Beonomic Resarch US. Department of
Agriculture. Geil by B Be Pens doe Faker! Rescrre Bowes Repor af Condition
‘and Report of Income files, December 31, 1990-1996,

Development finance professionals agree that recent bank mergers and acquisitions
in the region have led to significant changes in the credit environment, but offer divergent
opinions on the impacts. In many cases, the consolidations are seen as having produced
aggressive regional banks competing for commercial credit and providing more diverse lending
products and sophistication. However, other respondents report a loss of local sensitivity and
responsiveness flowing from consolidation trends. Some allege that the lack of proximity of the
consolidated banks chills their interest in local businesses. Others indicate that shifting
personnel among loan staffs makes it more difficult for lenders to familiarize themselves with
local conditions. A number of respondents note a decided shift among local businesses to the
remaining locally-owned banks.

While the impact of banking consolidation on credit availability for the region's
small firms has been mixed to date, bankers and development finance professionals agree
that the longer-term impacts are still uncertain. Bankers interviewed for our case studies, in
particular, noted that some local banks are still "in play" and that additional acquisitions are
likely to occur in the future. While competition among banks appears currently to be strong,
there are some concerns that increasing market concentration and product standardization
among larger banks create less favorable conditions for smaller firms.

Final Report Mt. Aubsen Assoctates, Inc.


t.

Arsen

‘ssociates

408 Highland Avenue * Somerville, (HA 02144
‘Telephone: (617) 625-7770 * Fax (617) 623-5943

Capital and Credit
Needs in the
Appalachian Region

FINAL REPORT

Prepared for:
Appalachian Regional
Commission

Prepared by:
Me. Auburn Associates, Inc.
with
Community Investment
Associates

Contract No.: @O-12612-97

February 10, 1998


available from ARC and other sources of RLF grant capital, as well as the procedural constraints
placed on ARC's ability to reprogram unused RLF grant capital, it is probably unrealistic to
assume that this demand can be fully met through additional capital grants. In addition, the
use of grant capital alone to meet financing demand is not necessarily an efficient use of grant
funding, particularly for RLFs with solid lending track records that have the ability to leverage
their core capital. Many nonprofit loan funds have been able to leverage capital grants with
additional debt financing to expand the total amount of funds available for loans. Others have
sold loans in secondary markets to increase their available capital.

ARC could help its RLFs to obtain additional loan capital in a number of ways. Some of
these could be relatively low-cost information or brokering initiatives. Others might involve
providing direct financing or credit enhancements. The following options are recommended for
consideration.

> Directly Provide or Guarantee Capital Loans to RLFs

ARC could provide capital loans to RLFs experiencing high loan demand. These
loans would not replace capital grants but would be offered as an additional level of financing
for RLFs that could not accommodate loan demand with grant capital. Such loans should be
structured to enable RLFs to meet near-term loan demand, not as permanent additions to RLF
capital. Interest rates should reflect the cost of funds for federal agencies and terms should be
for no more than five years. A loan could be renewed if the RLF demonstrates that loan demand
continues to require additional capital. It should be noted that an amendment to ARC's
authorizing legislation would be required to enable it to lend funds.

As an alternative to direct loans, ARC could guarantee loans to RLF s from banks or
other non-government financing sources. Such loans could be obtained from a number of
sources, including banks, foundation program-related investments, development
intermediaries, or socially-responsible mutual funds. Guarantees could be structured such that
ARC and the RLF share the risk and returns on the business loans underlying the guarantees.
For example, ARC could require the RLF to establish a reserve to back the guarantee and could
charge an annual guarantee fee. The terms of the guarantee should be tied to the RLF's
historical portfolio track record, i.e., larger reserves or higher fees might be required of RLFs
with weaker track records.

> Develop Mechanisms to Support the Sale of RLF Loans to Secondary
Market Investors

Secondary market transactions involve the sale by loan originators to other investors of
loans or financial instruments secured by loans in exchange for a negotiated cash value based on
Joan asset quality and revenue streams. Such transactions generally involve the pooling of
individual loans and the sale of these pools or of securities backed by the pools. Intermediaries
often play a role in assembling pools and negotiating transactions.

The sale of secondary market securities, first in the residential mortgage market, and
later in commercial mortgage and business loan markets, has been going on for several years. In

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Final Report Mt. Auburn Associates, Inc.


Tue Demanp ror Financine: Toe Region's Business Base

The manufacturing industry remains a relatively important component of the region's
economic basic. Manufacturing employment in 1995 comprised almost 25 percent of total
regional employment, compared to 15 percent statewide and under 13 percent nationally.
Important manufacturing sectors include powdered metals and metal fabricating, forest
products, and specialized electronics. Other industries that contributed to the region's traded
sector include warehousing and distribution, and tourism.

The powder metallurgy industry has become a particular success story in the region in
recent years. The powder metallurgy process involves placing metal powders in dies and
forming metal parts using a combination of heat and pressure. Powder metal parts are used
primarily in the automotive industry, but are also used in other products including household
appliances, tools and hardware, and industrial motors.

The local powder metallurgy (PM) industry has its roots in the carbon factories
established in the region in the late 1800s. The first powder metallurgy firm was started in the
region soon after World War II. Over time, employees of established PM firms left to found
their own companies. Today there are over 40 PM houses operating in the region. The market
for powder metallurgy products has been expanding in recent years because of the strong
performance of the automotive industry and the industry's increasing use of relatively
inexpensive PM parts. The industry is said to be highly profitable at the present time and is
thought to have considerable expansion potential.

The capital costs involved in starting a PM house have been relatively modest in the
past, but this is changing with the introduction of more advanced technologies. Today, the
equipment costs for a startup PM house are typically at least $1 million. This, in turn, has made
it more difficult for new entrepreneurs in the industry to attract startup capital as they have had
to reach beyond their own resources and those of friends and family members.

While far less important than the PM industry, other growth industries include
secondary wood products (e.g., cabinetmaking) and tourism. The region has substantial
hardwood forest resources suitable for the manufacture of secondary hardwood products. It
also has a number of rivers and scenic areas, including the Allegheny National Forest and three
state forests, suitable for a variety of outdoor recreational activities. Another trend noted by
bankers and economic development professionals has been the growth in the number of
home-based businesses operated by professionals who are attracted to the area by its rural
character.

Cc-2
Fonal Report Mt. Aubuen Associates, Ine.


aaaaaa————SSSSSSSSSSSSDEa>>E=a=EaE>E>E>EEEEE—

Cuaprer One: INTRODUCTION

1.1 Purpose or THE STuDY

Rural businesses, like businesses everywhere, need capital to fuel their development.
Businesses need particular types of capital at each stage of their development: equity capital for
startup, product development, major expansion, and buyouts; long-term debt for the purchase
of durable assets -- land, plant, and equipment; intermediate-term debt for permanent working
capital and equipment purchases; and short-term debt to finance inventory and accounts
receivable. Each of these types of capital must be available in adequate amounts and at
reasonable costs for a business to perform at its full capacity.

The market and regulatory changes that have transformed the financial service industry
during the past two decades have been strongly felt in rural communities. First, the scale and
locus of control of rural depository institutions have altered as the advent of interstate banking
has produced greater concentration of the banking and thrift industries at the national level and
reduced local control over credit decisions. Second, the number of depository institutions
operating in rural markets has declined, lessening competition. Finally, consumer savings have
increasingly shifted from local depository institutions to national non-depository intermediaries
such as mutual funds, putting smaller borrowers at a disadvantage.

As market innovation, new technology, and regulatory reforms have made traditional
savings and credit arrangements obsolete, policymakers and economic development
practitioners at the federal, state, and local levels have sought to implement regulatory and
programmatic responses to maintain and enhance credit availability for rural businesses and
other affected groups. This has included developing programs that establish new public and
quasi-public financial institutions to fill market gaps. One such program is the Appalachian
Regional Commission's Revolving Loan Fund Program. Since 1977, the Appalachian Regional
Commission (ARC) has provided $20.6 million to capitalize 29 loan funds in 10 states. These
funds have made a significant contribution to business credit availability in ARC communities,
making about 1,000 loans totaling over $50 million through August 1997.

As changes in the private financial market have spurred the establishment of RLF's and
other development finance programs during the past 20 years, so too have recent developments
in the financial markets and the field of development finance required a reexamination of
traditional development finance tools. With the development of new credit products and
lending procedures by private financial institutions and the proliferation of public,
quasi-public, and private nonprofit development finance institutions, administrators of
programs such as ARC's RLF Program, must revisit such issues as their programs’ market
niches, business targets, financing tools, and investment partners.

Final Report Mt. Auburn Associates, Inc.


recent years, a number of efforts have been undertaken to increase the sale to secondary market
investors of loans made for community development purposes. These include the establishment
of nonprofit secondary market intermediaries, such as the Minneapolis-based Community
Reinvestment Fund, and initiatives by state development finance agencies in South Carolina,
New Jersey, New Hampshire, and other states to sell secondary market securities backed by
business loans. Private loan brokers have also become involved in arranging secondary market
sales, both of individual loans and loan pools. Federal agencies, notably EDA and HUD, have
funded studies and pilot programs to promote secondary market sales of loans made with their
funding, although these efforts have, to date, not been very successful. One of the major
barriers to such efforts is the unwillingness of local and regional development finance
organizations to sell below-market loans at the discount required to provide the return
demanded by secondary market investors.

While efforts to establish secondary markets for small business loans have met with
mixed success, the concept of selling loans for cash to make additional loans is a sound one for
development lenders who would not otherwise have the resources to meet loan demand. While
loans originated at below-market interest rates are likely to be purchased at a discount, this may
be an acceptable trade-off for an RLF with no other means to finance a potentially viable local
business. Moreover, the discount does not actually represent a loss of funds to the RLF, but
rather the current value of the revenue losses from below-market interest rates that the RLF
would otherwise incur in the future. RLFs considering selling loans in the secondary market
would have to more carefully consider borrowers’ subsidy needs when pricing their loans.
While subsidizing interest costs, like reducing other business costs, may make certain
businesses more viable, this does not mean that interest subsidies are always necessary or even
desirable.

ARC should consider a number of options to develop mechanisms to facilitate secondary
market sales by ARC RLFs. These include the following:

® educate RLFs about existing opportunities to sell loans in the secondary market
and about the requirements of secondary market investors;

© provide technical assistance to individual RLFs in negotiating and packaging
secondary market sales to local banks. Local banks may be willing to purchase
seasoned loans made to current or prospective bank customers;

© solicit interest in purchasing RLF loans from national development
intermediaries or from social investors (e.g., foundations, religious pension
funds) with a particular interest in the Appalachian region or rural areas in
general. This might include retaining a broker to solicit interest among potential
purchasers and to broker loan sales;

® provide standby letters of credit for loan sales by individual RLFs. While the
RLF reserves would remain the first recourse for secondary market investors, ARC
could provide an additional layer of security to reduce investor risk and, therefore,
increase the yields to RLFs from the loan sales;

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Final Report St. Aubswn Associates, Inc.


The cost of credit is roughly comparable in urban and rural areas overall.
However, credit costs in some rural areas can be higher because of the risks associated
with a more homogeneous client base. In addition, transaction costs for large or
complex financings can be higher in rural areas.

Despite fewer banking choices and lower levels of competition in rural markets,
rural businesses tend to be much more satisfied with their lenders and have better
personal relationships with their lenders than urban businesses. Their assessment
of their banking relationship is dependent less on the terms of financing than on
other factors such as their relationship with their banker, the reliability of credit, and
the speed of loan decision-making. They are more likely to establish relationships
with small, locally-based institutions than larger non-local institutions, in part
because these institutions are more flexible in underwriting loans.

Financial market conditions are least favorable for businesses in persistent
poverty areas. These areas have fewer banking choices and lower levels of
competition, and businesses in these areas have more trouble accessing financing.
Other areas with less favorable conditions include those where there is a mismatch
between the size structure of businesses and banking organizations;

Rural businesses that are most likely to have problems obtaining financing
include those in emerging or overcrowded industries, startup firms, women- and
minority-owned firms, and businesses with non-traditional management
structures. This is also the case in urban areas.

The most significant financing gap for rural businesses is in the availability of
risk financing. Rural businesses have more difficulty than their urban counterparts
in identifying and securing this form of financing.

With respect to small business lending, the literature generally indicates that, at the

present time, small business customers are being well served by commercial lenders and by the
intense competition that has emerged from recent regulatory and market changes. Specific
findings include:

The number of financing entities targeting small business customers has
dramatically increased over the last decade. These entities are geographically,
philosophically, and structurally diversified, which has translated into greater
flexibility and choice for small business customers. For example, the entrance of
nonbanks into the small business market has meant more streamlined underwriting
through the use of credit scoring and faster approval processes. In the process of
competing with nonbanks and other banks alike as well as responding to regulatory
changes, banks are redefining themselves in ways that on the surface appear to be
advantageous to small businesses.

The variety of products designed and targeted for small businesses has
dramatically increased. For example, the entrance of credit card issuers into the
small business lending market has meant lower costs on other business expenses such
as airlines tickets and office supplies.

Final Report Mt. Auburn Associates, Inc.


capital is one, if not the sole, constraint to new enterprise formation. In addition, while scarcity
of risk capital does not appear to hinder most established firms, it is likely to pose the greatest
problem for the relatively small number of firms with the high-growth potential that requires
such financing.

5.2.2 Types or Firms

The research provides some evidence that smaller firms have more difficulty
obtaining financing than larger firms, although this evidence is not conclusive. Among
business survey respondents, a slightly larger proportion of small firms reported both having
difficulty obtaining financing in the past and anticipating future problems, although these
differences are not statistically significant. In addition, a higher proportion of smaller firms
reported unmet needs for most types of financing. In three cases, these differences were
statistically significant -- for fixed-rate mortgages (almost 10 percent versus 5.5 percent),
equipment leases (about 6 percent versus less than 3 percent), and revolving lines of credit
(almost 11 percent versus less than 5 percent). (See Table 3.8.) This data is bolstered by the
perceptions of development finance professionals, who generally report that small amounts of
financing (under $25,000 to 50,000) are more difficult to obtain. Some development finance
professionals also report that financing is a problem, however, for the small firms that supply
inputs or services to larger firms in important industries.

Low levels of risk capital availability strongly suggest a shortage of appropriately
structured financing for startup and high-growth firms. While it is particularly difficult to
assess whether potentially viable startup enterprises fail because of inability to obtain capital,
this finding is supported by the perceptions of development finance professionals in the region
and the general literature on rural financial markets.

There is some evidence that non-traditional industries and entrepreneurs have
particular difficulty obtaining financing. The role of non-traditional industries and
entrepreneurs in the region's economy remains relatively undeveloped, as data on the relatively
low proportion of service sector firms and women-owned firms in the region's business base
demonstrate. Development finance professionals identify several types of non-traditional firms
that have difficulty obtaining credit. These include seasonal businesses, particularly in tourism,
firms commercializing technology, and firms in emerging industries that are unfamiliar to local
bankers and private investors. The literature on rural financial markets further supports these
findings.

5.2.3 Firm Location

There are no substantial differences in measures of bank resources and financial
performance between urban and rural parts of the region. \n per-capita measures of deposits,
number of institutions, and number of banking locations, rural counties perform as well or
better than urban counties. The financial performance of urban and rural banks in the region
appears to be roughly comparable, with rural banks slightly outperforming urban banks on
some key measures. Rural-based banks tend to lend less aggressively than urban banks, but
this appears more related to differences in bank size than location.

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Final Report Mt. Aubsuen Associates, Inc.


There is, however, agreement that larger banks are more responsive to local
businesses when they grant some degree of flexibility to local loan decision-makers.

© Entrepreneurs and businesses in the Appalachian region remain heavily reliant
for risk capital financing on their personal savings, retained business earnings,
and support from family members, friends, and business colleagues. This is
particularly true of very small businesses and businesses in rural areas. Informal
local investors, or "business angels," are a much less important source of risk
financing, and primarily target larger and higher-growth businesses. Formal risk
capital sources, including venture capital firms and small business investment
companies, make very few investments in the region. Because of generally low levels
of personal wealth in the region, this reliance on informal investment from local
sources indicates that risk financing is relatively scarce.

© Despite recent innovation and structural change in the financial market, the
overall ability of Appalachian region businesses to obtain financing does not
appear to have changed substantially during the past three-to-five years, based on
the reported experiences of businesses and development finance professionals.

Final Report Mt. Aubuin Alasociates, Ine.


financing, the price cannot be overlooked. Recent evaluations of the cost of financing in rural
areas suggests that, overall, the costs of business credit in rural areas of the country are
relatively comparable to those found in larger urban areas. Rural homebuyers, however, tend to
pay more to mortgage homes than urban homebuyers (ERS, 1997). Additionally, Table 2.7
shows the characteristics of SBA guaranteed loans and the costs assumed by borrowers that are
associated with those loans. Here the cost of the loans assumed by business borrowers is much
less than if borrowed in urban areas of the country. Although SBA loans represent a small
portion of the total loans made to businesses in the United States, the percentage of SBA loans
made to rural businesses is actually higher. Thus, these findings have particular relevance to
the cost of capital and credit to rural businesses.

Table 2.7
Characteristics of SBA-guaranteed Small Business Loans, 1995

Interest rates on rural small business loans are lower, on average, than urban rates.

Average...

Number of | Interest Loan Gross Loan | Proportion
Item Loans Rate Maturity Amount | Guaranteed

Number Percent Months Dollars Percent

All Firms:

W171 118
Urban 35,159

New Firms:
Rural 3,979 10.84* 10* 113,455 87.1
Urban 11,268 1.00° 100* 116,623 87.1

* Indicates that the rural and urban means are significantly different at the 99 percent level of confidence.

Source: Credit in Rural America, 1977, Rural Economy Division, Economic Research Service, U.S. Department of
Agvidare, Agdeutural Ezonories Report No. 749. Calculated by ERS from data supplied by the U.S, Small Business
Administration.

Although the cost of financing is generally analogous across rural and urban regions,
there are some specialized circumstances that can fluctuate these financing costs for rural
businesses. Generally, the price of credit is significantly lower when the lenders’ clients are
more diverse (McClone, 1991). Lenders with more diverse clientele are able to offer credit at
slightly lower rates because they have a more diversified portfolio that helps to minimize the
risk involved in business investment. That is, they invest in a variety of industries at different
levels of the production cycle and, thus, are able to protect themselves against economic
downturn in any one part of the local and national economies. Unfortunately, rural lenders tend
to have a much more homogenous clientele that can result in higher financing costs in some
rural areas. As a result, although financing costs are comparable to urban areas overall, credit
costs differ across specific rural areas of the country.

It is interesting to note that rural business owners often rate the cost of credit as
secondary to its availability. Table 2.8 lists, in order of importance, the institutional
characteristics that attract rural businesses. Rural businesses indicate that the most important

13
Final Report Mt. Auburn Associates, Inc.


larger firms also appears to anticipate the need for equipment replacement and the development
of new products or production technologies, these differences are not statistically significant.

(See Table 3.9.)

Table3.9
Future Financing Needs for Different Types of Business Activity
By Firm Size (%)

Very Likely

Somewhat
Likely

Unlikely or
N/A to
Business

Small

Large

Small | Large

Small

Large

[Statistical
Significance

‘Construction of a new facility

22.0

23.0

55.0

Not Significant

Expension/modcrnization of existing facility

64

354] 224

45.1

Significant at .0S level

Replacement of old/outmoded equipment

38.2

B.S | 64

42.7

35.5

Not Significant

Development of new products/production
technologies

118

76.5

1

Not Significant

Exporting

36

92.6

92.7

Not Significant

Acquisition of other firms

93.9

73.6

|Significant at .01 level

76.8

76.4

Not Significant

63.4

Not Significant

According to the business survey results, smaller firms in the region are more likely
to anticipate future problems obtaining financing than larger firms. About twice as many
smaller firm anticipate having trouble obtaining needed financing over the next two to three

years than larger firms -- almost 18 percent versus about 8 percent.

This difference is

statistically significant. A slightly higher proportion of small firms also reported that recent
plans to expand, modernize, or renovate were affected by inability to obtain financing.
However, the difference is not statistically significant. (See Graphs 3.3 and 3.4.)

Funal Report

35

Mt. Auburn Associates, Inc.


SBA 504 Certified Development Companies

SBA 504 certified development companies (CDCs) make subordinated fixed asset loans
of up to $750,000 in partnership with banks or other senior lenders. ‘The senior lender must
contribute at least 50 percent of the total financing and the borrower must make a minimum 10
percent equity injection. There are 26 sub-state CDCs in the region. In addition, there are 18
associate development companies (ADCs). ADCs are not active lenders, but can assist
borrowers to obtain financing through active CDCs.

Regional coverage by sub-state CDCs is spotty. The most thorough coverage is in
Mississippi, Tennessee, and North Carolina. The sparsest coverage is in Kentucky, Ohio,
Virginia, and West Virginia. (See Map 5.2.) While all states except Pennsylvania also have
statewide CDCs (see below), these organizations are often located outside of the Appalachian
region and may not be well positioned or attuned to serve businesses in the region.

Other Private Nonprofit Development Finance Organizations

There are a small number of other private nonprofit development finance organizations
throughout the region that make small business loans. ‘These include:

* four nonprofit community development loan funds (CDLFs) serving parts of the
region, including southwest Pennsylvania, west central Alabama, parts of four states
in the Cumberland Valley region, and a region encompassing eastern Ohio, northwest
Pennsylvania, and the West Virginia panhandle. CDLFs generally make small loans
to low-incorne homeowners and small entrepreneurs;

© at least three community development credit unions, the largest of which is the
Self-Help Credit Union, which has $50 million in assets and four offices in rural
North Carolina. Another community development credit union is located in
southern New York, and a third, which was recently established, in southeast Ohio;
and

© while there are a number of private venture capital firms and small business
investment companies based in or near the Appalachian region, only one was
identified that has a clear economic development mission and an investment focus on
rural areas. This was Mountain Ventures, a $5 million SBIC managed by Kentucky
Highlands Investment Corporation of London, Kentucky. Mountain Ventures
invests in businesses in a nine-county area of eastern Kentucky.

CDBG-Funded Local RLFs

There are likely to be many CDBG-funded local revolving loan funds throughout the
region. No data is available on these funds.

97
Final Report Me. Auburn Assoctates, Inc.


Map 4.8

Total Number of Small Business Administration
7(a) Loans Outstanding Per 1,000
Enterprises, June 1996

Below 85% of U.S. Average
' | 85% to 115% of U.S. Average
[EBB Above 115% of U.S. Average

"
oO
:

0 50 100 150 200 Miles
Source: U.S. Smail Business Administration _—

Final Report 76 Mt, Auburn Associates, Inc.


The rate of enterprise formation is relatively low throughout the Appalachian
region. The rate of enterprise formation is another important indicator of demand for
financing. High rates of enterprise formation indicate a dynamic, entrepreneurial economy that
needs risk financing to fuel startups, but also is succeeding at some level in supplying this type
of financing. Additional startup capital may stimulate additional enterprise formation among
startup firms that have been unable to tap existing capital sources.

Low rates of enterprise formation may indicate either sluggish growth, the exodus of
entrepreneurs because of a lack of business opportunities, or the inability of potential
entrepreneurs to take advantage of increasing market opportunities because of the lack of a
critical capacity or resource, one of which may be capital (often key resources include
entrepreneurial training and management assistance). Increased supplies of capital can thus
play a role in a long-term strategy to address barriers to increased rates of enterprise formation.

In the Appalachian region, rates of enterprise formation, as measured by the percentage
of establishments classified as startups, are generally low throughout the region in relation to
the national average. With a few exceptions, enterprise formation is either at or, more
frequently below, the national average in counties throughout the region. This is true even in
areas experiencing high employment growth, such as parts of Kentucky and Tennessee.
Particularly in these areas, low rates of enterprise formation may indicate the shortage of
appropriate forms of capital to finance startup businesses. (See Map 3.3.)

Although a primarily rural region, Appalachia does not have a high proportion of
small companies. In almost every county in the region, the percentage of establishments! with
one to nine employees is at or near the national average. This fact may well be related to the low
rate of enterprise formation in the region. The implication for financing needs is that, in the
short-run, there are fewer very small established and startup firms requiring very small loans.
For the longer run, it may indicate that additional "micro" financing can contribute to the
formation of more microenterprises. (See Map 3.4.)

The importance of larger firms in Appalachia varies throughout the region. Certain
parts of the region have a high proportion of large establishments (defined as having 250 or
more employees). These include all of the South Carolina counties in the region, and several
clusters of counties in Alabama, Tennessee, New York, Mississippi, Georgia, and North
Carolina. Other parts of the region, particularly large clusters of counties in Kentucky and
West Virginia, have a relatively low proportion of large establishments. The demand for
large-scale financing is likely to be influenced by this distribution of larger companies. (See
Map 3.5.)

The number of establishments is used here as a proxy for enterprises. The term establishments refers to single-site business
facilities. One enterprise can be composed of more than one establishment. Therefore, there are more small establishments
than small enterprises. However, since the majority of enterprises have a single establishment (and the number of
multi-establishment enterprises is fairly evenly geographically distributed), use of establishment data provides a good
comparative measure of the relative importance of large and small firms in a local economy.

37
Final Report Mt. Auburn Associates, Inc.


in the banking industry have affected demand for credit as merged banks have purged their

portfolios, prompting businesses to seek credit from other sources.

Case studies of three areas of the Appalachian region served by multi-county
economic development organizations with ARC RLFs confirm and provide more detailed
illustrations of this improving economic picture. The three areas ~ north central
Pennsylvania, southeastern Kentucky, and northeast Mississippi -- are all benefiting from the
strength of the national economy. While traditional industries in these areas have continued to
decline, notably the primary metals industry in north central Pennsylvania, the coal mining
industry in eastern Kentucky, and the apparel industry in northeast Mississippi, new industries
are emerging to replace them. North central Pennsylvania has experienced very strong growth
in the powder metallurgy industry, which uses a compacting process to form metal parts,
primarily for the automotive, appliance, and hardware industries. Likewise, northeast
Mississippi has experienced growth in the furniture industry. Southeastern Kentucky, while
not as economically robust as these other two areas and still dependent on a declining number of
high-wage coal mining jobs, has seen some hopeful trends in manufacturing supplier firms,
secondary hardwood, and tourism. Because of infrastructure improvements and new
telecommunications technologies, these areas seem increasingly linked to and dependent on
larger national and global economic forces. According to development finance professionals
and bankers in these areas, demand for business credit and capital, particularly in north central
Pennsylvania and northeast Mississippi, has been strong.

Development finance professionals also generally report that demand for risk capital
has been either constant or growing, particularly where economies are expanding or the pace
of startups is increasing. Several respondents indicated that demand from technology
businesses is increasing. Bankers and development finance professionals in the three case study
areas all noted trends in the development of home-based and other microenterprises in their
areas, particularly among downsized managers and professionals, some recently having moved
or returned to the area. These individuals often seek small amounts of startup financing.

Based on the survey responses, the near-term investment plans of Appalachian
businesses are oriented heavily toward fixed asset financing needs. The most likely activities
requiring financing planned by respondents during the next two to three years are: replacement
of old or outmoded equipment (60 percent very or somewhat likely to undertake),
expansion/modernization of an existing facility (56 percent very or somewhat likely), and
construction of a new facility (39 percent very or somewhat likely). (See Table 3.4.)

Other, less frequently mentioned plans may require "softer," higher-risk kinds of
financing. These include general sales expansion (34 percent very or somewhat likely to
undertake), development of new products or production technologies (28 percent very or
somewhat likely), refinancing existing loans (22 percent very or somewhat likely), acquisition of
other firms (16 percent very or somewhat likely), and exporting (7 percent very or somewhat
likely). (See Table 3.4.)

Final Report Me. Auburn Associates, Inc.


Peterson, MA., and Rajan, R.G., "The Benefits of Lending Relationships: Evidence from Small
Business Data," Journal of Finance, Vol. 49, March 1994, pp. 3-37.

