Fintech, Small Business & the American Dream

by Karen G Mills

  The Financial Crisis

  For many years, little national attention was paid to the issue of small business access to capital. The U.S. economy, including small businesses, seemed to be doing well in the mid-2000s. Economic growth had been consistent, if not spectacular, for several years. Few financial policy experts, much less small business owners, understood the risk building up in the financial system due to soaring home prices, exotic financial products, and highly leveraged investment banks. They certainly did not foresee that it would all come crashing down, sparking the most severe economic downturn since the Great Depression.

  The Great Recession harmed the economy broadly, but small businesses were hit harder than most sectors. Between 2007 and 2012, small businesses employed 50 percent of the private sector workforce, but accounted for over 60 percent of the net job losses in the economy (Figure 3.1).

  Figure 3.1 Small Firms were Hit Harder in Crisis, Representing Over 60 Percent of Job Losses

  Net Job Gains or Job Losses by Firm Size (‘000s of Jobs)

  Source: Bureau of Labor Statistics, Business Employment Dynamics, Table E—Quarterly net change by firm size class, seasonally adjusted.

  Small businesses were hurt more, in part, because they have fewer financing options than larger firms. Large companies can raise money by issuing and selling debt to investors in capital markets (and in the Great Recession, they could take on this debt at historically low interest rates). Larger firms have these options because they usually have longer, more established track records, less volatile incomes and profitability, and are considered less risky to lend to than smaller firms. In addition, they borrow in the larger amounts that debt markets have traditionally required. Small businesses depend on banks, and when banks are in trouble, as many were during the Great Recession, they tap (or slam) the brakes on lending.

  During the financial crisis, banks and their regulators realized that the huge numbers of mortgages and financial products based on mortgages on their books were much riskier than previously thought. As the value of these assets dropped, banks didn’t have the capital and reserves they thought they had. To get back into regulatory compliance, some banks ended up allocating less money to small business lending. The four largest banks—Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo—dramatically reduced lending to small businesses, relatively more than the rest of the sector. Loan originations for these top four banks fell to just 50 percent of pre-crisis levels and remained there through 2014.7

  In addition, many community banks failed during the crisis. From 2007 through 2013, the number of U.S. banks declined by 800, including a 41 percent drop in the number of the smallest banks (those with less than $50 million in assets).8 Since community banks are disproportionately large lenders to small businesses, this was an additional disruptive force preventing small businesses from accessing capital during the recession.9

  Economic research demonstrates that credit markets act as “financial accelerators” that amplify both periods of growth and downturns for small businesses that rely on bank financing. One influential 1994 study showed that small firms contract significantly more than large firms when credit conditions are tight.10 More recent research found that firms that are more dependent on banks for their financing suffer more during banking crises.11 The Great Recession fit the pattern of previous financial crises in which the risk of unemployment was higher for people working in a sector that was more dependent on external financing. In effect, firms that couldn’t secure enough capital from banks to fund their operations had to downsize.12 Another analysis of the crisis found that, among all firms dependent on bank financing, small and medium-sized firms experienced the greatest drops in employment, partly due to the costs of switching lenders when their original lender ran into trouble.13

  Government’s Response to the Great Recession

  By January 2009, it was clear that there was a crisis in small business lending. Lehman Brothers had failed, and banks were suddenly facing uncertain times. Some of the most important U.S. banks were calculating their balance sheets every few hours to see if they were bankrupt or could continue operating. Small business credit markets were frozen. New lending came to a standstill, and, even worse, many small businesses received a surprise phone call from their banker: their lines of credit had suddenly been cancelled—many times not due to anything those businesses had done wrong. Without access to liquidity from their credit lines, small business owners were forced to cut back on spending. This meant anything from delaying an expansion to missing a rent payment to laying off employees.

  In the United States, the federal government knew that small businesses were in trouble, but the full extent of the problem was hard to quantify. In the West Wing of the White House, the economic team gathered in the early days of 2009 to discuss what should be done. The debate was fierce: should banks be forced to lend to small businesses? Should the government step in and lend directly? Were small businesses still creditworthy? What level of defaults should the government be willing to risk? The discussion was difficult because the exact data needed to define the state of the crisis did not exist. Despite bank regulation and quarterly call reports, there was no real-time collection of small business loan originations.14 Anecdotes, however, were pouring into the White House and into congressional offices from small businesses like the Zavalas’ who were caught in a credit squeeze and had nowhere to turn.

