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For Release on Delivery L!E2c^Ml¥d at 9:30 a.m. EDT Jsrai n < M ® r t S W » * W 1,85 of St* Louis v'-L 1 1985 STATEMENT BY EMMETT J. RICE MEMBER, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM BEFORE THE SUBCOMMITTEE ON GENERAL OVERSIGHT AND THE ECONOMY COMMITTEE ON SMALL BUSINESS HOUSE OF REPRESENTATIVES June 25, 1985 I appreciate the opportunity to participate in this hearing on small business and monetary policy. It is appropriate that we examine these issues because small businesses are such an important part of our economic system. They account for the vast majority of the firms in this country and operate in every area of the economy. Much of the growth in employment and output in this country reflects the success of new and small, but growing, enterprises. Estimates from the Small Business Administration, for example, suggest that between 1982 and 1984, the percentage change in employment in industries dominated by smaller firms was twice that of industries dominated by larger firms. The vital role played by small businesses highlights the importance of ensuring a stable economic and financial environment in which they can operate and expand. The environment for business activity has improved appreciably in the past two years. The rapid and variable inflation of the late 1970s and two recessions early in this decade— including the quite steep downturn in 1982— imposed hardships on all businesses. Small businesses, which tend to have fewer reserves for weathering adverse periods and frequently must rely on external credit sources, no doubt were hit particularly hard. environment today is much improved. But the Nineteen hundred and eighty-three and 1984 saw an unusually strong expansion in real activity; this growth was accompanied by a substantial moderation in inflationary pressures. Indeed, the inflation rate has remained at or below 4 percent over the past two years, and indicators show little evidence of price acceleration this year. A vital element in the continuing growth of smaller businesses is adequate access to credit at affordable rates. In this respect, the pro spects for small business financing have changed noticeably for the better. Short-term interest rates are at their lowest levels in five years, and the prime rate recently was lowered to 9-1/2 percent. These favorable economic and financial developments are reflected in the attitudes of the owners of small businesses: surveys reveal that they are quite optimistic about future economic conditions, and this optimism is reflected in their plans for capital spending and employment in coming months. Nonetheless, not all the problems of businesses have gone away. In particular, some sectors of the economy have not shared in the recovery, and small businesses operating in these areas have experienced some difficulties. The problems in agriculture are of concern, and they have created stresses for non-agricultural businesses in rural areas as well. Export industries and those subject to import competition have had difficulty competing with foreign goods as a result of the prolonged rise in the foreign-exchange value of the dollar. This latter factor perhaps has had less influence on small businesses because a smaller proportion of them operate in the manufac turing sector which has been markedly affected. Indeed, small businesses that import goods from abroad have benefited from the prevailing pattern of exchange rates and international trade. Nevertheless, the deterioration in our trade position has had a pervasive effect on all businesses through its broader macroeconomic implications. It has acted as a strong restraint on domestic production, damping growth in our economy. This weaker demand and lower growth than would otherwise have occurred have in turn contributed to financial stresses among some individual firms, whose earnings and cash flow have come under pressure. As problems have persisted and accumulated in some sectors, failures and bankruptcies have resulted. An index of business failures has risen in - 3 - recent months, and bankruptcy filings, typically a quite volatile series, have remained at a fairly high level# to interpret, however# The data in these areas are very difficult Changes in the bankruptcy laws in 1979— which make filing for bankruptcy an easier process— have made comparisons across different time periods difficult# While the actual number and size of firms failing is difficult to ascertain, we are aware of, and concerned about, the trend shown by the available statistics# In part, the data may reflect the cumulative effect on small businesses of the stresses incurred in earlier years that perhaps were exacerbated by the recent slowing in economic activity# be related to the life cycle of new businesses# Another element may There has been a sizable increase in the number of new incorporations since 1982# Historically, about half of firm failures have been among enterprises that were 5 years old or less# Firms opened in 1982 or 1983 only now may be feeling financial pressures as the resources of their owners are exhausted# The recent slowing in economic activity and unwinding of pent-up demands likely also have exposed new firms to increasing competitive pressures# These