Credit Cycle Turns Against Small Business

The San Diego Union-Tribune

It’s never been easy to raise capital for a small business.

The degree of difficulty usually runs in cycles, with periods of tight credit and risk aversion giving way eventually to easing and optimism, followed by recession and another round of capital scarcity.

Yet this cycle is different. Despite record sales and profits in 2015 for companies great and small, bank credit appears to be contracting for small-business owners.

This certainly isn’t stopping entrepreneurs. They are responding in classic fashion: When the bank says “no,” they hit up friends, family and even pawn shops to support their ambitions.

“We have a lot of small businesses that aren’t banked at all,” said Moris Adato, owner of CashCo Pawn chain of three shops in San Diego County, including the surprisingly modern, energy-efficient flagship in City Heights. “We’re the bank for the unbanked.”

Most of his commercial borrowers, who typically pay interest rates of 4 percent a month for loans of less than six months secured by whatever collateral is available, are trying to grab an opportunity quickly. About 90 percent repay their loans in full and retrieve collateral, he said.

“If you can finance $10,000 worth of inventory and turn it around in one month to make a 30 percent margin, it’s a no-brainer” to pawn an heirloom or idle equipment to raise cash, Adato said.

Others avoid lenders entirely.

“The only way to survive as a small business is to not take on a bunch of loans,” said Charlie Anderson, co-owner with chef Hector Reyna of the Privateer Coal Fire Pizza restaurant in South Oceanside. “We don’t want to owe anybody any money and we don’t want to bring any more partners on.”

Anderson, who previously started optical products and action sports media companies, lent the restaurant its startup capital in 2013, while Reyna contributed labor and expertise.

This year, after buying out a third partner, they’ve kicked in cash together to launch a wine bar and carryout operation they built themselves in leased space next door. A big help has been retained earnings from the restaurant, along with a labor force that includes multiple family members.

“The food is good, really good, and that’s helped us to bring that repeat business and that following,” Anderson said.
Still, credit remains a key lubricant for economic growth for companies that get past the startup phase and need capital to expand further.

And it appears that the lingering financial trauma of the Panic of 2008 — particularly the regulatory response — is holding back this sector of the economy that typically creates the most jobs, new products and society-changing services.

Federal Reserve data show that U.S. banks, after mostly loosening lending standards for commercial and industrial loans to small firms from 2008 through early 2013, have been tightening for the last three years, with the trend accelerating in late 2015.

Such movement in standards has shifted opportunities for expansion to larger competitors. From the first quarter of 2010 through the third quarter of 2015, the share of loans going to California’s small businesses shrank from 23 percent to 15.4 percent, state officials report.

“There’s been a retrenchment in terms of bank lending to small business,” said Tom Dressler, spokesman for the California Department of Business Oversight.

Because small companies create an outsized slice of new jobs and productivity gains, the entire economy could suffer.

The big question is why. The same Fed surveys show growing demand for loans. Why would bankers turn down business?

We’re overdue for a recession, and I’d love to think the fires of 2008 seared wisdom into the banking industry.

No such luck. Credit bubbles are inflating around the U.S. economy, with principal balances soaring and loan quality falling in a variety of consumer sectors such as car loans, student debt and credit cards.

One theory, espoused most cogently by economist and former Treasury official David Malpass, blames the Federal Reserve for choking off traditional business lending by pouring historic monetary stimulus into huge banks.

The details are highly technical. The simple version is that the Fed’s stimulus relied heavily on vacuuming up bonds to lower interest rates, with the unintended consequence of slowing the flow of money through the banking system as major institutions built excess reserves.

This froze the normal system of interbank lending that encourages banks with excess deposits to shift liquidity to those with higher loan demand. Unlike small community banks, the likes of Wells Fargo and J.P. Morgan could earn high returns with zero risk by lending assets to the Fed.

“The result was a dramatic swing in the allocation toward big, established entities and away from growth,” Malpass wrote in October, in an essay published by The Wall Street Journal. “Small-business formation, critical for new jobs, has slowed accordingly.”

By reducing market interest rates, Fed policy has also compressed a key source of banking profits, the margin between what banks pay depositors and what they charge for loans.

Regulators have also made it tough. The Dodd-Frank banking bill didn’t just create new paperwork for the money-center banks and mortgage giants that caused the financial crisis, it saddled community banks, too.

This has raised the cost of making loans. With interest spreads tight and costs high, making a large number of small loans simply doesn’t pay off for many banks. The result has been a sharp dropoff in the number of small community banks being founded each year in the U.S.

“Unless your assets have grown to the $500 million level, you’re not going to be able to handle the (regulatory) compliance costs,” said Dino D’Auria, executive vice president and chief banking officer at Silvergate Bank, a community bank with about $950 million in assets based in La Jolla.

“That makes it difficult to get out there and raise $10 million or $20 million in equity and start a community bank like people used to,” he said.

Here D’Auria is describing the classic business cycle for banking: Overconfidence and competition leads to risky loans and rising defaults, wiping out all but the institutions regulators decide to prop up. Then, when big banks shun small-business borrowers, community banks sprout to capture their accounts.

The apparent disruption of this ordinary pattern has taken a toll.

D’Auria encounters many of his potential customers after they’ve been turned down by larger banks without explanation.

Community banks often fill this gap by identifying problems with such nitty gritty as financial accounting, collections and cash flow management.

“We do a lot of educating. I think that’s a niche that we’ve developed over the last few years,” he said. “If you are going to go into small business, you need a really good CPA, a really good business lawyer, and a really good banker, and you shouldn’t skimp on any of those.”

Sensing an opportunity, venture capital has flowed into startups that use technology to cut underwriting costs and expand into various forms of nontraditional lending. You can find online companies to lend on cash flow, collateral and even just an owner’s credit score.

However, the “Fin-Tech” revolution is too small to help the overall economy, and there are signs that it is fizzling. Profits have been elusive and funding has dried up for many.

Borrowers seem unimpressed, too. A recent survey by the Federal Reserve Bank of New York found that online lenders had the lowest satisfaction rates in the industry, with borrowers complaining about high interest rates and unfavorable repayment terms.

If history is prologue, the banking industry will eventually rediscover small business. The tech industry could get its act together. The Federal Reserve is gradually tapering its big-bank stimulus measures and may unlock liquidity eventually.

Then again, there’s no sign that regulatory relief is on the horizon. And the next recession is coming someday, we just don’t know when.
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In the meantime, entrepreneurs will remain in familiar territory — mostly on their own.