Randall S Kroszner: Effects of the financial crisis on small business
Testimony of Mr Randall S Kroszner, Member of the Board of Governors of the US Federal
Reserve System, before the Committee on Small Business, US House of Representatives,
Washington DC, 20 November 2008.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
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Chairwoman Velázquez, Ranking Member Chabot, and members of the Committee, I am
pleased to appear before you on behalf of the Board of Governors of the Federal Reserve
System to discuss the availability of credit to small businesses.
Small businesses are critical to the health of the U.S. economy. They generate more than
half of nonfarm business gross domestic product, employ more than half of private-sector
workers, and over the past decade have created well over half of net new jobs annually.
Moreover, larger firms often begin as smaller firms that prosper and grow. If small
businesses are to continue to provide major benefits to the economy, their access to credit is
clearly a high priority. My statement today will address how the ongoing turmoil in the
financial sector and the weakening macroeconomy appear to be affecting small businesses'
access to credit, while recognizing that the impressive diversity across both industry and
geography of the small business sector makes it very difficult to draw too many general
conclusions. In addition, I will discuss the policy actions that the Federal Reserve, the
Congress, the Treasury, and other government agencies have taken in recent weeks to
address the overall functioning of financial markets and deteriorating economic conditions as
well as how these policies should assist small businesses going forward.
Recent financial market and economic developments
As you know, the U.S. financial sector has been under severe stress for more than a year as
a result of declining house prices, large losses on mortgages and mortgage-related
instruments at financial institutions, and an abrupt pullback from risk-taking by investors.
These strains intensified in late September and early October, and lending between banks
and other financial institutions beyond more than a few days virtually shut down. Withdrawals
from money market mutual funds and fears that net asset values would fall further severely
disrupted commercial paper and other short-term funding markets, and longer-term credit
became much more costly as risk spreads on corporate debt instruments jumped and private
interest rates rose. The problems in credit markets and concerns about the economy have
caused equity prices to swing sharply and to decline significantly, on net.
Even before the recent heightening of the financial market turmoil, economic activity had
shown considerable signs of weakening. In the labor market, private nonfarm payroll
employment fell in August by a notably larger amount than in the previous seven months of
the year, and in September and October, job losses were even more sizeable. The
unemployment rate in October moved sharply higher to 6-1/2 percent. On the spending side,
consumption expenditures, business investment outlays, and residential investment
spending all declined in the third quarter, and overall real economic activity contracted 1/4
percent. Consistent with the emerging slack in both product and labor markets and a drop in
the price of energy and other commodities, headline and core measures of price inflation
have both decelerated in recent months. In addition, measures of inflation expectations have
also declined.
Small business access to credit in the current environment
With this general background in mind, I will now turn to how current financial and
macroeconomic conditions appear to be affecting access to credit by small businesses. As
you may recall, former Federal Reserve Governor Frederic Mishkin testified before the
Senate Committee on Small Business in April and concluded that credit standards for small
businesses had almost certainly tightened since the onset of the crisis, and that much of this
tightening appeared to be reflected in an increased cost of credit to small businesses rather
than any significant reduction in the availability of credit.1 He noted, however, the high
degree of uncertainty surrounding this assessment, which remains the case now with even
more data in hand.
In my statement today, I will discuss how both credit supply and credit demand factors
appear to be affecting small business access to credit, while recognizing that, in practice, it is
normally quite difficult to separate the effects of these two forces. With respect to credit
supply, access to credit for both small and large businesses may be affected by a decline in
the willingness of banks and other lenders to make loans to small businesses because of, for
example, credit market disruptions or other stresses that financial institutions may be
enduring. In addition, small business access to credit can be reduced by a drop in the
creditworthiness of small businesses because of, for example, a decline in the value of
collateral they can post to back a loan. Alternatively, a drop in the demand for small
businesses' products and services resulting from, for instance, weakening macroeconomic
conditions will reduce current and expected sales and revenues. The likely resulting pullback
in expansion plans will reduce businesses' demand for credit over and above any effects
coming from the supply side of the market.
To summarize our conclusions, the information that we have received since April from both
banks and small businesses suggest, rather convincingly, that over the last six months it has
become more difficult for small businesses to access credit, but that at the same time, small
business demand for credit has declined. Commercial banks, the most common source of
credit for small businesses, have generally both imposed more-stringent credit standards and
increased interest rate spreads and fees. In addition, deteriorating financial positions in both
the small business and the household sectors are almost surely reducing the
creditworthiness of many small businesses and thereby constraining their access to credit.
