1

The Repercussions on Small Banks and Small Businesses of Bank Capital and Loan Guarantees

The opinions, analysis, and conclusions of this paper are solely those of the authors and do not necessarily reflect those of the Board of Governors of the Federal Reserve System.

Diana Hancock, Joe Peek, and James A WilcoxFederal Reserve Board, University of Kentucky, and UC Berkeley

2

Small Businesses and Banks

Small businesses rely more on banks than do large businesses

Much small business lending (SBL) lending based on “soft” information produced by banking relationships (Berger and Udell, 2002) Used to reduce information asymmetries between small

borrowers and lenders Can convey information through time and via various

aspects of borrower-lender interactions Past loan performance Information from deposit and other banking activities

3

Potential Credit Market Frictions

Relationship lending may not overcome all lending market frictions Small size or potential may not warrant banks’

incurring fixed costs of learning about newer firms Younger firms may not be able to fully participate in

the benefits of relationship lending policies As yet, short track record and relationship with bank

Non-bank capital markets may have less capacity for relationships and idiosyncratic lending terms

4

Public Guarantees of Small Business Credit

Perhaps justified by especially large credit market imperfections for smaller businesses Informational asymmetries may rise as firm size shrinks

Especially costly and/or risky evaluations of small borrowers and their projects

Potential benefits of public credit support Reducing inefficiencies generally Spurring innovations that have positive externalities

If new or small firms are particularly innovative

Subsidizing credit may reduce efficiency Especially if entrepreneurs are overly optimistic

5

Hypotheses

Small business loans and real activity are more affected than are larger businesses By shifts in bank loan supply, as measured by banks’

capital ratios, changes in monetary policy, and fluctuations in local economic activity

By changes in small banks’ capital Effects on small business vary with interest rates

and with economic growth SBA-guaranteed lending reduces the pro-

cyclicality of small business activity

6

Some Prior Literature

Peek and Rosengren (1998) Concluded bank size affected small business lending

Hancock and Wilcox (1998) Capital crunch had larger effects on smaller banks’

lending and smaller businesses’ real activity Declines in capital and lending at smaller banks was

associated with reduced gross state product Kishan and Opiela (2000)

Smaller banks with lower capital ratios reduced loans by larger amounts in response to tightening of monetary policy during the 1980-1995 period

7

Data and Variable Specifications

Panel data: by state and year (1990 – 2000) “Small business” defined

Independently owned and operated firms that had fewer than 500 employees

Measures of real activity at small businesses Private sector employment Number of employer firms Payrolls

8

Bank Size Categories

Small banks Less than $1 billion of assets

Medium banks Between $1 billion and $10 billion of assets

Large banks Between $10 billion and $50 billion of assets

“Megabanks” were omitted from our analysis More than $50 billion of assets

9

Banks’ Call Report Data

Total loans Sum of loans for C&I + real estate+ individual +

agricultural + lease financing receivables Delinquencies

Amounts of loans nonaccruing or past due > 89 days Separately for real estate loans and for business loans

Banks’ (equity) capital Perpetual preferred stock + common stockholders’

equity + surplus + undivided profits + capital reserves

10

SBA Section 7(a) Loan Guarantees

Guarantees loans provided by private-sector lenders meeting criteria for type of business, size of business, and use of loan proceeds Guaranteed up to 75 or 80% of total loan amount

Prior to loan guarantee, a business must invest a reasonable amount of equity and have first relied upon alternative financing sources

Aggregated across SBA offices to state-level “gross loans” approved and guarantees approved Data are not dollar amounts outstanding but, rather,

flows of newly extended loans

11

State and National Data

Economic activity Gross state product Personal income Wages and salaries (nonfarm) proprietors’ incomes

Business conditions Business failures Total and Chapter 7 business bankruptcies

Interest rates Federal funds rate Prime interest rate and Moody’s long-term bond yields

