3 Reasons Why Big Banks Loaned Less to Small Business

Policymakers who thought bailing out big banks would increase loans to small business were kidding themselves. Still, the bailout's Congressional Oversight Panel (COP) ran by Harvard Law Professor Elizabeth Warren published a report (.pdf) criticizing large institutions for disproportionally lending less money to smaller firms. The COP found Wall Street banks sharply reversed the trend of increasing their loans to smaller companies through 2007 by cutting their small business loan portfolios in 2008-2009 by 9% -- more than double the 4.1% decline of their entire loan portfolios. Despite the shock and rage Warren expressed this morning in an interview on CNBC (see below), big banks' behavior could have easily been predicted.

Small Business Loans Are Riskier

If there's any lesson of the financial crisis that the big banks took to heart, it was that they should be a little more careful about the loans they provide. Small business loans, however, generally include a great deal more risk than those to big businesses. A big firm may have other investors, a history of success, a capital base, a credit rating, etc. These features lead the large company to appear a much smaller credit risk than a start-up or a little firm that doesn't have as many factors that could help keep it going if problems arise.

Demand Fell

Although it's hard to pinpoint precisely how much less lending small businesses demanded, it's almost certain that loan demand fell from 2008 through 2009. That fact alone explains part of the decline. The U.S. was in a deep recession during this period, so few small businesses probably had the audacity to try to expand -- and that's the reason why a small business would be provided a loan. No bank in its right mind would provide a loan to cover day-to-day expenses, since that spells a recipe for disaster. The sorts of loans that would be more likely considered would be those including money for expansion-driven spending like new structures or equipment. If a bank doesn't see how a loan would provide additional profits for the firm to pay it off, the lender won't provide it.

Big Banks Care More About Relationships With Big Firms

There's also the reality of big banks' priorities: small business isn't that high on their list. Large Wall Street banks can provide a wide range of services to companies. They can underwrite debt and equity, help them with a merger or acquisition, manage their investment portfolio, etc. Small businesses rarely need those sorts of services, but big firms need them all the time. It's completely unsurprising that larger financial institutions would prefer to put big businesses ahead of small ones to ensure that their relationships remain string with the large companies. After all, there's a lot more revenue to be made by Wall Street bank due to all of the other services a strong relationship with a big firm can provide. And during this time period, their capital available to make more loans was scarce.

A report released Tuesday indicated that credit conditions have substantially worsened for small business since the financial crisis. Should large banks be chastised for loaning less to these smaller firms? Maybe, but given the logic above, it's pretty hard to blame them. If Congress really wanted to ensure small business lending didn't decline, it should have made that a specific provision in the bailout bill it passed in 2008. But considering the additional risk and lower profits additional small business lending would have led to, such a move could have hurt the big banks' stability. And healing the financial industry was the entire purpose of the bailout to begin with.

Here's that video of Elizabeth Warren talking about the report from earlier today on CNBC: