Collateral Damage for Small Business Credit

September 15 marked the fifth anniversary of the bankruptcy of Lehman Brothers, an event that many see as having catalyzed the passage of Dodd-Frank. While small business loans were not a cause of the financial crisis, the regulatory response to the crisis has made small business credit more difficult to obtain.

The number and value of small loans has shrunk substantially over the past five years. Federal Deposit Insurance Corporation Call Report data show that both the number of and the inflation-adjusted value of non-farm, non-residential loans of up to $1 million — a common proxy for small business loans — declined by 27 percent from June 2008 to June 2013.

Twenty-five percent of respondents to the third quarter 2013 Wells Fargo/Gallup Small Business Index, a survey of approximately 600 small business owners conducted every three months by Gallup on behalf of Wells Fargo, said that obtaining credit was difficult over the past 12 months, while 22 percent said it was easy. In the third quarter of 2008, those percentages were 14 percent and 41 percent, respectively.

While post-financial crisis regulations are far from the primary reason small business borrowing is down, they nonetheless have made it more difficult to get. Banks have tightened lending standards in response to new regulatory pressure, reducing loans to marginal borrowers—some of whom would have obtained credit under pre-crisis standards.

Moreover, adhering to the new rules takes time and money, reducing the resources that bankers have to make loans. As Greg Ohlendorf, president and chief executive officer of First Community Bank and Trust, told Congress, “This compliance burden is a distraction from our small business lending. Every hour I spend on compliance is an hour that could be spent with a small business customer.”

Because many small business owners borrow personally to finance their businesses, they have also been caught up in policy makers’ efforts to increase consumer financial protections. Credit-card lending is a good example. Four-fifths of small business owners have a personal or business credit card used for business purposes, the Federal Reserve reports (PDF).

New restrictions on credit-card issuers that were meant to protect consumers have made it harder for small business owners to tap credit-card financing. Take the regulation barring issuers from re-pricing credit card loans when borrowers’ creditworthiness falls. This change has increased credit-card issuers risk of loss and led them to increase the interest rate spread on their loans, according to an additional Federal Reserve report.

Higher interest rates necessarily mean that small companies need to pay more to borrow funds. Second, fewer small businesses can get loans. The inability to re-price loans has made the high risk segment of the credit-card market less profitable to lenders, causing many of them to reduce their participation in that part of the market. As a result, a sizable minority of high-risk small business borrowers that once obtained credit-card loans can no longer get them.

The Consumer Financial Protection Bureau’s efforts to regulate mortgage loans provide a further example of how policy makers’ response to the financial crisis inflicted collateral damage that’s expected to hit business owners’ efforts to access credit. The new “ability-to-repay rule” going into effect in 2014 limits most qualified loans to borrowers whose ratio of debt to income does not exceed 43 percent. The rule will adversely affect small business access to credit because some business owners tap home equity to finance their businesses, and some of them have debt-to-income ratios of greater than 43 percent.

Moreover, small business owners have a harder time than other borrowers to demonstrate their ability to repay loans. Lenders’ reliance on such standard forms of documentation as W-2 forms, which don’t readily demonstrate small business owners’ income, combined with concern about punishment for breaking the new rule, will make it more difficult for these borrowers to obtain mortgage loans.

In the interconnected world of finance, efforts of regulators to respond to the financial crisis have made accessing credit more difficult for small business owners. While the new rules aren’t the primary cause of the decline in small business credit since the financial crisis, they don’t help those markets return to pre-financial crisis levels.