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Remarks by Governor Laurence H. Meyer

Conference on Small Business Finance
Leonard N. Stern School of Business
Berkley Center for Entrepreneurial Studies and New York University Salomon Center
New York, New York
May 23, 1997

The Role of Banks in Small Business Finance
Good afternoon. It is a pleasure to be here to meet with you at New York University for this
Conference on Small Business Finance. It is clear from the conference program that there is
an excellent mix of academics, government representatives, and practitioners here to study
how small business is financed. Indeed, I am glad to see so much attention being paid to this
important topic. Small business is a vital and energetic part of our economy that plays a key
role in the generation of jobs, new ideas, and the encouragement of entrepreneurial activity.
Without doubt, a thriving small business sector contributes to the well-being of our nation.
Today, I would like to share with you some thoughts about the role of banks in supplying
credit to small business. The part played by banks in small business finance is not a new
topic for the Federal Reserve. In fact, for many years we have been devoting substantial
resources to collecting and analyzing data on small business finance generally, and the
credit supplied by banks in particular. We collect data from small businesses on how they
obtain financing -- or in some cases fail to obtain financing -- using the National Survey of
Small Business Finance and the Survey of Consumer Finances. We also gather information
directly on the small business credit extended by individual commercial banks. We have
collected information on the contract terms of bank loans to both small and large businesses
since 1977 through the Survey of Terms of Bank Lending to Business. Since 1993, the
banking agencies have required all commercial banks to report their quantities of loans to
businesses by size of loan on the June Call Reports. Lastly, as part of revised Community
Reinvestment Act procedures, the banking agencies have just this year begun to collect data
on small business loans by local geographic area. When these data become available, they
should prove to be a rich source of new information.
A number of economists have used the existing data in research that has helped us to better
understand the potential effects on the supply of small business credit of public policies
regarding bank mergers and acquisitions, financial modernization, and prudential
supervision and regulation. For example, some have argued that the consolidation of the
banking industry may be reducing the supply of credit to small business, since larger
banking institutions tend to devote smaller proportions of their assets to small business
lending. Solid economic research applying modern econometric techniques to accurate data
is needed to evaluate such claims and to determine the likely effects of policy actions in
order to improve future policy decisions.
The Importance of the Bank-Small Business Relationship

According to our survey information, commercial banks are the single most important
source of external credit to small firms. Small businesses rely on banks not just for a reliable
supply of credit, but for transactions and deposit services as well. Because of their needs for
banking services on both the asset and liability sides of their balance sheets, small
businesses typically enter into relationships with nearby banks. The data show, for example,
that 85 percent of small businesses use the services of a commercial bank within 30 miles of
their firm, and that small businesses typically obtain multiple different services from their
local bank. The 30 miles actually overstates the distance that small businesses are willing to
travel for most of their basic financial services. For example, the median distances from a
small business' offices to the institutions where it obtains deposit, credit, or financial
management services are all 5 miles or less.
One of the reasons why the banking relationship is so important to small business finance is
that banks can efficiently gain valuable information on a small business over the course of
their relationship, and then use this information to help make pricing and credit decisions.
The financial conditions of small firms are usually rather opaque to investors, and the costs
of issuing securities directly to the public are prohibitive for most small firms. Thus, without
financial intermediaries like banks it would simply be too costly for most investors to learn
the information needed to provide the credit, and too costly for the small firm to issue the
credit itself. Banks, performing the classic functions of financial intermediaries, solve these
problems by producing information about borrowers and monitoring them over time, by
setting loan contract terms to improve borrower incentives, by renegotiating the terms if and
when the borrower is in financial difficulty, and by diversifying the risks across many small
business credits.
Some recent empirical research suggests that this characterization of the bank-small
business borrower relationship is accurate. For example, as the relationship matures, banks
typically reduce the interest rates charged and often drop the collateral requirements on
small business loans. In short, the bank-borrower relationship appears to be an efficient
means for overcoming information and cost problems in small firm finance, and for
allowing fundamentally creditworthy small firms to finance sound projects that might
otherwise go unfunded.
One implication of the importance of the bank-small business relationship is that it may
impose limits on the migration of small business finance out of the banking sector. Over the
last two decades, many large business loans left the banking sector as improvements in
information technology, increased use of statistical techniques in applied finance, and the
globalization of financial markets have allowed nonbank and foreign bank competitors to
gain market share over U.S. banks. For example, over the 1980s and first half of the 1990s,
the share of total U.S. nonfarm, nonfinancial corporate debt held by U.S. banks fell by about
one-quarter from 19.6 percent to 14.5 percent. Banks compensated somewhat for these onbalance sheet reductions in a variety of ways. Many banks expanded their participation in
off-balance sheet back-up lines of credit, standby letters of credit, and the securitization and
sale of some large loans. Other adaptations included a shift in focus toward fee-based
services and derivatives activities.
The types of developments that might similarly reduce bank market share in small business
lending are proceeding rather slowly at present, but may accelerate in the future.
Improvements in analytical and information technologies such as credit scoring may
decrease the cost of lending to small businesses and make it easier for nonbank lenders to

