Understanding Small Business Lending: Differences between Small and Large Banks, Exercises of Object Oriented Analysis and Design

Download Understanding Small Business Lending: Differences between Small and Large Banks and more Exercises Object Oriented Analysis and Design in PDF only on Docsity! Small Business Lending Survey 5 SECTION 1. Introduction 1 On the need for access to credit, see Titan Alon et al., “Older and Slower: The Startup Deficit’s Lasting Effects on Aggregate Productivity Growth,” Journal of Monetary Economics 93 (2018): 68–85, https://doi.org/10.1016/j.jmoneco.2017.10.004; and Thor- sten Beck, Asli Demirgüç-Kunt, and Vojislav Maksimovic, “Financial and Legal Constraints to Growth: Does Firm Size Matter?” Journal of Finance 60, no.1 (2005): 137–77. On the role of banks, see Federal Reserve System, “Report on Employer Firms,” Small Business Credit Survey, April 2017. https://www.newyorkfed.org/medialibrary/media/smallbusiness/2016/SBCS-Report-Em- ployerFirms-2016.pdf; and Federal Reserve Bank of Cleveland. 2016 Small Business Credit Survey Report on Microbusinesses: Nonemployer and Small Employer Firms. November 2017. https://clevelandfed.org/global%20search?q=2016+Small+Business+- Survey%3A+Report+on+Microbusinesses%3A+Nonemployer+and+Small+Employer+Firms.+Published+November+2017.+Fed- eral+Reserve+Bank+of+Cleveland. 2 On the advantages of banks relative to other external credit options, see Gregory Udell, “What’s in a Relationship? The Case of Commercial Lending,” Business Horizons 51 (2008): 93–10. 3 On the importance of small businesses to the U.S. economy, see U.S. Small Business Administration, Office of Advocacy, Fre- quently Asked Question (2017), https://www.sba.gov/sites/default/files/advocacy/SB-FAQ-2017-WEB.pdf. 4 For a full description of the structural changes in the industry, see Federal Deposit Insurance Corporation, FDIC Community Banking Study, December 2012, https://www.fdic.gov/regulations/resources/cbi/report/cbi-full.pdf; and Eric C. Breitenstein and Nathan Hinton, “Community Bank Mergers since the Financial Crisis: How Acquired Community Banks Compared with Their Peers,” FDIC Quarterly 11, no. 4 (2017): 41–52, https://www.fdic.gov/bank/analytical/quarterly/2017-vol11-4/fdic-v11n4-3q2017- article2.pdf. 5 The Call Report measure is the sum (reported to regulators) of outstanding small commercial and industrial loans, small commer- cial real estate loans, and small agricultural and farmland loans. See the box at the beginning of Section 2 for a discussion of the small business lending captured by regulatory Call Reports. The survival and growth of small businesses depends on access to credit, and banks are the most common source of external credit for small firms.1 Banks are able to provide this degree of financing because they have a special ability to identify creditworthy small businesses that often lack verifiable evidence of their quality.2 Yet, despite the importance of banks to small businesses and the importance of small businesses to the larger economy, very little comprehensive information is available about small business lending by banks.3 In particular, evidence is scarce about how banks define small business lending, what approaches they take to meet the needs of these customers, and whether small banks and large banks approach small business lending in significantly different ways. The need for such information is important given the trends in the banking industry since the Great Recession. One such trend is consolidation: between 2008 and 2017 the number of small banks in the country dropped by nearly a third and small-bank assets dropped by more than 14 percent, whereas large banks increased their assets by 13 percent (in this report, small banks are defined as those with under $10 billion in assets, and large banks as those with at least $10 billion in assets).4 Even so, at the end of 2017 small banks, though holding only 17 percent of banking assets, held nearly 53 percent of small loans to businesses (according to the Call Report measure for small business lending).5 Another trend is the decline in the number of bank branches. In 2017 there were nearly 10 percent fewer branches in operation— for all sizes of banks—than there had been in 2008. The critical question, then, is how the continuation of these trends is likely to affect the availability of credit to small businesses. The answer to that question requires a many-faceted answer to a different question: how do banks manage their small business lending, and in particular do small banks differ from large banks and are any such differences likely to affect small businesses? The established understanding of small business lending is that small and large banks do differ in the practices they use, the geographic areas they serve, and the types of information on which they 6 FEDERAL DEPOSIT INSURANCE CORPORATION Section 1 base their decisions (see the box for detail on these differences). One implication is that the continued decline of small banks could have significant adverse effects on access to credit by these banks’ small business customers even if large banks continued to operate in the affected geographic area. This concern is most acute for firms that have little quantifiable evidence of their creditworthiness—most notably, start-ups. Although some evidence exists that is consistent with the established view of differences between small and large banks, no nationally representative survey has asked banks of all sizes to describe how they conduct small business lending, making it difficult to understand the possible implications of these practices for small businesses’ access to credit in the future. To fill this knowledge gap, the Federal Deposit Insurance Corporation recently conducted the Small Business Lending Survey (SBLS) to collect RELATIONSHIP LENDING AND TRANSACTIONAL LENDING The consensus explanation for banks’ centrality to small business finance is that banks have a unique ability to generate information that allows them to identify the high-quality small firm and, by extension, the profitable small business loan.a Although all banks are thought to use a variety of methods to identify high-quality small businesses, small and large banks are widely considered to hold distinct advantages in how they generate information. As a result, small and large banks are expected to manage their small business lending programs differently. Specifically, small banks are regarded as having a comparative advantage in gathering and using “soft” information—knowledge of both the local community and the small businesses within it— which the bank has accumulated over multiple interactions, and which is hard to quantify or transmit. Small banks are typically located within the communities they serve, which therefore lowers the transaction costs of engaging with and monitoring the firm or of gathering knowledge of the local market. Further, small banks are usually closely held organizations with few managerial layers between bank owners and loan officers, so that the loan officer may be more motivated to gather and use soft information when deciding whether to grant a business loan.b Small banks are therefore considered more flexible and able to engage with small businesses on a case-by-case basis. It is for these reasons that small banks as a group are believed to specialize their commercial and industrial lending to small businesses and are typically called relationship lenders. Large banks are regarded as taking advantage of economies of scale to gather and use large amounts of quantifiable, or “hard,” information about the borrower. This reliance on hard information requires that bank management specify the types of data used as well as the metrics for determining small business quality, usually well before any business applies for a loan. Further, since the information used by large banks is quantifiable, it can be submitted and shared electronically, which may reduce the need for the large bank decisionmakers to be in close proximity to the small business. This structure facilitates a high- volume small business lending model, and is often referred to as transactional lending. a Udell, “What’s in a Relationship?” b Allen N. Berger and Gregory F. Udell, “Small Business Credit Availability and Relationship Lending: The Importance of Bank Organisational Structure,” Economic Journal 112, no. 477 (2002): 32–53; and Jeremy C. Stein, “Information Produc- tion and Capital Allocation: Decentralized versus Hierarchical Firms.” Journal of Finance 57, no. 5 (2002): 1891–921, https:// doi.org/10.1111/0022-1082.00483.