The Big Problem in Small Business Bank Credit

The media is full of anecdotal reports about small businesses that had bank loans and lines of credit before the Great Recession—and now have neither. While these stories put a face on the entrepreneurs struggling to make do with less credit, they don't give a sense of the overall breadth or depth of the problem: The decline in bank credit to small businesses during the Great Recession is so large that it's unlikely to return to prerecession levels for many years.

To thaw the ongoing freeze, policymakers need to understand how much small business credit has evaporated since the Great Recession began, and why. Timid solutions won't work. The adverse effects on the small business sector's contribution to economic growth and job creation are potentially way too severe.

The Federal Financial Institutions Examination Council has the best information on small business lending by retail banks and commercial banks. Its data on millions of loans to businesses with less than $1 million in annual revenue provide a comprehensive look at what has happened since the beginning of the financial crisis. (I use this revenue ceiling as a proxy for small business because IRS statistics show that 95 percent of businesses generate less than $1 million per year in revenue.)

A Dizzying Plunge

FFIEC data show that in 2009, banks originated $73 billion in loans to small businesses, $64.6 billion less than they provided in 2007, a decline of 47 percent. Just to get back to the average amount of new loan dollars originated annually from 2001 to 2007, U.S. banks would need to lend an additional $50.5 billion to small businesses every year.

A similarly extreme drop occurred in the number of loans made to small businesses. In 2009, banks made 1.6 million new loans to small businesses, 3.6 million fewer than they made in 2007, a drop of 69 percent. Again, to return to the average annual rate of new loan origination made from 2001 to 2007, banks would need to make 1.9 million more small business loans every year.

During the Great Recession, the banks accelerated their departure from lending to Main Street businesses. True, the share of bank loans going to small businesses has been declining for years, as banks have focused on lending to large businesses. (The FFEIC reports that the share of loans to small businesses peaked in 1999 at 60 percent of loans.) The decline in bank lending to small businesses during the slowdown, however, was larger than the corresponding drop in bank lending to large companies. In 2007, 38 percent of new loans went to small businesses, but by 2009, that percentage had shrunk to 26 percent. And in 2007, 41 percent of new lending dollars went to small businesses, but by 2009, that share had fallen to 35 percent.

Variety of Causes

Economists don't all agree on why so much small business credit disappeared during the Great Recession. Part of the decline stems from the long-term trend of banks away from small business lending. Another part comes from the effect of economic contraction on the number of small businesses seeking to borrow money. The recession also cut the creditworthiness of many small business borrowers, making it more difficult for many of them to obtain loans. Declining housing prices eliminated an important source of small business credit—home equity. Banks became more conservative in the wake of high losses on their loan portfolios and so cut back on loans of all types. And tightened regulatory standards have made it more difficult for banks to make small business loans that satisfy regulators.

This multitude of causes for the decline complicates efforts of policymakers to return small business credit to prerecession levels. While many small business owners and elected officials are looking for easy answers, boosting bank lending to small businesses will take more than simply intructing bankers to make more loans. And it will require more than the recent effort to boost the Small Business Administration's loan guarantee program, because SBA-guaranteed loans are a tiny sliver of all bank loans to small businesses—about 44,000 of the 1.6 million small business loans made in 2009. The implications are stark: Unless policymakers implement effective solutions to the problem, the small business sector will receive far less bank credit than it used to, hampering the economy for years to come.

This article was written by Scott Shane and published in Bloomberg Businessweek.