That being said, the information we have on the volume of small business loans suggests
that credit is generally available, albeit on significantly stricter terms. In addition, small
businesses generally report that reduced demand for their products and services caused by
a lower level of economic activity is a more serious concern than is the tightening of credit
supply conditions. Put differently, while credit supply concerns are real, the weakened state
of the economy appears to be the more serious challenge facing most small businesses in
the current environment. Importantly, there is some evidence that concern over access to
credit is relatively stronger at larger businesses. The remainder of my statement discusses
the information on which we base these conclusions.
Incoming survey data for the banking sector suggest that small businesses access to credit
has tightened further over the past half year. For example, in the Board's most recent Senior
Loan Officer Opinion Survey on Bank Lending Practices conducted in October, a net 75
percent of the domestic banks surveyed - a larger net fraction than in the July survey -
reported that over the previous three months, they had tightened the standards applied when
approving commercial and industrial (C&I) loans to small firms.2 But small businesses were
not alone; almost a net 85 percent of the domestic banks surveyed reported having tightened
lending standards on C&I loans to large and middle-market firms over the previous three
months. In both the July and October surveys, a significant and increasing net fraction of
banks noted that they had increased the interest rate spreads over their cost of funds and
fees on the C&I loans they had approved for small firms, and a somewhat smaller net
fraction of banks reported tightening nonprice conditions, such as collateral requirements and
loan covenants. Importantly, in both the July and October surveys, the net fractions of banks
reporting tighter lending standards and tighter price terms on C&I loans to small firms were
very high by historical standards going back to 1990. These results are also true for loans
made to medium-size and large businesses.
Somewhat in contrast to the above results, information from the most recent (August)
quarterly Survey of Terms of Business Lending suggested that there has been relatively little
net change in average interest rate spreads on C&I loans since late 2006.3 Loan rate
spreads at small domestic banks, which are an important source of financing for small
businesses, remained toward the low end of the wide range within which they have
fluctuated since 2004. Spreads on C&I loan originations smaller than $100,000 at all banks,
which are loans that are likely made to small businesses, have also remained broadly
unchanged since 2006. While differences between the two surveys, including their relative
timeliness, likely explain part of the contrasting results, on balance, the quarterly Survey of
Terms of Business lending results serve to temper the Senior Loan Officer Opinion Survey
results.4
Data on changes in the quantity of C&I loans at banks also support the view that small
businesses have generally maintained their access to bank credit, although new loans and
new loan commitments are being subjected to stricter lending standards and terms. Based
on a sample of banks of all sizes that report weekly to the Federal Reserve, the dollar
volume of outstanding C&I loans at both large and small U.S. commercial banks expanded
robustly over the first four months of this year, increased moderately over the months of May
through August, and surged dramatically in September. A special set of questions on the
October Senior Loan Officer Opinion Survey attempted to help explain these patterns. The
results suggested that firms' drawing on unused portions of loans made under previous
commitments was not especially important for explaining the September surge in lending at
banks with less than $20 billion in total assets. Indeed, over one-third of those smaller banks
reported having increased loans not made under previous commitments. However, many of
those banks noted that the increased demand was accounted for, in part, by firms that were
substituting bank loans for other funding sources.
Incoming data from business surveys also indicate that lending conditions for small
businesses have tightened - in some cases, significantly. For example, recent monthly
surveys of the National Federation of Independent Businesses (NFIB), which are available
through October, suggest that financing conditions for small businesses have deteriorated
substantially over the past several months. In particular, the net percentage of respondents
that reported that credit was harder to obtain over the preceding three months and the net
percentage of respondents that expected credit conditions to tighten over the next three
months have climbed to the higher end or the top of their ranges over the past two decades.
That said, financing conditions have continued to be ranked as the top business concern by
only a modest fraction of small business - 5 percent in October - although this is up from 2
percent last March. However, this modest level of concern may, in part, reflect the
dominance of other factors, such as weak demand conditions, a topic to which I will return
shortly.
The Duke/CFO Magazine Global Business Outlook Survey, conducted most recently in
September, also suggested that the ongoing financial turmoil is having an increasingly
adverse effect on small businesses' access to credit.5 Almost 40 percent of the chief financial
officers (CFOs) of small businesses who responded to the survey said that credit had
become more costly, less available, or both as a result of the financial turmoil. This
proportion is up slightly from the March survey when this sentiment was reported by about
one-third of responding small business CFOs. This survey also asked respondents to rank
their top three concerns for their business, with (changing) options given in the survey.
