Goldilocks and Small Business Credit

Photograph by Martin Poole/The Image Bank/Getty Images

The Federal Reserve’s effort to manage small business credit is like the story of Goldilocks and the Three Bears. Small business credit can be too hot, with lenders providing too much financing, or it can be too cold, with too little available. The Fed’s job is to get the amount of credit just right, ensuring that the banks provide creditworthy businesses with the capital they need while denying it to those that are too weak to handle the debt.

That’s a tough task because the Fed doesn’t know what the optimal level of small business credit should be. Further complicating the Fed’s efforts is the pressure from regulators for banks to reduce risk and improve their own financials. While small business lending was too hot before the financial crisis and Great Recession, it’s now too cold. In its most recent annual study to examine access to lending, the National Federation of Independent Business noted “more small employers were shut out of the credit market [in 2011] than in prior years.”

Lenders say that they are providing the right amount of lending to small businesses. Creditworthy businesses are borrowing, they claim, and those businesses that aren’t getting money simply aren’t good credit risks.

The data disagree. First, small business lending has dropped much more than would have been necessary to correct for too-easy credit in the mid-2000s. Figures from the Federal Deposit Insurance Corporation reveal a 39 percent decline in the number of loans under $1 million to businesses (a proxy for small business loans) since June 2007. The current level is the lowest since 1999, when the U.S. had almost 1 million fewer small businesses than today.

Second, small business access to credit has not improved since the economic recovery began in 2009. In the most recent Wells Fargo Small Business Survey, the same share of small business owners report that credit was hard to get during the previous 12 months and will be hard to get over the next 12 months as made that claim at the end of the recession.

The fraction of companies obtaining the credit they need has not improved despite the growth of the economy. A recent National Federation of Independent Business study indicates that only half of respondents received some or most of the credit they needed in both 2011 and 2009. And FDIC figures show that the real dollar value of commercial loans under $1 million actually decreased 17 percent from 2009 to 2011, while the number of loans declined 8 percent.

While the small business credit market is too cold right now, that doesn’t mean all small business owners should get all the credit they want. There’s a good reason some are denied: They face problems that bankers think could impede their ability to repay. Regardless of how uncreditworthy they are, some owners will indicate credit is too tight if they don’t get loans.

Moreover, when credit is too loose, businesses that should never be started get started. When the market doesn’t respond to their owners’ ill-fated ideas, people lose money and are saddled with debt that could have been avoided had more reasonable credit standards been applied.

When credit is too easy to get, business owners fail to fix problems, responding to cash flow issues by borrowing, instead of boosting revenues or cutting costs. They are also slow to shut down failing operations, escalating commitment, and ultimately making bad outcomes worse than they need to be. Finally, when credit is easy, business owners overindulge, saddling their companies with debt they can’t handle.

Federal Reserve Chairman Ben Bernanke (call him Goldilocks) needs to get the banks to loosen up their lending standards if he wants bring the small business credit market to the right temperature.  He has his work cut out for him. In the Fed’s most recent survey of senior loan officers at banks across the country in January, 94 percent indicated their institutions had not changed credit standards for small businesses in the previous three months.