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Six years ago this week a crisis of unusual depth and duration hit Wall Street, turning a housing crisis that was already hammering Main Street into the worst recession since the Great Depression. In the months that followed the start of the financial crisis, the U.S. economy teetered on the brink of collapse. Job losses averaged nearly 800,000 per month between November 2008 and April 2009 as the unemployment rate climbed. The economy contracted at a staggering rate of 8.3 percent between the fourth quarter of 2008 and the first quarter of 2009. Equity markets fell into a tailspin, with the Dow Jones Industrial average falling to as low as 6,400 in March 2009. And, there was a palpable fear that the U.S. auto industry was going to collapse, and take down a significant portion of America’s manufacturing sector with it.
There is no question that both large and small businesses felt the wrath of the financial crisis. But, looking closer one sees that the recession’s effect was not uniform across business size. In fact, America’s small businesses were hit harder, took longer to recover, and may still be reeling from the economic fallout of the financial crisis.
In particular, access to credit for small businesses was severely constrained during the crisis, with small business loans falling more sharply relative to the peak—both in absolute and proportional terms—than large business loans, and access has remained relatively constrained during the recovery. This issue is of particular concern for us at Fundera; we are laser-focused on helping small business owners recover by making lending as simple, transparent and understandable to them as possible so that they can get the capital that they need to grow and create jobs.
This week we look back on what actually happened to America’s small business owners during the crisis, including their credit access, and how they’ve recovered so far.
(Net Job Gains and Losses by Firm Size in Thousands)
Source: Bureau of Labor Statistics, Business Dynamics Statistics (latest as of 4Q13). Small businesses defined as firms with fewer than 500 employees and large businesses defined as firms with more than 500 employees.
1. Small businesses are America’s job creators, but lost more jobs and took longer to recovery during the financial crisis: From the December 2007 start of the recession to December 2009, non-farm payroll employment declined by about 8.7 million, a drop in levels unmatched in the entire postwar period. Jobs at small businesses fell 60 percent from the pre-crisis peak in December 2007 until the private sector started adding jobs again in February 2010. That is a staggering number, and represents a decline that is 40 percent larger than the fall in jobs among larger businesses. This is especially problematic because small businesses employ half of the private sector workforce, and since 1995 small businesses have created about two out of every three net new jobs—65 percent of total net job creation.
2. Job creation at small businesses always falls faster and for longer than large businesses during financial crises: Credit markets act as a “financial accelerator” for small firms, such that they feel the credit market swings up and down more acutely because they are more dependent on bank capital to fund their growth. The seminal study to underscore this point is Gertler and Gilchrist’s 1994 study, which showed that sales, inventories and short-term debt decline more at small businesses than at large businesses during six periods of tight credit (1966, 1968, 1974, 1978, 1979, and 1988). More recent studies have expanded upon this point. Duygan-Bump, Levkov, and Montoriol-Garriga (2011) found that following the 2008 financial crisis, an employee was more likely to get laid off at a small business during a financial crisis because these firms are more dependent on outside capital for financing than larger firms. And, Kroszner, Laeven, and Klingebiel (2007) used cross-country evidence to show that banking crises negatively affect bank-dependent firms, specifically small businesses, more than they affect firms less dependent on bank finance.
3. Small businesses are back to creating two out of every three net new jobs: Small businesses have created jobs in every quarter since 2010, and are back to creating two out of every three net new jobs, but still remain well below the job creation levels that we need to see to fill the “jobs gap” left in the wake the recession.
(New Business Establishments in Thousands)
Source: Bureau of Labor Statistics as of March 2013 (latest available data).
1. New firm formation fell dramatically during the crisis: Part of the decline in job creation has also been due to anemic new business formation. Over the past 20 years, businesses less than two years-old accounted for one-quarter of gross job creation even though they employed less than 10 percent of workers. But, during the crisis new business formation fell sharply. In the decade prior to the crisis, more than 620,000 firms were started every year. But, starts have averaged just about 550,000 annually since 2009, a decline of about 11 percent.
2. Size of new businesses has also declined: In addition, the size of new businesses has been declining: in 2000, the average new firm had 7.7 employees; by 2010, that number had declined to 5.5. Part of this reflects a changing sector mix, with fewer firms in construction and manufacturing and more in professional services. It also reflects growth in outsourcing clerical functions such as accounting and finance.
