The Financial Crisis Affects Small Business

Executive Summary
How did the financial crisis that began in 2008 affect credit markets in the U.S.? Anecdotal evidence suggested that small businesses, which largely rely upon banks for credit, were especially hard hit. In this study, we analyze data on small-business lending collected by U.S. banking regulators to provide new evidence on how bank credit, in general, and bank credit to small businesses, in particular, were affected by the financial crisis. These data show that bank lending to small firms rose from $308 billion in June 1994 to a peak of $659 billion in June 2008 but then plummeted to only $543 billion in June 2011—a decline of $116 billion or almost 18%. Bank lending to all firms rose from $758 billion in 1994 to a peak of $2.14 trillion in June 2008 and then declined by about 9% to $1.96 trillion as of June 2011. Hence, the decline in bank lending was far more severe for small businesses than for larger firms.
We use a panel regression model with both bank- and year-fixed effects to analyze changes in bank lending in a multivariate setting. Our regression model includes controls for bank size and financial condition. Our multivariate regression results largely confirm what we see in the raw data—bank lending to all businesses and, in particular, to small businesses, declined precipitously following onset of the financial crisis, and hit commercial & industrial lending far more severely than commercial real estate lending.
We also examine the relative changes in business lending by banks that did, and did not, receive TARP funds from the U.S. Treasury following onset of the crisis in 2008. U.S. bank regulators injected more than $200 billion in capital into more than 900 banks, largely in hopes of stimulating bank lending, especially lending to small firms. Our analysis reveals that banks receiving capital injections from the TARP failed to increase their small-business lending; instead, they decreased their small-business lending by even more than other banks. This evidence shows that the TARP’s Capital Purchase Program was largely a failure in this respect.
Our study also provides important new evidence on the determinants of business lending. First, we find a strong and significant positive relation between bank capital adequacy and business lending, especially lending to small businesses. This new evidence refutes claims by the U.S. banking industry that higher capital standards would reduce business lending and hurt the economy. Instead, it shows that higher capital standards would improve the availability of credit to U.S. firms, especially to small businesses.
Second, we find a strong and significant negative relation between bank size and business lending. This new evidence suggests that proposals to reduce the size of the largest banks would likely lead to more business lending.
Third, we find a strong and significant negative relation between bank profitability and business lending. This new evidence is consistent with moral hazard induced by deposit insurance, which leads unprofitable banks to increase their risk exposure so as to exploit the subsidy from deposit insurance.
Fourth, we find a strong and significant positive relation between our indicator for de novo banks and business lending. This new evidence complements existing studies of lending by de novo banks and suggests that regulators should enact policies to encourage the formation of new banks as one way to increase business lending.
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How Did the Financial Crisis Affect Small-Business Lending in the U.S.?
1. Introduction
When the U.S. residential housing bubble burst in 2007 – 2008, credit markets in the U.S. and around the world seized up. Lax underwriting standards saddled U.S. banks, large and small, with levels of nonperforming loans not seen since the banking crisis of the late 1980s. During 2009, the FDIC closed more than 100 banks for the first time since 1992; and during 2009 – 2011, a total of 397 banks failed. As of year-end 2011, 813 banks appeared on the FDIC’s list of problem institutions, up more than an order of magnitude from a mere 76 as of year-end 2007, but down from a high of almost 900 as of year-end 2010. Almost 600 additional banks disappeared as a result of mergers, with the majority being motivated by capital-adequacy issues.
Anecdotal evidence suggests that small businesses, which largely rely upon banks for credit, were especially hard hit by the financial crisis.1 In addition, the Federal Reserve System’s quarterly Senior Loan Officer Opinion Survey on Bank Lending Practices found evidence that lending standards for small-business loans tightened during 2008 – 2009, as lenders’ tolerances for risk decreased following onset of the crisis.2 In response to the financial crisis, Congress passed a number of laws aimed at boosting the availability of capital to small businesses, beginning with the Troubled Asset Relief Plan (“TARP”) in 2008.
The availability of credit is one of the most fundamental issues facing a small business and therefore, has received much attention in the academic literature (See, for example, Petersen and Rajan, 1994; Berger and Udell, 1995, 1998; Cole, 1998; Cole, Goldberg and White, 2004). In this study, we extend this literature by analyzing data on small-business lending collected by
1 Using data from the Federal Reserve’s 1993, 1998 and 2003 Surveys of Small Business Finances, Cole (2010) finds that about 60 percent of all small firms use some form of bank credit.
2 The surveys can be found at http://www.federalreserve.gov/boarddocs/snloansurvey/.
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U.S. banking regulators to provide new evidence on how the financial crisis affected bank lending to small businesses. Our analysis reveals that, over the period from 2008 – 2011, small-business lending declined by $116 billion, or almost 18%, from $659 billion to only $543 billion.3 Small commercial & industrial lending declined by even more, falling by more than 20% over the same period. Worse yet, there is no evidence that the bottom had been reached by year-end 2011.