enter this market. These developments are already contributing to more competition for
small business loans within the banking industry and between bank and nonbank lenders.
Similarly, a significant secondary market for securitization of loans to some small
businesses may develop in the future. Those small businesses among current bank borrowers
whose information problems are the least severe -- that is, those that are the least
informationally opaque -- would presumably be the most likely to be funded outside of the
banking system.
Nevertheless, no matter how many advances there are in information processing and no
matter how sophisticated financial markets may become, there will likely remain a
significant role for bank-borrower relationship lending to solve the information and other
financing problems of small businesses. That is, in the foreseeable future it seems very
likely that there will remain many small business borrowers with sufficient problems that
only bank information gathering, monitoring, and financing can overcome, although this
group of borrowers will almost surely differ somewhat from current relationship borrowers.
As technology and markets improve to the point that some relatively transparent small
business borrowers can be financed outside the bank, other, more opaque potential
borrowers that previously had information and other problems too serious for even a bank
loan will enter the bank intermediation process. Put another way, the relationship lending
process will fund small business borrowers with increasingly difficult information problems
as the technology for resolving these problems improves. In my view, this should only
increase the efficiency and the competitiveness of small business finance. For example, the
improved ability of banks to lend to more opaque borrowers should provide some increased
competition for the venture capitalists and angel financiers that were discussed at the
conference yesterday.
The value of gathering information through the relationship between banks and small
businesses also bodes well for the survival of small community-based banks that tend to
specialize in these relationships. Most forecasts of the future of the U.S. banking industry
predict that thousands of small banks will survive. I hasten to point out that these are not my
personal forecasts. I stick to predicting interest rates, GDP growth, and inflation -- items
over which I have more control and inside information -- and I leave the banking forecasts
to others! But the forecast of thousands of small banks continuing to operate and do well
makes sense to me. They have information advantages, knowhow, and local community
orientations that are hard to duplicate in large organizations.
The importance of relationship lending to small business also raises prudential concerns
about bank risk taking. When a bank fails, the losses to society exceed the book values
involved because of the loss of the value of the bank's customer relationships. Even if small
business borrowers are able to find financing after their bank fails, it may be at a higher
interest rate and with additional collateral requirements until the new bank has had a chance
to learn about the borrower's condition and prospects. When many banks fail during a crisis,
this can create a credit crunch or significant reduction in the supply of credit to bankdependent small business borrowers. For example, research on the Great Depression
suggests that the loss of bank-borrower relationships in the 1930s may have deepened and
prolonged the economic downturn. More recently, it appears that the weak capital positions
of many banks in the late 1980s and early 1990s, not to mention the outright failure of over
1,100 banks during this period, contributed importantly to the sharp slowdown in bank
commercial lending during the early 1990s. While the ability of small businesses to find
alternative sources of funds is considerably greater today than in the 1930s, and will likely