3. Lackluster rate of new business formation has meant fewer U.S. jobs. In fact, if the rate of new business formation had continued at 620,000 per year from 2009 until 2013 and each start-up had hired even just 5.5 employees, the U.S. economy might have employed 2 million more people by 2014, pulling the unemployment rate closer to pre-recession levels.
(Index Levels, National Federation of Independent Businesses’ Optimism Index and Institute for Supply Management’s Manufacturing Index)
Source: National Federation of Independent Businesses, “Small Business Economic Trends” Monthly Survey (August 2014). Institute for Supply Management, “Manufacturing ISM Report on Business” (August 2014).
1. Small business confidence remains tepid: The yellow line on this chart highlights the National Federation of Independent Businesses (NFIB) Small Business Optimism Index, showing the 1986 baseline level of 100 and includes some labels to help us visualize that dramatic change in small business sentiment that accompanied the financial. The index is still 4 points below where it was before the start of the 2007 financial crisis and recession, though it has been making progress back toward that level. Interestingly small business optimism was relatively resilient during the 2000-2003 collapse of the tech bubble, but the index has been far weaker during and after the financial crisis of 2008.
2. Large company sentiment has recovered more quickly and evenly than small business confidence, and has been less vulnerable to exogenous shocks: As the chart above underscores, while the NFIB Small Business Optimism Index remains 90 percent below its pre-recession peak, the ISM index has nearly recovered to pre-recession levels. Moreover, small business optimism has been more volatile during the recovery, and has been particularly vulnerable to exogenous shocks. While measures of large business confidence like the ISM survey took political events like the 2012 debt ceiling row and the 2013 government shutdown in stride, small businesses optimism were rattled each time. Declines were broadly based among the subcomponents, though in both instances the largest declines came from falling expectations for a better economy, and business owners plans to expand took a hit as uncertainty increased.
(Small Business Loans on the Balance Sheets of Banks, $ billions)
Source: Federal Deposit Insurance Corporation, Call Report Data. As of June 2013 (latest available data).
1. Bank loans have historically been critical for small businesses. The formation and growth of small businesses depends on well-functioning credit markets, but throughout the recession and even during the recovery today critical parts of our credit markets are shut for small firms. Unlike large firms, small businesses lack access to public institutional debt and equity capital markets and the vicissitudes of small business profits makes retained earnings a necessarily less stable source of capital. About 48 percent of business owners report a major bank as their primary external financing relationship, with another 34 percent noting that a regional or community bank is their main financing partner for capital.
2. Small business lending continues to fall, while large business lending rises. In an absolute sense, as the figure above underscores, small business loans on the balance sheets of banks are down about 20 percent since the financial crisis. By contrast, loans to larger businesses have risen by about 4 percent over the same period.
(Quarterly Percentage of Senior Loan Officers Reporting Net Tightening or Net Loosening of Credit Standards)
Source: Federal Reserve, “Senior Loan Officer Survey” as of April 2014. The Survey of Senior Loan Officer is a survey of loan officers at 75 domestic and international banks nationwide, with combined assets of $8.4 trillion, or 71 percent of all assets at federally insured commercial banks.
1. Banks are more risk averse in the recovery: Measures of tightening on bank loan terms to small businesses, principally the Federal Reserve Senior Loan Officer Survey, increased at double-digit rates during the recession and recovery for small businesses, but have loosened at just single-digit rates over the past several quarters. Moreover, loosening has been much slower and more tentative for small firms than for large firms, underscoring that banks are more risk-averse in the recover than they were prior to the recession.
2. Small businesses continue to report difficulty finding credit: Based on regional survey data from the Federal Reserve Bank of New York, about 37 percent of all small businesses applied for credit in the fall of 2013. About 45 percent did not apply, presumably because they did not need credit, but about 20 percent did not apply because they were discouraged from doing so, either because they felt that they would not qualify or because they thought the process would be too arduous to justify the time commitment. Of businesses that did apply, over 40 percent either received no capital at all or received less than the amount that they requested. This underscores the manner in which seeking bank credit can be difficult, though not necessarily impossible, for many small businesses to secure.
(Small Business Loans as Share of Commercial Loans)
But, the crisis in small business lending is deeper than just a fall-out from the financial crisis as the banking industry in the aggregate has been increasingly less focused on small business lending for decades: While it’s easy to think that this is just a ripple effect of the financial crisis of 2008, that’s not the whole story. The truth is that over the past two decades, banks have switched from being community-focused to being Fed-focused and small business loans have fallen from about half to under 30 percent of total bank loans as a result. Moreover, small business owners report that competition among banks for their business peaked in the 2001 to 2006 period, and has sharply declined from 2006 to the present. That secular decline is due to a multitude of factors, including high transaction costs of small business loans and regulators that push banks to hold more capital against business loans than consumer loans, driving up the costs of small business lending.
