What is clear is that increased regulation raised costs for banks, which made it costlier to lend and likely caused some financial firms to reduce or eliminate their lending to small firms. The regulatory burden seems to have fallen on smaller banks the hardest. In a 2013 paper, the Federal Reserve Bank of Minneapolis found that the smallest banks, those with assets of less than $50 million, suffered the greatest hit to their profitability from having to hire compliance staff.38 This makes intuitive sense because the smallest banks have the fewest employees, so having to hire one more person for compliance costs relatively more than it does for a large bank that already has a robust compliance department. A 2016 paper from the Federal Reserve Bank of St. Louis presented evidence confirming that “compliance costs at banks with assets of less than $100 million represented more than 8 percent of noninterest expense, while the same costs at banks with assets of between $1 billion and $10 billion represented less than 3 percent of noninterest expense.”39
An Improved Funding Environment
Despite these issues, credit markets eventually improved. The 2017 Federal Reserve Small Business Credit Survey showed that over 46 percent of respondents said they had received all of the funding they applied for, up from 40 percent of respondents in the previous year40 (Figure 3.6).
Figure 3.6 Small Business Funding Has Improved
Amount of financing approved (percentage of applicants)
Source: “2017 Small Business Credit Survey: Report on Employer Firms,” Federal Reserve Banks, May 2018.
Note: Values may not total 100 percent due to rounding. Data from the 2014 and 2015 surveys is not included due to differences in sampling.
It is important to note that this number should not be close to 100 percent. Some small businesses are not creditworthy enough to qualify for the full amount they request, and lending to them would likely result in poor outcomes both for the lender and the small business owner. However, we also do not want a market gap in which many creditworthy small business borrowers are being turned away.
Unfortunately, there is evidence that, despite the improved environment, a credit gap did continue. Even as late as 2017, small business loan assets held at U.S. banks had not reached pre-recession levels. In fact, by 2017, the share of small business loans as a percentage of all business loans at banks had dropped to about 20 percent, down from over 30 percent before the crisis (Figure 3.7).
Figure 3.7 Small Business Loans at U.S. Banks, 1995–2017
Source: Author’s analysis of FDIC Quarterly Banking Profile Time Series Data.
Note: Small business loans are defined as those under $1 million.
* * *
If the cyclical pressures had receded, then why was bank lending to small business still so low? Small business lending was also affected by structural changes, which had begun before the Great Recession, were exacerbated by the crisis, and continued in its aftermath. In the next chapters, we will explore these changes in the structure of the banking industry and the response of fintech entrepreneurs who identified the unmet needs of small business owners seeking capital. The crisis and the sluggish recovery opened the door to a technology-driven revolution in small business lending that may be changing the game for small business owners like the Zavalas. To understand the impact that technology and fintech innovation will have, we need to go back to the trajectory of the last 40 years of U.S. banking and explore the structural decline of community banks, on which small businesses have relied for their capital needs.
© The Author(s) 2018
Karen G. MillsFintech, Small Business & the American Dreamhttps://doi.org/10.1007/978-3-030-03620-1_4
4. Structural Obstacles Slow Small Business Lending
Karen G. Mills1
(1)Harvard Business School, Harvard University, Boston, MA, USA
Karen G. Mills
Email: [email protected]
In 2016, Rich Square, North Carolina—population a bit south of 1,000—found itself without a bank branch for the first time in more than 100 years.1 Nearby Roxobel had lost its only branch in 2014, forcing small business owner Tommy Davis to drive 25 minutes each way to make deposits at his bank. Davis was not the only time-strapped small business owner facing this issue. These banks are the lifeblood of many local communities—rural and urban—and their small business ecosystems.
The financial crisis and the slow thawing of credit in the recovery that followed affected small businesses more than many others. But there were troubling signs for small business lending in the U.S. economy long before the crisis hit. The number of community banks, which have always been more likely to lend to small firms, had been declining since the 1980s. The Federal Reserve Bank of Cleveland summarized another problem: “The factors unleashed by the financial crisis and the Great Recession added to a longer-term trend. Banks have been shifting activity away from the small business credit market since the late 1990s, as they have consolidated and sought out more profitable sectors of the credit market.”2
As we saw in Chapter 3, the increase in post-crisis regulation caused a disproportionate burden to small banks, which affected small businesses’ access to capital. Some believe that if these regulations were reversed, small community banks would flourish again as they returned to their roles as the providers of smaller loans to local small businesses with whom they had relationships. But structural changes in the banking industry were also a root cause of the problem. Thus, the solutions are not as simple as just a rollback in regulations.
Small Businesses Rely on Community Banks
Community banks are an important thread in our story because they provide a disproportionate share of loans to small businesses. In 2017, small business loan approval rates were 68 percent at small banks versus 56 percent at larger banks.3 Given this, it is not surprising to find that, when compared with large banks, community banks dedicate a higher share of their assets to small business lending. In 2017, the smallest community banks held just 7 percent of the assets in the banking industry, but made 17 percent of the loans to businesses4 (Figure 4.1).
