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

1. The Repercussions on Small Banks and Small Businesses of Bank Capital and Loan Guarantees Diana Hancock, Joe Peek, and James A Wilcox Federal Reserve Board, University of Kentucky, and UC Berkeley 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.

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 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