Pulver, G.C., and Hustedde, R.J., "Regional Variables That Influence the Allocation of Venture
Capital: The Role of Banks," Review of Regional Studies, Vol. 18, No. 2, Spring 1988, pp. 1-9.

Rose, J.T., "Interstate Banking, Bank Consolidation, and Bank Lending to Small Business,"
Small Business Economics, Vol. 5, Sept. 1993, pp. 197-206.

Shaffer, R., and Pulver, G.C. "Rural Nonfarm Businesses’ Access to Debt and Equity Capital"
in Financial Market Intervention as a Rural Development Strategy, Staff Report AGES-9070.
Washington, D.C.: Economic Research Service, U.S. Department of Agriculture, 1990.

Small Business Administration, 1997. Directory of Small Business Lending in the U.S. for 1996. Small
Business Administration, Office of Advocacy Studies on Small Business Lending.

Spectrum, 1997. “Electricity deregulation: assessing impacts on small-business, residential and
low-income customers” Spectrum; The Journal of State Government, (Spring, 1997) vol. 70, no. 2,
p13(4).

Spiegel, John W. and Alan Gart, 1996. “What lies behind the bank merger and acquisition
frenzy” Business Economics vol. 31, no. 2, p47.

Stern, Gary, 1992. "Banking Middle Ground: Balancing Excessive Regulation and Taxpayer
Risk" Annual Report of the Federal Reserve Bank of Minneapolis.

Taff, SJ., Pulver, G.C., and Staniforth, S.D., Are Small Community Banks Prepared to Make Complex
Business Loans? Research Report 3263, Madison, WI: College of Agriculture and Life Sciences,
University of Wisconsin, 1984.

Walraven, Nicholas, 1997. "Small Business Lending by Banks Involved in Mergers" Federal
Reserve Working Paper, Board of Governors of the Federal Reserve System.

Zack, Jeffrey, 1996. “Why Do Customers Cross the Road? For Service” American Banker vol,
161, no. 172, p6A(2).

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Final Report Mt. Auburn Associates, Inc.


3.6.2 DirFERENCES BETWEEN SMALLER AND LARGER FIRMS

According to the business survey results, the level of demand for most types of
financing products is similar among smaller and larger firms.’ Among ten types of financing
products, larger firms (those with 10 or more employees) are more likely to seek three types of
products than smaller firms (those with fewer than 10 employees): fixed-rate mortgages (30
percent sought during the past three years versus 20 percent of smaller firms), equipment leases
(37 percent versus 15 percent), and revolving lines of credit (46 percent versus 28 percent).
These differences are statistically significant. The percentages seeking the other seven products
were roughly the same. While slightly higher percentages of larger firms sought most of these
products, the differences were not statistically significant. (See Table 3.8.)

Experience in Obtaining Financing in the Past Three Years
By Firm Size (%)

Sought

Turned | Did Not
Down Seek

Small | Large} Large | Small ‘Statistical Significance

|| Fixed rate commercial mortgage 61] 18} 37 37 ‘Significant at .05 level
Variable rate commercial mortgage 12] 09} 85) 45 . |Not Significant
Equipment loan 24) 09} 24 a7 Not Significant

Equipment lease 00] 18] 62] 09] 7. Significant at ,05 level

Medium-term working capital (1-5 6) 1.3 37] Not Significant

years)

Short-term working capital (under y 2s| 1 47 Not Significant

year)
|| Revolving line of credit 326| 19] 72| 28 Significant at .05 level

‘Asset-based financing 3] 25 19 : Not Significant

Export trade financing 0.0 0] 09 Not Significant

Equity of debt with equity features E .3| 09

Note: Small =5.9 employees

Large = 10+ employees
Source: Mt. Auburn Business Survey

In terms of future needs, larger firms are more likely to anticipate the need for
certain types of investments than smaller firms. These include expansion or modernization of
a facility (45 percent of larger firms very or somewhat likely versus 33 percent of smaller firms),
and acquisition of other firms (26 percent versus 6 percent). While a higher proportion of

5 While the "large firm” category includes businesses that are typically considered small, the division was selected because over
40 percent of survey respondents had fewer than 10 employees. Therefore, including more firms in the "small firm" category
would likely not have yielded statistically valid comparisons. About three-quarters of the firms in the large firm category
have between 10 and 99 employees. (Note that the survey included only businesses with five or more employees.)

54
Final Reporr Me. Aubun Assoctates, Inc.


Aprenpix DB: Nortueast Mississippi

PLANNING AND DEVELOPMENT Districr
(NMPDD) Recon

Reeronat Economic Conpirions

The region served by the Northeast Mississippi Planning and Development District
(NMPDD) spans six counties in northeastern Mississippi -- Alcorn, Benton, Marshall, Prentiss,
Tippah, and Tishomingo. The region had a population in 1995 of 135,552. Over one-fifth of
the population are minorities, primarily African-American, who are clustered in Marshall and
Benton counties in the western part of the region. Previously stable, the population has grown 3
percent since 1990, primarily in the western counties. About 75 percent of the residents live in
areas classified as rural. The region averages 46 people per square mile, compared to 70.3
nationally. The largest urban centers are Corinth (population 11,820), Booneville (7,995),
Holley Springs (7,261), and Ripley (5,371).

The topography of northeast Mississippi is generally hilly, mostly forested, with a
limited amount of good farmland, Three U.S. highways and seven state highways provide the
basic transportation network. Most towns have rail service, and the Tenn-Tom Waterway passes
through the eastern end of the region. Tennessee Valley Authority electric power and gas
pipelines serve much of the region.

The region has a rich history, as exhibited by its many attractive artifacts. Handsome
homes and commercial buildings cluster around towns and villages. Civil War sites are
commemorated and celebrated. The Natchez Trace Trail, an ancient Indian path along which a
parkway with historic sites now extends, traverses the District. Also, three state parks, a
national forest, and Army Corps of Engineers recreation areas offer outdoor recreation
opportunities.

The region suffers from higher rates of unemployment and lower incomes than the state
and nation as a whole. Average annual regional unemployment in 1995 was 7.8 percent
compared to 6.1 percent statewide and 5.6 percent nationally. While unemployment has fallen
in recent months, this pattern has continued. In April 1997, the regionwide unemployment rate
was 5.5 percent, compared to the state average of 4.7 percent and the national average of 4.8
percent.

NMPDD is a relatively poor area. Per capita income in 1995 was $14,985, compared to
$16,709 statewide and $24,426 nationally. The percentage of residents living below the poverty
level in 1990 was 23.4 percent, slightly lower than the statewide rate of 24.5 percent, but far
higher than the national rate of 13.1 percent. Households receiving Food Stamps exceed 20
percent. Over 48 percent of adults older than 25 lack a high school diploma. The NMPDD
reports that the low earnings of manufacturing workers -- less than $10.00 per hour -- reduces

D-1
Final Report Mt. Auburn Associates, Inc.


Table 3.4
Likelihood of Need for Financing in the Near Future (%)

[Replacement of old/outmoded equipment 33.2 73 35.6 19 20
[Expansion/modernization of existing facility 273 Ex 30.0 24 29
|General sales expansion 176 16.6 52.7 1.7 LS
[Development of new products/ production technologies 117 16.6 $3.2 166 24
[Construction of a new facility 205 18S 56.1 29 20
lExporting 29 44 618 24 LS
[Refinancing of an existing loan 107 17 63 98 LS
|Acquisition of other firms 63 10.2 678 11 15

\Note: Total number of respondents = 205
wee: Mt. Auburn Business Surrey

A substantial majority of these firms do not anticipate having trouble obtaining
financing for these plans. Only about 12 percent of survey respondents anticipate having
trouble obtaining financing.

3.6 Vaniations IN DEMAND For FINANCING

3.6.1 DirreRENCES BETWEEN URBAN AND RuRAL Parts OF THE REGION

A breakdown of the analysis between counties in metropolitan areas and counties in
non-metropolitan areas indicates substantial differences in factors affecting demand for
financing.

Non-metro counties tend to have higher employment growth but also higher
unemployment rates. While about the same percentage of metro and non-metro counties have
experienced substantially higher growth than the U.S. average, a higher percentage of
non-metro counties have experienced average growth (36 percent vs. 13 percent) and a higher
percentage of metro counties have experienced substantially lower than average growth (49
percent vs. 24 percent), At the same time, a substantially higher proportion of non-metro
counties have experienced substantially higher than average unemployment (61 percent vs. 29
percent). While the factors influencing these conditions are complex, the combination of high
employment growth and high unemployment in rural parts of the region may indicate a
near-term potential for business expansion that could be supported by additional flows of
capital. (See Table 3.5.)

Non-metro counties tend to have lower rates of enterprise formation. A lower
proportion of non-metro counties have substantially higher than average rates of enterprise
formation (6 percent vs. 10 percent), while a higher proportion have substantially lower than
average rates (77 percent vs. 60 percent). This may indicate a lesser short-term need for risk

50
Final Report Me. Auburn Associates, Inc.


4.3 Risk Frvancine Sources

Risk capital is the patient capital enabling firms to make long-term investments that do
not produce immediate cash flows. It is generally invested over long time periods and only
generates returns if the firm is profitable. As such, it is an essential element of financing for
startup, expansion, product development, and modernization. Risk capital includes equity
(common stock) and near-equity (preferred stock, convertible, and subordinated debt)
financing.

The largest sources of risk capital for businesses are owner-managers, their families,
friends, business associates, and informal investors (often known as “angels"). Institutional
sources of risk capital include formal venture capital partnerships and the public stock market.
Venture capital firms tend to concentrate their investments in a narrow range of industrial
sectors, most of them technology-oriented, and in the relatively small number of locations where
their preferred industries are clustered. The public stock market, while much more broadly
based, is generally only accessible to larger firms with established operating histories.

Among risk financing sources in the Appalachian region, the owner's personal
financial resources, either in the form of savings or loans secured by personal assets, are by
far the most important sources. Thirty-eight percent of respondents have found their own
personal savings to be very important sources of financing and 18 percent have found them
somewhat important. Twenty-two percent have found home equity loans to be very important
and 12 percent have found them to be somewhat important. (See Table 4.1.)

Not surprisingly, smaller firms are more likely to depend on these sources than
Jarger firms. One-half of smaller firms responding to the business survey considered the
owner's personal savings as very important financing sources and almost one-quarter considered
these as somewhat important. This compares to 34 percent and 17 percent, respectively, among
larger respondents. Likewise, one-third of smaller respondents considered home equity loans as
very important and 15 percent as somewhat important, compared to 17 percent and 11 percent,
respectively, among larger respondents. These differences were statistically significant. (See
Table 4.3.)

Secondary sources of risk capital include the owner's family members, friends, and
business colleagues. Sixteen percent have found family members and friends to be very
important and 13 percent have found them to be somewhat important. Thirteen percent have
found business colleagues to be very important and 1] percent have found them to be somewhat
important. (See Table 4.1.)

Businesses in rural areas have found friends and family members to be a somewhat
more important sources of risk financing than those in urban areas. Among survey
respondents, more non-metro respondents have found them to be a very important source of
financing (21 percent versus 11 percent), while more metro respondents have found them to be
somewhat important (19 percent versus 7 percent). About the same proportion have found
them to be unimportant or not applicable to their businesses. (See Table 4.2.)

79
Final Report Mt. Aubsuen Associates, Inc.


obtained equity or debt with equity features. However, for those who sought such financing,
the turn-down rate was very high -- 25 percent for both types.’ (See Table 3.2.)

Larger loans are generally in more ample supply than smaller loans. With some
important exceptions, development finance professionals generally agreed that competition was
directly related to loan size. In general, the larger the loan, the more active the competition.
Virtually every individual interviewed reported that competition is very active for loans greater
than $250,000. Usually, but less uniformly than for larger loans, competition is moderate for
loans in the $25,000 to $250,000 range. In contrast, competition is sparse for microloans.
Bankers interviewed at the three case study sites generally agreed with this characterization.
The business survey showed that, other than for commercial mortgage financing, the strongest
demand for financing among businesses in the region is for financing in the $50,000 and under
range

There are certain exceptions to this rule. \n areas where small local banks still
dominate the market, competition for large loans is limited and sometimes constrained by bank
lending limits. In these instances, competition is more active for microloans. Small local banks
are also more likely to make character loans based on their knowledge of their community, thus
making it easier to provide microloans. In other instances, interest in smaller loans is a product
of public programs, such as SBA's Low Doc Program, which has induced bank interest in
lending in the $25,000 to $250,000 range.

The terms of bank financing are largely reasonable. Increasing competitiveness
among banks and the low interest rate environment perhaps contribute to the perception of
reasonable terms. High interest rates were not viewed as a constraint to obtaining bank
financing. Occasionally, development finance professionals reported that the terms of loans
were too short to suit borrower repayment needs. Research on rural financial markets indicates
that rates and terms of bank financing in rural markets are comparable to those in urban
markets and that rural businesses are no less satisfied with loan pricing than urban businesses.

While risk capital is needed by a relatively small subset of firms, it is scarce for
those who do need it. Entrepreneurs and businesses in the Appalachian region remain heavily
reliant for risk capital financing on their personal savings, retained business earnings, and
support from family members, friends, and business colleagues. This is particularly true of
very small businesses and businesses in rural areas. Because of generally low levels of personal
wealth in the region, this reliance on informal investment from local sources indicates that risk
financing is relatively scarce. The general literature on rural financial markets supports the
finding that the most significant financing gap for rural businesses is in the availability of risk
financing.

While it is impossible to measure this gap with any precision, interviews with
development finance professionals and bankers strongly reinforce the notion that lack to risk

* As noted, this information is drawn from a survey of existing businesses. Since it reflects the financing
experience of survey respondents during the past three years, it does not reflect the demand for equity financing
during the business startup phase among respondents that have more than a three-year history. In addition,
since the number of respondents seeking these types of financing was so small, these results should be
interpreted very cautiously.

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Final Report Me. Auburn Associates, Inc.


Map 3.8

Women-Owned Establishments as a
Percentage of All Establishments, 1992

[__] Below 85% of U.S. Average
[85% to 115% of U.S. Average
[EBB Above 115% of U.S. Average

Source: Bu of the Census,
eee US. Department of Commerce; 0 50 100 150 200 Miles
14992 Economic Census _—— eee

‘Final Report 44 Mt. Auburn Associates, Inc.


private financial market. While the region could benefit from additional development finance
resources, particularly working capital, financing for early-stage businesses, and financing for
firms in emerging industries such as tourism and secondary wood processing, these would have
to be combined with other additional resources and capacity-building, particularly in the areas
of general education, entrepreneurial training, intensive business technical assistance,
infrastructure development, and institutional development.

Final Report Mt. Auburn Associates, Inc.


> Develop Shared Lending and Management Support Mechanisms

Whatever their level of capacity, the many small development finance organizations
populating the Appalachian region are too small to undertake certain infrequent or costly
development finance transactions. These may include large financings, financings involving
complex forms of collateral, or secondary market transactions. ARC should work with
development finance organizations to develop new tools or organizational mechanisms that
would assist organizations wishing to undertake such transactions. These could include the
following:

© developing communications systems to enable development finance organizations
to identify and share information with potential local and non-local financing
partners, both private and public, and with business technical assistance sources;

® establishing and providing startup capital for a service corporation that would
handle large or complex financings and structure secondary market transactions.
The service corporation could invest in specialized staffing and management tools,
and develop relationships with national financial institutions and funding sources
that would be beyond the reach of individual development finance organizations.
RLF representatives would participate in the design and management of this
organization to ensure that it remains responsive to local RLF needs.

4. Increase the Availability of Non-Financial Business Assistance and
Improve its Coordination With Development Finance

While this study did not directly address the demand for and supply of non-financial
business assistance, it is clear that the availability and quality of non-financial assistance is an
important factor in efforts to build and sustain a healthy business base throughout the
Appalachian region. Development finance professionals throughout the region have expressed
concerns that, without greater support for the provision of non-financial assistance and stronger
efforts to coordinate non-financial and financial assistance, the impacts of additional
commitments to development finance programs will be diminished. While we do not offer
detailed recommendations in this area, we recommend that ARC take the following steps to
improve the availability and quality of non-financial assistance in conjunction with ARC's
development finance initiatives:

© recognize that non-financial assistance is essentially an educational function that
cannot be fully supported through the normal operations of development finance
programs and, therefore, requires ongoing funding;

® ensure that recipients of ARC development finance funding have developed a
comprehensive non-financial business assistance plan that is appropriate to the needs
of targeted businesses, draws to the extent possible on existing public- and
private-sector service providers, and is adequately funded;

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Final Report Mt. Aubutn Associates, Inc.


See 5858585858

Aprenpbrix B: Cumper Ann VALLEY Area
DEVELOPMENT Districr (CVADD) Recion

Reerenat Economic Conpitiens

The region served by the Cumberland Valley Area Development District covers eight
counties in southeast Kentucky -- Bell, Clay, Harlan, Jackson, Knox, Laurel, Rockcastle, and
Whitley. The region had a population of 232,344 in 1995, The region is heavily rural -- its
largest cities are Middlesboro (population 11,328), Corbin (7,419), and London (5,757).

The economy of the region was centered around the coal mining industry from the early
1900s through the mid-1980s. Recent automation in the industry has greatly reduced
manpower requirements, leading to widespread unemployment in coal producing counties.
Unemployment in the region was 8.1 percent in 1995, compared to the state average of 5.4
percent and the national average of 5.6 percent. The region also suffers from low levels of
personal income and high rates of poverty. Per capita income in 1995 was $13,341, compared to
$18,847 statewide and $24,426 nationally. The poverty rate in 1990 was 33 percent, compared to
19 percent statewide and 13.1 percent nationally. Seven of the eight counties are designated as
"distressed" by the Appalachian Regional Commission.

Although distressed, the region has experienced moderate employment growth in recent
years. Between 1993 and 1995, employment increased by 4 percent. This compares favorably to
the statewide average of 2.5 percent but is about equal to the national average of 3.9 percent.

Economic conditions in the region vary somewhat by county. Harlan County, which
traditionally has been heavily dependent on the coal industry, is the most distressed of the eight
counties. Unemployment in Harlan County was 16.2 percent in 1995 and total employment in
the county declined by 4.9 percent between 1993 and 1995. Per capita income is lowest in
Jackson County ($11,386), one of the region's most rural counties. In contrast, the three
counties sitting along Interstate 75 between Lexington and Knoxville -- Laurel, Rockcastle, and
Whitley, have the strongest economies. Laurel County, with the lowest 1995 unemployment
rate in the region (6.3 percent) and the highest per capita income ($15,176), is also the only
county not designated by the ARC as distressed. Rockcastle had the highest 1993 to 1995
employment growth rate in region (9.2 percent), and Whitley outperformed the region as a
whole in both 1993 to 1995 employment growth (4.6 percent) and 1995 unemployment (6.4
percent).

Tue Demanp ror Financine: Toe Reeron's Business Base

With declining employment in the region's coal mining industry, the region's business
and employment bases have been shifting. Manufacturing has been increasing in importance in
the region, although it still lags behind mining as a source of employment. In 1995,

B-I
Final Report Mt. Auburn Associates, Inc.


serves the entire 49-county ARC region in Kentucky. MACED has a small ARC revolving loan
fund, capitalized at $262,000 in 1995. The fund has made four loans since its inception. Since
it is very small and serves such a large region, it is not a significant resource for the CVADD

region.

In addition to these organizations, five banks are in the process of establishing a
multi-bank CDC covering a three-county area in the region. The banks have committed
$125,000 of initial funding and will provide loans in the $1,000 to $15,000 range. The founding
banks hope to bring five other banks into the CDC and to increase its capital base.

State Programs

The state of Kentucky operates a number of development finance programs available to
businesses in the state:

© the Kentucky Economic Development Financing Authority (KEDFA) provides
low-interest fixed-asset loans in the $25,000 to $500,000 range, primarily targeted
to manufacturing firms. According to a state economic development official, these
loans are rarely for less than $200,000;

© KEDFA also has a loan guarantee program for craft businesses, which guarantees
loans of between $2,000 and $20,000;

© the Commonwealth Small Business Development Corporation provides SBA 504
certified development company loans. These are subordinated loans for fixed assets
in participation with a private lender. The 504 loan is 40 percent of the total financing,
with a minimum of $25,000 and a maximum of $750,000;

© the Kentucky Agricultural Finance Corporation provides tax-exempt industrial
revenue bond financing; and

© a state venture capital network that seeks to match private investors to companies
needing risk financing.

In general, state programs are viewed within the region as primarily serving
medium-sized and large established firms, primarily in the manufacturing sectors. Very few
firms in the region have received state financing.

ASSESSMENT OF CaprTAL AND Crepit NEEDs AND Gars

There is general agreement among development finance and business assistance
professionals and bankers in the region that among the most difficult types of business
financing to obtain from private sector financing sources are: 1) small amounts of working
capital; 2) financing for startup and early-stage firms; and 3) financing for small service and
retail businesses, particularly in the tourism sector.

B-6
Final Report Mt. Auburn Associates, Inc.


Appendix A:

Appendix B:
Appendix C:

Appendix D:
Appendix E:

Final Report

Business Survey Methodology and Characteristics of Respondents ........ Al
Cumberland Valley Area Development District Region ...............++++ B-l

North Central Pennsylvania Regional Planning and Development
Commission Region

Northeast Mississippi Planning and Development District Region was
Appalachian Credit and Capital Study Advisory Group ...........+..+++++

iit
Me. Auburn Associates, Inc.


diversification into transportation-related and service industries, and recent employment growth
has been flat.

The region's financial markets have turned in a mixed performance in meeting business
financing needs. Banking resources in the region are relatively high and the banking market is
reasonably competitive. The region has a good mix of small, locally-based and larger
institutions. However, banking practices are still conservative and heavily collateral-oriented.
This conservatism is echoed to some degree in the financing activities of local and state
development finance organizations. In addition, low levels of personal wealth in the region and
the lack of formal venture capital activity make risk financing extremely scarce. This, along
with limited availability of management and technical assistance, has constrained new
entrepreneurship. Financing constraints also exist for small-scale businesses and expanding
businesses with limited hard collateral.

Final Report Mt. Auburn Associates, Inc.


financing. (Rural businesses also tend to be more satisfied with their banking
relationships than urban businesses.) Development finance professionals interviewed
for this study did not identify capital costs as a serious constraint to business
investment in the Appalachian region.

10. A number of factors affecting the more rural parts of the Appalachian region
indicates a need to target development finance resources and build additional
development finance capacity in rural areas, particularly those suffering from
high levels of economic distress. These factors include less robust economic
performance, lower levels of personal financial resources, less activity by private
sources of business financing, higher unmet financing needs among businesses, and
greater reluctance among businesses to use any financing.

ll. Very small firms -- those with fewer than 10 employees -- generally face a less
favorable financing environment than larger firms, indicating the need for more
intensive targeting of development finance resources to these firms. While these
firms have similar financing needs as larger firms, they appear less likely to seek and
obtain external financing, They report higher levels of unmet financing needs, are
less likely to anticipate future business investment, and are more likely to anticipate
future financing problems. ‘These smaller firms also appear to have difficulty
obtaining very small bank loans, non-bank credit, and risk financing outside of their
own resources and those of family members and friends.

12. The slow pace of development of non-traditional industries and entrepreneurs in
the region may also indicate a need for targeting of development finance
resources. The role of non-traditional industries and entrepreneurs in the region's
economy remains relatively undeveloped. These include seasonal businesses,
particularly in tourism, firms commercializing technology, firms in emerging
industries that are unfamiliar to local bankers and private investors, and
women-owned firms. There is some evidence that these firms have greater difficulty
obtaining financing than more traditional firms.

13. Development finance programs are a moderately important supplement to the
private financial market for Appalachian businesses. Businesses in the more rural
parts of the region consider these programs particularly important, although they do
not appear to use them at a higher rate than urban businesses.

14, On balance, bank participation in development finance programs seems to be on a
par with that in other parts of the country. Bankers in the region have also
exhibited a greater willingness to participate in such programs than in the past.
However, banks in more rural parts of the region appear less inclined to participate in
some of these programs than their urban counterparts.

15. There is a mismatch between the region's unmet business financing needs and the
financing tools emphasized by the region's development finance organizations.
While the most difficult types of financing to obtain include risk financing, working
capital financing, and financing of less than $50,000, development finance sources
place a stronger emphasis on providing secured debt financing, particularly for fixed

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Map 4.4

Total Commercial Bank and Savings Institutions
Per 10,000 Population, June 1996

[__] Below 85% of U.S. Average

85% to 115% of U.S. Average
aa Above 115% of U.S. Average

Source: Federal Deposit insurance Corporation;
Office of Thrift Supervision, o 0 50 100 150 200 Miles
U.S. Department of the Treasury ee _—

Final Report 67 Mt. Auburn Associates, Inc.


According to the business survey results, there are few difference in the financing
needs anticipated by metro and non-metro borrowers, or in the proportion of metro and
non-metro borrowers who either have been recently affected by inability to obtain financing
or anticipate trouble obtaining financing in the near future. The only significant difference

is in the likelihood of needing refinancing.

While a similar proportion of respondents

considered it likely that they would need this type of financing, a higher proportion in metro
area businesses considered it "very likely," while a higher proportion in non-metro area
businesses considered it "somewhat likely." (See Graphs 3.1 and 3.2, and Table 3.7.)

Graph 3.1

Recent Plans to Expand, Modernize, or Renovate
Affected By Inability to Obtain Financing
By Urban/Rural Location (%)

ercerenge
Aeenewe

Graph 3.2
Anticipation of Trouble Obtaining Financing
By Urban/Rural Location (%)

[Statistical
Significance

Construction of a new facility

Not Significant

Expansion/modernization of existing facility

Not Significant

Replacement of old/outmoded equipment

Not Significant

Development of new products/ production
technologies

Not Significant

Exporting

46

Ll

37

Not Significant

‘Acquisition of other firms

73

55

13.8

Not Significant

Refinancing existing loans

14.7

55

9.2

‘Significant at .01 level

General sales expansion

211

43

16.5

Not Significant

Note: Metro = Inside federally-defined metropolitan statistical ares.
Non-Metro = Outside federally-defined metropolitan statistical area.
Source: Mt. Auburn Business Survey

Final Report

33

Mt. Auburn Associates, Inc.


programs. The development financiers, in their view, need more money to plug identified gaps
more completely. Many asserted they have worthy deals that they cannot finance simply due to
lack of available capital. A few have had to time funding their loan commitments to correspond
to scheduled repayments of outstanding loans. These financiers, in their opinion, are
addressing real needs, but lack sufficient resources to get the job done. ‘T’wo of the case studies
reinforce these general observations. In both north central Pennsylvania and northeast
Mississippi, strong demand for loans among key local industries has led to a shortage of RLF
funds.

However, not all RLFs are experiencing loan demand in excess of resources. For
example, among the 27 active ARC RLFs, about one-quarter of total capital, or $7 million, was
available for lending as of August 1997. Thirteen of these funds have not drawn down the full
amount of their ARC grant.

State development finance programs do not seem particularly well-tailored to the
rural areas covering most of the Appalachian region. While the quantitative evidence on state
development finance activity by geographic area is thin, development finance professionals
generally see state programs as having a limited role in their regions. These programs tend to be
either targeted to industrial recruitment, larger firms, or particular subsets of entrepreneurs
(e.g., women and minorities). In addition, program management tends to be somewhat
removed from rural areas. The exceptions are decentralized programs such as the microloan
programs in North Carolina and Virginia that provide capital to local and regional development
finance organizations to be managed locally.

Most development finance professionals feel that existing development finance
activities are closely coordinated. The need for coordination is understood and coordination is
increasing, although it is acknowledged that turf issues remain and there is room for
improvement. Most coordination mechanisms are informal, that is, development finance
personnel know one another as the result of conferences or previous joint efforts. They rely on
this network to make referrals and arrange co-financings. Some of those interviewed report
using more formal mechanisms, such as designating one agency as a formal coordinating body.
Regional development finance organizations, in particular, are emerging as coordinating bodies.
These organizations often operate multiple funds, take the lead role in packaging deals in which
they partner with state or local development finance organizations, and are viewed by bankers as
the contact point for public/private co-financings. For example, the regional development
organizations in two of the case study areas, north central Pennsylvania and northeast
Mississippi, were widely recognized within their regions as the lead organizations in
development financing.

Although those relying on informal mechanisms generally believe these to be
effective, they also generally believe that more formal coordination would be useful.
Suggestions for improving formal coordination include:

© better integration of local governments that operate financing programs, usually with
CDBG funds, into the system;

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services, reported feeling "forced" to offer such services to compete in the small business
lending market (Oppenheim, 1997).

As banks try to attract small business customers, they have actively promoted improved
service and a wide array of new banking products targeted at small business owners. Many
banks have initiated 24-hour, seven-day-a-week phone systems, bill-payer services, and
automated teller machines. But banks are feeling pressure to go beyond these conveniences to
attract small business customers. Comerica Bank in Detroit, Michigan, for example, offers free
seminars to small business owners facilitated by company chief executives on topics that run the
gamut from accounting and marketing to technology, succession planning, and exporting.
Commercial lenders at Patriot National Bank in Reston, Virginia now carry pagers so that their
small business customers have constant access to them as needed. Patriot also has couriers that
collect deposits from business customers and bank branches are open until 8 p.m. every day of
the week. Some banks now offer administrative and management services where they purchase
the company's receivables and handle all of their accounting, billing, and collecting of the
company's accounts. Other banks have added PC banking services where small business
customers can conduct financial transactions from their own offices. And, still, others have
placed loan applications on the internet, such as AT&T which now uses a standard "EZAPP."
Using the EZAPP, business owners complete and send their loan applications via the internet
and can receive loan approval the same day by e-mail or a phone call at their office.

Larger financial services firms, in particular, once chided for neglecting small business
customers, are now developing a wide array of services and products that cater specifically to
smaller customers (Allen, 1994). American Express, for example, which until recently offered
very few services that catered to small business clients, has recently announced a new line of
banking products and services specifically geared toward small businesses (Oppenheim, 1996).
Wells Fargo, one of the nation's largest banks, has launched a new line of credit products
nationwide through direct mail and telemarketing. And Bank of America, another well-known
name in the banking industry, now solicits small business customers through loan production
offices across the country.

In this increasingly competitive environment, small community banks have had to be
creative in protecting their small business customer base. Some of these banks have reported
running testimonial advertisements, giving substantial financial incentives for small business
referrals, and cold calling small businesses in the local area (Arndorfer, 1996). The willingness
of larger banking institutions to increase the variety of small business products and services
they offer has threatened the service advantage typically assumed by smaller, community banks,
raising concerns that they are ceding their niche in the small business lending market (Heady,
1994).

In addition to the introduction of new products, increased competition has affected
features of small business loans such as pricing, structure, and turnaround time on loans (Allen,
1994). Banks have been working harder to sell business banking products to small business
owners who may have relied on credit cards and personal credit lines to finance their businesses
growth. Many larger banks have instituted fast-reply loan review procedures using credit
scoring systems. Increased competition has also put small businesses in a better position to

27
Final Report Mt. Auburn Associates, Inc.


Table 2.13: Small Commercial and Industrial and Small Farm Loans at Banks
Involved in Mergers, June 1993 to June 1996

Median Ratio of Small C&I Loan to Assets
‘Size of Bank Acquired Banks
(Assets in millions of dollars) $ REE
1$250 or less 7.3 84 63 7.3
1 - $5,000 5.5 93 20 5.0
More than $5,000 3.7 N/A 03 3.0

Notes: (1) Assets and loan volumes are from the most recent June Call Report at the time of the merger.
(2) Each member of a bank holding company is treated separately. The data include independent banks and
individual members of a bank holding company.
(3) Data for members of each acquiring bank holding company are aggregated to the highest holding company.
‘The data for scquired institutions include independent banks and holding companies.
Source: Walraven, 1997.

Moreover, although there has been an enormous growth in bank mergers and
acquisitions in recent years, 60 percent of those mergers were between small banks that, even
when merged, only created slightly larger, small banks. Most recent assessment of these "still
small" merged banks indicates that they have been even more active in their efforts to attract
and maintain small business customers after such mergers (Federal Reserve, 1997; Walraven,
1997).

In addition, recent mergers and acquisitions activity has led to the creation of a new
wave of small banks. Bank charters increased by more than 300 percent in 1995 alone (Barry,
1996). Thus, while the banking industry may be in a state of dynamic transition, there is no
reason to believe that banking options for small businesses are diminishing as a result of this
transition. To the contrary, in recent years, lending opportunities for small businesses have
dramatically increased leaving them in a rare position to take advantage of the volatility in the
market.

Although newly merged banks have generally continued traditional lending patterns,
there are some geographic markets where small businesses have had difficulty obtaining credit
directly following major local industry consolidations. The most comprehensive examination of
the impact of mergers and acquisitions on small business lending concluded that although there
appears to be some negative impact on the availability of credit to small businesses directly
following major consolidations, other banks in the local area tend to pick up additional loans in
the small business market (Berger et al, 1997).

Overall then, while there has been concern that regulatory changes may have altered the
structure of the banking industry in ways that had deleterious effects for small businesses, most
recent analyses suggest that these concerns have not been confirmed.

2.3.4 THe EMERGENCE or NoNBANKS AS SIGNIFICANT SOURCES OF SMALL
Business CREDIT

The fluctuations and structural transitions within the financial marketplace have also
opened up opportunities for nonbank finance institutions to service the small business lending

23
Final Report Mt. Auburn Assoctates, Inc.


5. The region's banking industry is fairly well equipped to meet the demand for
most secured debt financing. Banks in the Appalachian region are as financially
healthy and have used their deposit base as aggressively to make loans as their peers
in the rest of the U.S. However, levels of bank deposits in the region are relatively
low, and are particularly low in economically distressed areas, This could potentially
be constraining the level of bank lending, although banks experiencing strong credit
demand do have access to funds in addition to local deposits. In addition bank
financing is supplemented on a modest scale by other secured debt sources, such as
equipment dealers and suppliers.

6. While risk capital is needed by a relatively small subset of firms, it is scarce for
those who do need it. Entrepreneurs and businesses in the Appalachian region
remain heavily reliant for risk capital financing on their personal savings, retained
business earnings, and support from family members, friends, and business
colleagues. This is particularly true of very small businesses and businesses in rural
areas. Informal local investors, or "business angels," are a much less important
source of risk financing, and primarily target larger and higher-growth businesses.
Formal risk capital sources, including venture capital firms and small business
investment companies, make very few investments in the region. Because of
generally low levels of personal wealth in the region, this reliance on informal
investment from local sources indicates that risk financing is relatively scarce.

7. Demand for business financing in the region has increased in recent years as a
result of a number of factors. These include the region's participation in the
sustained national economic expansion, in-migration, growth in business startups by
downsized professionals, and increased outsourcing and job shops.

8. The availability of business financing does not, on balance, appear to have
changed greatly in recent years, either for better or worse. The most significant
change has been brought on by banking industry consolidation. While this trend has
increased the presence of larger statewide and regional banks in the region, and has
reduced the number of locally-owned banks, the number of banks competing in local
markets remains relatively high in proportion to population. While larger banks
have introduced different lending practices and have sometimes targeted different
markets, these changes appear to have had differing impacts, some positive and some
negative, in different parts of the region and for different types of businesses. It is
probably too early to judge the full effects of these changes. Another trend that has
affected other parts of the U.S., the entry of nonbank lenders into the business credit
market, has not yet had a notable impact in the Appalachian region.

9. Evidence does not suggest that the cost of financing is a constraint to business
investment in the Appalachian region. Real interest rates in the U.S. have been
relatively low and stable throughout the 1990s. In addition, recent studies of rural
financial markets have shown that capital costs for rural businesses are comparable to
those for urban businesses and that rural businesses do not consider cost of financing
to be as important in their banking relationships as such factors as their bankers’
accessibility and knowledge of their businesses, and the reliability of access to

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Final Report Mt. Auburn Associates, Inc.


Map 3.1

Percentage of Employment Growth,
1993 - 1995

[___] Below 85% of U.S. Average
[I 85% to 115% of U.S. Average
isa Above 115% of U.S. Average

8

Source: Bureau of Labor Statistics, Oo. 50) 100_— 150-200 Miles
U.S. Department of Labor = eee

Final Report 35 Mt. Auburn Associates, Inc,


eee Tee
CHAPTER Two REFERENCES

Allen, James, 1994. "Bank loans to small firms grow fast, but terms ease" American Banker (Nov.
8, 1994) vol. 159, no. 216, p1(2).

Arndorfer, James B., 1996. “Smaller Banks Fight for Turf in Crowded Field” American Bankers
(April 8, 1996) no. 161, no. 66, p16(1).

Arndorfer, James B., 1996. “Banks Extending Reach to Compete with Nonbanks” American
Bankers (August 26, 1996) vol. 161, no. 163, p10(1).

Bacon, Kenneth H., 1993. “Regulators Seek to Boost Lending to Small Business” Wall Street
Journal (September 9, 1993).

Banking Strategies, 1996. “Technology, Deregulation, and Alliances Drive Product
Development” Banking Strategies p217.

Barry, John. S., 1996. “Banking Deregulation Work” Investor's Business Daily (Guest Editorial)
p42.

Berger, Allen, Anthony Saunders, Joseph Scalise, and Gregory Udell, 1997. "The Effects of
Bank Mergers and Acquisitions on Small Business Lending" Federal Reserve Working Paper.
Board of Governors of the Federal Reserve System.

Calem, P.S., "The Impact of Geographic Deregulation of Small Banks," Federal Reserve Bank of
Philadelphia Business Reiew, Nov./Dec, pp. 17-31.

Cline, Kenneth, 1995. “Small Business is Booming at Biggest Banks” American Banker vol. 160,
no. 225, p5(1).

Cole, R.A. and Wolken, J.D., "Financial Services Used By Small Businesses: Evidence from
the 1993 National Survey of Small Business Finances," Federal Reserve Bulletin, Vol. 81, July
1995, pp. 629-667.

Cole, Rebel, John D, Wolken, R. Louise Woodburn, 1996. "Bank and nonbank competition for
small business credit: evidence from the 1987 and 1993 National Surveys of Small Business
Finances" Federal Reserve Bulletin, (Nov) vol. 82, no. 82, p983(13).

D’Arista, Jane and Tom Schlesinger, 1996. “Financial Markets: Restructuring and the U.S.
Regulatory Framework” Reclaiming Prosperity: A Blueprint for Progressive Economic Reform edited by
Todd Schafer and Jeff Faux (Armonk, New York; M.E. Sharpe), p211 (16).

Deeton, William R., 1995. "Multi-office bank lending to small businesses: some new evidence"
Economic Review (Spring), vol. 80, no. 2, p45 (13).

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Final Report Mt. Auburn Associates, Inc,


Joans up to $200,000 for firms with less than 100 employees. The program made
about 100 loans in 1996;

the Pennsylvania Industrial Development Authority (PIDA) provides fixed asset
financing of up to $2 million targeted to small manufacturing and technology
firms; and

the Ben Franklin Partnership provides research seed grants of up to $750,000 for
new product development to firms with fewer than 250 employees. It funded
approximately 150 firms in 1996.

While these programs have been used by only a small number of businesses in the

region, bankers and development finance professionals generally view them as targeted more to
urban areas and firms that are larger than most of those located in the region. Yet, NCPRPDC
staff maintain a good relationship with state agencies, and believe that if the fit between the
borrower and the program is good, they can secure state participation.

ASSESSMENT oF CAPITAL AND Crepit NEEDs AND Gaps

In some respects, the region's financial markets are performing reasonably well in

meeting the demand for business financing:

Between the region's banks and development finance organizations, the supply of
secured debt financing appears to be largely adequate, particularly for
manufacturing firms. NCPRPDC staff believe that the organization could make
additional loans if it had additional capital, and, in fact, the organization has lent out
virtually all of the capital it has available. While staff speculate that many of the firms
they are unable to finance are able to obtain conventional financing, they believe that
the more favorable terms that NCPRPDC offers enable firms to obtain financing
earlier in their development cycle and to expand more quickly, thus stimulating more
rapid job creation.

While there is little formal venture capital investment in the region, informal risk
financing appears to be available for firms favored by local informal investors,
particularly firms in the powder metals industry.

Coordination among development finance organizations, and between development

finance organizations and banks, spearheaded by NCPRPDC, is seen as generally
effective.

At the same time, development finance professionals and bankers identify a number of

significant financing gaps. These include:

startup financing for firms not favored by local banks and informal investors,
including firms in less established manufacturing industries than powder metals,

C-7

Final Report Mt. Aubuwn Assoctates, Inc.


© the degree of banking market competition and bank accessibility in Appalachian
counties relative to the rest of the nation;

® recent and projected trends in the availability of business financing; and

© differences in financing availability between smaller and larger businesses, urban and
rural areas, and economically distressed and non-distressed areas.

The chapter is divided into three sections:

1. The first section assesses the availability of debt financing or credit, with particular
attention to the banking industry.

2. The second section assesses the supply of formal and informal risk capital.

3. The third section assesses recent trends in the availability of credit and capital in
the Appalachian region.

4.2 Banks anp Orner Sounces or Crepir

Debt, or credit, is an essential source of financing for less risky forms of business
activity. Debt is used to finance "hard" assets like land, buildings, and equipment. It is also
often used to finance "soft" assets like business inventories and accounts receivable. While debt
financing can be used by firms in all stages of development, it is most typically used for
expansion or general operations by businesses with established operating track records. Debt
financing is usually secured by collateral as a second source of repayment if the borrower cannot
repay the loan through earnings. Its use by established businesses and its collateral dependence
give debt its low risk level relative to equity. Debt is distinguished from equity by its fixed
repayment terms (interest rate, maturity, etc.), reflecting its lower risk level.

The major private source of debt financing for small- and medium-sized businesses is the
commercial and savings bank industry. Other private sources of business debt financing are
commercial finance companies, factors, insurance companies, and credit unions. Many new
entrepreneurs and small businesses also rely on personal credit through the use of credit cards
and obtaining home equity loans.

4.2.1 THE RELATIVE IMPORTANCE OF DIFFERENT CREDIT SOURCES

Based on the results of the business survey, banking institutions are considered the
most important source of credit for Appalachian businesses by a substantial margin.’
Forty-two percent of respondents to the survey have found small banks to be a very important
source of financing, and 20 percent have found them to be a somewhat important source. With
regard to large banks, 31 percent have found them to be an important financing source, and 18
percent have found them to be somewhat important. (See Table 4.1.)

' Note that financing from a business owner's personal savings and from family, friends, and business associates is discussed
under risk financing in Section 4.3.

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Final Report Mt. Auburn Associates, Inc.


3. Support Capacity Development Among Regional Development Finance
Organizations

In order to effectively utilize the above initiatives and, more generally, to enhance their
capacity to provide development finance services to businesses in the region, development
finance organizations will need to further develop their professional skills and adopt more
sophisticated management tools. The field of development finance has advanced greatly in the
last several years, and development finance organizations in the Appalachian region are no
exception to this trend. Yet, particularly in light of the economic development challenges
facing the region, the region's development finance organizations should be supported to stay on
the cutting edge of the field. ARC should consider the following options for strengthening
development finance capacity in the region.

> Establish a Professional Development Institute for Development
Finance

ARC could supplement existing development finance training programs and offer a
more systematic approach to professional development by establishing a Professional
Development Institute for Development Finance. The institute would not be a physical
structure, but rather could offer a series of meetings and training programs in different parts of
the region, along with publications. The institute would draw on the capacity of existing
training providers where possible, and would develop additional offerings as necessary either
directly or by contracting with other organizations. Program offerings and activities of the
institute could include the following:

© briefings on national and regional economic trends;

© briefings on developments in the financial market (e.g., banking consolidation,
growth of nonbank lenders) and their implications for business lending;

© training in market analysis and strategic planning;

© presentations on best practices in organizational development and program design
and management, and demonstrations of management tools and systems;

® training in non-traditional and complex lending and investment techniques (e.g.,
informal investment brokering, equity financing, working capital loans, export
financing);

® training in providing financing to particular industries;

® information on funding sources and mechanisms (e.g., national intermediaries,
secondary markets);

© informal networking and information exchange opportunities among development
finance professionals; and

® one-on-one technical assistance in program design and the adoption of new
management systems.

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Final Report Mt. Auburn Assoctates, Inc.


Map 4.9

Total Number of Small Business Administration
504 Loans Outstanding Per 1,000
Enterprises, June 1996

[___] Below 85% of U.S. Average

85% to 115% of U.S. Average
ea Above 115% of U.S. Average

¥
om
:

0 50 100 150 200 Miles
Source: U.S. Small Business Administration ————

Final Report 1 Mt, Auburn Associates, Inc.



In the consumer credit market, the increased use of credit scoring systems has made
obtaining credit faster and easier for consumers with established credit. In the small business
market, credit scoring has had much the same effect. Small businesses with established credit
and strong financial performance have often received larger credit lines and much better credit
terms from many banking institutions (Furash, 1997).

The decision to accept more risk when dealing with creditworthy small businesses has
not been completely based on the use of credit scoring systems. Much of the decision to accept
more risk has also been based on the expectation that resulting loans can be bundled,
repackaged, and sold in the securities market rather than held on the balance sheet of the
originating bank (Furash, 1997; Hansell, 1995). Many banks have also sought to manage risk by
greatly diversifying their loan portfolios over many different kinds of companies and industries,
and by reducing the size of loans made to smaller businesses (Hansell, 1995). This latter
practice has, to some degree, benefited the smaller, creditworthy companies by enabling them to
obtain financing from lenders who would have overlooked them in the past.

Credit scoring is not a panacea and there are some reasons to be concerned about the use
of this tool in evaluating the creditworthiness of small businesses. First, it is clear that credit
scoring is more appropriate for use by larger than by smaller banks. It has been found that, in
order to serve as accurate guides for credit decisions, credit scoring systems must be based on
performance data for a large body of loans over a period of at least two business cycles or ten to
15 years. Moreover, to ensure sensitivity to changes in local market conditions, the variables
and standards embedded in credit scoring systems must be routinely re-evaluated and
continually updated. As a result, banks with more industry depth and loan volume by line of
business will have a greater potential to generate accurate decision standards.

Second, while credit scoring systems have made it easier and faster to obtain business
loans for more established small businesses, they have not helped banks deal with the credit
needs of smaller, less established and less capitalized businesses. Credit scoring systems on the
whole do not have the capacity to consider a wide range of secondary credit issues that may
increase the likelihood that a small business will be considered creditworthy. For smaller banks
in particular, where relationships with small business owners very often form much of the basis
on which many loans are made, the use of credit scoring systems does not necessarily encourage
nor augment such relationships.

The use of credit scoring systems is, therefore, not necessarily a substitute for the
development of relationships between lenders and small business customers. To this end, many
banks have retained consulting firms to help them identify potential small business customers,
develop a more personal approach, develop more appealing product lines, and place senior level
managers in more visible and accessible positions (Morrall, 1997). Other banks that have been
unable to improve their service and product lines have had to negotiate strategic partnership
arrangements and outsourcing with nonbanks. And, still, others have put more loan officers
"on the street" and given them greater latitude to call on small business customers (Morrall,
1997).

Final Report Me. Auburn Associates, Inc.


Graph 5.5
Allowable Uses of Financing Provided by
RLFs in the ARC Region (%)

BeesBsssss

os

Netw: Total number of respendents = 105
Source: ML Auburn Assocaies Development Finance Gurvey

The data on outstanding ARC loans shows the actual uses of financing on a subset of
RLF loans. Taking into account total project financing, the highest proportion of loans were
used for machinery and equipment (about three-quarters), followed by land and buildings
(about 60 percent), and working capital (slightly under 50 percent). Analysis of the division of
loan dollars among different uses shows that about 80 percent of funds were used for fixed assets
-- about 40 percent each for land/buildings and machinery/equipment. Only 12.5 percent of
funds were used for working capital. (See Table 5.2.)

Table 5.2
Uses of Financings
Involving ARC RLF's (%)*

Percentage Percentage
of Loans of Loan $
}| Land and Buildings 614 41.9

Machinery and Equipment 748 39.9
Working Capital 47.9 125
26.4 5.7

210.5 100

*Data based on funding from all sources

**Adds to more than 100% because some projects involve multiple uses
Number of Respondents = 420

Source: Mt. Auburn Business Survey

Interest rates. Most RLFs provide deeply subsidized interest rates. Of RLF s providing
information on their interest rates, about 40 percent charged 4.5 percent or lower, about 25
percent charged 4.75 to 6.5 percent, about 20 percent charged 6.75 to 8.5 percent, and about 15

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Final Report Mt. Auburn Associates, Ine.


Table 2.5:
it Ratios, by Bai

|| Under $100 million
$100.500 million T2.3A% 72.22%
$500 million to $1 billion 84.18% 76.96%
|] $1-5 billion 87.03% 86.02%
Over $5 billion 3 19% 95.37%
Total 72.62% 87.86%

Source: Rural Economy Division, Economic Research Service, U.S. Department of Agriculture. Calculated by ERS
from the Federal Reserve Board's Report of Condition and Report of Income files, December 31, 1996.

Table 2.4 also suggests that rural commercial banks have reflected larger market
consolidation trends as the number of rural commercial banks declined from 6,459 in 1990 to
5,493 in 1995, As the number of banks has decreased, average assets, deposits, and loans have
increased correspondingly.

Although Table 2.4 indicates that rural banks have performed as well as other U.S.
banks, there are some trends that call into question the availability of debt financing for rural
businesses and the capacity and willingness of rural banks to provide such financing. Since
1990, for example, rural commercial banks have decreased the percentage of their portfolios
invested in commercial loans. Between 1990 and 1995, rural commercial banks and savings and
loans financed fewer commercial loans in favor of increased home mortgage investments. In
1990, commercial loans reflected more than 18 percent of the total loan portfolio of these
institutions. By 1995, these loans reflected only 14.7 percent of this portfolio. This slight shift
can be partially explained as increased preference for investments in home mortgages and real
estate development because of the greater stability and lower risk of these types of investments.

While the displacement of business lending in favor of other forms of local lending
might be a cause for concern, this slight shift in rural commercial lending does not appear to
have significantly harmed the availability of credit for rural business. Recent consolidation
within the banking industry has not resulted in less financing availability for rural businesses
(ERS, 1997; Rose, 1993; Calem, 1994; Nakamura, 1994), Rather, the upsurge of the nation's
economy in recent years cushioned the impact of this displacement so that both rural and urban
businesses have experienced significant increases in financing availability. Rural businesses, in
particular, have been the beneficiaries of recent economic growth as they have actually
experienced a greater increase in the proportion of debt financing than urban firms (ERS,
1997). In addition, rural businesses have seen their consumer base increase and broaden as
rural population increased dramatically during the last decade. In fact, overall population
growth in rural areas has outpaced population growth in metropolitan areas of the country.

Another important measure of the performance of rural financial markets is the
distribution and accessibility of financial institutions in those markets. Table 2.6 provides a
fairly concise assessment of bank market structure across rural counties. It indicates that as
recently as 1994, almost 73 percent of rural counties were served by at least three banks
(including the branches of banks headquartered elsewhere). This compares to 96 percent in

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Final Report Mt. Auburn Associates, Inc.


differences cannot be attributed wholly to bank behavior. They are also likely to reflect local
industry characteristics, the relative aggressiveness of different CDCs, or whether a particular
area is served by or accessible toa CDC at all. (See Section 5.2.1.)

Use of these programs tends to be lower in rural Appalachia. Use of the 7(a) program
tends to be somewhat lower in non-metro counties than in metro counties. Eighty-nine percent
of metro counties substantially exceed the national average, compared to only 71 percent of
non-metro counties. Likewise, only 4 percent of metro counties substantially trail the national
average, compared to 19 percent of non-metro counties. The disparities in 504 program use are
similar. Forty-six percent of metro counties substantially exceed the national average compared
to only 30 percent of non-metro counties. Likewise, only 47 percent of metro counties
substantially trail the national average, compared to 69 percent of non-metro counties. This
may indicate a lesser willingness to use development finance programs among rural bankers,
but may also indicate a greater willingness to be flexible with conventional financing. (See
Table 4.5.)

Use of these programs also tends to be lower in economically distressed parts of the
region. Use of the 7(a) program tends to be much lower in distressed counties than in other
counties. Eighty-two percent of other counties substantially exceed the national average,
compared to only 59 percent of distressed counties. Likewise, only 10 percent of other counties
substantially trail the national average, compared to 31 percent of distressed counties. The
disparities in 504 program use are similar. Thirty-nine percent of other counties substantially
exceed the national average, compared to only 13 percent of distressed counties. Likewise, only
56 percent of other counties substantially trail the national average, compared to 87 percent of
distressed counties. This likely indicates a lower demand for these programs among borrowers
because of poor economic conditions. It may also indicate a higher level of conservatism among
lenders developed in response to these conditions. (See Table 4.6.)

Development finance professionals point to a number of factors that affect bank
aggressiveness in participating in development finance programs. These include: 1) bank
knowledge of programs; 2) the size of the loans (following a trend of more competitiveness for
larger loans); and 3) a bank's past experience working with the SBA. Some respondents report
that banks hesitate to do business with SBA because of concerns about loan terms, paperwork,
or the SBA's follow-through on commitments.

chi]
Final Repore Mt. Auburn Associates, Inc.


Bankers in the region appear to be growing increasingly comfortable working with
Jocal and regional development finance organizations. This fact emerged particularly
strongly from the three case studies. While some bankers continue to be reluctant to work with
government-sponsored programs, many have become more sophisticated about using these
programs (including obtaining SBA certified or preferred lender designation), view them both
as competitive tool and a stimulus to the local economy, and have developed good working
relationships with local development finance professionals. Some banks have taken an
aggressive role in forming private sector development finance organizations, such as the
consortium of banks in southeastern Kentucky that recently formed a bank CDC.

Development finance professionals see less in the way of recent changes in risk
capital availability. Some note recent efforts to increase the supply (through such initiatives as
venture capital networks and venture capital fairs), but generally do not see systematic change
in either the system of providing such financing or in its availability to the region's businesses.

4.5 SumMARY oF FINDINGS

© In spite of the growth of nonbank business credit sources nationwide, businesses
in the Appalachian region remain heavily reliant on the banking industry as a
source of debt financing. Important nonbank credit sources, such as nonbank SBA
lenders and commercial finance companies, are not very active in the region.
However, businesses in the region do have access to other credit sources, including
equipment dealers, suppliers, credit cards and, among larger firms, leasing
companies.

© Banks in the Appalachian region are as financially healthy as and have used their
deposit base as aggressively as their peers in the rest of the U.S. to make loans.
However, levels of bank deposits in the region are relatively low, and are
particularly low in economically distressed areas. This could potentially be
constraining the level of bank lending, although banks experiencing strong credit
demand do have access to funds in addition to local deposits.

© Overall, businesses in the region are somewhat more reliant on small, local banks
than on large statewide or regional banks. However, larger businesses and
businesses in urban areas are about equally reliant on small and large banks.

© Banking industry consolidation in the Appalachian region has occurred at about
the same pace as in the rest of the country. Despite this trend, competition in
local banking markets generally remains strong and businesses continue to have
banking options. In most markets, small independent banks continue to compete
with larger banks. In one important indicator of bank aggressiveness in meeting
small business needs -- use of the SBA 7(a) loan guarantee program -- banks in most
parts of the region outperform national averages.

© As large banks increase their presence in the region, there are differing
perceptions about their impacts. Development finance professionals have varying
opinions, both positive and negative, about how the changes in banking products and
underwriting practices associated with larger banks have affected small businesses.