be even greater in the future than it was in the early 1990s, such arguments do reinforce the
importance of the connection between macroeconomic and bank supervisory policy.
Financial Modernization and Bank Small Business Lending
In the remainder of my remarks, I will touch on three additional concerns about the potential
effects of financial modernization on the supply of bank credit to small business. I will first
discuss the effects of increases in market concentration created by bank mergers and
acquisitions within a local market; second, the effects of consolidation of the banking
industry as a whole; and third, the possible impacts of the increased complexity of financial
service firms in which banking and other organizations may provide a multitude of
traditional banking and nonbanking services.
At the outset, I would emphasize that the overriding public policy concern regarding these
issues is not the quantity of small business lending, but rather economic efficiency. If some
banks are issuing loans to finance negative net present value projects, then such loans should
be discouraged. If consolidation of the banking industry or the increased complexity of
financial services firms reduces such lending, then economic efficiency is promoted by
freeing up those resources to be invested elsewhere, even though the supply of small
business credit to these borrowers is reduced. Similarly, a lack of competition or poor
corporate control may currently be keeping some positive net present value loans from being
made. If modernization increases the supply of loans to creditworthy small business
borrowers to pursue financially sound projects, then economic efficiency is also raised as
the supply of credit to these small businesses rises.
Antitrust analysis in banking has typically been based on the concentration of bank deposits
in local markets like Metropolitan Statistical Areas (MSAs) or non-MSA rural counties.
Under the traditional "cluster approach," small business loans and other products are
assumed to be competitive on approximately the same basis as bank deposits in local
markets. While on-going technological and institutional changes seem likely to erode the
usefulness of this assumption over time, evidence continues to generally support this
assumption. As I noted earlier, small businesses typically get their loans and other financial
services from a local bank. Additional research finds that the concentration of the local
banking market is a key determinant of the rates that are charged on small business loans.
For example, it is estimated that small business borrowers in the most concentrated markets
pay rates about 50 to 150 basis points higher than those in the least concentrated markets.
This exceeds estimates of the effects of local market concentration on retail deposit rates of
about 50 basis points.
Research has also suggested that high local-market deposit concentration may lead to
reduced managerial efficiency, as the price cushion provided by market power allows a
"quiet life" for managers in which relatively little effort is required to be profitable.
Managers in these concentrated markets may choose to work less hard or pursue their own
personal interests because the lower rates on deposits and higher rates on small business
loans raise profits enough to cover for inefficient or self-serving practices.
These findings support the need to maintain competition in local banking markets to deter
the exercise of market power in pricing consumer deposits and small business loans, and to
ensure that the local banks are under sufficient competitive pressure that they are operated in
a reasonably efficient way.

When bank mergers and acquisitions involve banks operating in different local markets, the
issues raised are typically quite different from those I have just discussed. Since the late
1970s, states have been liberalizing laws that previously restricted mergers and acquisitions
between banks in different local markets, including allowing holding company acquisitions
across state lines. The U.S. banking industry has responded strongly and has been
consolidating at a rapid rate over the last 15 years. Consolidation has picked up even more
in the first half of the 1990s -- each year bank mergers have involved about 20 percent of
industry assets. This trend is likely to continue or accelerate under the Riegle-Neal Act,
which has already allowed increased interstate banking, and which will allow interstate
branching into almost all states this summer.
Importantly, an increase in local market concentration is not a major issue in most of these
mergers and acquisitions, as they are primarily of the market-extension type. As such, these
consolidations, and sometimes merely the threat of such actions, may be pro-competitive
and reduce the market power of local banks over depositors and small business borrowers in
the markets that are invaded. They may also improve the diversification and efficiency of
the consolidating institutions. Research generally suggests that most mergers and
acquisitions, by improving diversification, allow the consolidating institutions to make more
loans and improve their profit efficiency.
Mostly as a result of these mergers and acquisitions, the mean size of banking organizations
has approximately doubled in real terms in the last 15 years. As I mentioned earlier, a
frequently voiced concern about this consolidation is whether the supply of credit to small
business may be decreased, since larger banking institutions tend to devote smaller
proportions of their assets to small business lending. To illustrate, banks with under $100
million in assets devote about 9 percent of their assets to small business lending on average,
whereas banks with over $10 billion in assets invest only about 2 percent of assets in these
loans.
While such a simplistic analysis may sound appealing on the surface, it is clearly
incomplete. It neglects the fundamental nature of mergers and acquisitions as dynamic
events that may involve significant changes in the business focus of the consolidating
institutions. That is, banks get involved in mergers and acquisitions because they want to do
something different, not simply behave like a larger bank.
The simplistic comparison of the lending patterns of large and small banks also ignores the
reactions of other lenders in the same local markets. Other existing or even new local banks
or nonbank lenders might pick up any profitable loans that are no longer supplied by the
consolidated banking institutions. These other institutions may also react to M&As with
their own dynamic changes in focus that could either increase or decrease their supplies of
small business loans. Thus, even if merging institutions reduce their own supplies of small
business loans substantially, the total supply of these loans in the local market need not
decline.
There have been a number of recent studies of these dynamic effects of bank mergers and
acquisitions, some of which we heard about this morning. The results suggest that the
dynamic effects of mergers and acquisitions are much more complex and heterogenous than
would be suggested by the increased sizes of the consolidating institutions alone. For
example, mergers of small and medium-sized banks appear to be associated with increases
in small business lending by the merging banks, whereas mergers of large banks may be