(Number of FDIC-insured Banks)
Source: Federal Deposit Insurance Corporation, Call Report Data.
New bank charters issued by the FDIC are down to a trickle, while bank failures has risen significantly. Banks obtain charters from their primary regulatory agency, either state banking regulators or, for national banks, the Office of the Comptroller of the Currency. But the charters are contingent on the applicants’ obtaining deposit insurance from the FDIC. Historically, the FDIC issued anywhere from 100 to 200 new charter deposit insurance certificates per year—for example, 151 and 175 charters were issued in 2006 and 2007, respectively. But new community or savings bank entrants have all but evaporated in the aftermath of the recession, falling to just 1 new bank in 2010 and an additional 10 that were previously shuttered but re‐opened and just 3 in 2011. Almost two years recently went by with no new bank charters being founded—the first time that has happened in the 78‐year history of the FDIC. This environment—where troubled local banks appear unable to meet re‐emerging small business credit needs—would normally be an ideal environment for new banking institutions to emerge. But, raising capital has been difficult given the scarcity of capital and the uncertainty that has clouded predictions about the sector over the last several years. These uncertainties include interest rate risk, unrealized losses, and the prospect of tighter capital requirements, among other things.
1. Crisis exacerbated the decades-long trend toward banking consolidation, with community banks hit hardest by bank failures. The crisis accelerated the decades-long consolidation in the U.S. banking sector. The number of banks and thrifts in the U.S. has been declining steadily for 25 years because of consolidation in the industry and deregulation in the 1990s that reduced barriers to interstate banking. There were 6,840 banks and 1,173 thrifts last year, down from 14,507 banks and 3,566 thrifts in 1984. Accompanying this consolidation has been an increasing concentration of banking assets and loans within money center and super regional banks. The recession exacerbated this trend. Our economy lost 932 financial institutions or nearly 13 percent of the total since the onset of the recession. The vast majority of those closed institutions had less than $1 billion in assets, and were mostly community banks that were often the backbone of small business lending.
2. The concentration of assets in ever‐larger financial institutions is problematic for small business credit because large banks are less likely to make small loans. The Federal Reserve Bank of Atlanta recently noted that on a scale of 1 (offering no loan or line of credit to small businesses) to 4 (offering the full amount requested), community banks ranked 2.4 versus 2.3 at regional banks and 1.85 at large national banks. And, in the January 2012 survey conducted by NFIB, 57 percent of respondents whose primary financial institution is a large bank obtained their loan from it. However, 87 percent obtained the loan from a regional or local financial institution when that institution was their primary institution as small businesses consistently appear more willing to ask for credit when their bank is a regional or community bank and they appear to be more successful in their requests.
(Percentage of Small Businesses Identifying Item as “Largest Concern” in NFIB Small Business Optimism Index)
Source: National Federation of Independent Businesses, “Small Business Economic Trends Survey”.
1. Small business owners’ creditworthiness was hit during the crisis: Part of the decline in small business lending is due to a reduction in credit worthiness among small business owners. After all, any loan is a contract between two parties: a bank that is willing and able to lend, and a business that is creditworthy and in need of a loan. Despite recent progress, many small businesses, even those that have weathered the recession, have nonetheless been battered by it and many may look less creditworthy to banks today than prior to the crisis.
2. Sales was small business owners’ single biggest concern throughout the crisis: According to the National Federation of Independent Businesses index, small businesses reported sales as their biggest problem for about four years starting in August 2008 until early 2012. Income of the typical household headed by a self-employed person declined 19 percent in real terms between 2007 and 2010, according to the Federal Reserve’s Survey of Consumer Finances. And, the Wells Fargo/Gallup Small Business Index shows that while from 2004 until 2007 about half of all small business owners surveyed reported revenue for the last 12 months as either “very good” or “good”, that number fell to as low as 21 percent in 2009 and 2010, and has only modestly recovered over the past few years, hovering at around 35 percent for most of the past few quarters.
3. Small business cash flow was hit particularly hard during the crisis: According to the latest Wells Fargo/Gallup Small Business Index, 65 percent of small business owners said their cash flow was “very good” or “good” in the first quarter of 2006, compared to a range of just 30 to 40 percent reporting good cash flow for most of the recovery, although the number has risen slightly to about half as of the second quarter of 2014.