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Table 2.1
Sources of Credit for Agriculture and Rural Housing, Business, and Development

lit sources vary depending on the nature of the loan.

Community
ype of Lender Small Business| Development
Retail Lenders:

Regulated financial institutions
Commercial banks Major Major Major Major
Farm Credit System Major Minor Minor Minor
Thrift institutions Minor Major Minor Minor
Insurance and pension funds Moderate 3 Moderate! Minor
[Unregulated Lenders
Finance companies Moderate Minor Moderate B
Mortgage brokers Minor Major = *
Trade credit suppliers Moderate 5 Moderate =
Nonprofits (revolving loan funds, etc.) zs Minor Minor Minor
Individuals Moderate Moderate Moderate Moderate
Government Direct Loan Programs
U.S. Department of Agriculture Moderate Minor ~ Minor
Other Federal agencies = Minor Minor 2
State and local agencies Minor Minor Minor Major

ondary Markets and Credit Enhancements:
|Government-sponsored Enterprises

Federal National Mortgage Assn. = Major - -
Federal Horne Loan Mortgage Corp. = Major - -
Federal Home Loan Bank System = Major - Minor
Federal Agricultural Mortgage Corp. Minor Minor Minor Minor*
Farm Credit Systern (OFT) Lending Minor - =~ -
Government Agencies
U.S. Department of Agriculture Moderate Moderate Minor Moderate
Other Federal Agencies Minor Moderate Moderate Minor
State and Local Agencies Minor Minor Minor Minor
Private Sector
Loan poolers Minor Minor Minor’ Minor
Loan guarantors/insurers Minor Moderate Minor Minor

Note: Precise estimates of the relative importance of specific lenders within rural credit markets are generally unavailable.
Categorizations are based on survey data, administrative records, and anecdotal evidence. A major participant provides or
supports more than 20 percent of the market; moderate participants handle S to 20 percent of the et; minor participants
handle less than 5 percent of the market.

' The insurance industry's assets include substantial commercial real estate holdings as well as corporate stocks and bonds
and tax-exempt securities. While not considered major lenders to small independent rural business, insurance company
investments may directly and indirectly finance the rural branch plants of large and medium-sized businesses.

Support is provided primarily for federally-guaranteed loans.

.- Indicates no lending or an insignificant amount of lending.

Source: Credit in Rural America, 1997. Rural Economy Division, Economic Research Service, U.S. Department of]
Agriculture, Agricultural Economics Report No. 749.

Foal Report Mt. Auburn Associates, Inc.


case of SBA-funded funds, $25,000 or less, few development finance organizations focus on the
$10,000 to $50,000 financing niche. ARC should establish a funding window targeted to
development finance organizations that seek to address this gap.

ARC has already made a number of grants for microenterprise funds through its state
partners. Such funds can also be provided through the new Appalachian Entrepreneurship
Initiative. States should be encouraged to consider financing mechanisms that provide a step
up from microenterprise financing as part of the strategies they develop for the Initiative.

ARC should also consider establishing a set-aside for direct grants to local economic
development organizations to be used as a match for other funding sources. These grants would
be made through a competitive application process. The grants would be small -- no more than
$250,000 dollars, and would be targeted toward organizations in more rural parts of the region.
Additional funding should be made available for the provision of entrepreneurial training and
technical assistance. Organizations receiving such grants would be required to submit a detailed
business plan tying small and microenterprise development to a broader economic development
strategy and demonstrating the capacity to provide related training and business assistance.

In addition to direct investment, ARC should draw in the resources of other funding
sources and intermediaries supporting microenterprise development. \t could identify and
seek co-inyestors from among other national or regional co-inyestors, including private and
corporate foundations and bank community investment units. It should also seek to draw in the
financial and technical resources of organizations such as ACCION International or Working
Capital, which support local organizations in implementing their microlending models.

> Invest in Socially-Oriented Ventare Funds

Our study has shown that conventional venture capital funds and even SBICs have very
little presence in most parts of the Appalachian region. At the same time, a few organizations in
the region, including Kentucky Highlands Investment Corporation and the Self-Help Ventures
Fund in North Carolina, have demonstrated that, with the right types of investment capital,
sufficient scale, and strong staffing and technical capacity, socially-oriented venture investing
can be successful. However, these organizations only cover a small part of the region.

ARC should establish a fund to make direct seed investments in a limited number of
socially-oriented venture funds. \t should establish rigorous criteria for investing in such
funds based on experience from successful models. These criteria include minimum
capitalization, sufficient operating revenues, and a management team with strong investment
and technical assistance skills. In order to ensure that these funds reach an
economically-efficient scale, attract sufficient funding, and achieve sufficient portfolio diversity,
ARC should require that they serve substantially larger areas than do its RLF's. It should also
require a non-governmental match component of at least 1:1.

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There is no difference in the perceptions of metro and non-metro respondents
regarding changes in the availability of financing. (See Table 4.9.)

Table 4.9
Availability of Financing
Over the Past Three Years
By Urban or Rural Location (%)

Metro Non-Metro
| Much harder to obtain now 94 7.6
}| A little harder to obtain now 5.3 58
|About the same 22.2 158
|| A little easier to obtain now 11.1 8.2
Much easier to obtain now 58 88
Jn =171
Note:
ll Metro = Inside federally-defined metropolitan statistical area.
Non-Metro = Outside federally-defined metropolitan statistical area.
|| Not statistically significant
Source: ‘Mt. Auburn Business Survey

A higher proportion of smaller than larger business survey respondents appears to
believe that obtaining financing has recently become more difficult. Thirty-six percent of
smaller firms indicated increasing difficulty over the past three years versus 24 percent of larger
firms. These differences were not statistically significant, however. About the same proportion
indicated declining difficulty. (See Table 4.10.)

Table 4.10
Availability of Financing
Over the Past Three Years
By Firm Size (%)

Small
Much harder to obtain now 20.3
| A little harder to obtain now 159
About the same 29.0
A little easier to obtain now 18.8

Much easier to obtain now 15.9
n= 167
Not statistically significant
Note: Small = 1.9 employees
Large = 10+ employees

Final Report Mt. Auburn Associates, Inc.


assets, and on participating in financings of greater than $50,000, and, more typically,
greater than $100,000. State development finance programs are particularly poorly
matched to needs in the region. In addition, development finance resources in some
areas are insufficient to meet demand, in part because of inefficiencies in the
allocation of these resources.

16. Finally, there is strong need for expanded non-financial business assistance and
better coordination between non-financial and financial assistance. Beyond
additional resources, this requires the application of more sophisticated tools to
support coordination.

6.2 Srnatecy RECOMMENDATIONS

6.2.1 Srrarecic Focus

The findings from the study suggest four critical needs that should be addressed by
ARC development finance initiatives:

1. Develop flexible mechanisms to channel capital in a timely manner to existing
ARC RLFs that are experiencing high levels of demand for financing that cannot
be accommodated with existing RLF resources. ‘This is particularly important to
maintaining economic momentum in areas where key manufacturing or other
industries are expanding rapidly.

2. Increase capital resources to support small entrepreneurship, particularly in
economically lagging parts of the region and for non-traditional entrepreneurs.

3. Support capacity development among regional development finance organizations
to increase their ability to access financial resources, engage in more sophisticated
forms of financing, and more effectively manage the development lending process
within their regions.

4. Increase the availability of non-financial business assistance and improve its
coordination with development finance activities.

6.2.2 RECOMMENDED INITIATIVES

1, Expand Capital Availability to Existing RLFs

Revolving loan funds remain an important development finance tool in the Appalachian
region. They can play a particularly important role in financing the expansion of small- and
medium-sized manufacturers and other “traded sector" firms. Many ARC-funded revolving
loan funds have been able to meet loan demand with ARC capital grants, and some have
substantial liquid capital to meet future loan demand. However, others are finding that demand
for loans exceeds their existing financial capacity. Given the limited amount of funding

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Map 5.1

ARC-, EDA-, and USDA-Funded RLF's,
and Non-Federal Multi-County RLF's

None
1 RLF
2-3RLF's

Gs -srrs

Source; Mt, Aubum Associates’ .) 50 100 150 200 Miles
Development Finance Survey eee

Final Report 93 Mt. Auburn Associates, Inc.



rural areas. With few exceptions, respondents reported limited activity among non-regulated
lenders. The level of activity of these lenders appears directly related to proximity to urban
areas. Development finance professionals and bankers interviewed in the course of the three
case studies also reported that, with the exception of some equipment leasing by vendors and a
few nonbank SBA lenders, activity among nonbank credit sources is very limited.

The relative importance of different nonbank credit sources does not vary
significantly between urban and rural parts of the region. Among respondents to the
business survey, there were no statistically significant differences in the importance of five
major nonbank credit sources - credit unions, commercial finance companies, leasing
companies, equipment dealers and suppliers, and credit cards -- among respondents in metro
and non-metro counties. (See Table 4.2.)

Table 4.2
Importance of Financing Sources
By Urban or Rural Location (%)

Somewhat Unimportant
Very Important | Important orN/A to
Business

Statistical
Metro | Non-Metro| Metro | Non-Metro| Metro | Non-Metro Significance
383 41.6} 20.6 18 40.4 Not Significant
238 23} 133 62.9 65.5 Not Significant
213) 189 67) 08 nd ‘Significant at .0S level

16.9 76.6 Not Significant

Venture capital firms or small 44 82.7 [Significant at .0S level
business investment companics

Other private investors 66 76.6 Not Significant
‘Small commercial or savings 49.5 44 ¥ Significant at .01 level

banks with headquarters in or
near community

Larger commercial or savings x 5 Not Significant
banks operating throughout the

state or in several states
Credit unions 9 | 86. [Not Significant
Commercial finance companies ; Not Significant
Leasing companies ; g Not Significant
|] Equipment dealers or suppliers ; z Not Significant
Credit cards Not Significant
Government loan programs of
loan programa operated by local . ! Significant at 01 level

Note:

Metro = Inside federally-defined metropolitan statistical area,
Non-Metro = Outside federally-defined metropolitan statistical area.
Source: Mt. Auburn Business Survey

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Final Report Mt. Auburn Assoctates, Inc.


© Some parts of the region, notably New York, northern Pennsylvania, and parts of
Tennessee, North Carolina, and states to the south, have high proportions of
Jarge firms. This is often correlated with high proportions of manufacturing
firms. This may indicate a relatively high demand for larger-scale and more
complex financings in these areas.

© The role of non-traditional industries and entrepreneurs in the region's economy
remains relatively undeveloped. ‘This includes firms in the service sector and
women-owned firms. If these segments of the economy are to expand, additional
financing for firms with which local financing sources are less familiar than their
traditional clients is likely to be required.

© Other than for commercial mortgage financing, most businesses need financing in
the $50,000 and under range.

° The most frequently sought types of business financing are for equipment and for
short-term working capital needs.

° Anecdotal evidence indicates that demand for financing in the region has
generally been increasing, driven by a number of factors, including downsized
professionals seeking to launch new businesses, in-migration, increasing
outsourcing and job shops, and an overall improving economy. Based on the
survey responses, the near-term investment plans of Appalachian businesses are
oriented heavily toward fixed-asset financing needs.

© There are some differences in financing demand between urban and rural parts of
the region.

+ Non-metro counties tend to have higher employment growth but also higher
unemployment rates, indicating a near-term potential for business expansion
that could be supported by additional flows of capital.

+ Non-metro counties also tend to have lower rates of enterprise formation,
higher percentages of manufacturers, lower percentages of service firms, and
lower women-enterprise-ownership rates.

+ Businesses located in non-metro counties are less likely to seek financing than
their metro area counterparts.

+ There are few difference in the financing needs anticipated by metro and
non-metro borrowers, or in the proportion of metro and non-metro borrowers
who either have been recently affected by inability to obtain financing or
anticipate trouble obtaining financing in the near future.

© The level of demand for most types of financing products is similar among
smaller and larger firms. However, there are notable differences in their
expectations regarding future financing. Larger firms are more likely to anticipate
future financing needs, while smaller firms are more likely to anticipate future
problems obtaining financing.

57
Final Report Mt. Aubsuin Associates, Inc.


through many phases of regulatory reform. Although many of these regulatory changes have
occurred at both state and federal levels, the most fundamental changes have occurred at the
federal level. The most sweeping transformations have resulted from four legislative acts: 1)
the Depository Institutions Deregulation and Monetary Control Act of 1980; 2) the Garn-St.
Germain Depository Institutions Act of 1982; 3) the Financial Institutions Reform, Recovery,
and Enforcement Act of 1989 (FIRREA); and 4) the Federal Deposit Insurance Corporation
Improvement Act of 199] (FDICIA).

Over the years, concerns have been raised about the impact of these regulatory reforms
on access to credit for small businesses. Some have argued that more stringent banking
regulations following the savings and loans debacle actually led to reductions in credit
availability to small businesses in the early 1990s (Cole et al, 1996). Recent analyses of this issue
suggest that small business credit availability has not suffered at the hands of some of the most
recent efforts to deregulate the banking industry, although this has not been the case through
the entire 1990s period (Barry, 1996).

The most recent major regulatory reform affecting the banking industry, the Riegle-Neal
Interstate Banking and Branching Act of 1994, has paved the way for full-scale interstate
banking. This legislation is expected to substantially increase the number of multi-office
banking institutions. Although states have the option to resist interstate banking by opting out
of the legislation, thus far only a few states have opted out while many more of them have
welcomed interstate banking.

One of the favorable outcomes expected from this legislation is that it will reduce banks’
vulnerability to local economic downturns (Keeton, 1995). It is also expected to increase the
potential to shift capital to regions of the country experiencing high capital demand. Beyond
this, its likely outcomes are subject to considerable debate.

Many have expressed concerns about the short-term impact of this legislation on access
to credit for small businesses. While changes in banking market structure may theoretically
affect all consumers of banking services, particular concern has been expressed about its affect
on small businesses. While larger firms may have access to other sources of credit and financial
services, small firms are heavily dependent on local financial institutions. Changes in the way
banks are regulated then, may have much larger repercussions for small businesses than for
other banking customers.

One major concern about the impact of interstate banking is the potential reduction in
the number of local, smaller banks that tend to lend more frequently to small businesses
(Keeton, 1995). Another concern is that the decision-making process for credit approval will be
removed from the locality and will not give small business customers the opportunity to develop
lending relationships with local bankers. These relationships, it is argued, have been important
in helping small businesses that, on the face of it, were not deemed creditworthy by credit
scoring systems, obtain credit. Finally, major concerns have been expressed about changes in
the variety and quality of banking services available to small businesses. Traditionally, local
bankers have been able to tailor their services to the particular needs of the customers in their
localities. The specific concern is that nonlocal banks may offer more standardized financial

19
Final Report Mt. Auburn Associates, Inc.


3.5

Final Report

that category), except export trade financing (33 percent of total requests), for which
there was only a total of three financing requests among respondents. Other than for
that type of financing, this size range was most important for equipment leases (22
percent of total requests), revolving lines of credit (14 percent), and equipment loans
(11 percent).

Financings of $10,000 to $49,000: This was generally the most frequently
requested size of financing. The main source of demand in this financing size was for
equipment loans and leases, working capital loans, and revolving credit lines. This
financing size was particularly important for the following categories of financings:
equipment leases (46 percent of total requests in that category), equipment loans (42
percent), and asset-based financing (42 percent). Also frequently sought were
medium-term working capital loans (36 percent), revolving lines of credit (31
percent), and short-term working capital loans (29 percent).

Financings of $50,000 to $99,000: The main source of demand in this financing
size was for equipment loans, commercial mortgages, revolving lines of credit, and
short-term working capital. This financing size was particularly important for the
following categories of financing: short-term working capital (25 percent of total
requests in that financing category) and equipment loans (23 percent). Seventeen
percent of commercial mortgage requests were also in this amount.

Financings of $100,000 to $499,000: The main source of demand in this financing
size was for commercial mortgages, working capital, and revolving credit lines. This
financing size was particularly important for the following categories of financings:
fixed-rate commercial mortgages (40 percent of total requests in that category),
asset-based financing (33 percent), export trade financing (33 percent), medium-term
working capital (32 percent), short-term working capital (29 percent), and
variable-rate commercial mortgages (28 percent).

Financings of $500,000 or greater. The main source of demand in this financing
size was for commercial mortgages and revolving lines of credit. This financing size
was particularly important for the following categories of financings: equity or debt
with equity features (80 percent of total requests in that category), export trade
financing (33 percent), variable-rate commercial mortgages (28 percent), fixed rate
commercial mortgages (26 percent), and asset-based financing (25 percent).

Recent AND Prosecrep TRENDs IN DEMAND FoR
FINANCING

Anecdotal evidence indicates that demand for credit in the region has been
increasing. Among development finance professionals interviewed, the general observation was
that demand for credit is increasing as a result of one or more of several factors: downsized
professionals seeking to launch new businesses; in-migration; increasing outsourcing and job
shops; and an overall improving economy (the latter observation consistent with national and
regional trends in employment growth). A few respondents indicated that consolidation trends

Mt. Auburn Associates, Inc:


higher share of total establishments comprised by manufacturers than the national average (66
percent vs. 44 percent), while a substantially higher proportion has a substantially lower share
of total establishments comprised by service establishments (58 percent versus 29 percent).
This indicates that, while manufacturing is still relatively important throughout the
Appalachian region and the service economy is relatively undeveloped, these phenomena are
particularly pronounced in the more rural parts of the region. (See Table 3.5.)

Non-metro counties tend to have lower women enterprise ownership rates. Women
enterprise ownership is far more frequently below the national average in non-metro counties
than in metro counties. Seventy-five percent of non-metro counties have lower than average
rates of women enterprise ownership compared to 50 percent of metro counties. This indicates a
lesser near-term demand for financing by women-owned firms, but also a greater need to
develop strategies to support women entrepreneurship (of which financing is one component).
(See Table 3.5.)

According to the business survey results, businesses located in non-metro counties
are less likely to seek financing than businesses located in metro counties. The survey data
suggest, although not conclusively, that respondents from non-metro counties have sought
many types of financing less frequently than those from metro counties. The most notable
difference is in the demand for medium-term working capital. Only 12.5 percent of respondents
from non-metro counties have sought this type of financing during the past three years
compared to 23 percent from metro counties. (See Table 3.6.)

"Table 3.6
Experience in Obtaining Financing in the Past Three Years
By Urban or Rural Location (%)

Sought ‘
Obtained ‘Turned Down | Did NotSeck

|Metro | Non-Metro| Metro | Non-Metro J Metro | Non-Metro| | Significance
25.0 185} 29 43] 58 Ll Not Significant

43 65) LO Ll] 67 54) f Not Significant

324 7) 19 Li} 38 22) é £ Not Significant
276 23) 19 00} 38 22) Not Significant

Medium-term working capital | 21.4 19 Ll] 97 34) 67: Significant at 1 level
(1-5 years)

Short-term working capital 4| 29 Lif 68 57 F Not Significent
(under 1 year) a“

Revolving line of credit . 38 56] 47 a0 Not Significant
‘Asset-based financing ¥ 29 oo] 20 22 : [Not Significant
Export trade financing E a] 00 Lif 10 00] 97. Z Not Significant
Equity of debt with equity 20 10] 20 00 i
features

|] Note: Metro = Inside federally defined metropolitan statistical aces.
Non-Metro = Outside federally-defined metropolitan statistical area,

52
Final Report Me. Auburn Assoctates, Inc.


Development finance professionals have very little knowledge about informal risk
capital investors. Many were vaguely aware of informal investment activity, but knew little
about preferred investments or investment terms. Those familiar with informal investors
reported that they tend to be successful retired executives, professionals, or business people. A
few respondents indicated that informal investors were successful people seeking to reinvest the
products of their success in their community. Several respondents noted that venture capital
networks were active in their areas, although some considered them ineffective. More
frequently, respondents indicated that such networks had not been established.

Mt. Auburn's case studies indicate that informal investors can play an important role
in financing high-growth local industries. \n both north central Pennsylvania and northeast
Mississippi, there has been a fairly high level of informal investment activity in the dominant
growth industries -- powder metallurgy and furniture, respectively. Investors primarily include
individuals already involved in the industry, but also sometimes include other wealthy area
residents. However, interest in these particular industries does not appear to attract
entrepreneurs in other, less familiar lines of business. Also, in the case of powder metallurgy,
the increasing cost of initial capital investments for startups has begun to outstrip the financial
capacity of informal investors.

4.4 Recent Trenps in Business FINANCING

Based on the survey responses, the availability of financing does not, on balance,
appear to have changed greatly over the past three years. Thirty-two percent of respondents
said availability is about the same, 30 percent said financing is much or a little easier to obtain,
and 24 percent said it is much or a little harder to obtain. Sixteen percent were not sure. Note
that businesses’ perceptions about changes in the availability of financing might be a result of

changes in their own financial condition as well as changes in the financial market environment.
(See Table 4.8.)

Table 4.8
Change in Availability of Financing
Over the Past Three Years

Number of | Percentage of
Respondents | Respondents
Much harder to obtain now 14.1
A little harder to obtain now 9.7
About the same 32.0
A little easier to obtain now 16.0
Much easier to obtain now 12.1
Don't know 16.0
Total 100.0

Source: Mt. Auburn Business Survey

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Sources OF DEVELOPMENT FINANCE
Local and Regional Organizations

Northeast Mississippi Planning and Development District (VMPDD). NMPDD is
the lead economic development organization in the region. It has revolving loan funds funded
by three federal agencies, ARC, the Economic Development Administration, and the U.S.
Department of Agriculture. The total capitalization of these funds in mid-1997 was
approximately $11.75 million. NMPDD also offers small and minority business financing
through state of Mississippi programs.

NMPDD provides RLF loans on the following terms:

© fixed-asset and working capital financing;

© senior lien required for most loans;

© 7percent fixed interest rate;

© maximum 10-year term;

© leverage of 2:1 on EDA and ARC RLFs; 1:1 on USDA RLF; and

© maximum amount of $200,000 on EDA and ARC RLFs, $150,000 on USDA RLF.

Through October 1997, the NMPDD's RLFs have made 183 loans totaling $17.9
million.’ It made 20 loans in 1996 and currently has 107 active loans. Its loans have assisted in
creating or retaining over 4,000 jobs and leveraged $2.25 in private investment for each RLF
dollar. It has written off only 3.4 percent of its loans. It is seen as coordinating well with state
and local public financiers and sources of business assistance and in "fulfilling a real need" for
non-conventional financing.

NMPDD focuses heavily on providing fixed asset financing for manufacturing firms.
Over 90 percent of the funds have been used to acquire or improve fixed assets. Over 58
percent of the loans and 41 percent of the loan volume has been invested in the manufacturing
sector. NMPDD has financed both expansions and startups -- over half of its loan volume
supports business expansion, while almost 40 percent assists startups.

NMPDD has experienced strong demand for its financing and has aggressively lent out
its funds. Of the $2.17 million in RLF funds it currently has available to lend, it has $2.16
million in outstanding loan commitments. Since certain projects can only be financed by
particular RLFs (because of differing financing criteria), some RLFs have available funds while
others do not have sufficient funds to meet current commitments. In the cases of the ARC and
EDA sources, commitments exceed available funds by $208,000 and $223,000, respectively.

‘ Letter report of 13 November 1997 from Pat Falkner of NMPDD provided all data describing the RLF lending
and portfolio.

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because of bank lending limits. Third, some of the deals are weak in some respects (e.g.,
collateral, equity participating -- NCPRPDC's participation can reduce the bank's risk and this
makes it more comfortable with the deal. NCPRPDC staff believe that these advantages
translate into accelerated business development and more jobs for the region.

NCPRPDC is viewed by bankers and other development finance organizations in the
region as the lead organization in development finance. Bankers interested in partnering with a
local, regional, or state development organization typically contact the NCPRPDC lending staff
to inquire about appropriate options. If other organizations need to be contacted or joint
financing packages developed, NCPRPDC typically plays a coordinating role.

NCPRPDC's RLFs are part of its Enterprise Development Program, a comprehensive
one-stop center for business. It provides assistance with financing, market development
(including exporting), product development, and application of advanced technologies, and also
offers operating space for small startups. In addition to its Enterprise Development Program,
NCPRPDC's activities include: infrastructure development, social services, workforce
development, transportation, and planning and development assistance to communities. Three
of NCPRPDC's staff are involved in operating the loan programs -- the Deputy Director for
Enterprise Development, the Loan Program Director, and the Loan Program Assistant.

Other local and regional loan programs. The region does not have a 504 certified
development company to make SBA 504 loans. These are subordinated below-market fixed-rate
loans for fixed assets, in partnership with private lenders. NCPRPDC refers borrowers
interested in obtaining these loans to a certified development company operated by another of
the state's regional development organizations, SEDA-COG, which serves a region just to the
east of the NCPRPDC region. NCPRPDC lending staff report that the program has been used
infrequently and that they do not consider the terms of the financing attractive to the borrowers
they typically serve.

The region also has at least three small RLFs operated by local governments and
development organizations. Some of the banks in the region are also considering forming a
bank consortium to make higher-risk loans.

State Programs

The Commonwealth of Pennsylvania operates a number of development finance
programs available to businesses in the state:

© the Pennsylvania Economic Development Finance Authority (PEDFA) provides
tax-exempt industrial revenue bond financing;

© PEDFA also operates a Machinery and Equipment Loan Fund providing loans up
to $500,000 targeted to manufacturing firms;

© the Department of Community and Economic Services operates the Small Business
First Program, an $18 million fund that provides fixed asset and working capital

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Final Report Mt. Auburn Assvetates, Inc:


characteristic of their financial institutions is the existence of a personal relationship with their
lenders. Rural businesses then, are clearly concerned that their lenders understand their
priorities and constraints. Generally, rural businesses tend to be much more satisfied with their
lenders and have much better personal relationships with their lenders than urban businesses
(McGlone, 1991). Additionally, capital and extensions of credit are more likely to flow to
businesses that have established personal relationships with their lenders and those that use
other services of that financial institution to transact business (Peterson and Rajan, 1994).

Table 2.8
Importance of Financial Institution Characteristics to Business Firms and Financial
Institution Performance

Credit availability is more often rated as important by rural businesses than is the cost of credit.

Source of Capital

Knows you and your business E : W2
Reliable source of credit : ; 6
Easy access to loan officer 0.1
Speed of decisions/services g . ; 2B
Offers the cheapest money available 125
Knows the local market/ community 5 : : 26
Convenient location ; 4 |
Knows your industry 35.6 19.9 y 136 |]
Offers a wide range of services 25 2.6 256 ||

Provides helpful suggestions, advice, and/or 49 165 m1 |]
seminars

Social contact with loan officer 174 20.3 9 13

Note: Firms were asked to indicate the importance of each characteristic on « scale of 1 to S, where 1 is very important, 3 is important, and
‘5 is not important. Firms then rated their principal financial institutions on # scale of | to 5, where | is good, 3 is acceptable, and 5 is poor.
Firms that did not answer a particular question (value 0) were included in calculating the percentages reported above.

Source: Credit in Rural America, 1997. Rural Economy Division, Economic Research Service, U.S. Department of Agriculture,
Agricultural Economics Report No. 749. Based on Economic Research Service's computations from the 1995 NFIB Credit, Banks, and
Small Business survey.

2.2.3 CaprraL AND CrepiT Gaps IN Rurat FINANCIAL MARKETS

Most assessments of financing availability to rural businesses have concluded that these
firms are not at a disadvantage in terms of acquiring necessary financing. Rather, these
businesses have regular and significant opportunities to attract capital and credit from financial
institutions. Recent business surveys by the National Federation of Independent Businesses
and by the Federal Reserve, for example, indicate that financing availability for rural firms is
similar to that of urban firms. Moreover, these surveys found that interest rates paid by rural
businesses are similar to the terms found in urban areas and that rural business owners are
relatively satisfied with the financial institutions that serve them (ERS, 1997).

