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Behind Small Biz Problems Lie the Banks

By Marc Tracy

The cover story in today's New York Times Business section concerns the continued tightened state of small business credit. (Reuters ran a similar state-of-small-business-credit story recently, and found similarly cramped circumstances.)

There are two crucial points the Times makes about this particular credit squeeze: one concerns its causes, and one concerns why it's small business-specific.

As for the cause: it's not just the usual things you'd hear about, namely, a combination of a genuine lack of available credit coupled with a drop in demand for credit, which would have the effect on the statistics of making it look like there was a further crunch. In addition to those factors, there's this: "the enduring credit squeeze appears to reflect an aversion to risk among lenders confronting great uncertainty about the economy rather than any lingering effects of the panic that gripped financial markets last fall." And not only is this psychology playing a big role, it's a psychology that is not justified by the external circumstances (well, other than everyone else's risk-averse psychology!): "some economists worry that bankers have overshot the boundaries of a healthy reaction, as even strong companies are finding it difficult to borrow."

Is there a more pro-cyclical force than psychology? Risk aversion leads to data that would seem to suggest the wisdom of further risk aversion, and so on. The trick is to break the cycle. Where the cycle is mostly due to concrete economic circumstances, usually the government can play a pretty substantial role in righting it. But what sort of government intervention can definitively alter underlying psychology? We'd say something like a broader regulatory overhaul, to ensure that, structurally, something like September 2008 will not happen again, is the only thing that can overturn this underlying pessimistic psychology, other than simply the forgetfullness that comes with additional time. And broader regulatory overhaul, unlike the forgetfullness that comes with additional time, has the added benefit of actually preventing another meltdown. But what do we know? End rant.

The other valuable point the Times makes is that small businesses are susceptible to things like the psychology and whims of big and small banks in ways big companies are not. The article quotes a Goldman Sachs economist thusly: "small businesses rely more on bank financing, whereas large businesses have the alternative of raising money in the capital markets.” If you're a gigantic business with access to bond markets, and you need to raise some quick cash, and don't want to dilute your equity, then you float a bond. Small companies simply don't have that luxury, and so are at the whims of banks and other traditional lenders.

This dynamic means that small businesses are disproportionately affected by banks' behavior. (Anonymous Banker offered a great example of this yesterday, when he noted that the federal contracting mess actually involves, yes, banks' reluctance to lend.) In turn, the effects of bank policy on small business ought to be given special, disproportionate consideration.

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