  In the United Kingdom, George Osborne, the Chancellor of the Exchequer, noted that during the crisis, there was not a day that went by when he did not hear from small business constituencies about the depth of their plight.15 As a result, the U.K. government made small business lending a priority, coming to the aid of their four major banks that together made up over 80 percent of small business lending. For the United States, the situation was more complicated. In 2008, the U.S. government took bold action, implementing the Troubled Asset Relief Program (TARP) to provide capital to banks and prevent their collapse. However, TARP legislation did not require that a certain amount of the capital infusion be used to lend to small businesses and keep their credit lines active. Although some banks used the capital for small business lending, most had what they viewed as more pressing needs. Between 2008 and the first quarter of 2012, outstanding small business loans (defined as the stock of commercial and industrial—C&I—loans under $1 million) dropped by 17 percent.16

  In the face of the devastation, the United States had at least one often overlooked asset: a widespread loan guarantee network through the Small Business Administration (SBA). The SBA had relationships with 5,000 banks throughout the country and the ability to guarantee loans—a powerful tool that did not exist in the United Kingdom or many other countries. However, as the financial crisis peaked, even SBA-guaranteed lending had ground to a near halt, as banks pulled back and SBA securitization markets froze. In response, starting in early 2009, the SBA took aggressive steps to boost credit availability for small businesses.17

  Before 2009, the SBA generally guaranteed 75 percent of the value of a loan. In early 2009, Congress passed the American Recovery and Reinvestment Act—popularly known as the stimulus bill—which temporarily raised the guarantee to 90 percent of the loan value, making these loans less risky for lenders to offer.18 In addition, the bill eliminated almost all SBA fees. The combination worked. Using the new guarantees, more than 1,000 banks that had not made an SBA loan since 2007 made at least one during the next six months. The turnaround helped many businesses survive and contributed to three record years of SBA-backed lending from 2011 to 2013.19

  More legislation followed. The Small Business Jobs Act of 2010 contained additional lending and tax support for small businesses. One program, the Small Business Lending Fund (SBLF), provided capital to community banks, with the stipulation that they increase small business lending. According to the U.S. Department of the Treasury (Treasury), the SBLF invested $4 billion in 281 community banks and 51 community development loan funds. S
mall business lending increased by almost $19 billion at those institutions from the time the program began.20,21

  In August 2011, President Obama sat down with small businesses at Northeast Iowa Community College in Peosta, Iowa. One owner was visibly unhappy. His business had a government contract, but had not been paid for nearly a year. From that meeting, the QuickPay program was born. On September 14, the White House directed all government agencies to speed up federal payments to small business contractors from 30 to 15 days.22 This acceleration of payment was designed to increase the cash liquidity of these small business suppliers and offset their need to seek credit in the still tight post-recession markets. The program worked. Payment times were cut in half and firms that received the quicker payments showed higher growth in employment, although the impact was less pronounced in tight labor markets.23 (See box.)

  Impact of QuickPay

  Necole Parker is the Founder and CEO of The ELOCEN Group LLC, a construction and renovation project management firm located in Washington, employing 47 people. The company works with a number of federal agencies, including the Food and Drug Administration, the Bureau of Land Management, and the General Services Administration. Before QuickPay, Necole was constantly in touch with her contracting officers to make sure she got her invoices paid within 30 days. In addition, she had to frequently check to make sure she had enough in the bank to meet payroll. QuickPay’s reduction of the payment cycle from net 30 to net 15 days allowed The ELOCEN Group to have a significant buffer of cash in the bank on a more regular basis. Necole reported that as a result of QuickPay and better cash balances, she was able to convince her bank to increase her line of credit from $250,000 to $1 million. In her words, QuickPay “had an incredible impact, [allowing] us to … provide a better service not only to our clients, but to our subcontractors who help us with our capacity.”24

  The Slow Post-Recession Recovery for Small Business

  Government action helped spur small business lending, but the recovery still took time.25 Employment growth returned in 2010, but it took until mid-2014 for jobs to reach pre-crisis levels26 (Figure 3.2).

  Figure 3.2 Change in Unemployment for Post-WWII Recessions

  Source: “Current Employment Statistics,” Bureau of Labor Statistics; US Business Cycle Expansions and Contractions,” National Bureau of Economic Research; Adapted from Bill McBride, “Update: ‘Scariest jobs chart ever,’” Calculated Risk Blog, February 2, 2018.

  Similarly, lending was slow to come back, as compared to past recessions (Figure 3.3). The levels of total loans in the economy, even eight years after the crisis, were below the recovery levels of any of the previous seven recessions.

  Figure 3.3 Growth in Bank Lending Since the End of the Recession

  Source: “Financial Accounts of the United States,” Federal Reserve; Adapted from Steven T. Mnuchin and Craig S. Phillips, “A Financial System That Creates Economic Opportunities: Banks and Credit Unions,” U.S. Department of the Treasury, June 2017.

  The story of post-crisis bank lending was different for small and large businesses. The volume of C&I loans under $1 million dropped substantially during the Great Recession, and only reached its pre-crisis level in 2016. Larger loans, usually made to larger businesses, also dropped during the recession, but recovered more quickly and continue to grow at a rapid rate (Figure 3.4).