4
Final Report Att. Auburn Associates, Inc.


such as secondary wood processing, and firms in the retail and service industries,
including those related to tourism;

© working capital for early-stage firms that have not reached profitability;

¢ small loans (especially under $25,000) for home-based and other microenterprises,
a growing presence in the region's economy. Banks will not typically make these
loans, particularly to individuals with limited personal assets, and there are no
SBA-funded or other microloan programs serving this market; and

© loans for firms that do not fit traditional financing practices of conventional
lenders or the targeting criteria of development finance programs. One banker
notes that, despite the growing importance of the region's retail economy, banks
continue to resist financing retail firms. Development finance programs tend to target
manufacturing firms.

Aside from the issue of financing, development finance professionals express concern
about the limited availability of management and technical assistance to the region's small firms.
NCPRPDC's Enterprise Development Program offers specific forms of technical assistance but
does not provide one-on-one assistance in such areas as business plan development and financial
management. The major source of that type of assistance is a small business development center
that is located just outside the region and is not easily accessible for many businesses. The
SBDC has not been aggressive in its outreach or in trying to make its services more easily
accessible. NCPRPDC would like to bring a staff person on board to work with businesses on
business plan development, but is concerned about potential conflicts of interest of interest with
its lending function.

SUMMARY

The economy of the North Central Pennsylvania region, while lagging in some respects,
has weathered recent economic transitions reasonably well and is showing strength in its
important manufacturing sector, particularly through the healthy growth of its powder
metallurgy industry. The region is experiencing other positive trends, including the
development of secondary wood processing, tourism, and home-based professional businesses.

The performance of the region's capital market in responding to the resulting demands
for business financing has been good in some respects but has fallen short in others. The
region has a highly competitive banking industry and a fairly active informal investment
market. Firms in the powder metallurgy industry have largely been able to meet their needs for
both risk capital and secured debt financing. However, firms in industries that are not as well
established have had greater difficulty. Development finance organizations have played an
important and effective role as partners with banks and private investors, but are limited by a
narrow range of financing tools that does not include flexible risk financing and financing for
small-scale enterprises. The region also lacks sufficient capacity to provide small business
management assistance to fully capitalize on the region's entrepreneurial potential.

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Graph 3.4

Graph 3.3
Recent Plans to Expand, Modemize, or Renovate
Anticipation Apa: chic inh Financing Affected By Inability to Obtain Financing
7 y (%) Pecermgecttemontes By Firm Size (%)
400 a0
60 0
60 oo
« S77 © aly Ries
a 42
»
. ‘Small Lome 0
ee ‘Smalt SK Large
ce Tee mee respects © 2

| 3.7 SumMARY OF FINDINGS

| © The demand for business financing has to be seen in the context of other business
needs. Businesses and development finance professionals note a number of factors

aside from financing that significantly affect business development, including labor
force and infrastructure.

| © Data measuring economic structure and performance vary greatly throughout the
region, making broad generalizations about demand for financing difficult.
However, the data can be useful in developing economic profiles of various parts of
| the region and in considering the implications of these profiles for business financing
needs. For example, areas with both high employment growth and high
unemployment rates might benefit from additional business financing to enable
expanding firms to accommodate growth and hire additional workers. Regions with
low growth and high unemployment may require more long-term financing as part of

comprehensive economic development strategies to address economic stagnation or
decline.

© Generally high rates of unemployment throughout the region and the
corresponding high levels of surplus labor indicate a continuing need for
economic stimulus, particularly in areas of low employment growth. Access to
business financing for startup and expanding firms can play a role in broader
economic development strategies to address these conditions.

© Enterprise formation rates are generally low throughout the region. In addition,
the proportion of smaller firms is only average, surprising for a heavily rural area.
A shortage of small-scale risk financing could be one factor contributing to this
situation.

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Final Report Mt. Aubun Associates, Inc.


1.2 A Nore on Caprrat Marker ANALYsIs

‘As we have noted, the purpose of this study is to assess the availability of capital and
credit for businesses in the Appalachian region. This involves determining whether businesses
in the region have sufficient access to capital in sufficient amounts, types. and at a reasonable
risk-adjusted cost. While the question is straightforward, the ability to find an answer is
seriously constrained by data collection and measurement problems.

In order to assess the performance of financial markets in the Appalachian region in
meeting business financing needs and to quantify financing "gaps," it would be necessary to:

1. measure the demand for funds by examining the status and financing needs of firms
in the region by characteristics such as size, stage of development, industry sector,
and location; and

2. know precisely how capital and credit are being allocated to firms of these varying
characteristics.

To date, no satisfactory empirical method has been developed to precisely measure
supply of and demand for financing. To understand the true nature of capital and credit
availability in the region would require methods that both quantify the demand for financing on
a regional and sub-regional level, and precisely measure the supply and allocation of financing
by all significant financing sources. There are serious limitations to accurate quantification of
both demand and supply.

On the demand side, measuring a financing "gap" would require examining all users of
financing to evaluate whether they are able to support the cost of financing at the current
risk-adjusted market price. This involves making the difficult distinction between a business’
or prospective business desire for financing and its ability to pay for that financing. Even the
most direct data collection methods, such as business surveys, only measure perceived need and
do not arrive at real demand. At any given moment in time, the desire for capital is absolutely
infinite, but the effective demand is relatively finite. The problem is that the measure of its
relative finiteness is a human judgment call, not one that is mathematically measurable.
Moreover, the ability to even identify all seckers of financing, particularly discouraged
entrepreneurs and failed businesses, is problematic.

On the supply side, measuring the financing "gap" would involve not only quantifying
the amounts and types of capital available but distinguishing the ability to provide financing
from the willingness to provide financing. Many factors particular to given individuals,
institutions, and industries can influence their risk preferences in a way that reduces their
willingness to invest below a desired level from the standpoint of regional economic
development. These can include institutional policies, the behavior of individual
decision-makers, or the market, technological, and regulatory forces affecting an entire segment
of the financial industry. Even if an outside analyst were able to study the financing decisions
of a representative sampling of all important business financing sources, it is questionable

3
Final Report Jt. Auburn Assoctates, Inc.


Table 4.6
Measures of Supply of Financing:

Comparison of Distressed and Other Counties
85% to 115%

of U.S. Average

17.5%
BB%

Distressed counties
Other counties

The financial performance of urban and rural banks in the region appears to be
roughly comparable, with rural banks slightly outperforming urban banks on some key
measures. Among commercial banks headquartered in the region, rural-based banks have, on
average, higher net interest margins, slightly higher returns on assets, higher capitalization
levels, and a lower proportion of problem loans. An exception is the higher average loan loss
provision for rural banks, which could indicate either more conservative financial management
or expectation of higher future portfolio losses. (See Table 4.7.)

73
Final Report Mt. Auburn Associates, Ine.


negotiate the terms of their loans and other banking products and services, and has driven down
the prices of these products and services (Cline, 1995; Oppenheim, 1996). The Federal Reserve
reported earlier this year that the disparity between loan rates and market rates has recently
been relatively similar for businesses of all sizes with only slightly better rate spreads for larger
loans (Federal Reserve, 1997).

2.3.6 CHANGES IN UNDERWRITING TOOLS AND PRACTICES

One of the criticisms of small business lending practices by larger banks has been the
use of centralized loan decision-making systems that are too slow, require excessive
documentation, and do not sufficiently incorporate the knowledge gained of the borrower and
the local business environment through direct borrower/lender relationships. These criticisms
have particularly come to the fore in instances where large banking organizations have acquired
local, independent banks.

In response to these criticisms and in an attempt to improve profitability and gain
market share in the small business lending market, some banks are returning to more
decentralized lending processes where local bankers are given the authority to make final
decisions about loans. Although the latter can be more expensive and substantially more risky,
it has returned some larger banks to more customer-focused lending.

A much higher proportion of larger banks has responded to these criticisms by adopting
credit scoring systems. Investment in these systems has allowed banks to expand small business
lending volumes while managing associated risks. Credit scoring systems allow banks to
statistically evaluate the creditworthiness of an applicant as well as to standardize the credit
availability to those applicants. The emergence of credit scoring systems as a lending tool in the

small business market has had industry-wide implications, the benefits of which are thought to
be:

© shorter cycle time and improved information quality resulting from fewer
hand-offs;

© higher loan volume as work associated with shepherding a smaller number of
bankable credit applications through the approval process increases;

© better elimination of subject inconsistencies in the approval process;

© more effective leveraging of a bank's skills -- more customer face-to-face time for
relationship managers;

*® more focused credit review that uses analyses to monitor the individual
borrower's risk profile, to adjust aggregate loan loss reserves, and to feed directly
back into the pricing process through some form of performance pricing; and

© greater opportunity to securitize loans because of standard analysis, to transfer
tisk portfolio risk, and to price loans according to their incremental risk in
relation to the loan portfolio (Furash, 1997).

238
Final Report Me. Auburn Associates, Inc.


Table 4.4: Measures of Commercial Bank Performance
(12/31/96)

‘Average Assets ($000) $419,981 $480,882
Net Interest Margin 3.65% 354%
Return on Assets 1.29% 1LM4%
Equity Capital/Asset Ratio 8.51% 8.18%
Loan/Deposit Ratio 89.89% 87.86 %
Loan Loss Provision 0.22% 0.56%

Problem Loans/Equity Capital 6.24% 7.8%

Source: Rural Economy Division, Economic Research Service, U.S. Department of
Agriculture. Calculated by ERS from the Federal Reserve Board's Report of Condition and
|] Report of Income files, December 31, 1996.

Commercial banks headquartered in the region appear, on average, to lend as
aggressively as banks across the U.S. while maintaining superior loan portfolio quality.
The average loan-to-deposit ratio for Appalachian-based commercial banks slightly exceeds the
national average. At the same time, portfolio quality, as measured by provisions for loan losses
and the ratio of problem loans to equity capital, also exceeds the U.S. average. (See Table 4.4.)
There are a number of reasons that the region's banks may be able to use their deposits as
aggressively for lending as banks outside the region while maintaining higher portfolio quality.
One is that they may simply be better managed. Another is that, because they have relatively
low levels of deposits, they use a relatively high proportion of these deposits for less risky loans
like residential mortgages or loans to highly creditworthy businesses and consumers.

Differences Banking Indastry Characteristics and Lending
Performance by Bank Location, Bank Size, and Basiness Size

There are no substantial differences in measures of banking resources between
urban and rural parts of the region. The distribution of Appalachian counties around average
U.S. measures of deposits per capita is about the same for metro and non-metro counties,
although a slightly higher proportion of metro counties exceeds the U.S. average for combined
commercial bank and thrift institution deposits per capita. With respect to both the number of
institutions and number of offices in relation to population, a somewhat higher proportion of
non-metro counties substantially exceed the national average. (See Table 4.5.)

71
Final Report Me. Auburn Associates, Inc.


Arprenprix E: ArrpaLacnmiAN Crepir AND
Caprrau Srupy Apvisory Group

Gregory Bischak

Senior Economist

Appalachian Regional Commission
Washington, DC 20235

Robert Brandwein
Policy and Management Associates
Boston, MA 02116

Richard Dorwalt

RLF Coordinator

Appalachian Regional Commission
Washington, DC 20235

Alison Feighan

Vice President

Rapoza Associates
Washington, DC 20004

Thomas M. Hunter

Executive Director

Appalachian Regional Commission
Washington, DC 20235

Vernon R, Kelley, III

Executive Director

Three Rivers Planning and Development
District

Pontotoc, MS 38863

Peter Kwass

Principal

Mt. Auburn Associates
Somerville, MA 02144

John W. Magee

Senior Vice President - Market Manager for
Business Banking

PNC Bank Northwest

Erie, PA 16508

Final Report

Katherine McKee
Director of Policy Self-Help
Durham, NC 27701

Ray Moncrief

Executive Vice President

Kentucky Highlands Investment Corp.
London, KY 40743-1738

William Steiner

Executive Director

Northwest Pennsylvania Regional Planning &
Development Commission

Franklin, PA 16323

Sakina Thompson

Policy Advisor to the Federal Co-Chairman
Appalachian Regional Commission
Washington, DC 20235

Jeffrey W. Thompson

Manager, Entrepreneurial Development
Appalachian Regional Commission
Washington, DC 20235

Wendell Waites

Budget Officer, Federal Office
Appalachian Regional Commission
Washington, DC 20235

William Walker

States Washington Representative
Appalachian Regional Commission
Washington, DC 20235

Jesse L. White, Jr.

Federal Co-Chairman

Appalachian Regional Commission
Washington, DC 20235

Mt. Auburn Assoctates, Inc.


Map 4.1

Total Commercial Bank and Savings Institutions
Deposits Per Capita, June 1996

[__] Below 85% of U.S. Average
[9G 85% to 115% of U.S. Average
He Above 115% of U.S. Average

Source: Federal Deposit Insurance Corporation;
Office of Thrift Supervision, 0 50 100 150 200 Miles
U.S. Department of the Treasury ee —

Final Report 64 Mt. Auburn Associates, Inc.


From the period between 1987 to 1993, nearly 3,000 mergers in the United States
banking industry took place. In 1995 and 1996, bank merger and acquisition activity remained
at record levels (Spiegel and Gart, 1996). The 50 largest banks in the United States now account
for over 75 percent of the total banking assets in the United States and continuing consolidation
in the banking industry is expected to reduce the number of banks by at least 25 percent before
the year 2000 (Spiegel and Gart, 1996). Table 2.11 provides a more detailed examination of
merger and acquisition activity over the past two decades.

a SST
Merger and Acquisition Activity 1979-1994

3,398

3,658
14,041] 3,838
13,538 | 3,823
12,965] 3,833
12,554] 3,866
12,194 | 3,801
11,789] 3,707] 256 00
11,347] 3,681 337
10,866 | 3,803 519
10,359] 4,024] 323 192

]| Note: (1) GTA refers to the gross total assets; (2) all G'TA's are shown in billions of dollars.
|| Source: Berger et al, 1997

élals/R8[sle/8]s|ols]s[slals

While bank deregulation has been the primary catalyst for the intensified merger and
acquisitions activity, the characteristics of these mergers have varied substantially. Table 2.12
provides a typology of the characteristics of mergers that occurred between 1990 and 1995, and
provides specific examples of each type.

21
Final Report Mt. Auburn Associates, Ine.


Map 3.3

Startups as a Percentage
of all Establishments, 1992

[___] Below 85% of U.S. Average
[yy 85% to 115% of U.S. Average
ee Above 115% of U.S. Average

0 50 100 150 200 Miles
Source: Dunn & Bradstreet ee

Final Report 38 Mt. Auburn Associates, Inc.


Cuapter Four:

Tue Supe ry or Business Financine From Private

SEcTOoR SOURCES IN THE APPALACHIAN REGION

4.1 INTRODUCTION

This chapter assesses the supply of business financing from private sector sources in the

Appalachian region. It synthesizes analysis of three sources of data on the supply of financing.
These sources are:

I.

Statistical data on financing resources. This data is primarily drawn from the
banking industry, the only major business financing source from which data is widely
available because of data collection by banking regulators. The data indicate the
levels of bank deposits, the number of banking institutions operating in local
markets, the number of banking offices, lending activity, and overall financial
performance. Per capita income data is also used to indicate the levels of personal
wealth potentially available for business investment either directly or through
financial intermediaries, This data is analyzed at the county level, and is compared
for urban and rural areas, and, when available, for economically distressed and
non-distressed areas.

Results of the business survey conducted for this study. This data indicate the
levels of use of different sources of financing by businesses in the region, and the
ability to obtain different types of financing. This data is broken down by firm size
and by urban vs. rural location.

Results of telephone interviews with development finance professionals, and case
study interviews conducted with development finance professionals, economic
developers, local officials, and bankers. These interviews are used to supplement
statistical and survey data by providing anecdotal information on the activity levels,
products, and financing preferences of different financing sources.

The analysis and synthesis of data from these sources enables us to develop the following

indirect indicators of the supply of business financing:

the overall supply of private sector financial resources in counties of the Appalachian
region relative to the rest of the nation;

the relative importance of different types of financing sources as providers of business
financing;

the relative ability of businesses to obtain different types of business financing;

58

Final Report Mt. Auburn Associates, Inc.


market. For the most part, nonbanks "consist of finance companies, insurance companies,
mortgage companies, leasing companies, brokerage firms, other business firms, families and
individuals, and government sources of credit" (Cole et al, 1996). Nonbanking entities have
continued to make inroads into the small business credit market and have been a major part of
the growth in this market (Allen, 1994).

Over the last several years, the banking industry has consistently lost shares of the small
business lending market to nonbank entities (Arista and Schlesinger, 1996). Evidence from the
1987 and 1993 National Surveys of Small Business Finances demonstrates that small businesses
are relying much more heavily on nonbank institutions for small businesses loans and other
small business services. Nonbanks like the Money Store and Merrill Lynch have become major
competitors for small business customers. The Money Store, for example, loaned more than
$457 million in 1995, becoming the largest Small Business Administration lender with more
1,502 loans to small businesses.

As the market grows and more institutions begin offering services to small businesses,
the definition of "nonbanks" keeps expanding. For example, consumer credit card issuers are
entering the small business finance market as nonbanking entities. American Express, Visa
International, Diners Club, and Mastercard International have all launched small business
corporate divisions whose purpose is to target small business customers. Saturation of the
consumer credit card market has pushed many credit card issuers into the small business
finance market. In response, more banks have begun offering credit card services to their small
business customers and have enhanced them by co-branding with other companies like major
airline companies and office supply companies. Overall, efforts to increase the credit card usage
by small business has been extremely successful with the industry showing strong and steady
growth. In the process, the availability of credit to small businesses has increased and the terms
of credit have improved.

In their efforts to attract small business customers, most major credit card companies
have enhanced the services they already provide rather than introducing completely new and
innovative services and products to small business customers. For example, cards can be
restricted to selected employees with customized spending limits per employee, transaction, and
merchant. Improved services of this nature allow small businesses greater flexibility and
control over their use of credit. The cards offer small businesses better control over minor

purchases, inherent recordkeeping systems, electronic payment and reporting features, as well
as time savings.

Overall, as the competition for small business customers intensifies, banks and
nonbanks have had to define and exploit their strategic advantages. Nonbanks have a number
of strategic advantages over banks that have enabled them to make inroads into the small
business market fairly easily and quickly. First, they are not, on the whole, new to the
financial services market. The most successful nonbanks have been institutions with
prestigious and long-standing traditions in other areas of the financial markets that have
introduced small business products and services, such as Merrill Lynch and American Express.
Merrill Lynch, for example, now offers a small business product called Working Capital
Management Account that includes business checking accounts, lines of credit, term loans,

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ASSESSMENT OF CAPITAL AND Crepit NEEDs AND Gars

Development finance professionals and bankers identify a number of significant
financing gaps. These include:

© equity financing , particularly for startups -- both formal and informal sources are
lacking, and the region lacks the personal wealth to support substantial private
investment;

© financing of less than $25,000;
© financings for businesses in struggling or mature industries;

© financing for working capital -- this is influenced by heavy reliance of bankers on real
estate collateral. Reliance on real estate as collateral sometimes even makes equipment
financing difficult to obtain; and

© financing for deals that vary from the standard,

NMPDD financing, while seen as an important supplement to bank financing, is viewed
by some economic development actors as sometimes too collateral-oriented to leverage bank
financing for riskier deals. The fact that only seven of NMPDD's 30 most recent RLF
financings were co-financed with private debt indicates that NMPDD loans may, to some
degree, be supplanting rather than supplementing private financing. This impression is
reinforced by the low rates and other favorable terms on which NMPDD loans are provided.
NMPDD takes the position that taking junior positions on collateral compromises the objective
of preserving capital and that sufficient demand for NMPDD loans exists without providing
subordinated loans. Despite any reservations about NMPDD's lending practices, other
economic development actors interviewed for this study almost uniformly expressed a need for
more RLF funding, particularly in light of the RLF's current lack of resources to make new
financing commitments.

Aside from financing gaps, other commonly reported constraints to business
development include inadequate managerial expertise and poor infrastructure. Although the
community college is reportedly surfacing as a training resource, few training programs are
available to address weak management skills. While infrastructure is seen as having been
substantially improved over the past several years, contributing to the region's development,
further improvements are seen as needed.

SUMMARY

While economic conditions in the northeast Mississippi region have improved in recent
years, the region still suffers from high levels of economic distress, as evidenced by relatively
low income levels and high rates of unemployment. This is particularly true in the more rural
parts of the region with large numbers of African-American residents. The region's economy is
highly dependent on a mature manufacturing base, some of which (i.e., the garment industry) is
vulnerable to the effects of offshore competition and NAFTA. The region has seen only modest

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Firms in rural and urban parts of the region are about equally likely to be affected
by inability to obtain financing. There was little difference reported by firms in metro and
non-metro counties on the impacts of inability to obtain financing.

In general, a higher proportion of firms in urban parts of the region report having
unmet financing needs than firms in rural parts of the region. A higher proportion of firms
in metro areas reported unmet needs for almost all types of financing. However, the only
statistically significant difference was in the case of medium-term working capital. Almost 12
percent of respondents in metro areas reported an unmet need for this type of financing versus
4.5 percent in non-metro areas, (See Table 3.6.)

Rural areas of the region lag urban areas in some key economic measures. More
business financing may be one component in strategies to address these disparities. Rural
areas have lower rates of enterprise formation, and lower proportions of non-traditional
industries and entrepreneurs.

Distressed areas of the region lag other areas in certain measures of economic and
financial market performance, which may indicate less availability of business financing.
Distressed counties in the region, by nature, have lower levels of personal wealth and are much
more likely than other counties to have levels of per capita deposits that are substantially below
U.S. averages. Banks in distressed counties are also much less likely to use SBA financing
programs. These findings are consistent with the general literature on rural financial markets
which indicates that businesses in persistent poverty areas have more difficulty accessing
financing.

5.3 Toe Roxie of DEVELOPMENT FINANCE INSTITUTIONS IN
Appnressiné Capirar AnD Crepit Gaps

5.3.1 PRoFILe oF DEVELOPMENT FINANCE RESOURCES

This section profiles some of the major sources of development finance available to
businesses in the Appalachian region. These sources include sub-state regional revolving loan
funds, microloan funds, SBA 504 Certified Development Companies, nonprofit development
loan funds, and state and multi-state development finance programs.

Revolving Loan Funds

There are about 100 revolving loan funds in the region operated by sub-state regional
economic development organizations. In addition to 27 active ARC funds, there are 46
sub-state EDA funds, 12 sub-state USDA IRP funds, and at least 15 funds capitalized with state
government, local government, and/or private funds. In addition to these funds, there are a
large number of RLFs operating at the county and municipal levels. Data on these RLFs are
difficult to obtain and are, therefore, not included in Mt. Auburn's analysis.

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3.3 Tne Importance or FiInancine To Business
CoMPETITIVENESS

In considering the need for measures to expand the availability of capital and credit in
the Appalachian region, it is important to take into account the importance placed on financing
availability to business competitiveness relative to other factors. Mt. Auburn has gained some
insights into this issue, mainly from the business survey and interviews with development
finance professionals.

The responses to the business survey indicate that availability of financing is only
one of many factors that have an important influence on business competitiveness. When
asked about the importance of eight major factors affecting business competitiveness to their
ability to do business at their current location, respondents ranked financing, on average, sixth
out of eight factors. Of the eight factors, the five considered more important (in order of rank)
were: availability and/or quality of labor; general quality of life; state and local tax levels;
transportation links; and cost and/or availability of utilities. The two considered less important
were: ayailability and/or cost of sites and buildings; and availability and/or cost of housing.
While availability of financing was not ranked among the most important factors, still 35
percent of respondents said it had a strong impact, and 23 percent said it had a moderate impact
on their competitiveness. (See Table 3.1.)

Table 3.1
Factors Affecting Doing Business (%)

JAvailability and/or cost of housing 17 315 55.3 15
[Availability and/or cost of sites and buildings 6.2 272 45.1 1S
JA vailability of financing 35.4 B3 40.3 10
[Availability and/or cost of utilities 335 35.4 20.6 0S
[Transportation links 308 23 35.4 15
tate and local tax levels 42.7 35.4 20.9 10
|General quality of life 295 42.2 24 05
[Cost, availability, and/or quality of labor 52.0 36 194 0.0

(Note: Total number of respondents = 206
LSource: Mt. Auburn Business Survey

Development finance professionals have a somewhat different perspective, ranking
the availability of financing among the most important factors affecting competitiveness.
Among those we interviewed, obtaining financing was generally considered either the most
significant challenge or comparable in importance to other challenges facing their clients. Other
challenges most frequently mentioned were, in order of frequency: lack of suitable
infrastructure (i.e., water and sewer, roads, as well as buildable sites, especially in mountainous
areas); an inadequately skilled labor force; lack of access to markets; and unfavorable local
permitting/zoning regulations or practices.

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CnHaprer Five:
PrivaTe Sector FINANCING Gaps IN THE
APPALACHIAN REGION AND THE ROLE OF
DEVELOPMENT FINANCE INSTITUTIONS

5.1 INTRODUCTION

This chapter identifies current financing gaps resulting from imbalances in demand for
and supply of business financing in the Appalachian region, and assesses the capacity of existing
development finance programs to fill these gaps. Findings on private capital gaps are drawn
from a synthesis of the findings in previous chapters along with the reported experiences and
perceptions of businesses and development finance professionals in the region. Data on
development finance programs is drawn from several sources: 1) directories and funder data on
almost 400 development finance programs; 2) data collection from organizations operating over
200 of these programs; and 3) in-depth analysis of the current loan portfolios of ARC-funded
revolving loan funds.

5.2 Gaps in AVAILABILITY OF Private Sector FINANCING

There is no evidence of widespread, systemic gaps in the availability of private
sector financing for firms in the Appalachian region willing to pay the risk-adjusted market
rate of return. Several observations form the basis for this conclusion.

e First, recent literature on rural business financing has generally found that rural
businesses are not at a disadvantage in terms of access to or terms of financing.

© Second, recent regulatory and market trends in the financial services industry have,
on balance, had a fayorable impact on the availability of small business financing in
urban and rural areas alike throughout the U.S, particularly by increasing
competition within the banking industry and by introducing nonbank lenders to the
business market.

© Third, the banking industry in Appalachia, the most important source of debt
financing for the region's businesses, appears to perform generally as well as its
counterparts in the rest of the U.S. Banks in the Appalachian region are as financially
healthy and have used their deposit base as aggressively to make loans as their peers
in the rest of the U.S. And despite banking industry consolidation that has occurred
at about the same pace as in the rest of the county, competition in local banking
markets generally remains strong and businesses continue to have banking options.
Other research has found that rural businesses tend to be much more satisfied with
their lenders and have better personal relationships with their lenders than their
urban counterparts.

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Banking industry resources are generally low throughout the Appalachian region.
For combined commercial bank and savings institution deposits, deposits per capita in most
counties of the region are substantially below the U.S. average.” Scattered counties throughout
the region, particularly in central and southwestern Pennsylvania, southeastern West
Virginia/southern Virginia, and northwest Alabama, equal or exceed the U.S. average. For
commercial bank deposits alone®, the region is in a somewhat better position, with most
counties either equaling or exceeding the U.S. average. Counties that lag the U.S. average are
most frequently found in New York, Ohio, Kentucky, and South Carolina. Low levels of per
capita deposits appear to be highly correlated with the low levels of per capita income prevalent
throughout the region. (See Maps 4.1, 4.2, and 4.3.)

While resources are somewhat low, the number of institutions in relation to
population tends to be relatively high, indicating a relatively high level of banking market
competition. Almost every county in the region has a substantially higher ratio of the
combined number of commercial banks and savings institutions in relation to population than
the U.S. average. The same is true for commercial banks. The relatively large number of
banking institutions throughout most of the region is related to the relatively large number of
small independent banks typically present in rural banking markets, as discussed in Chapter
Two. (See Maps 4.4 and 4.5.)