problems can be addressed by continuing to direct public policy toward a sustainable rate of growth in an environment of price stability# Such policies will have a salubrious effect on business of all sizes# In such an environment, financial uncertainties will be reduced for both borrowers and lenders, and credit needs can be more efficiently met# Past studies have suggested that small businesses have relatively limited access to equity capital and thus are heavily reliant on debt financing, particularly commer cial bank loans, to meet their funding needs# Because of the structure of - 4 - their balance sheets, interest on debt likely absorbs a relatively greater portion of cash flow than at larger firms. Both the cost and availability of credit, therefore, are crucial issues for small business. Despite some problems, financing opportunities of small businesses appear more positive than at any time in the last few years. First, as I noted earlier, market interest rates have declined substantially. In partic ular, the prime rate has declined about 350 basis points from its peak in 1984, and relative to 1982, the reductions are even more substantial. These interest rate changes have translated into substantial cost reductions for small businesses. Second, small businesses are less likely to be cut off from credit owing to disintermediation. In earlier periods, lending at banks, particularly at small banks, was constrained when they had difficulty attracting funds as a result of limitations on the interest rates payable on deposits. Small businesses often encountered trouble obtaining credit at any price under these circumstances. Deregulation of the rates financial institutions can pay on most deposits lessens the likelihood of disintermediation during periods of high rates and should help assure adequate access to credit for small busi nesses. There will, of course, be periods when interest rates are high and credit is tight, but it does not seem likely that small businesses will be rationed out of the credit market in the future. small businesses have been strong recently. Indeed, credit flows to Growth in business loans at small banks, which make a very large share of their loans to small businesses, has equaled or exceeded that at large banks in the last 2-1/2 years. Third, legislation and regulations also have been employed to increase the access of small businesses to credit. The Community Reinvestment -5 - Act encourages banks to meet the credit needs of their community, which encompases their small business community. An institution’s performance under the act is assessed during periodic bank examinations, and it is one of several factors considered by regulatory agencies when applications for mergers, acquisitions, or holding company formations are evaluated. Through this process, the Federal Reserve System encourages banks to be flexible in meeting the needs of small business. Finally, sources of capital also have improved as small businesses have increased their presence in equity markets. Since 1983, almost 1500 stock registrations have been recorded by firms making their first, or initial, public offering. Although this figure also includes larger firms, it indicates a market receptive to new offerings, which may ease the access to equity capital for smaller firms. In my discussion this morning, I have focused upon aggregate trends in the small business sector. However, small businesses are a diverse group, and individual firms face a wide variety of needs about which it is difficult to generalize. Aggregate statistics thus may obscure some of the problems of which policymakers should be aware. To deal with this concern, the Federal Reserve recently established Advisory Councils to the Federal Reserve Banks composed primarily of representatives from small business and agriculture. Since the Councils are based at the district banks, a wide variety of geo graphic areas will be represented# These Councils have been structured so that each one can best reflect the characteristics of the district. Each Council will meet regularly with the President of its District Bank, and at least once a year, representatives of the Councils will meet with the Board of Governors. We are hopeful that these Councils will become effective -6 - communication channels between the small business community and the Federal Reserve System, In conclusion, there have been improvements in the environment in which small businesses operate during the last few years. Their cost of credit has declined and their access to credit has expanded. Legislation such as the Community Reinvestment Act and groups such as the Reserve Bank Advisory Councils will help us continue to monitor the needs of the small business community. Problems still remain, of course, but we must not forget that the most serious problem small businesses have faced in this decade has been inflation and the resulting high interest rates. During periods of inflation, financing costs of small businesses increase rapidly, and profit margins are squeezed. Public policies that are oriented toward sustained growth but that do not sacrifice price stability are also policies that create an environment in which small businesses can flourish.
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