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For Release on Delivery
10 a.m. EDT
May 1, 1996

Statement by
Janet L. Yellen
Member, Board of Governors of the Federal Reserve System

Before the

Committee on Small Business

of the
U.S. House of Representatives

May 1, 1996

Introductory

comments

I am pleased to be here today to discuss the
environment for small business financing and the role of
banks in providing credit to small firms.
Small businesses are a vital part of our economy.
They play a key role in the generation of jobs, new ideas,
and the preservation of the entrepreneurial spirit;

no

one would question the contribution that a thriving small
business sector makes to the well-being of our nation.

It

is therefore appropriate that small businesses hold a
special place in the considerations of policy makers at all
levels of government.
The Federal Reserve Board has devoted considerable
effort to building our knowledge of the characteristics of
small businesses and their use of financial services.

As

the Committee is aware, we have recently completed our
secor.: National Survey of Small Business Finances; Board
staff are now processing the results of extensive interviews
with more than 5,000 small business owners around the
country.

Some of the early findings from the survey were

published in the July 1995 Federal Reserve Bulletin. and we
will continue to analyze and report on the data as they
become available.

I will refer to this and other survey

information in my remarks this morning.
Credit Availability

Today

As I developed my thoughts for this hearing, I
came to appreciate how much more pleasant it is to report on
conditions in good times than in bad times.

When Chairman

Greenspan appeared before this committee in early 1993, a
tepid recovery from recession was beginning to give way to

more solid expansion.

But commercial banks were still

struggling with severe loan problems that resulted from
excessive optimism in real estate and certain other loan
markets in the 1980s.

Because of large loan losses, many-

depository institutions had failed or been merged.

Although

there were signs in 1993 that banks were on the mend, credit
conditions generally remained quite tight.

The sting of the

"the credit crunch" was still a fresh memory in the minds of
borrowers and lenders, not to mention policy makers.

Out of concern that exaggerated lending restraint
might have been fostered by regulatory and legislative
reactions to the numerous problems in the industry, the
regulatory agencies undertook an extensive review of their
policies and practices.

This review produced a number of

measures aimed at removing impediments that might stand in
the way of lending to creditworthy borrowers.

Former

Federal Reserve Governor John LaWare, in testimony two years
ago, highlighted for this Committee many of these changes.

Since then, the agencies have continued their
efforts to reduce the burden of regulation and to ensure
that examiners evaluate bank lending in a consistent,
prudent and balanced manner.

I think w e would all agree that the financial
environment today is markedly improved from that of 1993.
While undoubtedly there remain pockets of weakness and
problems for individual small businesses, a wide array of
statistical indicators suggest that access to bank credit
has eased appreciably for all businesses.
banks have expanded rapidly since 1993.

Business loans at
Indeed, the volume

of commercial and industrial loans at banks grew strongly in
1994 and then last year registered its largest percentage
increase in more than a decade

(13 percent).

Small businesses have participated in this
expansion.

Data collected from banks in their June Call

Reports reveal that small commercial loans (defined as loans
of $1 million or less and including those secured by
commercial real estate) increased more than 7 percent
between June 1994 and June 1995.

Roughly one-third of the

growth in small loans over that period occurred at 7,000
mostly small and regional banks whose business loan
portfolios comprise only small loans.

A good portion of the expansion, however, was at
large banks

(those with assets of $5 billion or more).

Part

of the growth at large banks reflected the effect of bank
mergers that moved more banking assets into the largest size
categories.

Nonetheless, even after adjusting for these

transactions, large institutions expanded their lending to,
small firms an estimated 4 percent.

We sometimes forget

that large banks account for an important share of loans to
small businesses, even though such loans may only be a small
fraction of a large institution's total assets.

Xhe pickup in business loan growth has been, in
important part, a demand - related phenomenon.

As the economy

has grown, business needs for financing have expanded as
well.

But the willingness of banks to supply credit also
has been on the upswing.

Continued improvements in bank

profits, healthy capital positions, and low delinquency
rates on business loans have encouraged banks to compete
aggressively for business customers.

The Federal Reserve

conducts quarterly surveys of senior loan officers at
sixty large banks around the country.