The number of banking offices in relation to population is also high in many
counties compared to the U.S, average, although not as frequently as in the case of banking
institutions. The number of banking offices in relation to population is an indication of the
relative ease of access to banking institutions for an area's residents. In the Appalachian region,
most counties have either about the same or a substantially higher ratio of combined
commercial bank and savings institution offices in relation to population than the U.S, as a
whole. This is true of even more counties when considering only commercial bank offices.
Only in scattered counties, notably in east central Kentucky and in Georgia, are these ratios
substantially below the U.S. average. (See Maps 4.6 and 4.7.)

The financial performance of commercial banks headquartered in the Appalachian
region is comparable to national industry averages. In selected measures of bank financial
performance, the average performance of commercial banks headquartered in the region* equals
or exceeds national industry averages. These measures include net interest margins (the spread
between interest paid on deposits and interest earned on loans), return on assets, and
capitalization ratios. (see Table 4.4)

Note that while deposits-per-capita is a good measure of core banking resources in relation to an area's population, banks have

a number of means to draw in non-local financial resources to meet loan demand. This is particularly true of larger regional

banks.

* Commercial banks have traditionally been more important sources of business loans than savings institutions, although this
distinction has become less pronounced as savings institutions have diversified their lending markets.

* This data does not include savings institutions or commercial banks with offices in the region but headquartered elsewhere.

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© Fourth, the vast majority of existing businesses in the Appalachian region do not
identify lack of access to financing as a serious problem. As noted in Chapter Three,
only about 12 percent of respondents to the business survey anticipated problems
meeting their financing needs.

© Fifth, development finance professionals in the region generally agree that capital and
credit availability is not an overriding concern and is not as critical to economic
development as other issues such as infrastructure and workforce development.

Certain factors characterizing rural financial markets in general and the Appalachian
region in particular make access to financing more problematic than in other parts of the

GS.

© First, businesses in Appalachia and other rural areas remain more heavily dependent
on the banking industry than their urban counterparts. The literature on trends in
the financial services industry indicates that nonbank lenders, which have greatly
increased credit choices for small businesses, have not entered rural markets to the
same degree as urban markets. Research specific to the Appalachian region
conducted for this study is consistent with this finding.

© Second, rural businesses generally have fewer banking choices because the lower
population density of rural areas cannot support the participation of as many banking
organizations in local markets.

© Third, the smaller banking institutions that are more prevalent in rural areas offer a
narrower range of financial services than larger institutions. This is a particular
problem for businesses needing complex forms of financing or financing bundled
with other financial services. Research specific to Appalachia confirms that
businesses in the region are somewhat more reliant on small, local banks than on
large statewide or regional banks.

© Fourth, levels of personal wealth in the Appalachian region are very low, reducing the
level of financial resources that can be drawn from within the region for the purpose
of business financing. This is a particular problem in segments of the financial
market, such as small-scale risk capital financing, where intermediaries do not exist to
import capital into the region when local resources are inadequate to meet demand.

A small but still significant proportion of established Appalachian firms, as well as a
Jarger proportion of startup firms, are seriously affected by inability to obtain sufficient
financing. Lack of the right types of capital in the right amounts and at the right times is
slowing the pace of enterprise formation and business expansion. The responses to the business
survey support this conclusion. Seventeen percent of survey respondents indicated that their
plans to expand, modernize, or renovate during the past three years were affected by inability to
get financing. Among those, about two-thirds said plans were either delayed or scaled back, and
about one-third said plans were canceled.’ (See Graph 5.1.) In addition, development finance

‘ The survey data does not address the impact of inability to get financing on business failure (since respondents
were all existing firms) nor on the experience of firms with fewer than five employees (since they were not
included in the survey),

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Foal Reporr

Table A.5
Profile of Survey Respondents
Geographical Distribution

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Mt. Aubuin Associates, Ine.


City Bank of Kentucky, has a significant presence in the region. It has offices in five of the
eight counties and holds about 12 percent of the region's total deposits.

The region has a relatively low level of banking resources. Total deposits per capita in
commercial and savings banks were 25 percent below the state average and 29 percent below the
national average. When commercial bank resources alone are considered (commercial banks
have traditionally been more active business lenders than savings banks), the disparity is about
the same -- 28 percent below both the state and national averages.

While banking resources are somewhat low, the region's banking environment appears
to be highly competitive. No bank holds more than 15 percent of the region's total bank
deposits and the three largest banks hold just under 40 percent. The level of competition does
vary by county, however. While five counties -- Bell, Harlan, Knox, Laurel, and Whitley - have
between five and six banks, the other three counties -- Clay, Jackson, and Rockcastle, only have
one or two banks. (These three counties also have the smallest populations.)

In measures of availability of banking services, the region also does reasonably well. It
has more banks in relation to population than the national average but about the same as the
state average. Its ratio of savings and commercial banks to population is over twice the national
average while its ratio of commercial banks to population is almost twice the national average.
In both of these measures, the region is roughly the same as state averages. In measures of
banking offices to population, the region is somewhat below state averages although it is still
higher than national averages. The ratio of both combined commercial and savings bank offices
and commercial bank offices alone to population is about 10 percent below state averages.
These ratios are about 25 percent above national averages in both categories. The region's less
favorable standing with respect to this second set of measures reflects the smaller than average
size and less extensive branch networks of the region's banks.

The region's banks, while viewed by development finance professionals and bankers
themselves as conservative, are also viewed as generally responsive to the needs of local
businesses, within the market and regulatory constraints placed on the banking industry.
Banks are seen as doing a good job of meeting the demand for secured debt financing.
Non-bank lenders are not considered a significant source of business financing in the region.

While the region's banking environment has been affected by banking consolidation and
other changes within the industry occurring nationally, this is not seen as having a major impact
on business financing in the region, at least to date. Some observers do detect a somewhat more
competitive environment for small business lending resulting from a combination of factors,
including acquisitions of local banks by non-local banking organizations, the entry of some
savings banks into the commercial lending market, and the improving economy. It is also noted
that the few large banks active in the region tend to focus on high-volume loan products, are
introducing credit scoring systems for business loans, and are reducing the discretion given to
local branch personnel in lending decisions. This is seen as beneficial to businesses that fit
these banks' standard lending criteria, but as harmful to businesses that may be creditworthy
but may not have all the information required by the bank or may not meet certain financial
performance ratios.

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The competition for small business customers has resulted in more relaxed credit
standards, better credit terms, less collateral requirements, and increased lines of
credit. Increased competition has also meant that small businesses are in a slightly
better position to negotiate the terms of their loans and other business products.

Lenders are casting wider nets to attract small businesses, which has meant that
many small businesses that have previously had difficulty obtaining credit or
have not been targeted by lenders, have greater opportunities to obtain credit.

While regulatory reforms appear to have had generally positive effects on small
business lending in the short run, the long-run impacts are still uncertain.
Because impacts may vary as the structure and performance of the economy changes,
regulatory reforms should be closely monitored for their impacts on the credit
availability for small businesses. The Small Business Regulatory Enforcement
Fairness Act, enacted in 1996 to ensure that small business are not being unfairly
burdened by regulatory excess, may prove an important tool in this regard.

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Final Report Mt. Auburn Associates, Inc.


Table 2.3: Sources of Business Investment Capital During the Last Fiscal Year
Commercial banks are also the most often used source of funds for capital outlays.
 Rura ERR: Bo: si #8 ITER

Primary

Source of Capital Secondary

Bank loans (excluding credit cards) 29.7 84
Finance company loans 25 34 3.7 26
Other loans (family, investors, etc.) 6.7 7 96 8.3
‘Trade credit 3.9 3.6 3.9 4.2
Retained earnings 4B 89 7 91
Credit cards 12.1 N/A 14.3 N/A
No secondary source N/A 26 N/A 23.9

Source: Credit in Rural America, 1997, Rural Economy Division, Economic Research Service, U.S.
Department of Agriculture, Agricultural Economics Report No. 749. Based on Economic Research Service's
computations from the 1995 NFIB Credit, Banks, and Small Business survey.

Note: The columns do not sum to 100 percent because some firms did not answer the question.

N/A = not applicable.

From this data, it is clear that rural business rely more heavily on commercial banks as
their primary source of both working capital and investment capital. It is also clear that they
also rely less on non-institutional investors (family, friends, etc.) than do urban businesses
(McGlone, 1991). Moreover, rural businesses rely less on credit cards for both working and
investment capital than do urban businesses.

2.2.2 PERFORMANCE OF RuRAL BANKING MARKETS

Overall, rural commercial banks are much smaller in terms of their asset size, but are
well capitalized, profitable, and are characterized by a strong portfolio of financially sound loans
(ERS, 1997). Moreover, in recent years, the performance of rural commercial banks has largely
paralleled the performance of urban commercial banks around the country in most respects.
Table 2.4 provides a comparison of U.S. and rural commercial banks from 1990 to 1995.
Overall, this comparison indicates that rural commercial banks have performed at least as well
as larger, urban commercial banks.

Final Report Mt. Auburn Associates, Inc.


the per capita income and constrains the level of non-basic jobs that the economy can support.
The NMPDD also reports that employers are experiencing increasing difficulty in recruiting
and retaining quality workers

The region has experienced flat employment growth in recent years. Between 1993 and
1995, employment increased by only 0.4 percent. This compares with 4.1 percent at the state
level and 3.9 percent nationally.

Economic conditions in the region vary by county, Benton and Marshall counties have
the lowest incomes and the highest unemployment. These counties also have the greatest
concentration of minority populations and, along with Tishomingo County, are the most rural.
Prentiss and Tippah counties have the strongest recent employment growth and the lowest
unemployment. Alcorn and Tishomingo have the highest income levels.

Tae Demanp ron Frnancine: Tue Reeion's Business Base

The primary industry in the region is manufacturing. Manufacturing grew vigorously
from 1950 to 1980, but has declined modestly since then. Between 1980 and 1990, agriculture,
government, and transportation/communications/utilities shed 32 percent of their jobs.
Although northeast Mississippi remains rural, its agricultural sector has especially declined,
losing 89 percent of its jobs from 1960 to 1990. Furniture manufacturing, employing
approximately 7 percent of the labor force, is the most important industry, recently replacing
the garment industry, which has suffered due to NAFTA. More than 30 furniture firms employ
some 4,400 workers. Retail trade is the second industry. With the growth of metropolitan
Memphis, located about 100 miles northwest of Booneville, businesses, especially warehousing
firms, have begun locating in the western areas of the District. Tourism is growing in some
localities and is increasingly promoted.

The region is far more reliant on manufacturing jobs than the state or the nation.
Manufacturing employment in 1995 comprised almost 35 percent of total regional employment
compared to a little over 19 percent statewide and under 13 percent nationally. In 1990,
manufacturing firms comprised over 11 percent of all startups in the region, compared to 6.7
percent statewide. The NMPDD maintains that low startup costs continue to facilitate the
growth of the furniture industry. Availability of quality workers, however, is limiting this
growth.

Public expenditures have resulted in varying impact on the business base. On the one
hand, public work projects such as the Tenn-Tom Waterway created temporary jobs and vital
infrastructure. On the other hand, the demise of a NASA aerospace project displaced hundreds
of workers.

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Table 3.3
Amounts of Financing Sought and/or Obtained (%)

Fixed rate commercial mortgage 24 43 16.7 05 95 16.7 42
Variable rate commercial mortgage | 56 22 167 28 0.0 278 18
Equipment loan 13 as 26 132 19 94 53
Equipment lease 216 459 108 81 00 135 37
Medium-term working capital (1-5 91 364 45 318 91 ol 2
m
55
12
3
5

years)

Short-term working capital (under 1 83 29.2 3.0 29.2 0.0 83
year)

Revolving line of credit 45 30.9 14.5 218 5.5 12.7
Asset-based financing 0.0 4.7 0.0 33.3 0.0 3.0
Export trade financing 33.3 0.0 0.0 33.3 0.0 33.3
Equity of debt with equity features

Source: Mt. Auburn Business Survey

© Commercial mortgages: Among those seeking fixed-rate commercial mortgages,
two-thirds sought $100,000 or more, most of those in the $100,000 to $499,000 range.
Among those seeking variable rate commercial mortgages, over half sought $100,000
or more, half of those in the $100,000 to $499,000 range.

© Equipment loans and leases: Among those seeking equipment loans, over half
sought less than $50,000, while almost one-quarter sought $50,000 to $99,000.
Among those seeking equipment leases, two-thirds sought less than $50,000.

*© Working capital loans: Among those seeking medium-term working capital loans,
45 percent sought less than $50,000, most of those in the $10,000 to $49,000 range.
About one-third sought $100,000 to $499,000. Among those seeking short-term
working capital, 38 percent sought less than $50,000, 25 percent $50,000 to $99,000,
and 29 percent $100,000 to $499,000.

© Revolving lines of credit: 45 percent sought less than $50,000, 14 percent sought
$50,000 to $99,000, and 22 percent sought $100,000 to $499,000.

It is also useful to assess the nature of demand for financings of particular sizes. The
relative importance of different financing sizes for particular types of financings was as follows:
(See Table 3.3.)

© Financings of under $10,000: The main source of demand in this financing size was
for equipment loans and leases. This financing size was not particularly important in
any financing category (as a proportion of the total number of financing sought in

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Final Report Me. Auburn Associates, Inc.


As Table 2.1 attests, the most important sources of financing for rural business
enterprises are commercial banks. And, rural businesses, not unlike their urban counterparts,
rely heavily on these banks to supply them with credit and capital. While the role of
commercial lenders in providing financing to rural businesses is clear, other financial
institutions also provide significant forms of financing. Other sources of business financing
considered at least moderately important to credit and capital availability for rural business
enterprises include insurance and pension funds, finance companies, trade credit suppliers,
individuals (angels), and federal agencies.

Other research has shown that rural businesses use a much narrower group of financial
institutions than do urban businesses. This is primarily because of the less diverse group of
financial institutions that compete in rural areas of the country. Nondepository institutions
(such as finance companies, brokerage firms, and leasing companies) are also less likely to be
used by rural businesses (Cole and Wolken, 1995; ERS, 1997).

Surveys conducted by the National Federation of Independent Businesses illustrate
these differences. Tables 2.2 and 2.3 provide the 1995 results of that survey and delineate the
sources of working and investment capital utilized by rural businesses.

Table 2.2: Sources of Business Working Capital During the Last Fiscal Year

Commercial banks are the most often used source of working capital for rural businesses and the most often
used external source for urban businesses.

Source of Capital Primary
Percentage

Bank loans (excluding credit cards) 40.7 13.2 20.7 123
Finance company loans 4 37 19 18
Other loans (family, investors, etc.) 8S 10 18 118
Trade credit TA 74 96 8
Retained earnings 316 99 7 84
Credit cards 3.6 93 $3 lt
No secondary source N/A 23.1 N/A 23.6

Source: Credit in Rural America, 1997, Rural Economy Division, Economic Research Service, U.S.
Department of Agriculture, Agricultural Economics Report No. 749. Based on Economic Research
Service's computations from the 1995 NFIB Credit, Banks, and Small Business survey.

Note: The columns do not sum to 100 percent because some firms did not answer the question.

N/A = not applicable.

Final Report Mt. Aubuen Associates, Inc.


Much of the Appalachian region remains a strong manufacturing region relative to
the nation as a whole. Many parts of the region have a substantially higher proportion of
manufacturing establishments’ than the national average. These include most of the
Appalachian counties in Mississippi, Alabama, and South Carolina, as well as many counties in
Tennessee, Georgia, North Carolina, northern West Virginia, and northwestern Pennsylvania.
Only a few parts of the region, notably a cluster of counties spanning southern West Virginia,
southwestern Virginia, eastern Kentucky, and the southern tip of Ohio, have a relatively low
proportion of manufacturing establishments. The clustering of large establishments and
manufacturing establishments appears to be closely related. Suitable forms of financing should

be available to maintain this important component of the region's economic base. (See Map
3.6.)

The service sector in Appalachia remains relatively undeveloped. Nationally, the
service sector is becoming an increasingly important part of the "traded sector" traditionally
dominated by manufacturing. The "traded sector" refers to firms that export products and
services to consumers outside a region, thus importing income and stimulating economic
activity. Traded services include components of financial and business services, transportation
services, and tourism.

The region has generally lagged the nation in the shift to a service economy. Only one
county in the region substantially exceeds the national average in its proportion of service
establishments. Most counties have a lower than average proportion of service establishments.
It is also likely that the bulk of service firms in the region is in the "non-traded" sector, that is,
serves primarily local markets, not in the economically more important traded sector, which
serves non-local markets and thus draws new income into the region. Therefore, financing for
service firms is not likely to be as important to promoting economic development as financing
for manufacturing firms, at least in the short run. In the longer run, as the nation continues to
shift to a service economy, the availability of financing for service firms in the region is likely to
take on greater importance. (See Map 3.7.)

The participation of non-traditional entrepreneurs in the region's economy is
relatively low. Throughout the U.S., representation of non-traditional and socially or
economically disadvantaged entrepreneurs among small business owners has been growing.
While this is true in Appalachia, the region is lagging behind the country in the level of
business ownership within at least one such group, women entrepreneurs. In most counties of
the region, the percentage of women-owned enterprises is well below the national average.
There are some parts of the region in which the rate is at or near the national average, notably
New York State's Appalachian counties, and in some parts of West Virginia and Ohio. In no
county in the region does the percentage of women-owned enterprises substantially exceed the
national average.’ (See Map 3.8.)

* Note that we are measuring the proportion of manufacturing establishments, a better indicator of demand for financing than
the proportion of manufacturing employment.

* Data on minority business ownership was not available for » majority of Appalachian counties because the number of such
firms was below the threshold required for public release.

Al
Final Report Mt. Aubumn Associates, Inc.


Table A.4
Profile of Survey Respondents
Current Financial Situation

Number of | Percentage of
Respondents | Respondents
Established firm with healthy profits 8 416
Established frm experiencing just breaking even or 80 388

experiencing mix of profitable and unprofitable years

Start-up firm (operating for two years or less) 12 58

Established firm experiencing operating losses 6
Don't know or N/A 10 48
Total 205 100

Source: Mt. Auburn Business Survey

Graph A.1
Profile of Survey Respondents
Company Ownership (%)
Percentage of
Respondents poate we
. Yes No Don't Know " Yes No Don’t Know

or WA

Note: A minorty-owned firm is defined as being at least 51% owned by one or more members of the following ethic groups: African-American;
Hispenic; Asian American; or Native American. A woman-owned firm is defined as being at lest 51% owned by one or more women.
Source: Mt, Aubun Business Survey

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Fonal Report Mt. Aubsen Aasectaces, Ine.


products and services that may not meet the particular needs of the local small business
community.

Thus, overall concerns with this legislation from the small business perspective have
focused on its impact on the reduction of community banks and the banking products and
services that they provide, as well as the overall availability of credit to smaller, less
creditworthy businesses. Although few major studies have tried specifically to assess the impact
of this regulatory change on small businesses, other relevant studies have indicated that small
business lending is not reduced when acquisitions by out-of-state banks occur (Berger et al,
1997). While this is only one kind of interstate banking, it may ease some concerns about the
impact on small businesses.

Aside from these broader regulatory changes, a number of regulatory reforms designed
specifically to increase small business access to credit and financial services have had a more
clearly positive impact. Most important among these is the Community Reinvestment Act. To
avoid challenges to merger applications, banks (particularly larger ones) have been willing to
invest more heavily in the small business market particularly in urban areas. Chase Manhattan
and Chemical Bank, like many other larger banks, have announced plans to invest billions of
dollars in inner-city neighborhoods over the next several years (Drier, 1995). While these
investments are being made in a variety of instruments, such as residential mortgages and
nonprofit housing, a sizable portion of these kinds of investments is being targeted at small
business customers, many of whom would not have received business loans due to their credit
issues, redlining, and/or other industry-related issues.

Another significant regulatory reform was adopted in the latter part of 1993, when
federal regulators increased the size of loans that banks could make to small businesses without
requiring an appraisal. They also allowed banks to reduce the amount of capital they must hold
against small business loans (Bacon, 1993). The purpose of these steps was to increase credit
for small business development and to deal with credit shortages in the small business market.
The impact of these actions was a significant increase in the amount of capital available to small
business. Generally, business borrowing has risen steeply and small businesses have
significantly increased their borrowing from both banks and nonbank institutions. Consistent
with other assessments of credit availability, the results of the most recent survey by the
National Federation of Independent Businesses indicated that small business owners believed

that credit has been more accessible and easier to obtain than during previous periods (Allen,
1994; Federal Reserve, 1997).

2.3.3 BANKING INDUSTRY CONSOLIDATION

One of the most explicit impacts of regulatory changes on the banking industry generally
has been on the structure of the banking industry. In this context, structural changes refer to
the number, kind, and character of banking institutions. Bank mergers and acquisitions that
would have been challenged under old guidelines, were deregulated under the Garn-St. Germain
Act of 1982. In this context, deregulation provided greater incentives for banks to consolidate
and they have done so in large numbers.

Final Report Mt. Auburn Associates, Inc.


Not all rural areas, however, have experienced the level of capitalization in their local
financial markets and some rural areas have experienced diminished economic growth due to
inadequate level of capital investment. Although in recent years economic growth in rural areas
has been strong, there is a need to identify the characteristics of rural areas and rural businesses
that are systematically underserved in terms of access to financing.

In terms of the characteristics of rural areas, underserved rural areas are more likely to
exist in areas where: (1) larger banks dominate the financial services market in the area and
small businesses characterize the business population overall; (2) small banks dominate the
financial services market in the area and larger businesses characterize the business population
overall; and (3) the businesses are either from nontraditional or overly-crowded industries
(Shaffer and Pulver, 1990). Moreover, where financing inadequacies exist, they have been
attributed to the lack of competitive pressure among financial institutions in the particular rural
markets (ERS, 1997; Shaffer and Pulver, 1990).

As might be expected, the most underserved rural business enterprises in terms of
financing needs are those that are marginally creditworthy or have some difficulty qualifying for
traditional financing in both the primary and secondary markets. These businesses are more
likely to rely on debt financing and smaller local lenders rather than larger financial institutions
or venture capital investors. In addition to these rural businesses, other rural businesses have
been traditionally underserved in rural financial markets such as: (1) small businesses
(particularly new and young ones); (2) businesses in persistent poverty or economically
depressed areas; (3) rural businesses in emerging sectors; (4) minority- and women-owned firms;
and (5) businesses with nontraditional management structures such as cooperatives,
worker-owned businesses, nonprofits, and some community development corporations.

A recent report by the Department of Agriculture suggests most rural businesses will
face at least three major problems in identifying and acquiring financing in rural markets:

e risk financing (equity for new businesses, long-term operating loans for
businesses and community organizations, etc.) is difficult to find;

© transaction costs are often higher for rural borrowers whose financial needs are
unusually large or complex (by local standards) as they have to shop over a wider
geographic area and deal with a broader range of institutions than is typically true
in urban settings; and

® access to credit and other financial services remains a problem for those who fail
to qualify for commercial loans because of low incomes, low skills, and lack of
collateral (ERS, 1997).

The most significant gap in the availability of financing in rural areas is the availability
of equity or risk capital. Rural businesses have had much difficulty in identifying potential
sources of risk capital and even more difficulty in securing such forms of capital for their
businesses. Rural businesses encounter more difficulties as they attempt to obtain risk or
equity financing (Taff et al, 1984). These businesses are also less likely than urban businesses to
be directed to alternative sources of financing when lenders are unable to provide startup capital

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Final Reporr Mt. Aubuwn Associates, Inc.


whether a research methodology could be developed to accurately evaluate the efficiency of each
individual lending or investment decision.

Consequently, our approach to the task of capital market analysis has been to use
available and accessible information selectively to develop a profile of the regional business base
and financial market that assesses capital needs, resources, and institutional structures from the
perspectives that are most relevant to policymakers. We have synthesized our findings from
several analytic methodologies that have proven to be reliable and valuable in many similar
circumstances. These methodologies have been developed over time from in-depth strategic
analyses in several states and regions.

1.3 OnGaniZATION OF THE REPorT

In the following chapters, financing issues facing businesses and development finance
professionals in the Appalachian region are assessed, and preliminary recommendations to the
Appalachian Regional Commission for addressing these issues are presented. The report is
organized as follows:

© Chapter Two presents a literature review of: 1) conditions and recent trends in rural
financial markets and their impact on rural business financing; and 2) the impacts of
recent trends in national financial markets on small business financing generally.
The purpose of this chapter is to provide a context for the report's findings regarding
issues more specific to the Appalachian region.

© Chapter Three summarizes findings regarding the demand for credit and capital
among businesses in the Appalachian region.

© Chapter Four summarizes findings regarding the availability of capital and credit to
businesses in the region.

© Chapter Five identifies current financing gaps resulting from imbalances in demand
and supply for financing in the region and assesses the capacity of development
finance organizations to fill these gaps.

© Chapter Six summarizes the overall findings from the study and presents
recommendations for ARC initiatives to address financing gaps.

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Tue Surry or Frnancine: Toe ReGionan FrNanciat
MARKET

PRIVATE DEBT AND Equity MARKETS
Secured Debt Financing

There are 20 commercial banks and savings institutions operating in the region. The
region's banking market has a mix of large non-local banks and smaller community-owned
banks, but remains largely dominated by smaller banks headquartered in or near the region.
The two largest banking organizations with offices in the region are National City Bank of
Pennsylvania, based in Pittsburgh and a subsidiary of an Ohio-based holding company, and
PNC Bank, also based in Pittsburgh. Both of these banks have offices in five of the region's six

counties. Together, they controlled a little over one-quarter of the region's banking desposits in
1996.

The region has a relatively low level of banking resources overall. Total deposits per
capita in commercial and savings banks were 39 percent below the state average and 29 percent
below the national average. Approximately the same disparities exist for commercial bank
resources alone (commercial banks have traditionally been more active business lenders than
savings banks).

While banking resources are somewhat low, the region's banking environment appears
to be highly competitive. No bank holds more than 18.5 percent of the region's total bank
deposits and the three largest banks hold just under 46 percent. The level of competition does
vary by county, however. While four counties -- Clearfield, Elk, Jefferson, and McKean -- have
between six and 1] banks, the other two counties -- Cameron and Potter, only have two or three
banks. (These two counties also have, by far, the smallest populations.)

In another sign of relatively robust competition, the region also has more banks and
banking offices in relation to population than national averages. Its ratio of savings and
commercial banks to population is about three times the state average and over twice the
national average while its ratio of commercial banks to population is about five times the state
average and almost twice the national average. Its ratio of banking offices to population
compares somewhat less favorably to national and state averages, although it is still higher -- by
over 15 percent over the state average and almost 60 percent over the national average for
savings and commercial bank offices combined and by almost 25 percent above the state average
and 50 percent above the national average for commercial bank offices alone. This smaller gap
reflects the smaller than average size and less extensive branch networks of the region's banks.

Bankers and development finance professionals agree that the market for small business
lending in the region is highly competitive. This is attributed to a number of factors, including
the improving economy, the entry of savings banks into the small business lending market, and
the acquisition of local banks by non-local banks, who then try to expand market share by
aggressively pursuing new customers. One banker in Dubois noted that, whereas two banks

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* pool loans from several RLFs and package them for sale as secondary market
securities. ARC could either sell loan packages directly or warehouse the loans and
issue notes backed by loan repayments. It could provide credit enhancement either
through full or partial guarantee of the securities, and/or by creating two "tranches,"
senior and subordinated, and either holding the subordinated portion or selling it to
higher-risk investors; and

® work with other federal agencies, including EDA, HUD, and USDA, to establish
a multi-agency loan pooling and packaging mechanism.

To be sure, there are certain inherent tensions between engaging in lending with a
developmental function and meeting standards established by secondary market investors.
Initiatives to support increased use of the secondary market by ARC RLF must be sensitive to
the need to maintain this developmental function.