12

Effects on Bank Loans by Bank Size:Capital, Delinquencies, and Conditions

* * * * * * * * * * * * *1 2 3 1 2 3 1 2 3 1 2 3 4

Y B B B R R R C C C G F S LS M L S M L S M L

Specification for regression results reported in Table 1:

Dependent Variables: First-differences of real, per capita bank loans

Explanatory Variables for small (S), medium (M) and large (L) banks• (BS, BM, BL) : First-differences of state-level, per capita bank capital• (RS, RM, RL): Lagged real estate delinquency rates• (CS, CM, CL): Lagged C&I loan delinquency rates• (G): Lagged percentage growth rate of real, per capita gross state product• (F): Lagged nominal Federal Funds rate• (S): Lagged spread between prime rate and Federal Funds rate• (L): Lagged spread between Moody’s Aaa and Baa bond yields

13

Table 1 Results

Generally, consistent with prior studies Bank capital raised loans statistically significant

amounts Cross-size effects of capital on bank loans

typically negative “Other” banks partially offset “own” effects on loans

Interest rates lowered lending, but incomes didn’t consistently affect loans

14

Table 2: Effects on States’ Real Activity

Dependent variables, by state Gross state product (GSP), personal income, wages

plus salaries, and nonfarm proprietors’ income Similar explanatory variables to Table 1

Added SBA-guaranteed loan disbursements First-difference of real, per capita disbursements, lagged 1

year Deleted lagged GSP

15

Table 2 Results

Same variables associated with bank loans also tended to have important effects on real economic activity

Real, per capita GSP responds positively to capital of banks by size

Other real measures respond most to small bank capital SBA-guaranteed loans exert separate, additional effects on

real economic activity Consistent with Craig, Jackson, and Thomson (2007) Especially affected were proprietors’ income, wages plus salaries,

and personal income Largest effects on smaller businesses

16

Table 3: Effects on Real Economic Activity,By Firm Size and by Bank Size

Dependent variables Private sector employment, numbers of firms, and

annual payrolls, by (small) firm size Similar explanatory variables to Table 1

Added a variable for SBA-guaranteed loan disbursements

17

Table 3 Results

Capital consistently affects real economic activity Loan delinquencies do not

“High powered capital” at smaller banks Stronger effects of smaller banks’ capital Raised employment, payrolls, and numbers of firms

Significant effects of SBA loan disbursements On employment, payrolls, and on numbers of firms

Interest rates lowered and state income (GSP) increased real activities at small firms

18

Table 4: Effects on SBA-Guaranteed Loans

Dependent variables Numbers of SBA-guaranteed loans approved per

million residents Real, per capita SBA gross loan amount approved Real, per capita SBA loan guarantee amount

Same explanatory variables as in Table 1 Result: SBA-guaranteed lending might stabilize

It responds less to capital and income It rises as loan delinquencies rise at small banks Thus, SBA program may reduce pro-cyclicality of

small business lending

19

Table 5: Effects on Business Failures and Bankruptcies

Dependent variables Business Failures Business Bankruptcies

Per 1000 residents Per 1000 firms

Same explanatory variables as in Table 1 Results

Small bank capital tended to reduce failures Weak tendency of SBA lending to reduce failures

20

Tables 6 & 7: Effects on Small Businesses When Growth Is Slower or Interest Rates Are Lower

Split sample by years of low state growth Split sample by years of low interest rates Dependent variables

Measures of real activity by firm sizes Same set of explanatory variables as in Table 1

21

Tables 6 and 7 Results

Capital and loan delinquencies have larger effects on real activities when growth is lower

Tighter monetary policy tends to make effects of bank capital even larger and more significant Real economic activity responds more at higher rates

During periods of recession and higher interest rates, SBA-guaranteed loans appear to stimulate business activity more

22

Summary

Bank capital Had larger impacts on smaller firms’ real activities Smaller banks had larger real impacts

SBA-guaranteed loans Associated with higher incomes across states Associated with higher employment, wages plus

salaries, and non-farm proprietors’ incomes at small businesses

Less affected by bank and economic conditions Perhaps somewhat stabilized lending and real activity