For ten consecutive

quarters since mid-1993 until the end of last year, these
banks, on net, reported easing the terms and standards

-4applied to business loans for all sizes of borrowers.
Respondent banks last year attributed their easing primarily
to increased competition from other banks and, to a lesser
extent, from nonbank lenders.
up in surveys of lending terms:

This easing has shown
for example, the spread

between rates on business loans and market interest rates
fell last year for loans of all sizes.

Perhaps the most telling evidence of improved
financing opportunities are reports from small businesses
themselves.

Small and mid-sized firms surveyed by the

National Federation of Independent Businesses (NFIB) had
reported that "interest rates and financing" were among
their most pressing problems in the early 1990s.

However,

only a small percentage of firms cited this as a concern in
recent surveys.

In addition, the net percentage of NFIB

respondents reporting that credit was more difficult to
obtain dropped appreciably from peaks in 1990 and 1991 and
has fluctuated around low levels over the past year.

The

NFIB surveys have been consistent with reports heard at the
Federal Reserve.

For example, the Federal Reserve District

Banks meet periodically with representatives from the small
business and agricultural sectors; representatives at these
meetings generally have been quite positive with regard to
credit availability.
It would appear from our latest quarterly surveys
of banks that the trend toward easing standards for business
loans has come to an end, but there is no sign of reversal,
and banks, on balance, remain accommodative to business
credit demands.

Given prospects for moderate growth in

economic activity and the healthy position of banks, the
outlook for bank lending to small businesses continues to be
favorable.

-5 While we are pleased with the improvements in
credit availability, it would be foolish to assume that no
problem areas exist or that small businesses are no longer
vulnerable to changes in the financial environment.
small business community is diverse.

The

Many are quite small

without the operating history or assets that make them good
credit risks.

Start-up businesses may have high growth

potential but little equity.

Because most small businesses

have no access to public debt markets and equity markets,
they are likely to be especially sensitive to developments
that affect institutional lenders and local credit markets.
As we consider the potential problems that
small businesses may face down the road, we would like to
know more about their sources of credit.

Our survey of

small businesses provides some useful insights in this
regard.
Sources

of Small Business

Credit: Survey Evidence

In our 1993 survey, 84 percent of small and mediumsized businesses identified a commercial bank as their
primary financial institution.
than any other type of supplier.

Banks were used more often
Most small firms used

checking services at banks, and commercial banks are used
twice as often as any other source for lines of credit,
loans or leases.
Most small businesses used a commercial bank
located close to the firm-- indeed, about 85 percent of all
suppliers of financial services to small businesses were
located within 30 miles and about half of the depository
institutions were within two miles.

- 6 -

About one-third of small firms also used
nondepository institutions for financial services, and
twenty percent had some loan from a nondepository source.
The most common loans from these sources are vehicle loans
and capital leases.

Such loans are generally secured by

tangible assets and often supplied by the captive finance
companies of manufacturers of automobiles and other
equipment.

In contrast, small businesses rarely obtain

unsecured loans or lines of credit from nondepository
institutions.

Slightly fewer than

ten percent had loans

from family and friends.
The survey indicates that the use of nonbank
sources increases with firm size.

In particular, very small

firms rarely used nondepository sources, whereas about forty
percent of firms with fifty or more employees used
nondepository sources.
Overall, the survey confirms that banks, especially
local institutions, continue to play a major role in small
business finance.

The relationship between banks and small

businesses involves a wide range of services supplied by the
bank.
Looking Ahead: Banks and Small Business Lending
Looking ahead, there are a number of developments
in banking markets that may be significant for small
business borrowers.

Perhaps the most prominent is the

ongoing consolidation of the banking industry.

Some fear

that this trend may impede the flow of credit to small
businesses and disrupt the relationships that many small
businesses have with their local banks.

This issue deserves

careful attention, and I think it worthwhile to offer a few
thoughts on the subject this morning.

-7First, it is important that we put the trend in
merger activity in perspective.

In the past ten years, the

U.S. banking structure has undergone extensive change as
banks have adjusted to the removal of longstanding
restrictions on interstate banking and have responded to
technological change and growing international competition.
One result has been a sharp decline in the number of banking
institutions--from more than 14,000 in 1985 to near 10,000
in 1995.