> More Rigorously Enforce Time Limits on Draw-Downs of Initial
Capital Grants by RLFs

ARC RLFs are currently given three years to draw down their capital grants. Funds not
initially disbursed during this time period can be deobligated and returned to state allocations
for use in other projects. ARC and individual Appalachian states should rigorously enforce
this time limit to encourage RLFs to use their capital aggressively. Changes in ARC regulations
should also be considered that would facilitate reprogramming these funds directly into grants
or loans to capital-short RLFs.

2. Provide Capital to Support Small Entrepreneurship

The results of this study confirm long-running concerns about the low level of
entrepreneurship in the Appalachian region and the lack of financial resources to support new
entrepreneurs and early-stage microbusinesses. The need to support small, home-grown
entrepreneurship is particularly great in the poorer, more remote portions of the region that
have not benefited as much from the economic recovery and that are unlikely to attract larger
firms. This need is also particularly great with respect to non-traditional entrepreneurs,
including women and minorities, who face heightened barriers to entrepreneurship. ARC has
recognized the importance of supporting entrepreneurship, as reflected in its current
Appalachian Entrepreneurship Initiative and past initiatives.

ARC should consider the following options for increasing the amount of capital available
to support new and small entrepreneurship.

> Invest in Small Enterprise Funds

ARC should expand the use of capital grants for small enterprise funds. As noted in
Chapter Five, ARC RLFs infrequently participate in financings of $50,000 or less even though
this is the amount of financing most frequently needed by startups and even existing firms in
the region. While microenterprise funds typically provide financing of $10,000 or less or, in the

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Map 4.7

Total Commercial Bank Offices
Per 10,000 Population, June 1996

[___| Below 85% of U.S. Average
[-] 85% to 115% of U.S. Average
[EEE Above 115% of U.S. Average

0 50 100 150 200 Miles
EE ——

Source: Federal Deposit Insurance Corporation

Final Report 70 Mt. Auburn Associates, Inc.



equipment financing, investment portfolio products, 401(k) planning, key person insurance,
merchant card services, pension planning, stock option planning, employee stock purchase
planning, executive financial management, and initial public offerings. American Express has
recently announced its entrance into the small business credit market and is now offering credit,
accounting, and tax services to small businesses.

Second, nonbanks have broad geographic scope and ability to concentrate on
particular lines of business or products, and often on particular industries. Additionally,
with less commitment to particular areas and less reliance on "brick and mortar distribution
systems," these entities have been able to evoke greater efficiency and invest more in
technological enhancements (Glassman, 1996).

Third, nonbanks have adopted aggressive measures to attract small business
customers. Merrill Lynch and the Money Store have used radio, television, and other popular
media fronts to attract small business customers and consumers generally (Morrall, 1997).
Union Planters Corporation now offers pre-approved small business credit up to $25,000 in its
direct mail campaigns. Nonbanks have been successful in their attempts to attract small
business customers for many reasons, one of the most important reasons being that they have
been more aggressive in using data and technology applications, such as credit scoring.
Nonbanks typically approve loans with much less information about the applicant, which allows
them a faster approval process, and they have been more flexible in structuring their loans
(Glassman, 1996).

Fourth, nonbanks face less stringent regulatory restrictions on products and
underwriting practices. Nonbanks, for example, do not have depository regulators monitoring
their investments because they collect no depositor money. Regulatory agencies have been slow
in responding to the diversity and variety of nonbanking institutions currently offering
financial services to small businesses. As a result, banks have lobbied hard in recent years for
further deregulation of commercial banking on the basis that their competitors operate under
much less stringent federal regulations.

One indication of the success of nonbanks is that while approximately 55 percent of
small businesses use some type of credit, about 37 percent use banks, 20 percent use nonbanks,
while only about 10 percent use savings institutions. Moreover, while banks dominate business
lines of credit, leasing is dominated by nonbanks (Glassman, 1996). Finally, recent surveys
indicate that small businesses are increasingly reporting that they have some kind of credit
relationship with a nonbank entity. More indication of their success is given by the fact that the
top three SBA lenders are nonbanks as demonstrated by Table 2.14 which lists the top 10 SBA
lenders as of September 30, 1996.

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Final Report Mt. Auburn Associates, Inc.


NMPDD is involved in a number of activities in addition to business financing. These
include planning and obtaining funding for regional transportation projects, water and sewer
facilities, and community facilities, and expanding industrial parks.

State Programs

The state of Mississippi operates a number of development finance programs available to
businesses in the state. Two state entities, the Mississippi Business Finance Corporation and the
Department of Economic and Community Development provide business financing. Among
the major financing programs of these entities are the following:

Mississippi Business Finance Corporation

© Through the Small Enterprise Development Program, MBFC provides fixed-asset
senior secured loans of $300,000 to $2 million at fixed rates (currently 7.25
percent). It made 15 such loans in 1996.

® Through its Small Business Loan Guaranty Program, MBFC guarantees loans in
the $25,000 to $500,000 range for fixed assets and working capital. It made seven
such guarantees in 1996.

© Through the Minority Business Enterprise Loan Program, MBFC provides
fixed-rate low-interest subordinated loans of $2,000 to $250,000 for fixed assets and
working capital to minority-owned businesses. It made 26 loans in 1996. MBFC
also has a Minority Surety Bond Guaranty Program.

© MBFC provides tax-exempt industrial revenue bond financing.

Mississippi Department of Economic and Community Development

© Through the Agribusiness Enterprise Loan Program, DECD provides fixed-asset
subordinated loans of $10,000 to $200,000 at market rates to agribusiness
enterprises. It made 239 such loans in 1996.

© Under the Mississippi Business Investment Program, DECD provides senior
secured real estate loans of $500,000 or more at a fixed, 3 percent rate, The
program is aimed primarily at attracting Jarge industrial facilities to the state. It
made two such loans in 1996.

The state's direct financing programs, with the exception of those that are narrowly
targeted to minorities and agribusiness enterprises, are directed primarily at medium-sized and
larger enterprises. Its guaranty program is the most applicable to small enterprises, but does a
very small number of financings.

Final Report Mt. Auburn Associates, Inc.


urban counties. Only 25 percent of rural counties are served by six or more banking firms
compared to 74 percent of urban counties. Although rural counties have, on average,
substantially lower populations, the data indicate that businesses in rural counties have fewer
banking choices than their urban counterparts. Nonetheless, most rural borrower do have some
choice in their local banking relationships. Also, although relatively few rural counties are
served by only local banking firms, about 30 percent of them are served by only small banking

firms.

Distribution of Urban and Rural Counties by Bank Market Structure, 1994
Rural bank markets have far fewer competing lenders.

Counties with an office of:
No banking firms’

1-2 banking firms

3.5 banking firms

65 banking firms

10 ot more banking firms

Counties served by:
Only local banking firms? 69 z 8.9 16.1 |
Only “non-local” banking firms 9.2 32
Both local and non-local firms 63.9 716 39 525 |
Only small banking firrns* 6 42 48.2

Atleast one large banking firm 67.4 93.6 58
Only small banks 373 8.1 04
‘Atleast one large bank $0.7 84.4 38.7 B6

Number
Total number of counties [__3,089| 813 2,276 | 535

"A banking firm is an independent bank or « bank holding company. All of the bank offices and affiliates of « bank or holding
company constitute one banking firm. Thus, « banking firm may own many banks in a county, but we treat those banks as
] , sins competitor,
* A local banking firm has all of its offices and affiliates in one county; all others are considered non-local, even if the banking
firm includes « locally-headquartered affiliate.
* A small bank or banking firm has assets of under $250 million; a large bank or banking firm has assets over $1 billion.

Source: Caleulated by ERS from the June 30, 1994, Summary of Deposits file of the Federal Deposit Insurance Corporation, and
from the June 30, 1994 Report of Condition and Repott of Income of the Board of Governors of the Federal Reserve System.
Source: Credit in Rural America, 1997. Rural Economy Division, Economic Research Service, U.S. Department of Agriculture,
Agricultural Economics Report No. 749.

Counties that experience persistent poverty are the most clearly disadvantaged and
underserved areas in terms of bank presence. This dearth of bank presence has meant that
almost half of persistent poverty counties have nearby access to less than three banking firms.

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Final Report MMe. Aubuen Associates, Ine.


access to these smaller loans from local banks. Many interviewees suggest these banks have very
conservative lending practices, thus constraining available financing. In some cases, banks
either lack competition or are very aggressive in satisfying the market. One bank reported that
it enjoyed a 72 percent market share in its rural county, and that it loaned almost 64 percent of
its deposits.

The level of banking resources and the banking market environment vary significantly
within the region. The two counties with the lowest income levels and highest minority
populations -- Marshall and Benton -- also have the smallest deposit base, with per capita
deposits of less than half the regional average, and about one-third the level of the two most
deposit-rich counties, Tippah and Tishomingo. Marshall County also has the lowest ratio of
banks and bank offices to population, while Benton County has the lowest absolute level of
banking operations, with only two banks. Tishomingo County has the highest ratio of banks
and bank offices to population while Alcorn, the most populous county, has the highest level of
bank operations, with six banks.

Area banks reportedly use development finance resources in varying levels. Banks in
the six-county region use some SBA programs heavily and other others less so. Across all six
counties, banks use the 7(a) loan guarantee program at a rate exceeding 115 percent of the U.S.
average, as reflected in the number of 7(a) loans outstanding per 1,000 enterprises in 1996. In
contrast, banks’ use of the 504 program, which provides secondary co-financing for 40 percent
of the total financing, is below 85 percent of the U.S. average. Some public officials believe that
some banks lack information needed to effectively use development finance programs. Others
report that banks do not need these programs to conduct a profitable lending division.

The region has been affected to some degree by the national trend toward banking
consolidation. Within the past year alone, two small, local banks were acquired by large banks.
However, as noted, most of the banks in the region remain locally-owned. Opinion is mixed on
the local impact of banking consolidation. Many economic development officials and some
bankers believe that the reduction in the roster of local banks has resulted in a less responsive
banking system, less familiar with community needs. On the other hand, most agree that banks
now offer more diverse, sometimes more sophisticated loan products.

Non-bank sources of financing are limited. Leasing companies are active, but other
non-bank sources seldom finance businesses in the area.

Risk Financing

Formal sources of risk capital are virtually nonexistent in the region. According to
knowledgeable business people, a limited amount of informal investment activity occurs in the
region, but informal investors are not organized into any sort of network, and are thus difficult
to approach. Consequently, entrepreneurs in the region are left to rely heavily on their own
resources, and those of friends and family members, for investment capital. However, low per
capita income levels in the region suggest that these resource are limited.

Final Report At. Auburn Assoctates, Inc.


Although there has been a good deal of theorizing about the impacts, both positive and
negative, of credit scoring systems on small business lending, the literature on this practice is
fairly new and has not produced much analysis of actual impact. To date, the literature has
largely focused on the variety of ways these systems can be utilized by lending institutions.

Credit scoring must be seen in the context of other technology-based enhancements in
the banking industry. Many new, technology-based products such as credit scoring are
emerging in the banking industry in ways that have substantial implications for small
businesses. The new Automated Loan Machine, (ALM) for example, processes a loan
application from $1,000 to $5,000 and delivers the money in about 10 minutes. The ALM looks
like an ATM machine, does not require a large bank investment in equipment, and serves as a
loan outlet in locations where banks cannot afford to staff a loan officer. Additionally, more
advanced credit scoring systems are being introduced to the banking industry such as credit
scoring systems that allow banks to geo-code for CRA compliance when reviewing loan
applications.

While the ALM and other similar technology-based products are new, have only been
used in a small number bank sites, and are still largely targeted at individual banking
consumers rather than small business, the development of banking services in this area is
important. These kinds of technology-based automations, coupled with reduction of regulatory
restrictions on the kinds of products banks can sell (such as insurance products), are expected
to provide banks with increased flexibility in dealing with small business customers, increase
larger banking product lines, and move banks toward becoming "one-stop" resources for many
small business customers as well (Banking Strategies, 1996).

2.4 Conclusions

The literature on the performance of rural financial markets offers a mixed picture of
their ability to meet the credit and capital needs of rural businesses. Specific findings include:

© Most assessments of financing availability to rural businesses have concluded that
these firms are not at a disadvantage in terms of acquiring necessary financing.

© Rural businesses remain heavily dependent on commercial banks for financing.
They are more dependent on commercial banks and less likely to use nonbank
lenders and other external financing sources than their urban counterparts.

© Business lending has increased in recent years in urban and rural banks alike,
and the financial performance of rural banks has been roughly comparable to that
of urban banks.

© Rural businesses have a choice of banking organizations, but not as great as their
urban counterparts, primarily because of the sparseness of rural areas. The nature
of banking choice also varies between rural and urban markets. Rural areas are much
more likely to be served only by small banks. These institutions offer a narrower
range of financial services than larger institutions. As a result, rural banking markets
are somewhat less competitive than urban markets.

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Final Report Mt. Auburn Associates, Ine.


State and Multi-State Development Finance Programs
Statewide Certified Development Companies

Ten states have statewide SBA 504 certified development companies. Of the remaining
three, Alabama and Mississippi are served by a multi-state CDC operated by the Southern
Development Council, a private nonprofit organization. Only Pennsylvania is not served by a
statewide or multi-state CDC.

Industrial Development Bonds

All states offer tax-exempt Industrial Development Bonds (IDBs), either through state
agencies or county industrial development authorities. In general, [DBs are for amounts of $1
million or more because issuance costs and underwriting standards make smaller loans
unfeasible. Two states, Virginia and South Carolina, have umbrella bond programs that allow
pooling of smaller loans, However, even these loans generally exceed $100,000.

Statewide Loan Programs

Twelve states have statewide revolving loan programs or other direct small business loan
programs, provided either through state agencies or quasi-public development finance
institutions. Georgia, New York, Pennsylvania, West Virginia, and South Carolina are
particularly active in this area, Only Tennessee has no statewide direct loan programs.
However, Tennessee, along with the Appalachian region of Mississippi, and parts of the
Appalachian regions of Kentucky, Virginia, North Carolina, Georgia, and Alabama, are served
by the Tennessee Valley Authority's (TVA) Economic Development Loan Fund, a multi-million
dollar RLF that makes low-interest loans of up to $2 million for industrial expansion and
relocation projects. TVA, through its Special Opportunities Counties fund, also makes loans of
up to $300,000 for industrial development projects in 50 economically distressed counties
within its service area.

Seed and Venture Capital Funding

Four states, New York, Pennsylvania, West Virginia, and South Carolina, provide seed
or venture capital directly through state quasi-public development finance institutions. Other
states, including Virginia, Pennsylvania, West Virginia, and Ohio, have invested in or provided
tax incentives to private venture capital funds and SBICs that promise to target investments in
these states. In addition, the Tennessee Valley Authority has invested in a regional private
venture capital fund, an SBIC, and a Specialized SBIC that targets minority-owned businesses.

Microloan Funding

Three states, Virginia, West Virginia, and North Carolina, provide capital and technical
assistance to local microloan programs.

Final Report SMe. Aubin Associates, Ine.


Tne Suprpry or Financing: Toe ReGionar FINanciaAn
MARKET

PRIVATE Dest AND Equity MARKETS
Secured Debt Financing

The six-county region is served by 14 commercial banks and savings institutions. These
include both small locally-based community banks with less than $250 million in assets and
large statewide or multi-state institutions exceeding $1 billion in assets. However, most of the
banks are small and locally-based. Ten have home offices in the region and another two have
home offices located just outside the region. Only three of the banks with a significant presence
in the region are large banks with assets exceeding $1 billion and with statewide or multi-state
operations. One of these, BancorpSouth (formerly Bank of Mississippi), is based in nearby
Tupelo.

The banks with the strongest presence in the region are BancorpSouth; People's Bank, a
community bank with headquarters in Ripley; Deposit Guaranty National Bank, a statewide
bank based in Jackson; and People's Bank and Trust, a community bank based in nearby
Tupelo.

The region has a relatively high level of banking resources for a rural area. Total
deposits per capita in commercial and savings banks (as of June 30, 1996) were about 5 percent
above the state average, but still 19 percent below the national average. When commercial bank
resources alone are considered (commercial banks have traditionally been more active business
lenders than savings banks), the region's position is even stronger. Commercial bank deposits
per capita are 9 percent above the state average and only 7 percent below the national average.

The region's banking environment appears to be reasonably competitive. No bank holds
more than 16 percent of the region's total bank deposits and the three largest banks hold about
43 percent of the total. In another sign of relatively robust competition, the region also has
more banks and banking offices in relation to population than state and national averages. Its
ratios of both savings and commercial banks combined and commercial banks alone to
population are about two-and-one-half times the state average and almost three times the
national average. Its ratio of banking offices to population compares somewhat less favorably to
state and national averages, although it is still higher -- by 9 percent over the state average and
60 percent over the national average for savings and commercial bank offices combined, and by
15 percent above the state average and 70 percent above the national average for commercial
bank offices alone. This smaller gap reflects the smaller than average size and less extensive
branch networks of the region's banks.

Development finance professionals, economic developers, and banks offer varying
assessments of competition among banks. Bankers suggest competition is active. Others report
that competition is active for small loans in the $25,000 to $250,000 range, but limited for
larger loans, and languid for microloans. Community relationships often prevail in opening

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Foal Report Mt. Auburn Associates, Inc.


There are also 14 statewide RLFs, including four in Georgia, two each in Pennsylvania,
North Carolina, and West Virginia, and one each in Kentucky, Maryland, South Carolina, and
Virginia. Some of these are federally-funded, either through EDA or USDA, while others are
state-funded.

The analysis yields the following profile of these RLFs.

Geographic coverage. Most counties in the region are served by at least one regional
RLF. Many counties are served by two or more RLFs, and some are served by as many as six.
The thinnest regional RLF coverage is in Tennessee, and Alabama, where most counties are
served by either one regional RLF or none at all. (See Map 5.1.)

Loan size. Most eligible RLF loan amounts appear to be in the $10,000 to $150,000
range. About two-thirds of RLFs have a minimum loan amount of less than $25,000 and about
one-third have a minimum of less than $10,000 or no minimum. (See Graph 5.2.) Almost
three-quarters have a maximum loan amount of at least $100,000, and about one-quarter have a
maximum of at least $175,000. (See Graph 5.3.) The average loan amount in 1996 was
$94,500.

paces he isi Picts Maes Oat
agteeie Seer es hay by RLFs In the ARC Region (%)
ie *
« «
» *
» »
” °
7 }
(eee ees OO ee Cad Li lene seme er cme _—-
a ee

While data on individual loan amounts was not collected for all RLFs, data was analyzed
on 420 outstanding loans by ARC RLF (as of February 1997). About 70 percent of these loans
are in the $10,000 to $99,999 range. The average loan amount was $68,000. While these
amounts are relatively small, the total project funding from all sources is much larger. Over 60
percent of the loans involved total project funding of at least $100,000, and almost one-quarter
involved total project funding of at least $500,000. (See Table 5.1.)

Loan types and uses. Most RLFs, over 90 percent, provide secured debt financing.
Among these, a high proportion, almost three-quarters, are willing to take a junior collateral
position to other lenders. Very few RLF s provide other types of financing. Fewer than
one-third provide debt with equity features, and even fewer provide equity or unsecured debt.
Also, very few provide loan guarantees. (See Graph 5.4.)

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Rural financial markets have reasonably served the demand for business financing, and
financial institutions appear to be widely distributed across rural counties (ERS, 1997). The
fact that there are not only local and non-local banks in most rural areas, but also three to five
different financial institutions in the majority of rural areas, is a positive indication of the
vitality of rural financial markets.

In their use of commercial banks, rural businesses are more likely to use local
institutions. In this regard, local commercial banks are better able than non-local commercial
banks to identify and anticipate the financing needs of local businesses (Ellichausen and
Wolken, 1990; Nakamura, 1994; Levonian and Soller, 1996). For rural businesses there are
clear economic advantages in patronizing local lenders rather than non-local banks. Rural
businesses face fewer collateral requirements than urban businesses and are more likely to have
their loans approved when they approach locally-based banks (McGlone, 1991).

In the case of both rural and urban banks, multi-office banks make fewer loans to small
businesses than do smaller, independent banks and, as a result of interstate branching, there has
been a significant increase in the number of multi-office banks (Keeton, 1995). Although there
has been much speculation, it is still unclear how the increase in multi-office banks will affect
the availability of credit to small businesses in rural areas.

In general (with the exception of persistent poverty areas), rural financial institutions are
well positioned to handle the credit and capital needs of rural residents and businesses. But if
access to financial institutions is one measure of the stability and performance of rural financial
markets, then the economic competitiveness of their services is another. It is in this area that
differences in the performance of rural and urban financial markets are most visible. Rural
financial institutions are not as diverse in terms of the types of financial services nor the
combination of services they offer (ERS, 1997; McGlone, 1991). A more limited combination of
financial services is offered more sporadically and less systematically in rural financial
institutions. Less system-wide financial service offerings are not only a product of the attempt
by rural banks to be more flexible in meeting the specialized needs of local businesses, but also a
reflection of vast disparities in institutional capacity among rural financial institutions.

Excluding persistent poverty areas, much of the difference in the competitive
environments of rural and urban financial markets can be explained by the smaller size of rural
markets. Competition for loans in rural areas is not as intense as in urban areas, for example,
and fewer borrowers in rural areas mean that lenders' ability to successfully and profitably
compete for local loans is notably reduced. That is, the market is much smaller and larger
lenders are not economically compelled to enter rural financial markets. As a result, rural
financial markets have not been as competitive as urban markets. Persistent poverty counties
have been particularly impaired by the lack of competition in the banking industry in these
areas where financial institutions are fewer and less active. Generally then, although rural
banks have adequate capitalization to meet the needs of rural businesses, rural banking markets
are less competitive urban markets (ERS, 1997).

Finally, the performance of rural financial markets can be measured by the comparative
cost of financing. Although the cost of financing is less important than the availability of

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Map 5.2

Substate 504 Certified
Development Companies

None

Associate Development Company
[) 1 Certified Development Company
[ay .20) 2 Certified Development Companies

O50 100150 200 Miles
Source: U.S, Small Business Administration —<—<

Final Report 98 Mt. Auburn Associates, Inc.


* more decentralized administration of state programs so that personnel are available to
coordinate and make decisions; and

© use of computer systems (e.g., bulletin boards, home pages) to provide updates on
programs and activities.

There is broad recognition among development finance professionals that
development finance activities must be more effectively supported with other forms of
business assistance. Business assistance is either viewed as insufficient or too loosely
coordinated with development finance programs. Some development finance professionals
believe that quality business assistance is simply in short supply in their areas, although many
acknowledge growth in business assistance capacity, particularly among community colleges.
Others feel that, while such assistance is available, it is not well coordinated with financial
assistance. They point to the need for "one-stop" delivery systems that meet all business
assistance needs. They also see this as a way to help bankers direct their customers to needed
assistance. Although some of the stronger development finance organizations incorporate and
coordinate the services of various business assistance providers, coordination of business
services is generally viewed as too informal and haphazard. Some of those interviewed also
expressed the concern that if they desire better coordination, the responsibility for identifying
and bringing together different organizations will fall primarily on their shoulders.

Problems related to non-financial business assistance are viewed as a particular
constraint to new enterprise formation. Startup entrepreneurs, many with very limited
management assistance, need entrepreneurial training and one-on-one management assistance in
order to develop and implement sound business plans and to institute effective management
practices. Financing alone is viewed as insufficient for supporting these firms.

A number of suggestions were made for improving coordination between
development finance and other business assistance providers. These include:

© formal mechanisms charged with this responsibility, limiting the burden placed on
development financiers to organize coordination;

© central reporting mechanisms so financiers and other business assistance providers
can learn about one another's activities; and

© reducing the number of entities involved in providing business assistance.

5.4 Summary or Finpinés

* There is no evidence of widespread, systemic gaps in the availability of private
sector financing for firms in the Appalachian region willing to pay the
risk-adjusted market rate of return. At the same time, certain factors characterizing
rural financial markets in general, and the Appalachian region in particular,
including heavier dependence on the banking industry, fewer banking choices, and
the prevalence of the smaller banking institutions offering a narrower range of

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SS eeu
Aprenpix A: Bustivess Survey Mrernopo.ocy

AND CHARACTERISTICS OF RESPONDENTS

A telephone survey was conducted of businesses in the Appalachian region during June
1997. A sample of 800 businesses with five or more employees was drawn from Business
ConnX, a database of over 650,000 businesses in the region compiled by TRW Credit Services.
A random sample was drawn, stratified by state to ensure proportional representation of
businesses in each ARC state. The survey was conducted by Atlantic Marketing Research of
Boston, a professional survey research firm. The number of surveys completed was 206,
translating to a response rate of 25.75 percent. Data was entered into a database, with standard
quality control procedures used to ensure that responses were complete, legible, and consistent,
and that data was coded and keyed accurately. The data was analyzed using Systat, a PC-based
statistical analysis package .

The data in the following tables provide a profile of survey respondents.

Table A.1
Profile of Survey Respondents
Employment (%)

Potal Employt

]/5 to 9 employees

1/10 to 24 employees

25 to 49 employees

| 50 to 99 employees

|] 100 to 249 employees
250 to 499 employees
500 or more employees

Source: Mt. Auburn Business Survey

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Map 4.3

Per Capita Income, 1994

| Below 85% of U.S. Average
[FJ] 85% to 115% of U.S. Average
[EEE Above 115% of U.S. Average

‘Source: Bureau of Economic Analysis,
U.S. Department of Commerce

0 50 100 150 200 Miles
EE _ —

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Table 4.5
Measures of Supply of Financing:

Comparison of Urban and Rural Counties =
Below 85% of | 85% t0 115% [Above 115% of

— US. Average of U.S. Average U.S. Average Total

69.7% DA% 0.9% | 100.0%
5.9% 0.3% 100.0%

Substantial disparities in banking resources do exist between the most economically
distressed areas of the region and other areas. Distressed counties® in the region are much
more likely to have levels of per capita deposits that are substantially below U.S. averages. In
addition, while the distribution of the number of banking organizations in relation to
population is roughly the same for distressed counties as other counties, distressed counties are
slightly more likely to have fewer banking offices, making access to banks a little more difficult.
However, over half of distressed counties still have substantially more banking offices in
relation to population than the U.S. average. (See Table 4.6.)

5 ‘The Appalachian Regional Commission classifies counties as “distressed” based on a formula taking into account
unemployment, per capita income, and poverty. Under this formula, each county is placed in one of four economic
classifications ~ distressed, transitional, competitive, or attainment.

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$26 billion and SBA guaranteed loans in the secondary market allocated $12 billion (SBA,
1997).

Banks have been quite generous with loans to consumers and small businesses alike
since 1994, and this has raised some questions concerning the lending practices that generated
this lending (Hansell, 1995). While credit standards have not reverted to the level they were
before the savings and loans debacle, many are concerned by the fact that credit both to small
businesses and to consumers generally, has been expanding much faster than the overall
economy. Even as the federal government has decreased its size, for example, government
securitized lending is up at higher levels than ever before.

Yet, small business customers are not the only ones on the receiving end of more
aggressive lending activity. As Tables 2.9 and 2.10 attest, loans to large and mid-sized
companies have increased dramatically over the last two years as well.

Table 2.9
Characteristics of Loans to Small Businesses By Loan Size, 1994-1996

63,517

152,022
490,078
805,91

Table 2.10
Average Data on Small Business Lending in U.S. Banks for 1996

\(b) In millions of dollars.

Banks have not only been generous with credit but, because of intense competition in
the small business lending market, have also been more liberal with the terms of their loans.

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5.3.2 THe Rote oF DEVELOPMENT FINANCE INSTITUTIONS IN MEETING BUSINESS
Financinc NEEDS

Financing programs operated by government or local economic development
organizations are viewed by established firms as a moderately important sources of
financing. Eighteen percent of business survey respondents have found them to be very
important while another 12 percent have found them to be somewhat important. (See Table
4.1.) During the past three years, almost 1] percent of respondents have applied to one of more
of these programs for financing.