associated with decreases in small business lending by the participants.
On average, mergers appear to reduce small business lending by the participants, but this
decline appears to be offset in part or in whole by an increase in lending by other banks in
the same local market. These other banks may pick up profitable loans that are dropped by
merging institutions, or otherwise have dynamic reactions that increase their supplies of
small business lending. Moreover, these results do not include the potential for increased
lending by nonbank firms. The bottom line is that small business loan markets seem to work
quite well. Creditworthy borrowers with financially sound projects seem to receive
financing, although they sometimes have to bear the short-term switching costs, such as
temporarily higher loan rates and collateral requirements, of changing banks after their
institutions merge. On-going technological change in small business lending should only
help to improve the efficiency of this process.
Again, I would emphasize that it is not the quantity of small business loans supplied that is
most important, but rather the economic efficiency with which the market chooses which
small businesses receive credit. To the extent that mergers and acquisitions are procompetitive and improve corporate control and efficiency, the supply of credit to some
borrowers with negative net present value projects may be reduced, as it should be. That is,
the protection from competition provided by interstate and intrastate barriers may have
allowed some firms with market power to be inefficient or make uneconomic loans.
Similarly, any improvement in competition and efficiency may increase the supply of credit
to borrowers with positive net present value projects that inefficient lenders previously did
not fund. In either of these cases, economic efficiency is improved.
As promised, the final issue I will discuss is that aspect of the modernization of financial
markets in which financial service firms are likely to become more complex, providing
more types of financial services within the same organization. At the present time, we do not
know if and when the Glass-Steagall Act will be repealed, whether nontraditional activities
will be provided by bank subsidiaries or bank holding company affiliates, and in which
activities banking organizations will be allowed to engage or choose to engage. However,
similar to the arguments regarding consolidation of the banking industry, concern is
sometimes expressed that small business borrowers may receive less credit from these
larger, more complex financial institutions.
There is much less research evidence available regarding the potential effects on small
business lending of this type of financial modernization than there is about the consolidation
of the banking industry, so my remarks here are substantially more speculative. However, I
believe there are several reasons for optimism regarding adequate supplies of services to
creditworthy small businesses. First, a limited amount of research suggests that there is little
if any effect of the current organizational complexity of U.S. banks on their treatment of
small businesses, other things equal. In particular, banking organizations with multiple
layers of management, those that operate in multiple states, those with Section 20 securities
affiliates, and those with other organizational complexities tend to charge about as much for
small business credit as other banks of their same size. Second, the research results for the
consolidation of banks alone suggest that if profitable loans are dropped by the newer
universal-like banks, other small banks or nonbank firms will be standing by to pick up
these loans. Finally, the additional insurance, securities underwriting, or other financial
services provided by the new institutions should provide greater opportunities for small
businesses to have access to these nontraditional services.

I want to leave time for questions, so let me conclude with a few summary comments. It is
gratifying to see all of this attention being paid to the financing of small business, which is a
vital part of our economy, and the Federal Reserve is working actively to stay abreast of the
issues with its data collection and research efforts. Small businesses tend to rely on banks
for their credit needs and other financial services, and relationships between banks and small
businesses are important and efficient means of distributing these services. While
technological and institutional changes are and undoubtedly will in the future affect these
relationships, it seems unlikely that the core bank-small business relationship will be
replaced. The continued heavy dependence of small businesses on local banks also suggests
an on-going need for bank supervisors to be sensitive to antitrust issues when considering
mergers and acquisitions of banks in the same local market. In contrast, cross-market
mergers rarely raise antitrust concerns; indeed, such mergers can be quite pro-competitive.
Finally, while some observers have argued that banking consolidation and other aspects of
the modernization of the banking industry and financial markets raise concerns about the
supply of credit to small business, the market for small business loans in fact seems to work
rather well. If there is a merger or other event that reduces the supply of profitable loans to
small businesses, other banks seem to step in and provide this credit, and there is every
reason to expect that such responses will continue in the future.
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