Part of this decline was a result of bank

failures: nearly 1,200 banks were forced to close and many
weak institutions were merged.
Despite the decline in the number of banks, the
number of banking offices and branches has risen sharply.
(Banking offices jumped from 53,000 in 1980 to 65,000 in
1995.)

There appears to have been no reduction in the

availability of banking offices serving the public.

Moreover, analyses of banking markets over the
years have provided little support for the notion that when
large banks enter a market, they drive out the smaller
banks.

Rather, small banks have been and continue to be

able to retain market shares and operate profitably in
competition with larger banks.

Our staff studies have shown

that smaller banks typically perform as well or better than
their larger counterpart, even in markets dominated by large
institutions.
This makes it hard to accept the notion that
profitable lending opportunities in our local communities
will be unmet.

If the local bank is making profitable small

business loans, it seems logical that its acquirer would
continue to make those loans.

Should large banks find it is

too costly to establish a lending presence in small business
markets--perhaps because it is inefficient for large, remote

institutions to maintain close working relationships with
small customers--then other small banks in the area will
be positioned to fill the gap.

Consistent with this

view, there were reports that community banks were eagerly
looking to increase their market shares following some of
the larger bank mergers last year.
Although some banking relationships inevitably will
be disturbed when ownership and management change, we would
expect these effects to be short-lived.
I offer these generalizations with caution.

The

Federal Reserve takes very seriously its responsibility for
evaluating the possible impact of bank mergers on local
markets.

We have found that each assessment must be done on

a case-by-case and market-by-market basis. To this end, we
devote considerable resources to assessing competitive
impacts, CRA concerns, and a variety of other factors. We
will be watching closely for evidence that small businesses
are being disadvantaged by bank mergers.
0.ther Developments
A number of other changes in the credit markets
seemingly bode well for small business financing, including
the efforts of large institutions to meet community
development concerns and enhance their presence in local
markets.

Recently, large West Coast banks have announced

programs that would channel billions of dollars into small
business lending.

Some of these programs reportedly have

been structured to streamline the application process and
make it easier for small businesses to obtain loan approval
on a timely basis.

In addition, new technologies and information flows
are providing opportunities for banks and other lenders to
more efficiently evaluate loan risks.

One technique that is

rapidly gaining acceptance is credit scoring.

Credit

scoring is a statistical procedure that provides an estimate
of default probability for individual loans, based on
borrower and loan characteristics.

The development of

credit scoring models requires that lenders have access to a
large amount of historical information on the performance of
loans with similar characteristics.

It inevitably will take

time to develop data bases of small business loans, given
the diverse characteristics of the millions of small
borrowers.

But, once developed, credit scoring and loan

standardization may offer significant cost advantages for
evaluating the risks associated with lending.

Many large

banks already have begun to probe the possibilities of
credit scoring techniques for small business markets.

As credit scoring and loan standardization
become more commonplace, we may well see. growth in the
amount of small business loan securitization.

To date that

growth has been hampered by the huge diversity among small
business borrowers and the difficulty in accurately
assessing the riskiness of pools of nonstandard small
business loans.

In contrast, the bulk of loans that are

backed by the Small Business Administration

(SBA) have been

more easily securitized because they are known to be low
risk by virtue of their guarantee.

The ability to

securitize non-SBA loans would increase the liquidity of
small business lending and provide banks and other lenders
with additional sources of funding.

We anticipate that the

cost savings generated through these new processes will be
passed on, at least in part, to small business customers.

- 1 0 -

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-11-

specific methods for achieving those goals to each
institution.
Summary
Let me conclude by saying that I am optimistic
about the outlook for small business credit availability.
We have emerged from the credit crunch into a much sounder
financing environment and a well-balanced economic
expansion.

Bank balance sheets are vastly improved.

Moreover, many of the new developments in banking point to
more efficient risk management techniques that could lower
costs of small business lending.

At the same time, many of

our large banks have become quite actively involved in small
business and community development programs.
Our conversations with bankers and small business
groups suggest that bank regulatory issues are not the
pressing concern today that they were a few years earlier.
Nonetheless, we as regulators will continue to review our
rules and procedures to ensure that unnecessary burdens do
not hinder banks' willingness to lend to creditworthy small
businesses.