We also examine the relative changes in small-business lending by banks that did, and did not, receive funds from the Troubled Asset Relief Program. As part of the TARP, the U.S. Treasury injected more than $200 billion of capital into more than 700 U.S. banking organizations to stabilize their subsidiary banks and promote lending, especially lending to small businesses. This effort is more formally known as the Capital Purchase Program (“CPP”), which began in late October of 2008 with capital injections into the eight largest bank holding companies.4 The success of CPP in promoting lending, in general, and small-business lending, in particular, has not been rigorously assessed until now.
Here, we provide the first rigorous evidence on how successful, or, more accurately, how unsuccessful the CPP turned out to be. Our evidence points to serious failure, as small-business lending by banks participating in the CPP fell by even more than at banks not receiving CPP funds. In other words, TARP banks took the taxpayers’ money, but then cut back on lending by even more than banks not receiving taxpayer dollars.
3 See Appendix Table 1, which is based upon annual data provided by the June Call Reports.
4 On Oct. 28, Citibank, J.P. Morgan Chase, and Wells Fargo each received $25 billion, Bank of America received $15 billion, Goldman Sachs and Morgan Stanley (both primarily investment rather than commercial banks) each received $10 billion, and Bank of New York and State Street received $3 billion and $2 billion, respectively. On Nov. 14, an additional 21 banks received a total $33.6 billion.
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Why is this analysis of importance? According to the U.S. Department of Treasury and Internal Revenue Service, there were more than 23 million nonfarm sole proprietorships, more than 2 million partnerships with less than $1 million in assets, and more than 5 million corporations with less than $1 million in assets that filed tax returns for 2006.5 Small firms are vital to the U.S. economy. According to the U.S. Small Business Administration, small businesses account for half of all U.S. private-sector employment and produced 64% of net job growth in the U.S. between 1993 and 2008.6 Therefore, a better understanding of how bank credit to small businesses was affected by the financial crisis can help policymakers to take actions that will lead to more credit, which will translate into more jobs and faster economic growth.
We contribute to the literature on the availability of credit to small businesses in at least six important ways. First, we provide the first rigorous analysis of how severely bank lending to small businesses in the U.S. was curtailed by the financial crisis. Both theory, dating back to Schumpeter (1934),7 and more recent empirical research (e.g., King and Levine, 1993a, 1993b; Rajan and Zingales, 1998) indicate that capital-constrained firms grow more slowly, hire fewer workers and make fewer productive investments than firms utilizing debt in their capital
5 See the U.S. Internal Revenue Service statistics for nonfarm sole proprietorships at http://www.irs.gov/taxstats/indtaxstats/article/0,,id=134481,00.html, for partnerships at http://www.irs.gov/taxstats/bustaxstats/article/0,,id=97153,00.html, and for corporations at http://www.irs.gov/taxstats/bustaxstats/article/0,,id=97145,00.html. The year 2006 is used for reference because it was the latest year for which statistics were available at the time this article was written.
6 See, “Frequently Asked Questions,” Office of Advocacy, U.S. Small Business Administration (2009). For research purposes, the SBA and Federal Reserve Board define small businesses as independent firms with fewer than 500 employees. We follow that definition in this research.
7 Aghion and Howitt (1988) provide a comprehensive exposition of Schumpeter’s theory of economic growth.
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structure. A better understanding of how the financial crisis impacted bank lending to small businesses should provide policymakers with guidance in how to tailor economic and tax policies to boost bank lending to small firms, thereby increasing both employment and GDP.
Second, we provide the first rigorous evidence on the success or failure of the Capital Purchase Program in boosting bank lending to small firms. More than $200 billion in taxpayer dollars was invested in this program, which officially ended on April 3, 2011, with an expected loss (according to the U.S. Congressional Budget Office) of more than $25 billion. Our results strongly suggest that this program failed to boost lending to small businesses, or to businesses of any size, by banks that received capital injections. Instead, participating banks cut back on business lending by even more than did non-participating banks.
Third, we provide new evidence on the relation between capital adequacy and bank lending. We document a strong and robust positive relation between a bank’s capital ratio and its subsequent change in business lending. This has important policy implications as bank regulators in both the U.S. and around the world consider raising minimum capital ratios for banks in response to the outcome of the financial crisis. Our new evidence supports a move to higher capital requirements and refutes claims by banking industry lobbyists that higher capital requirements would reduce bank lending. To the contrary, we show that higher capital standards would improve the availability of credit to U.S. firms, especially to small businesses.
Fourth, we find a strong and significant negative relation between bank size and business lending. This has important policy implications as bank regulators consider proposals to limit and/or reduce the size of banks. Our new evidence suggests that proposals to reduce the size of the largest banks would lead to more business lending.
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Fifth, we find a strong and significant negative relation between bank profitability and business lending. This new evidence is consistent with moral hazard induced by deposit insurance, which leads unprofitable banks to increase their risk exposure so as to exploit the subsidy from deposit insurance.
Finally, we find a strong and significant positive relation between our indicator for de novo banks and business lending. This new evidence complements existing studies of lending by de novo banks and suggests that regulators should enact policies to encourage the formation of new banks as one way to increase business lending.