Resolving the puzzle: Banks say credit has not declined but small businesses say credit has contracted

James Wilcox of UCB tries to resolve the puzzle.

There is an apparent puzzle when you read views on US economy. Banks say credit growth has hardly declined. However companies say it has contracted like never before. With corporates, small business say they are badly effected. How does one resolve this puzzle?

Wilcox says answers lie in securitization market which has dried up post crisis. Small businesses rely indirectly on these markets as earlier banks would just sell small sector loans for securitization. Now this does not happen as there is no market to sell. Hence despite banks saying no decline, small firms feel the contraction.

Small businesses have long had less access to credit than large businesses. Large enterprises have traditionally been able to borrow both from banks and from the broader credit markets by issuing bonds, commercial paper, and other debt securities. By contrast, small businesses generally could not access these broader credit markets and were generally regarded as “bank dependent.” Small business lending was long the province of smaller community banks and finance companies. Small businesses tend to have less collateral, shorter track records, and less verifiable financial statements than large businesses. These financial market frictions may have impinged on smaller businesses’ borrowing, even from community banks.

Perhaps because of such frictions, small businesses often turn to sources other than banks and finance companies for credit. Federal Reserve surveys indicate that traditional bank loans substantially fund small businesses. But the surveys also show that small businesses rely heavily on other sources of funds, including personal and business credit cards; residential mortgages and home equity loans; and family and friends.

He sayssmall business loans are pooled with large business loans:

In contrast to the widespread securitization of consumer credit, securitized pools consisting solely of small business loans (SBLs) are relatively rare, perhaps because it is difficult to deal with the great heterogeneity in business loans and in the collateral that might be repossessed in the event that those loans default.

Despite the rarity of SBL pools, the growth of securitized markets has significantly increased access to credit for small businesses in several ways. First is through the securitization of consumer loans, which owners often use to fund small businesses. Another way is commercial real estate mortgages. Over the past two decades, the volume of commercial real estate mortgages pooled to create commercial mortgage-backed securities (CMBS) grew enormously. Although CMBS have been partly backed with pools that include commercial real estate mortgages owed by large businesses, these pools also came to include considerable volumes of mortgages owed by small businesses.

These pools were popular with buyers worldwide which pushed SBL as well.

Now, as the sec. market has dried, overall small businesses credit has declined as well. Banks on the other hand have increased lending to large and medium enterprises and hence not much decline in credit numbers.

Securitization and relationship lending may help answer an apparent puzzle. Why did banks and small businesses report that credit was so much tighter, while bank data showed relatively small declines in outstanding SBLs during the financial crisis? Fed surveys registered a record tightening of bank loan underwriting standards during the crisis and the National Federation of Independent Business recorded its lowest readings ever for loan availability. At the same time, bank small business loan portfolios shrank less than 2% in the year ending June 2009.

Part of the reason for this modest decline in business loans is that many businesses were able to draw upon existing lines of credit. However, another potential explanation may lie in the drastic decline in securitization. Although bank holdings of small business loans may have declined only modestly, the flow of new SBL securitizations declined sharply. Thus, the virtually complete cessation of securitization during the crisis importantly reduced credit supplied to small businesses, even though banks initially continued to hold almost the same volume of small business loans.

Hmmm. therefore old loans remain but new ones have not really happened because of sec. market

What are the lessons?

Recognition of the particular vulnerabilities of small business to financial crises is vital if we are to develop effective credit maintenance policies, such as public loan guarantees.

Public loan guarantees?? Interesting…

How the world is increasingly moving to lessons which were just rejected outrightly earlier..