Mr. Meyer looks at the role of US banks in small business finance Remarks
by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve
System, at the Conference on Small Business Finance held at the Leonard N. Stern School of
Business, Berkley Center for Entrepreneurial Studies and New York University Salomon Center
in New York on 23/5/97.
It is a pleasure to be here to meet with you at New York University for this
Conference on Small Business Finance. It is clear from the conference program that there is an
excellent mix of academics, government representatives, and practitioners here to study how
small business is financed. Indeed, I am glad to see so much attention being paid to this
important topic. Small business is a vital and energetic part of our economy that plays a key role
in the generation of jobs, new ideas, and the encouragement of entrepreneurial activity. Without
doubt, a thriving small business sector contributes to the well-being of our nation.
Today, I would like to share with you some thoughts about the role of banks in
supplying credit to small business. The part played by banks in small business finance is not a
new topic for the Federal Reserve. In fact, for many years we have been devoting substantial
resources to collecting and analyzing data on small business finance generally, and the credit
supplied by banks in particular. We collect data from small businesses on how they obtain
financing -- or in some cases fail to obtain financing -- using the National Survey of Small
Business Finance and the Survey of Consumer Finances. We also gather information directly on
the small business credit extended by individual commercial banks. We have collected
information on the contract terms of bank loans to both small and large businesses since 1977
through the Survey of Terms of Bank Lending to Business. Since 1993, the banking agencies
have required all commercial banks to report their quantities of loans to businesses by size of
loan on the June Call Reports. Lastly, as part of revised Community Reinvestment Act
procedures, the banking agencies have just this year begun to collect data on small business
loans by local geographic area. When these data become available, they should prove to be a
rich source of new information.
A number of economists have used the existing data in research that has helped us
to better understand the potential effects on the supply of small business credit of public policies
regarding bank mergers and acquisitions, financial modernization, and prudential supervision
and regulation. For example, some have argued that the consolidation of the banking industry
may be reducing the supply of credit to small business, since larger banking institutions tend to
devote smaller proportions of their assets to small business lending. Solid economic research
applying modern econometric techniques to accurate data is needed to evaluate such claims and
to determine the likely effects of policy actions in order to improve future policy decisions.
The Importance of the Bank-Small Business Relationship
According to our survey information, commercial banks are the single most
important source of external credit to small firms. Small businesses rely on banks not just for a
reliable supply of credit, but for transactions and deposit services as well. Because of their needs
for banking services on both the asset and liability sides of their balance sheets, small businesses
typically enter into relationships with nearby banks. The data show, for example, that 85 percent
of small businesses use the services of a commercial bank within 30 miles of their firm, and that
small businesses typically obtain multiple different services from their local bank. The 30 miles
actually overstates the distance that small businesses are willing to travel for most of their basic
financial services. For example, the median distances from a small business' offices to the
institutions where it obtains deposit, credit, or financial management services are all 5 miles or
less.
One of the reasons why the banking relationship is so important to small business
finance is that banks can efficiently gain valuable information on a small business over the
course of their relationship, and then use this information to help make pricing and credit
decisions. The financial conditions of small firms are usually rather opaque to investors, and the
costs of issuing securities directly to the public are prohibitive for most small firms. Thus,
without financial intermediaries like banks it would simply be too costly for most investors to
learn the information needed to provide the credit, and too costly for the small firm to issue the
credit itself. Banks, performing the classic functions of financial intermediaries, solve these
problems by producing information about borrowers and monitoring them over time, by setting
loan contract terms to improve borrower incentives, by renegotiating the terms if and when the
borrower is in financial difficulty, and by diversifying the risks across many small business
credits.
Some recent empirical research suggests that this characterization of the
bank-small business borrower relationship is accurate. For example, as the relationship matures,
banks typically reduce the interest rates charged and often drop the collateral requirements on
small business loans. In short, the bank-borrower relationship appears to be an efficient means
for overcoming information and cost problems in small firm finance, and for allowing
fundamentally creditworthy small firms to finance sound projects that might otherwise go
unfunded.