Figure 4.1 Community Banks Provide a Disproportionate Share of Small Business Loans
Source: Author’s analysis of FDIC Statistics on Depository Institutions Report, 2nd Quarter 2018.
Note: Small banks are defined as those with $1 billion in assets or less, and mid-sized banks as those between $1 billion and $10 billion in assets. The largest banks are those with assets over $250 billion. Small business loans consist of commercial and industrial loans of $1 million or less.
What is it about community banks, their local presence, and the relationships they build that is so important in small business lending?5
Defining Community Banks
It’s helpful to be explicit about what a community bank is. As with small businesses, there is no universally agreed-upon definition. The term most often refers to banks that are small—generally with less than $1 billion in assets, but sometimes going up to $10 billion—do business within a limited geographical area, and are focused on traditional lending and deposit-taking.
These banks do not have the resources, geographic footprint, or diverse product offerings that larger banks often possess, but they tend to know the communities they serve more intimately.
To understand the advantage a community bank might have in making loans, imagine that Michelle owns an ice cream parlor and wants to open a second one across town. She runs into problems securing the financing she needs because three years ago, she was late on several loan payments, a red flag for lenders. However, a local banker who knows Michelle personally may understand that the reason for the late payments was a family medical emergency, that other locals vouch for Michelle’s character and ability, and that her credit is otherwise spotless. That banker will likely consider Michelle a better credit risk than she would appear if her numbers were run through a standardized formula.
Small firms tend to be more “informationally opaque”—that is, they don’t have as much pu
blicly available, transparent information for lenders to review as larger companies would have. Local banks are more able to invest the time and personnel to build closer relationships with borrowers, which then makes it easier for them to assess a borrower’s creditworthiness.6 The economic literature indicates that larger banks are more likely to rely on standardized, quantitative criteria when deciding whether to make a loan to a small firm, while smaller banks are more likely to use qualitative criteria that look beyond the numbers to the applicants’ personal qualities.7,8
Focusing on local markets and having more insights into the borrower may be an advantage for community banks. One study found that loans performed better when borrowers were located closer to their lenders. Borrowers 25 to 50 miles from the lending bank were 10.8 percent more likely to default on a loan, while those located 50 or more miles away were 22.1 percent more likely to default.9
Relationship lending can have additional benefits, including providing the function of monitoring loans and counseling small businesses after the loans have been made. About three-quarters of borrowers ask bankers or lenders for financing advice, making these sustained relationships valuable for the borrowers, who can run more successful businesses as a result, and for the lenders, who can provide more credit and other financial services to those businesses over time.10 Research found that firms with longer-term banking relationships experienced stronger credit growth and lower interest rates during a financial crisis, and maintained greater investment and employment growth than firms that did not have such relationships.11
With higher approval rates and a focus on relationship banking, small businesses are more likely to hear a “yes” in response to their application at local banks than they are at larger banks. Thus, it is no surprise that community banks are more highly rated when it comes to customer satisfaction. In 2016, small banks had a satisfaction rate of 80 percent, similar to credit unions and Community Development Financial Institutions (CDFIs). Meanwhile, satisfaction for large banks sat at just 61 percent and online lenders trailed the pack at only 46 percent (Figure 4.2).
Figure 4.2 Borrower Satisfaction by Institution Type
Percentage of borrowers satisfied
Source: “2016 Small Business Credit Survey: Report on Employer Firms,” Federal Reserve Banks, April 2017.
The Decline of Community Banks
Not every country has a large ecosystem of community banks serving small businesses locally. In order to understand how this came about in America, we need to go back 200 years to the early days of the Republic. Since the time of our Founding Fathers, many Americans have been skeptical of an energetic government and a powerful financial system, such as the one Alexander Hamilton advocated, and have more or less sided with Thomas Jefferson, who favored decentralized and relatively weak government. The history of U.S. central banking is a microcosm of this ongoing conflict. Congress created two central banks, in 1791 and 1816, only to see both charters expire under Presidents Jefferson and Jackson. The creation of the third central bank, the Federal Reserve, only happened after a difficult and acrimonious political battle in the early 1900s.
As a result, the U.S. banking system was often chaotic, with state-chartered “wildcat” banks proliferating between 1816 and the Civil War, along with more frequent banking crises than in many other Western countries. The number of U.S. banks boomed with more than 10,000 commercial banks operating by the mid-1890s. By 1921, there were more than 30,000 banks in the country, an all-time high.12 The vast majority were small and focused on serving their local communities.
After a series of failures in the 1920s and 1930s largely due to the agricultural depression of the 1920s and the Great Depression that followed, the number of U.S. banks dropped to about 15,000 and stayed roughly around that level until the 1980s. But midway through 2018, only about 4,800 commercial banks remained. Through failure, consolidation, and mergers, the number of U.S. banks had dwindled, even while the banking sector had grown much larger13 (Figure 4.3).