"Credit markets/interest rates" was ranked second to "consumer demand" as the top concern
among small business CFOs in both the September 2008 and the March 2008 surveys. This
survey also suggested, as did the Senior Loan Officer Survey discussed above, that access
to credit is a relatively more serious concern for larger firms. For example, some 38 percent
of the Duke/CFO Magazine survey respondents with less than 500 employees indicate that
the financial turmoil is adversely impacting their access to credit, but 47 percent of larger
firms say this is true. Consumer demand is the top business concern for firms of all sizes.
The effect of the current crisis on household balance sheets is an additional channel through
which small business access to credit is being affected. As you know, small business and
household finances are, in practice, very closely intertwined. For example, data from the
Board's 2007 Survey of Consumer Finances indicated that about 11 percent of households
own and actively manage a small business, and of these households, about 18 percent use
personal assets to guarantee or collateralize loans for the business.6 A broadly similar
fraction of households that own and actively manage a small business also have made one
or more loans to the business. In addition, the most recent Survey of Small Business
Finances (SSBF) indicated that about 15 percent of the total value of small business loans in
2003 was collateralized by "personal" real estate (and some 37 percent was collateralized by
business real estate assets).7 Because the condition of household balance sheets can be
relevant to the ability of some small businesses to obtain credit, the fact that declining house
prices have weakened household balance-sheet positions suggests that the housing market
crisis has likely had an adverse impact on the volume and price of credit that small
businesses are able to raise over and above the effects of the broader credit market turmoil.
Another indicator of the stress that current conditions have placed on small business credit
access is the recent experience of the Small Business Administration's (SBA) 7(a)
guaranteed loan program. This program is generally used to provide loans to small
businesses when they cannot get conventional loans. Although SBA-guaranteed loans are
only a small portion of total small business loans, in recent months the dollar volume of these
loans has dropped significantly, and in October 2008 the volume was less than 50 percent of
its level 12 months earlier. These declines are the result of a number of factors - lower
demand overall for loans due to the weaker economic outlook, tightened credit standards by
lenders, and declining creditworthiness among applicants because of their deteriorating
financial condition. In addition, market reports indicate that in recent weeks, banks and other
lenders that make SBA loans have not been able to securitize and sell SBA-backed loans to
other institutions in the secondary market.
Turning to credit demand, the NFIB survey's results are even more pessimistic than they
were in April. For example, the survey's index of small business optimism dropped in October
to its lowest level since the monthly surveys began in 1986. This subdued level reflects
deterioration in several components of the index, including that the fraction of respondents
considering expansion in the next three months and the fraction considering capital
expenditures in the next three to six months have fallen to the bottom of their ranges over the
past two decades. Weak plans for business expansion will likely reduce demand for loans,
which could result in future declines in small business loans even without any tightening of
credit supply conditions. As noted earlier, although only 5 percent of small businesses in the
NFIB survey ranked financing conditions as their top concern, some 23 percent of firms
indicated that sales were their main concern. These results, when combined with the
Duke/CFO Magazine survey data, suggest that consumer demand concerns generally
provide the most serious challenges facing small businesses.
Policy responses to financial and economic developments and their implications for
small business credit access
I would now like to turn to a discussion of the policy actions that the Federal Reserve, the
Congress, the Treasury, and other government agencies have taken in recent weeks to
address the overall functioning of financial markets and the weakening of economic activity
as well as how these policies should assist small businesses going forward.
In response to the escalation in financial market stress that began in late September,
policymakers both in the United States and other countries have taken a series of
extraordinary actions aimed at restoring market functioning and improving investor
confidence. The Federal Reserve has continued to address ongoing problems in interbank
funding markets by expanding its existing lending facilities, increasing the quantity of term
funds that it auctions to banks, and accommodating greater demand for funds from banks
and primary dealers. The Federal Reserve has also implemented several important
temporary facilities to alleviate the pressures on money market mutual funds and commercial
paper issuers.
The Emergency Economic Stabilization Act (EESA), enacted by Congress in early October,
provides critically important new tools to address financial market problems. The Troubled
Asset Relief Program (TARP), authorized by the legislation, allows the Treasury to provide
capital to financial institutions across a wide spectrum of sizes and to purchase or guarantee
troubled mortgage-related and possibly other assets held by banks and other financial
institutions. The EESA also temporarily raises the limit on the deposit insurance coverage
provided by the Federal Deposit Insurance Corporation (FDIC) from $100,000 to $250,000
per depositor and temporarily fully covers non-interest-bearing transactions accounts, such
as payroll accounts. As you know, this latter action was aimed particularly at helping small
businesses.