One implication of the importance of the bank-small business relationship is that
it may impose limits on the migration of small business finance out of the banking sector. Over
the last two decades, many large business loans left the banking sector as improvements in
information technology, increased use of statistical techniques in applied finance, and the
globalization of financial markets have allowed nonbank and foreign bank competitors to gain
market share over U.S. banks. For example, over the 1980s and first half of the 1990s, the share
of total U.S. nonfarm, nonfinancial corporate debt held by U.S. banks fell by about one-quarter
from 19.6 percent to 14.5 percent. Banks compensated somewhat for these on-balance sheet
reductions in a variety of ways. Many banks expanded their participation in off-balance sheet
back-up lines of credit, standby letters of credit, and the securitization and sale of some large
loans. Other adaptations included a shift in focus toward fee-based services and derivatives
activities.
The types of developments that might similarly reduce bank market share in small
business lending are proceeding rather slowly at present, but may accelerate in the future.
Improvements in analytical and information technologies such as credit scoring may decrease
the cost of lending to small businesses and make it easier for nonbank lenders to enter this
market. These developments are already contributing to more competition for small business
loans within the banking industry and between bank and nonbank lenders. Similarly, a
significant secondary market for securitization of loans to some small businesses may develop in
the future. Those small businesses among current bank borrowers whose information problems
are the least severe -- that is, those that are the least informationally opaque -- would presumably
be the most likely to be funded outside of the banking system.
Nevertheless, no matter how many advances there are in information processing
and no matter how sophisticated financial markets may become, there will likely remain a
significant role for bank-borrower relationship lending to solve the information and other
financing problems of small businesses. That is, in the foreseeable future it seems very likely
that there will remain many small business borrowers with sufficient problems that only bank
information gathering, monitoring, and financing can overcome, although this group of
borrowers will almost surely differ somewhat from current relationship borrowers. As
technology and markets improve to the point that some relatively transparent small business
borrowers can be financed outside the bank, other, more opaque potential borrowers that
previously had information and other problems too serious for even a bank loan will enter the
bank intermediation process. Put another way, the relationship lending process will fund small
business borrowers with increasingly difficult information problems as the technology for
resolving these problems improves. In my view, this should only increase the efficiency and the
competitiveness of small business finance. For example, the improved ability of banks to lend to
more opaque borrowers should provide some increased competition for the venture capitalists
and angel financiers that were discussed at the conference yesterday.
The value of gathering information through the relationship between banks and
small businesses also bodes well for the survival of small community-based banks that tend to
specialize in these relationships. Most forecasts of the future of the U.S. banking industry predict
that thousands of small banks will survive. I hasten to point out that these are not my personal
forecasts. I stick to predicting interest rates, GDP growth, and inflation -- items over which I
have more control and inside information -- and I leave the banking forecasts to others! But the
forecast of thousands of small banks continuing to operate and do well makes sense to me. They
have information advantages, knowhow, and local community orientations that are hard to
duplicate in large organizations.
The importance of relationship lending to small business also raises prudential
concerns about bank risk taking. When a bank fails, the losses to society exceed the book values
involved because of the loss of the value of the bank's customer relationships. Even if small
business borrowers are able to find financing after their bank fails, it may be at a higher interest
rate and with additional collateral requirements until the new bank has had a chance to learn
about the borrower's condition and prospects. When many banks fail during a crisis, this can
create a credit crunch or significant reduction in the supply of credit to bank-dependent small
business borrowers. For example, research on the Great Depression suggests that the loss of
bank-borrower relationships in the 1930s may have deepened and prolonged the economic
downturn. More recently, it appears that the weak capital positions of many banks in the late
1980s and early 1990s, not to mention the outright failure of over 1,100 banks during this
period, contributed importantly to the sharp slowdown in bank commercial lending during the
early 1990s. While the ability of small businesses to find alternative sources of funds is
considerably greater today than in the 1930s, and will likely be even greater in the future than it
was in the early 1990s, such arguments do reinforce the importance of the connection between
macroeconomic and bank supervisory policy.
Financial Modernization and Bank Small Business Lending
In the remainder of my remarks, I will touch on three additional concerns about
the potential effects of financial modernization on the supply of bank credit to small business. I
will first discuss the effects of increases in market concentration created by bank mergers and
acquisitions within a local market; second, the effects of consolidation of the banking industry as
a whole; and third, the possible impacts of the increased complexity of financial service firms in
which banking and other organizations may provide a multitude of traditional banking and
nonbanking services.