Figure 4.3 Banks are Declining, 1984–2018
Source: FRED Economic Data, Federal Reserve Bank of St. Louis.
The Banking System Has Been Growing More Concentrated
As the number of lenders was decreasing, assets in the U.S. banking system were becoming increasingly concentrated in a small number of larger banks. From 1984 to 2017, while the number of banks declined by 66 percent, the total assets in the industry grew from $3.7 trillion to $17.4 trillion.14 Almost all of that growth went to non-community banks (Figure 4.4).
Figure 4.4 Total Assets by Type of Bank
Source: Adapted from FDIC community banking research project, “Community Banking by the Numbers,” February 16, 2012.
Note: For the FDIC definition of large and small community banks, as well as non-community banks, see: https://www.fdic.gov/regulations/resources/cbi/report/cbsi-1.pdf.
The largest banks have seen the lion’s share of this growth. The assets of the four largest banks grew from $228 billion (6 percent of total banking assets) in 1984 to $6.1 trillion (44 percent of total banking assets) in 2011.15 Another way to express the widening gap between the smallest and largest banks is that, in 1984, the average non-community bank was 12 times as large as the average community bank. By 2011, the multiple had grown to 74 times as large.
The size of the average community bank also grew significantly during that time. Banks with assets less than $100 million accounted for essentially the entire decline in the number of bank charters from 1984 to 2011. Meanwhile, the number of community banks between $100 million and $1 billion in assets increased modestly during this period.
Wave of Consolidation
Until the early 1990s, most states limited or prohibited banks from acquiring or opening branches across state lines, while a few states even restricted branching within the state itself. These rules were put into place in the 1920s because policymakers worried that larger, multi-state financial firms would be too hard to supervise. As a result, the number of U.S. banks was kept artificially high.
After large numbers of small banks and thrifts failed during the 1970s and 1980s, Congress decided that the banking system was not concentrated enough.16 They came to believe that small, local banks were too susceptible to local economic conditions, and consolidation would help them diversify their geographic risk. The Riegle-Neal Act of 1994 eliminated most of the restrictions on interstate branching and contributed to a wave of consolidations in the banking sector.
From 1995 to 1998, an average of 5.7 percent of banks consolidated each year. One analysis suggested that this was almost entirely due to mergers and acquisitions, which Riegle-Neal made easier.17 The rate gradually declined, but between 2004 and 2007—prior to the financial crisis and in good economic times—3.7 percent of banks were still merging or consolidating every year. Financial crises also precipitated a decline in the number of community banks. Between 1984 and 2011, 2,555 banks and thrifts failed, mostly during the savings and loan crisis of the early 1990s, and during the 2008 crisis.18
Few New Bank Charters
Of course, bank failures and consolidations are nothing new. In the past, however, new banks would step in to fill some or all of the market gaps left when incumbent banks retreated. In recent years, that has not been the case. From 2000 to 2008, the Federal Deposit Insurance Corporation (FDIC) approved more than 1,000 de novo, or new bank, charter applications.19 Before that, the fewest number of de novo charters approved in any single year was 15 in 1942.20 In contrast, from 2009 to 2016, the FDIC approved a total of just five de novo applications21 (Figure 4.5).
Figure 4.5 Rate of New Bank Formation Declines
Source: FDIC Statistics at a Glance, Historical Trends. Adapted from Kelsey Reichow, “Small-Business Lending Languishes as Community Banking Weakens,” Dallas Fed Economic Letter 12, no. 3, February 2017.
One reason for the slow pace of applications and approvals is that the FDIC and other regulatory agencies h
ave been more cautious since the crisis. De novo banks chartered between 2000 and 2008 were more financially fragile and failed at a higher rate than more established small banks.22 After the 2008 crisis, regulators required a higher level of capital at banks to make them safer, and many would-be bankers saw the application process as too difficult and the level of regulation as too onerous. The FDIC has taken steps to make the process easier, and higher interest rates sparked a slight increase, but the number of applications for new banks remains historically low.
Impact of Low Interest Rates
It may be more than economies of scale that are weighing on the ability of small banks to compete. Former FDIC Chairman Martin Gruenberg is among those who have blamed long-term economic conditions for the dearth of new banks, saying that “low interest rates and narrow net interest margins have kept bank profitability ratios well below pre-crisis levels, making it relatively unattractive to start new banks.”23
There is strong evidence for this point of view. The persistence of historically low interest rates has been challenging for banks, but especially for community banks, which rely more on loan interest income than larger banks. Net interest income as a percentage of community banks’ assets has decreased since the early 1980s.24 The advantage larger banks have over community banks in being able to efficiently generate revenue widened significantly between 1998 and 2011, mostly due to lower interest income.25 In addition, low rates have limited a traditional advantage that community banks had of being able to pay higher interest rates to their depositors.
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