In response to weakening macroeconomic activity and the increased downside risks to
economic growth and employment implied by the recent escalation in financial market stress
(along with diminished upside risks to inflation), the Federal Open Market Committee
(FOMC), in a coordinated effort with other central banks, lowered the target federal funds
rate 50 basis points to 1-1/2 percent on October 8. This cut was followed by a further 50
basis point easing to 1 percent at the October FOMC meeting.
Additionally, on November 12, the federal banking agencies released an interagency
statement aimed at ensuring that all banking organizations fulfill their fundamental role in the
economy as intermediaries of credit to businesses, consumers, and other creditworthy
borrowers.8
These actions should have a wide range of positive effects across the entire economy,
including small businesses. Policymakers' actions over the last two months in interbank
funding markets, commercial paper markets, and the money market mutual fund industry
should help restore market functioning and allow short-term funding to be directed to where
the economy most needs it. Likewise, the activities permitted as part of the EESA legislation
should help rebuild confidence in the financial system, increase the liquidity of financial
markets, and improve the ability of a broad range of financial institutions to raise capital from
private sources. The expansion in the coverage of deposit insurance provided by the FDIC
should also bolster public confidence and provide additional liquidity to FDIC-insured
institutions. The FOMC's cumulative 1 percentage point reduction in the federal funds rate in
October, combined with previous reductions between September 2007 and May 2008,
should lower lending costs and stimulate economic activity in coming quarters. And, the
agencies' recent guidance should encourage lending to creditworthy borrowers.
The benefits to small businesses from some of the above-described policy actions will be
largely indirect, but nevertheless real. For example, although small businesses do not
themselves issue nonfinancial commercial paper, they nonetheless benefit when large
nonfinancial firms can issue commercial paper in well-functioning markets and thus do not
have to tap backup lines of credit at banks. Similarly, improving interbank funding markets
and restoring public confidence in banks and other financial institutions benefits small
businesses - again, indirectly - by lowering intermediaries' and thereby small businesses'
borrowing costs and increasing the volume of loans that banks can extend. The temporary
increase in FDIC deposit insurance coverage should reinforce these effects by further
strengthening public confidence and providing additional liquidity to FDIC-insured institutions.
Importantly, some of these policy actions will also directly benefit small businesses. For
example, the higher deposit insurance coverage limits confer direct benefits by greatly
reducing the volume of exposed small business deposits as well as by decreasing the
number of small businesses with exposed bank deposits. Data from the 2003 SSBF indicate
that under the $100,000 deposit insurance ceiling, an estimated $178 billion of small
business deposits were uninsured, and 8.7 percent of small businesses had some deposit
exposure. With the increased ceiling of $250,000 and the full insurance of
non-interestbearing transactions accounts, the 2003 SSBF data suggest that total small business deposit
exposure fell to $37 billion and that less than 1 percent of small businesses have any deposit
exposure. Among firms with fewer than 10 employees - which represent over 80 percent of
all small businesses - the broader deposit insurance coverage reduces total deposit
exposure from an estimated $22.1 billion to $1.6 billion and leaves only 0.3 percent of these
businesses with any deposit exposure.
The recent reductions in the federal funds rate should directly benefit small businesses.
Lower policy rates should result in small businesses facing lower borrowing costs, especially
because rates on small business loans tend to be tied to the prime interest rate, which
generally moves closely with the federal funds rate.9 In addition, stronger economic activity
resulting from lower interest rates should result in small businesses enjoying increased
demand for their products and services.
Of course, the magnitude of the effects of recent policies are highly uncertain, given the
current climate of extreme financial stress as well as the nonconventional nature of a number
of these policy actions. Thus, the Federal Reserve will continue to monitor closely how the
effects of recent policy actions are affecting small business conditions and economic activity
more broadly.
Conclusion
The health of the U.S. economy depends importantly on the vitality of the small business
sector, and continued access to credit on competitive terms is necessary for that vitality. On
balance, credit supply conditions to small businesses have tightened substantially since last
April. Although credit appears to be generally available, such availability usually comes with
tougher standards and at a higher cost. However, while credit concerns are real, the
weakened state of the economy and the resulting drop in demand for their products and
services appear to be the more serious challenge for small businesses in the current
environment.
How small businesses' access to credit will evolve will likely be strongly influenced by the
success of recent policies undertaken by the Federal Reserve, the Congress, and other
policy institutions aimed at improving the functioning of financial institutions and markets,
rebuilding confidence in the financial system, and stimulating economic activity. Given the
current financial and economic environment, the sizes of the effects of recent policies on
both the economy and small businesses are highly uncertain. For these reasons, the Federal
Reserve will continue to monitor evolving financial market and economic conditions and their
effects on small business access to credit as part of its broader efforts to restore the health of
the U.S. financial system and our economy.