At the outset, I would emphasize that the overriding public policy concern
regarding these issues is not the quantity of small business lending, but rather economic
efficiency. If some banks are issuing loans to finance negative net present value projects, then
such loans should be discouraged. If consolidation of the banking industry or the increased
complexity of financial services firms reduces such lending, then economic efficiency is
promoted by freeing up those resources to be invested elsewhere, even though the supply of
small business credit to these borrowers is reduced. Similarly, a lack of competition or poor
corporate control may currently be keeping some positive net present value loans from being
made. If modernization increases the supply of loans to creditworthy small business borrowers
to pursue financially sound projects, then economic efficiency is also raised as the supply of
credit to these small businesses rises.
Antitrust analysis in banking has typically been based on the concentration of
bank deposits in local markets like Metropolitan Statistical Areas (MSAs) or non-MSA rural
counties. Under the traditional "cluster approach," small business loans and other products are
assumed to be competitive on approximately the same basis as bank deposits in local markets.
While on-going technological and institutional changes seem likely to erode the usefulness of
this assumption over time, evidence continues to generally support this assumption. As I noted
earlier, small businesses typically get their loans and other financial services from a local bank.
Additional research finds that the concentration of the local banking market is a key determinant
of the rates that are charged on small business loans. For example, it is estimated that small
business borrowers in the most concentrated markets pay rates about 50 to 150 basis points
higher than those in the least concentrated markets. This exceeds estimates of the effects of local
market concentration on retail deposit rates of about 50 basis points.
Research has also suggested that high local-market deposit concentration may
lead to reduced managerial efficiency, as the price cushion provided by market power allows a
"quiet life" for managers in which relatively little effort is required to be profitable. Managers in
these concentrated markets may choose to work less hard or pursue their own personal interests
because the lower rates on deposits and higher rates on small business loans raise profits enough
to cover for inefficient or self-serving practices.
These findings support the need to maintain competition in local banking markets
to deter the exercise of market power in pricing consumer deposits and small business loans, and
to ensure that the local banks are under sufficient competitive pressure that they are operated in a
reasonably efficient way.
When bank mergers and acquisitions involve banks operating in different local
markets, the issues raised are typically quite different from those I have just discussed. Since the
late 1970s, states have been liberalizing laws that previously restricted mergers and acquisitions
between banks in different local markets, including allowing holding company acquisitions
across state lines. The U.S. banking industry has responded strongly and has been consolidating
at a rapid rate over the last 15 years. Consolidation has picked up even more in the first half of
the 1990s -- each year bank mergers have involved about 20 percent of industry assets. This
trend is likely to continue or accelerate under the Riegle-Neal Act, which has already allowed
increased interstate banking, and which will allow interstate branching into almost all states this
summer.
Importantly, an increase in local market concentration is not a major issue in most
of these mergers and acquisitions, as they are primarily of the market-extension type. As such,
these consolidations, and sometimes merely the threat of such actions, may be pro-competitive
and reduce the market power of local banks over depositors and small business borrowers in the
markets that are invaded. They may also improve the diversification and efficiency of the
consolidating institutions. Research generally suggests that most mergers and acquisitions, by
improving diversification, allow the consolidating institutions to make more loans and improve
their profit efficiency.
Mostly as a result of these mergers and acquisitions, the mean size of banking
organizations has approximately doubled in real terms in the last 15 years. As I mentioned
earlier, a frequently voiced concern about this consolidation is whether the supply of credit to
small business may be decreased, since larger banking institutions tend to devote smaller
proportions of their assets to small business lending. To illustrate, banks with under $100 million
in assets devote about 9 percent of their assets to small business lending on average, whereas
banks with over $10 billion in assets invest only about 2 percent of assets in these loans.
While such a simplistic analysis may sound appealing on the surface, it is clearly
incomplete. It neglects the fundamental nature of mergers and acquisitions as dynamic events
that may involve significant changes in the business focus of the consolidating institutions. That
is, banks get involved in mergers and acquisitions because they want to do something different,
not simply behave like a larger bank.
The simplistic comparison of the lending patterns of large and small banks also
ignores the reactions of other lenders in the same local markets. Other existing or even new local
banks or nonbank lenders might pick up any profitable loans that are no longer supplied by the
consolidated banking institutions. These other institutions may also react to M&As with their
own dynamic changes in focus that could either increase or decrease their supplies of small
business loans. Thus, even if merging institutions reduce their own supplies of small business
loans substantially, the total supply of these loans in the local market need not decline.