  Figure 3.4 Comparison of Change in Small vs. Large Business Loans

  Source: FDIC Quarterly Banking Profile Time Series Data; Adapted from Steven T. Mnuchin and Craig S. Phillips, “A Financial System That Creates Economic Opportunities: Banks and Credit Unions,” U.S. Department of the Treasury, June 2017.

  Why was the recovery so slow for small business lending? The financial crisis caused cyclical damage to both small businesses and small business lenders, which was deep and lasted well beyond the official end of the crisis. As a result of this trauma, small businesses became less creditworthy and banks became more risk-averse, in ways that took years to reverse.

  Cyclical Damage to Small Business Lending

  One version of the narrative in the period after the financial crisis was that the market was functioning as it should: banks were not providing loans to small businesses because they weren’t creditworthy. In the post-recession period, bankers believed that they were making loans to all viable small business owners.27 At the same time, small business owners were telling stories of going from bank to bank and being rejected. The reality was likely a combination of a decrease in demand by recession-damaged small businesses and a slow recovery of supply by the banks.

  Lending has always been simple at its core: banks make loans when they are reasonably confident they will be repaid. Banks ask themselves many questions when deciding whether to lend to a small business: does the firm have a good chance at sustained profitability? Is it managed well? Can it put up collateral to reduce the risk of making the loan? Can it find the workers it needs to start or expand? Do the owners have a track record of success and paying their debts on time? Is the economic outlook positive?

  During the Great Recession, it became harder for banks to get to “yes” on these questions. The prime culprits were cyclical issues: declining revenues, damaged collateral for potential borrowers, and more risk-averse lenders facing new regulatory pressures.

  Declining Revenues

  During a recession, revenues can decline even for otherwise healthy companies. For about four years after August 2008, small businesses reported disappointing sales as their biggest problem.28 The Wells Fargo/Gallup Small Business Index shows that, from 2004 to early 2008, 40 to 50 percent of small businesses reported increased revenue in the previous year. That metric plummeted to 21 percent following the crisis and did not return to above 40 percent until the second half of 2014.29 These revenue issues had lasting effects. Even when revenues improved during the recovery, the tough times that many small businesses went through in the recession made potential borrowers, like the Zavalas, look less attractive to banks.

  Collateral Damage

  If a bank can take possession of collateral assets when the borrower defaults on a loan, the loan is less risky to make. Home equity has traditionally played an important role in financing small businesses.30 Unfortunately, the financial crisis wreaked havoc on this collateral, in large part because the crisis was built on an unsustainable bubble in the value of home prices. Once the bubble burst, home values dropped substantially, erasing trillions in asset value.

  We do not know for sure how many small businesses finance themselves using their homes as collateral for a loan or a home equity line of credit (HELOC). In 2007, at the peak of U.S. home prices, the estimate was as high as 56 percent.31 However, in 2011, after the collapse, a survey by the National Federation of Independent Business (NFIB) found that only 22 percent of small business employers either took equity from their homes and used it for their businesses or used their homes as collateral to finance their businesses. The collapse also left nearly a quarter of small business owners underwater on their home mortgages.32

  Risk Aversion

  In late 2007, with their balance sheets reeling and the devastating effects of risky loans like subprime mortgages fresh in their minds, banks began to tighten their credit standards. At the peak of the crisis in 2009, over 70 percent of senior loan officers surveyed by the Federal Reserve said that they were tightening their credit standards, including higher collateral requirements, calling in loans ahead of maturity, increasing the amount of equity businesses needed for new loans, and increasing personal credit thresholds. Credit standards remained tight until 2010, and only loosened slowly in the following years (Figure 3.5).

  Figure 3.5 Tightening Credit Standards for Small Businesses

  Quarterly Percentage of Bankers Reporting Net Tightening or Loosening of Loan Conditions

  Source: “Net Tightening or Loosening of Financial Conditions for Small Businesses,” Federal Reserve’s Senior Loan Officer Survey.

  Regulatory Overh
ang

  An excessive regulatory burden was at least in part to blame for the slow post-crisis recovery in small business lending. The Dodd-Frank Act required hundreds of new rules and regulations to be written, and U.S. regulatory agencies opted to develop others. One study found that regulation after the recession reduced the incentives for all banks to make very small loans, and also reduced the viability of banks with assets of less than $300 million.33 Since Dodd-Frank, the small loan share at larger banks fell by nine percentage points, while the magnitude of the decline was twice as great at small banks.

  A 2016 Bipartisan Policy Center paper found that while post-crisis reforms had generally made the financial system and consumers safer, they had also created unintended consequences. Some regulations were unnecessarily duplicative, or even in conflict with each other, causing firms to stop offering certain services.34 Attempts have been made to quantify the costs of compliance to banks.35 The American Action Forum estimated in 2016 that the Dodd-Frank Act had imposed more than $36 billion in final rule costs and 73 million hours of paperwork.36 Estimates published in the Federal Register pegged the cost much lower, at $10.4 billion.37 Other estimates of the total compliance cost to the industry vary widely.