Rural borrowers in the region report that they are substantially more dependent on
these programs than urban borrowers. Thirty-three percent of non-metro respondents found
these programs to be very important, compared to only 12 percent of metro respondents. Only
53 percent of non-metro respondents found them to be unimportant, compared to 73 percent of
metro respondents. (See Table 4.2.) This was the most substantial difference between rural and
urban areas of the region regarding the relative importance of different financing sources. In
seeming contradiction to this data, about the same percentage of rural as urban borrowers have
used financing from development finance programs during the past three years. While the
reasons for this contradiction are not clear, it may indicate that, despite placing greater
importance on these financing sources, rural borrowers have greater difficulty obtaining their
financing. Alternatively, it may indicate that, while rural borrowers have used these programs
at about the same rate as urban borrowers in the past, they consider them more important to
future plans.

With the exception of microenterprise funds, development finance organizations are
oriented toward participation in larger-scale financings. Most of the financings in which
RLFs, 504 Certified Development Companies, and state development finance organizations
participate exceed $100,000.

There is some evidence from the business survey that larger firms are more likely to
use development finance programs than smaller firms, although this evidence is
inconclusive. ‘Thirty-seven percent of larger firms responding to the survey considered
development finance programs very or somewhat important, compared to 23 percent of smaller
firms. (See Table 4.3.) In addition, 13.5 percent of larger respondents indicated that they had
recently used a development finance program, compared to only 7.3 percent of smaller
respondents. While neither of these differences was statistically significant, they are consistent
with the data on the sizes of financings provided by the majority of development finance
programs.

Most development finance programs are heavily oriented to secured debt financing,
although some of this financing is provided on a subordinated basis. \n addition, while
some provide working capital financing, the bulk of the funding is used for fixed assets. This
pattern is also reflected in the use of these programs. The types of financing most frequently
sought from development finance programs by business survey respondents were commercial
mortgages, primarily fixed rate (10 respondents). Other types of financing sought included
equipment loans or leases (five respondents), short- or medium-term working capital (five

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Table 2.12
s of Bank Mergers 1990-1995

= ons

Fizet/SHawaut

Bank America/Securrry Paciric

In Market TRANSACTIONS Boatmen's/WorTHEN

Cremicat BANkING/MANUFACTURERS HANOVER
First Cuicaco/NBD Bancorp.

Characteris

Finst Union/Fiast Fipeury

BankAmertca/ConTINENTAL

Market Expansion Banc Onc/Vautey National

Comerica/Ptaza Commerce, Pactric WesTeRN, METROBANK
Western, KeyCorp/Society,

Cueicat BankinG/MANurACcTURERS HANOVER
Meacers or Equais KeyCorp/Soctery

Dime/Anctor BANCORP

First Cxicaco/NBD Bancorp.

Metton/Drevrus AND THE Boston Company
Business Lines Extension Norwest/Istanp Finance
NationsBank/US West
BankAmertca/Anpor NATIONAL

Source: Spiegel and Gart, 1996

One overall effect of these mergers has been the reduction in the number of smaller
banking institutions, most of which have historically been more aggressive small business
lenders and haye devoted a much larger portion of their assets to small business loans
(Walraven, 1997). In 1995, for example, the smallest banks reported that approximately 97
percent of their total commercial and industrial loan portfolios were comprised of small
business loans compared to 17 percent of the largest banks in the country (Barry, 1996). As a
result, there has been some concern about the impact of banking industry consolidation on the
availability and terms of small business loans. (Cole et al, 1996).

In recent years, however, fears that small businesses would not be served by newly
merged banks, made much larger as a result of the mergers, have not been confirmed. Newly
merged banks have continued to invest in the small business market at roughly the same rates as
they did prior to the merger. (See Table 2.13.)

Final Report Mt. Auburn Associates, Inc.


financing, but a greater long-term need for development strategies (including development
finance tools) that promote new enterprise formation. (See Table 3.5.)

Table 3.6
Measures of Demand For Financing:
Comparison of Urban and Rural Counties
99.9%!
JAverage Unemployment Rate, 1853-1996
Metro counties ET EIFs3 a 000%
Non-metro counties: 12.4% 26.9% ee 400.0% |
{Startups as a Percentage of All Establishments, 1992
| Metro counties 59 6% 10.1% 100.0% |
| Non-metro counties 76.8% ries 5.9% 100.1%
With 1-9 Employees as a Percentage
| _ Metro counties 0% 100 0% 0.0%
Non-metro counties 0.0% ony 5.9% 100.0% |
With 250+ Employees as a Percentage
28. ES 99.9%
os rari Bat S| — sooo
Establishments as a Percentage of |
Metro counties. 25.7% DI% 40% | 100.0%.
| “Non-metro counties 17.9% 16.6% 5.5% 100.0%
eee eet
ae 745% 743% 08% E13
| —Non-metro counties 58.3%. MTS 91.0% 100.0%
hese eer
| __Motro counties. 95%| o.6%| | 100.0%]
Non-metro counties: 75.2% 248% 0.0% 100.0%

Metro and non-metro counties have about the same proportion of small
establishments. However, a different pattern emerges in the proportion of large
establishments. There is very little difference between metro and non-metro counties in the
proportion of total establishments comprised by small establishments (1 to 9 employees). With
respect to large establishments (250+ employees), metro counties are more likely to mirror the
national average (28 percent in the middle tier vs. 13 percent), while non-metro counties are
more likely to be substantially above the national average (43 percent ys. 33 percent in the top
tier), or below the national average (44 percent vs. 38 percent in the bottom tier). This
indicates that rural counties tend to break into two distinct groups --
large-establishment-dominated and small-establishment-dominated. (See Table 3.5.)

Non-metro counties tend to have higher percentages of manufacturers and lower
percentages of service firms. A higher proportion of non-metro counties has a substantially

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percent charged more than 8.5 percent. Prime rate is currently 8.5 percent, and bank interest
rates are typically 1 to 3 percent over prime.

Interest rates set by RLFs are almost always fixed. Of RLFs providing this information,
about 95 percent always or primarily offered their loans at fixed rates.

Maturities. While data on loan maturities were not collected on all RLF's, the ARC loan
database provides data on maturities for this subset of loans. Most of these loans are for terms
of five to nine years (almost 60 percent), and of ten to 15 years (almost 40 percent). This is
consistent with the use of the loans for machinery/equipment and real estate. (See Graph 5.6.)

Graph 5.6
Maturity of Loans by ARC RLFs (%)

o

Less than 5 years 79ers 1S years
56 yours Yoywers

Note: Total number of respondents = 408
‘Source: Mt Auburn Associates Development Finance Survey

Capitalization and loan volume, Average RLF capitalization is about $2.3 million.
Among RLFs reporting 1996 financing activity, the mean number of loans made was eight and
the median was four.

Other Local and Regional Development Finance Programs
Microloan Funds

There are at least 35 microloan funds scattered throughout the region. Among
microloan funds reporting 1996 financing activity, the mean number of loans made was 20 and
the median was nine. The average loan amount was about $8,500.

Regional coverage by microloan programs is spotty. The most thorough coverage is in
Virginia, North Carolina, and West Virginia, where state programs support local funds, and in
Pennsylvania and Ohio. The sparsest coverage is in Alabama, Mississippi, and Tennessee.

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© differences in the nature and magnitude of demand for financing between smaller and
larger businesses, and between businesses in urban and rural locations.

The analysis in this chapter will be viewed in relation to the analysis of the supply of
business financing, to be presented in Chapters Four and Five, to identify if and how the
demand for and supply of business financing in the Appalachian region are out of balance.

3.2 Broap MeEasunes or DEMAND ror CapPiraL AND CREDIT

In this section, broad measures of economic structure and performance in the region are
looked at briefly and their relationship to business demand for capital and credit is considered.
These broad measures are not, of course, precise indicators of business financing demand.
However, they do provide some indication of the extent, nature, and trends in demand.

These economic measures have both short-term and long-term implications for business
financing needs. For the short-term, they can identify the types of companies that currently
play an important role in a region's economy. For the long-term, they can highlight issues that
call for long-term development strategies to improve economic performance, of which business
financing may be an important component.

In general, county-by-county analysis of the region's economic performance in
relation to national averages shows a moderate pace of growth but still high levels of need
for economic stimulus. The employment growth picture is mixed. Employment data for the
1993 to 1995 period shows a high pace of growth in some parts of the region, a moderate pace in
others, and a slow pace in still others. Some of the largest growth clusters are in Tennessee,
Alabama, Kentucky, South Carolina, and Georgia. Other areas, notably New York and
Pennsylvania, show relatively slow employment growth. (See Map 3.1.)

The unemployment picture is also mixed. In general, average unemployment rates for
the 1993 to 1995 period were at or above the national average in most counties. Unemployment
rates tended to be particularly high in Maryland, West Virginia, Pennsylvania, Ohio, and
Kentucky counties. The lowest rates of unemployment were found in North Carolina, South
Carolina, and Georgia counties. (See Map 3.2.)

Regions with both high employment growth and high unemployment rates indicate both
a strong economy and a potential for further growth because of an underutilized labor force.
These areas might benefit from additional business capital and credit infusions to enable firms
to accommodate growth and hire additional workers. Of course, there may be other factors,
such as insufficient labor force skills, that retard firm expansion.

On the other hand, regions with low growth and high unemployment are likely to
require long-term, comprehensive economic development strategies to address economic
stagnation or decline. Initiatives to increase the supply of business capital and credit,
particularly longer-term financing, can be one important component of such strategies.

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used to control the local market, at least five banks are actively competing today. Development
finance professionals see this competitive environment demonstrated in the large number of
bankers willing to serve on their loan committees and the high level of interest in joint
financings. A number of banks are also SBA Preferred or Certified Lenders, indicating that
they actively use the SBA 7(a) Loan Guarantee Program. However, use of the program in the
region is only about two-thirds of the national average, as measured by the number of
loans-to-enterprises. One small banker indicates that his bank steers away from the program
because of the extra expense and reduced flexibility for the borrower.

The region has been affected to some degree by banking industry consolidation, with the
entry into the region of large banks such as National City and PNC. A number of small
community banks have also been acquired by mid-sized banking organizations. The impact of
this trend on the availability of business financing in the region is seen as mixed. A
development finance professional in the region sees both positive and negative impacts. On the
positive side, banks are reaching into new territories, resulting in more competition and a
stronger bargaining position for borrowers. On the negative side, non-local banks strip local
lenders of some of their lending authority and make lending decisions at more distant locations,
reducing flexibility and the role of subjective factors, such as the borrower's background and
character, in the lending decision.

At this ‘point, the region is seen as having a good mix of large, medium-sized, and small
banks. While banks acquired by large banking organizations have become less hospitable to
smaller businesses that do not meet standard lending criteria, smaller banks have been eager to
attract these customers. At the same time, there is uncertainty about future trends in the
region's banking structure, and concerns that additional consolidations may lead to a
deterioration in the lending climate for small firms.

Aside from banks, leasing companies are reported to be fairly active in the region.
However, a development finance professional reports that they tend to be less flexible than
banks on collateral positions. Non-bank SBA lenders are not known to be active in the region.

Risk Financing

Bankers and development finance professionals report that there is very little formal
venture capital financing activity in the region, even though Pittsburgh, the home of several
venture capital firms, is less than a three-hour drive. There is, however, an active informal
investment market, centering primarily around the powder metallurgy industry. Informal
investors include successful entrepreneurs from the industry and wealthy professionals. Some
of these investors participate in investment groups. In addition, some established PM houses,
believing that growth in the number of PM houses will benefit the entire industry in the region,
help startups by subcontracting small jobs to them and paying receivables quickly. Outside of
the PM industry, startup entrepreneurs are primarily dependent on their own resources or those
of friends and family members.

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Fonal Report Mt. Auburn Associates, Ine.


Many banks in the small business market are lending money to businesses with less collateral at
narrower margins and less restrictions (Hansell, 1995). Overall, banks have been more willing
to require less collateral, increase limits on lines of credit, and, generally, improve the terms of
credit to large and middle market businesses as well. A smaller minority of banks have invested
in long-term loans that were more risky, and others have set margins so low that, after
accounting for future loan losses, the loans are unlikely to be profitable. Such losses are
expected to be more than offset by profits from money transfers, management of corporate
pension plans, and other banking services (Hansell, 1995).

Although the price of credit is being driven down by competition, the small business
market is still considered highly profitable. A recent report by the Federal Reserve
demonstrates that small-business-friendly banks were more profitable than banks that made few
loans to small businesses (SBA, 1997).

Given the potential for additional profitability in the small business lending market,
many larger banks have begun to focus on the smaller end of the small business market such as
auto repair shops and other firms where the size of the loan often does not exceed $20,000
(Cline, 1995). In this economic climate, even the lower end of the small business market is
considered too profitable to ignore. Even recently merged or acquired banks have continued to
add significant levels of small business loans to their portfolios (Barry, 1996; Federal Reserve,
1997). In doing so, newly merged banks have increased the total value of loans to small
businesses over the past two years by more than $439 billion or 10.3 percent (Federal Reserve,
1997). Private industry surveys of the largest banking institutions and holding companies have
generally found increased small business lending as well. (Cline, 1995).

To be sure, even with this high level of competition in the small business market,
marginally creditworthy small businesses continue to have considerable difficulty in obtaining
credit from traditional lenders. The growth in nonbank lenders, however, has helped to
somewhat mitigate these difficulties. A significant alternative market comprised mostly of
nonbank entities has developed that caters to the less than creditworthy clientele. The price of
credit in this alternative market has traditionally been higher than with traditional banking
institutions, but the strong economy, coupled with significant competition even in this
alternative market, has made the dichotomy in the price of credit between traditional banks and
nonbanks less divergent.

In the following sections, some of the factors that have contributed to the current
environment in the small business lending market will be examined in greater detail. These
include: 1) federal financial regulatory reform; 2) banking industry consolidation; 3) the
growing role of nonbank lenders in small business lending; 4) innovations in banking products
and services; and 5) the adoption of new loan underwriting tools and practices.

2.3.2 FEDERAL FINANCIAL REGULATORY REFORM: CATALYST FOR CHANGES IN
FINANCIAL MARKET STRUCTURE AND COMPETITION

A major catalyst for the enormous structural changes in U.S. financial markets is the
regulatory reforms aimed at the banking industry. Since 1980, the banking industry has gone

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The relative importance of most nonbank credit sources does not vary significantly
among smaller and larger firms in the region. Among the business survey respondents, there
were no statistically significant differences between smaller and larger firms in the importance
attributed to four of the five major nonbank credit sources. The only exception was for leasing
companies. Twice as many larger firms consider them very or somewhat important credit
sources than smaller firms -- 48 percent versus 24 percent. (See Table 4.3.)

Table 4.3
Importance of Financing Sources
By Firm Size (%)

'Unimportant
Very Important} Somewhat N/A to e|
jt Business

|Statistical

Small Large | Large [Significance

Owner's personal savings 49.1 [Significant at .O1 level
Loan secured by owner's home 72.2 ‘Significant at .01 level
Owner's family members or friends 73.4 |Not Significant
Owner's business colleagues Not Significant
Venture capital firms or small business 85.6 Not Significant
investment companies
Other private investors z r ; @4 Significant at .01 level

‘Small commercial or savings banks with . 38.7 Not Significant
headquarters in or near community

Larger commercial or savings banks 42 [Significant at .01 level
operating throughout the state or in
|] several states

Credit unions 4 E Not Significant
‘Commercial finance companies i Not Significant
Leasing companies ‘Significant at .01 level
Equipment dealers or suppliers i |Not Significant
Credit cards Not Significant
Government loan programs orloan

programs operated by local economic Not Significant
development organizations

4.2.2 Tue BANKING InpustTRY

Overview of Banking Industry Characteristics and Lending
Performance

The major source of secured debt financing for Appalachian businesses remains the
banking industry. The following discussion focuses on the banking industry, both because of
its relative importance and the greater availability of local data on the industry than for other
sources of credit.

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SS SSS
Aprenpix C: Norra CeEntrat PENNSYLVANIA

REGIONAL PLANNING AND DEVELOPMENT
Commission (NCPRPDC) Recon

Reeronan Economic Conpiriens

The region served by the North Central Pennsylvania Regional Planning and
Development Commission (NCPRPDC) covers six counties -- Cameron, Clearfield, Elk,
Jefferson, McKean, and Potter. The region had a population of 232,769 in 1995. The region is
heavily rural, but has a number of small towns, the largest of which are Bradford (population
9,965), Dubois (8,286), and Punxsutawney (6,782).

The region has long been heavily dependent on the manufacturing sector. Over the last
few decades, the character of the manufacturing sector has changed, as traditional industries
have declined and new ones have emerged. In addition, the total size of the manufacturing
sector has declined, and other sectors such as services and retail have increased in importance.
These structural changes have resulted in dislocations for large segments of the workforce and
have changed the nature of employment opportunities for new workforce entrants.

The region generally underperforms the state and the nation as a whole in indicators of
employment and income. Unemployment in the region was 7.3 percent in 1995, compared to
the state average of 5.9 percent and the national average of 5.6 percent. The region also has
lower-than-average levels of personal income and higher-than-average rates of poverty, although
these disparities are relatively modest. Per capita income in 1995 was about $18,869, compared
to $23,588 statewide and $24,426 nationally. The poverty rate in 1990 was 13.1 percent, higher
than the statewide average of 10.8 percent but equal to the national average. None of the six
counties are designated as "distressed" by the Appalachian Regional Commission. Five are
characterized as "transitional" and one as "competitive."

The region has experienced moderate employment growth in recent years. Between 1993
and 1995, employment increased by 3.9 percent. This was more rapid than the statewide growth
rate of only .3 percent but about equal to the national rate.

Economic conditions in the region vary by county, although not drastically. Elk County
has experienced the most robust recent economic performance. It experienced employment
growth of 8.6 percent between 1993 and 1995 and had an unemployment rate of 5.7 percent in
1995. Jefferson and McKean counties experienced the lowest rates of 1993 to 1995 employment
growth, 3 percent each. Clearfield County, the most populous county in the region, had the
highest 1995 unemployment rate, 8.6 percent, and a 1993 to 1995 employment growth rate of
3.5 percent.

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support, through funding and information dissemination, the application of tools and
mechanisms that link development finance organizations with private financing
sources and technical assistance providers ; and

* use the Professional Development Institute to train development finance

professionals in both the direct provision and effective utilization of non-financial
business assistance.

ms
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Drier, Peter, 1995. “A Dagger Pointed at the Nation's Cities” The Houston Chronicle, Outlook
Section, p19,

Economic Research Service, 1997. "Credit in Rural America" Rural Economy Division,

Economic Research Service, U.S. Department of Agriculture, Agricultural Economics Report
No. 749,

Elliehausen, G.E. and Wolken, J.D., "Banking Markets and the Use of Financial Services by
Small and Medium Sized Businesses," Federal Reserve Bulletin, Vol. 76, Oct. 1990, pp. 801-817.

Federal Reserve, 1997. “Monetary Policy Report to the Congress” Federal Reserve Bulletin
(August, 1997).

Furash, Edward E., 1997. “Risk Warfare: Risk Management” The Journal of Lending and Credit Risk
Management vol. 79, no. 6 (February) p7.

Glassman, Cynthia, 1996. “Nonbank Competition for Small Business: The Race is On” The
Journal of Lending and Credit Risk Management vol. 79, no. 4 (December) p28(10).

Hansell, Saul, 1995, “Banks at the Dawn of New Worries” New York Times (February 21, 1995).

Healy, Beth, 1994. “Small enjoy niche but face new threats” Boston Business Journal (January
14-20, 1994) p7.

Keeton, W.R., "Multi-office Bank Lending to Small Businesses: Some New Evidence," Federal
Reserve Bank of Kansas City Economie Review, Vol. 80, No. 2, 1995, pp. 45-57.

Levonian, M. and Soller, J., "Small Banks, Small Loans, Small Business," Federal Reserve
Bank of San Francisco Weekly Letter, No, 96-02, Jan. 12, 1996, pp. 1-3.

Marshall, Jeffrey, 1995. “Credit Issuers Target Business” US Banker, vol. 105, no. 11, p55(3).

McGlone, James M., 1991, "Rural Businesses Voice Few Complaints About Their Bankers"
Rural Development Perspectives, V ol. 7, Issue 2, Feb-May 1991.

Morentz Markley, Deborah, 1990. "Availability of Capital in Rural America: Problems and
Options." Prepared with support from W.K. Kellogg Foundation and the Ford Foundation.

Morrall, Katherine, 1997. “Small Business is Beautiful” Bank Marketing (January 1997) vol. 29,
no, 1, p42(7).

Nakamura, L.I., "Small Borrowers and the Survival of the Small Bank: Is Mouse Bank Mighty
or Mickey?" Federal Reserve Bank of Philadelphia Business Review, Nov./Dec. 1994, pp. 3-15.

Nasar, Sylvia, 1991. “Foreign Banks Filling the Loan Gap” New York Times (February 27, 1991).
Oppenheim, Sara, 1997. “Union Planters Launching Direct-Mail Promotion” American Banker
(February 18, 1997), vol. 162, no. 32, p13(1).

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SSS

Carrer Two: Overview or Rurar
FuvanciaL MARKETS AND THE AVAILABILITY OF
Smauy Business Carrrat ann Crepir

2.1 INTRODUCTION

Before examining the business financing environment in the ARC region specifically, it
is useful to examine two broader issues that affect the availability of financing to small
businesses in the region: 1) the recent performance of rural financial markets in meeting small
business financing needs; and 2) and the impacts of regulatory and market changes in the
financial services industry on the availability of small business financing. The following
sections summarize the findings from a general literature review on these two topics, drawn
mainly from Federal Reserve reports and working papers, and banking and business journals.

2.2 Trenps «In Rurar Financia, MARKETS

This section identifies rural financial institutions, and provides an overview of the
performance of rural financial markets and the availability of capital and credit for rural
business development. Access to financing in rural areas has generated particular concern
among economic development policymakers and practitioners because these areas are smaller
and more removed from major metropolitan centers of economic activity and investment
necessary for business development. Moreover, rural areas may not have the kind of supportive
economic infrastructure to facilitate business development because many of these areas are
poorer, lack economic diversification, lack higher risk lending opportunities, and have
relatively fewer financial institutions from which to obtain financing (Morentz Markley, 1990).

2.2.1 Rura FINANCING SouRCES

An assessment of rural capital and credit availability should emerge from an
understanding of the financial institutions (both private and public) responsible for providing
that financing. In this regard, the most traditional business financing sources are banks and
they provide the majority of financing for rural business development. In addition to
traditional banks, a wide range of institutions provides financing to rural areas. These
institutions run the gamut from purely private sources of financing to publicly-owned and
managed sources. Table 2.1 outlines the variety of financing sources for agriculture, housing,
businesses, and community development by relative importance to rural communities.

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Table 5.1
Size of Financings

By ARC RLFs (%)

Less than $10,000
$10,000 to $49,999
$50,000 to $99,999
$100,000 to $499,999
$500,000 to $999,999
$1 million+

Total 100

Number of Respondents = 420
Source: Mt. Auburn Business Survey

Graph 5.4
Types of Financing Provided by RLFs
in the ARC Region (%)

Sad Ont

Seer eerdrme — Urmnera eke Oat fay tom
Secured Ont Seared Ont CqayFemese wr

Note: Total number of respondents =104
Source: Mt Auburn Associates Development Finance Survey

Most RLFs permit a range of uses for their financings. The most frequent allowable uses
are for the purchase and improvement of land and buildings and for the purchase of machinery
and equipment. About 90 percent of RLFs allow their loans to be used for these purposes.
Between 70 and 80 percent of funds allow loans to be used for inventories and accounts
receivable, business acquisition, and longer-term working capital. (See Graph 5.5.)

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Map 3.4

Establishments with 1 to 9 Employees
as a Percentage of all Establishments, 1994

Below 85% of U.S. Average
85% to 115% of U.S. Average

[EBB Above 115% of U.S. Average

Source: U.S. Department of Commerce, 0 50 100 150 200 Miles
‘County Business Patterns NN —

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Banks in the region are not very active users of SBA loan products. In 1996, the number
of SBA 7(a) guaranteed loans made in the region was less than one-third the national average.
One small business assistance professional notes that, in addition to the traditional reluctance of
small, rural banks in the region to use SBA programs, the local SBA office is also somewhat
conservative.

Risk Financing

Bankers and development finance and business assistance professionals all agree that
there is very limited private risk capital activity, either formal or informal, in the region. While
there is some private wealth in the region, there is not a strong tradition among wealthy
individuals of investing in small, entrepreneurial enterprises in the region. Because of generally
low income and asset levels in the region, would-be entrepreneurs have very limited personal or
family resources from which to draw. These problems are particularly severe in the poorer,
more remote parts of the region.

It is also generally noted that, while risk capital is in limited supply, it is not the sole or
even the primary barrier to new enterprise development. Many would-be entrepreneurs lack
management skills and have not developed good business plans. For these individuals, the need
for technical assistance is greater than the need for capital. Entrepreneurs are also reluctant to
cede any ownership in their ventures to outside investors.

Sources oF DEVELOPMENT FINANCE
Local and Regional Organizations

Private sources of credit and capital within the region are supplemented by four
well-established development finance organizations, some with substantial financial resources:

Cumberland Valley Area Development District (CVADD): CVADD is nonprofit
organization designated by the state and federal governments as a regional development district.
It is governed by a board of directors comprised of public officials and citizens from the
eight-county Cumberland Valley region. In addition to development finance, it is involved in a
range of planning, development, and social service activities in the region.

CVADD has two revolving loan funds, one capitalized by ARC, the other by the
Economic Development Administration. The combined capitalization of these funds is almost
$1.5 million. As of May 31, 1997, they had a combined portfolio of 21 outstanding loans with a
total principal balance of $882,118. Characteristics of the portfolio included the following:

® average loan amount of about $70,000, with a range of between $10,000 and
$100,000;

® average total financing amount of about $1.28 million, with a range of $30,000 to
$5.33 million;

© interest rates of 5 to 6 percent;

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respondents), equity or debt with equity features (four respondents), revolving lines of credit
(three respondents), and asset-based financing (two respondents). Among those who sought
development financing, the financing requests most likely to be denied were for unsecured
financing or financing secured by "soft" assets. The highest turndown rates were for working

capital loans (60 percent), equity or debt with equity features (50 percent), and asset-based
financing (50 percent). (See Table 5.3.)

Table 5.3
Types of Financing Sought and/or Obtained
from State/Local Development Finance Organizations

Fs

Fixed rate commercial mortgage

Variable rate commercial mortgage
Equipment loan

Equipment lease

Medium-term working capital (1-5 years)
Short-term working capital (under 1 year)
Revolving line of credit

Asset-based financing

Export trade financing

Equity of debt with equity features 4
Note: Figures represent numbers of respondents, not percentages
Total number of respondents = 22 who sought financing

Source: Mt. Auburn Business Survey

Olte|elelrm|Rlal-jo

rlolelrmlele|elalela

Local development finance professionals, while generally positive about the system
of development finance, identify a number of gaps remaining in the system. These include:

J. working capital -- many development finance programs lack the authority or
expertise to provide such financing;

2. risk capital, either universally or in particular industry sectors;

3. financing for startups; and

4. microbusinesses financing -- this is difficult to provide because of the small loan
amounts and the relatively high costs of origination and administration.

Other gaps less frequently mentioned include financing for young, rapidly growing firms, often
in technology industries, financing for "Mom and Pop" businesses in the tourism industry, and
financing for remote rural businesses.

Development finance professionals frequently assert that financing gaps are related
more to the adequacy of the existing funds, than to the suitability or effectiveness of

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Map 3.6

Manufacturing Establishments as a Percentage
of All Establishments, 1994

[__] Below 85% of U.S. Average
[EE 85% to 115% of U.S. Average
[EBB Above 115% of U.S. Average

Source: U.S. Department of Commerce, ] 50 100 150 200 Miles
County Business Patterns VV ——

Final Report 42 Mt. Auburn Associates, Inc.