There have been a number of recent studies of these dynamic effects of bank
mergers and acquisitions, some of which we heard about this morning. The results suggest that
the dynamic effects of mergers and acquisitions are much more complex and heterogenous than
would be suggested by the increased sizes of the consolidating institutions alone. For example,
mergers of small and medium-sized banks appear to be associated with increases in small
business lending by the merging banks, whereas mergers of large banks may be associated with
decreases in small business lending by the participants.
On average, mergers appear to reduce small business lending by the participants,
but this decline appears to be offset in part or in whole by an increase in lending by other banks
in the same local market. These other banks may pick up profitable loans that are dropped by
merging institutions, or otherwise have dynamic reactions that increase their supplies of small
business lending. Moreover, these results do not include the potential for increased lending by
nonbank firms. The bottom line is that small business loan markets seem to work quite well.
Creditworthy borrowers with financially sound projects seem to receive financing, although they
sometimes have to bear the short-term switching costs, such as temporarily higher loan rates and
collateral requirements, of changing banks after their institutions merge. On-going technological
change in small business lending should only help to improve the efficiency of this process.
Again, I would emphasize that it is not the quantity of small business loans
supplied that is most important, but rather the economic efficiency with which the market
chooses which small businesses receive credit. To the extent that mergers and acquisitions are
pro-competitive and improve corporate control and efficiency, the supply of credit to some
borrowers with negative net present value projects may be reduced, as it should be. That is, the
protection from competition provided by interstate and intrastate barriers may have allowed
some firms with market power to be inefficient or make uneconomic loans. Similarly, any
improvement in competition and efficiency may increase the supply of credit to borrowers with
positive net present value projects that inefficient lenders previously did not fund. In either of
these cases, economic efficiency is improved.
As promised, the final issue I will discuss is that aspect of the modernization of
financial markets in which financial service firms are likely to become more complex, providing
more types of financial services within the same organization. At the present time, we do not
know if and when the Glass-Steagall Act will be repealed, whether nontraditional activities will
be provided by bank subsidiaries or bank holding company affiliates, and in which activities
banking organizations will be allowed to engage or choose to engage. However, similar to the
arguments regarding consolidation of the banking industry, concern is sometimes expressed that
small business borrowers may receive less credit from these larger, more complex financial
institutions.
There is much less research evidence available regarding the potential effects on
small business lending of this type of financial modernization than there is about the
consolidation of the banking industry, so my remarks here are substantially more speculative.
However, I believe there are several reasons for optimism regarding adequate supplies of
services to creditworthy small businesses. First, a limited amount of research suggests that there
is little if any effect of the current organizational complexity of U.S. banks on their treatment of
small businesses, other things equal. In particular, banking organizations with multiple layers of
management, those that operate in multiple states, those with Section 20 securities affiliates, and
those with other organizational complexities tend to charge about as much for small business
credit as other banks of their same size. Second, the research results for the consolidation of
banks alone suggest that if profitable loans are dropped by the newer universal-like banks, other
small banks or nonbank firms will be standing by to pick up these loans. Finally, the additional
insurance, securities underwriting, or other financial services provided by the new institutions
should provide greater opportunities for small businesses to have access to these nontraditional
services.
I want to leave time for questions, so let me conclude with a few summary
comments. It is gratifying to see all of this attention being paid to the financing of small
business, which is a vital part of our economy, and the Federal Reserve is working actively to
stay abreast of the issues with its data collection and research efforts. Small businesses tend to
rely on banks for their credit needs and other financial services, and relationships between banks
and small businesses are important and efficient means of distributing these services. While
technological and institutional changes are and undoubtedly will in the future affect these
relationships, it seems unlikely that the core bank-small business relationship will be replaced.
The continued heavy dependence of small businesses on local banks also suggests an on-going
need for bank supervisors to be sensitive to antitrust issues when considering mergers and
acquisitions of banks in the same local market. In contrast, cross-market mergers rarely raise
antitrust concerns; indeed, such mergers can be quite pro-competitive. Finally, while some
observers have argued that banking consolidation and other aspects of the modernization of the
banking industry and financial markets raise concerns about the supply of credit to small
business, the market for small business loans in fact seems to work rather well. If there is a
merger or other event that reduces the supply of profitable loans to small businesses, other banks
seem to step in and provide this credit, and there is every reason to expect that such responses
will continue in the future.